I am stuck on a particular concept regarding investment activities in the consideration of forecasting long term growth rates. “Somewhat counter-intuitively, dispositions of weaker assets with below-average growth prospects are often dilutive to earnings because the cap rates at which such properties are sold are higher than the yields at which proceeds are re-invested, which reflects lower risk premiums.”
Can someone please “dumb” this down for me? Why do weaker assets have higher cap rates? Shouldn’t weaker assets have a lower NOI and hence a lower cap rate? On the other hand, a low cap rate implies a higher predicted market value (as NOI/cap rate = MV of property). And how does all this related to lower risk premium? Apparently, I am quite confused with the concepts.
Any help with explaning this would be greatly appreciated.
imagine you have a REIT which owns and manages shopping malls. it has a portfolio which consist of downtown and out-of-town malls.
the downtown malls have high occupation rates, it has been possible to regularly increase rents and the land values of these addresses has grown at 10% on average over the past 10 yrs.
out of town malls have <50% occupancy, they are old ( average 30yrs) and there is pressure from local government to update the malls which would be uneconomic for the REIT.
A developer with close links to local government would like to purchase one of the out-of-town malls. this mall was build in 1966, tenants have regularly negotiated rent cuts in recent years. it’s understood the developer has secured a government grant and will close the mall for complete redevelopment.
the mall has a NOI of $1000. the developer offers $2000.
you agree to the sale and invest the proceeds in a downtown mall. the $2000 will provide a NOI of $100.
weak asset cap rate = 1000/2000 = 50%
strong asset = 100/2000 = 5%
higher the rate the riskier the asset if the asset is weak you should justify the cash flows with an opportunity cost greater than other stronger assets