Risk Premium

A risk premium is the extra return investors demand for holding a risky asset instead of a risk-free one, such as a government bond. In real estate, the premium shows up as the gap between cap rates and Treasury yields. It prices vacancy, expense surprises and the difficulty of selling quickly.

If the 10-year Treasury yielded 4.25%, the default house's 5.78% cap rate would carry a premium of about 1.5 points. A buyer who wanted 3 points over Treasuries would need a 7.25% cap rate, and would pay only about $398,500 for the same NOI.

Premiums vary by property type, location and the quality of the NOI. Leases to strong tenants and stable expenses narrow it. Older buildings, weak markets and short lease terms widen it, which pushes cap rates up and values down.