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Cap rate discussions can become confusing when people start to discuss “spreads” — Wharton Emeritus Professor Peter Linneman makes it all crystal clear.
Bruce Kirsch: When people talk about cap rates, there is often a mention of spreads. And for people who don’t come from the finance world this is totally mysterious, so can you just enlighten us what does it mean if spreads are expanding or contracting? Because when I first heard that my eyes glazed over.
Dr. Peter Linneman: Yeah. I mean, it’s a great question. And let me just regress one moment, most equity sectors, if you’re buying companies, if you’re buying stocks, they tend to refer to price earning multiples. And that’s because that’s been the nomenclature of equity for a long time. When you go to the debt side of things, they’ve always historically spoken about yield, namely income to price.
Obviously one is just the inverse of the other. Price divided by income is the inverse of income divided by price. Real estate, going way back in its history, used to be about signing real long leases with high grade tenants and you got your rent and there wasn’t much inflation so you pretty much got the same rent forever.
And therefore it kind of had a debt like dimension of a fixed income that didn’t change much divided by a price. So people in real estate tended to talk and yield or cap rate context rather than multiple, and the only reason the multiple is gee, since the earnings changed more people felt it was a better metric.
When you started describing real estate pricing in the debt world, the obvious question that the debt world always did was, OK, your corporate bond is yielding 8%, what is the spread between your corporate bond and comparable maturity treasury? And that’s the spread that people would talk about in the bond world, a 10 year corporate bond versus a 10 year US treasury. And you’d say, oh, the difference is the treasury is at 3% and the corporate bond’s at 5% and it’s a 200 basis point spread. My bond had a spread of 200 over.
And if you think about where the income for, at least the office buildings, and warehouses, and medical buildings, industrial, it comes from tenants signing these leases. So the spread notion came from well, OK, it’s kind of like a corporate bond. It’s not but it’s kind of a fixed income stream associated with a certain credit. Tell me what the spread is over treasury.
So if I told you your cap rate is 8% on a piece of real estate the spread says, well, tell me what the spread of that yield, that cap rate is over the yield on a treasury. Well, real estate is how long lived and the answer is real long. So you can’t do quite the matching you can with a corporate bond and the generic thing people have done, at least in developed countries have said, well, let’s take it versus 10 year treasury.
Not because anybody says that the duration of a piece of real estate is 10 years, but rather because 10 year treasuries are very liquid, they’re highly quoted, they’re easily found out what their quote is, and again, is a matter of language.
So if a cap rate is 8 and 10 year treasuries or at 3%, you’d say 8 minus 3 is 500 basis points. That is there’s a five percentage point or 500 basis point spread. And nobody finishes, again it’s slang like, nobody is finishing the full sentence. As professionals we’d say I’m buying it an 8 cap and that’s a 500 spread but what you’re really saying is an 8 cap on prospective income is 500 basis points, initial yield above a 10 year treasury yield.
It’s a sense of how much extra am I being compensated versus just taking a 10 year treasury.
Bruce Kirsch: And so really the spread, or the premium, that you pay in essence above treasury is a symptom or a reflection of the additional risk that you’re taking on with the real estate, is that right?
Dr. Peter Linneman: That’s the spirit. And the reduced liquidity. Nothing is as liquid as the 10 year treasury. You give me the most liquid piece of real estate in the country, it’s not as liquid as a 10 year treasury. So the fact that my yield has to be higher, that is you have to give me more income, to get me to pay any given price, the fact that you have to give me more income to get me to pay any given price means that the risk is higher and the liquidity is lower. And the combination of those, you have to essentially bribe me or induce me to buy your asset or I’ll just go buy a treasury.