Risk Premium

A risk premium is the return an investor demands above a risk-free rate for bearing uncertainty. A cap rate contains one: it is roughly the risk-free rate plus a premium for illiquidity, management, vacancy and repairs, minus expected growth. The spread between cap rates and Treasury yields is the property market's risk premium.

Historically, residential income property has traded at cap rates two to four points above the 10-year Treasury yield. When the spread narrows toward zero, property is expensive relative to bonds; when it widens, property is cheap or perceived as risky.

The premium varies by property. Older buildings, weaker tenants and slower markets carry a larger premium and therefore higher cap rates. New construction in strong locations carries a smaller one. This is why a high cap rate is not free: it is the market's charge for risk it sees. The income approach makes the premium explicit when it builds a cap rate from a safe rate plus risk adjustments minus growth.

Further reading: Risk Premium on Wikipedia.