Wharton Emeritus Professor Peter Linneman gives us the answer and explains the rationale for cap rate comparisons across properties.
Bruce Kirsch: Students will often ask me about cap rates. What has a higher cap rate, retail or apartments? For instance, if we have a mixed use project with residences above and ground floor retail, you would ideally like to be able to assign different independent cap rates to the retail component and to the residential component. People want to know, which one should have a higher cap rate? And the answer like most things in real estate is, it depends.
Dr. Peter Linneman: Yep. Theres no mathematical answer to it. Or you cant go to a website and go find the answer. You actually have to think about it. It depends on risk and liquidity. And is the retail in your example low risk leased to Publix supermarket, a very high credit supermarket, for 20 years in central Manhattan, so even if Publix were to leave, there’s going to be plenty of people who would love to have that space, so my retail would have a very low cap rate, about as low as you can get.
On the other hand, take the same physically designed retail and put it in suburban Kansas City with a startup retailer selling used dresses and if they move out I dont know who I replace them with, it is very different. Both in the sense of who I sell it to and who would I replace them with and also the credit of the party there.
So the same way with apartments, if you get me in a very strong apartment market where people are anxious to invest because they want exposure there — New York, Los Angeles, San Francisco, DC — cap rates are going to be low on multifamily because I can always replace one tenant and there is always money for it. You get me an apartment building in Detroit where the population is shrinking, the occupancy is weak, and no capital wants to go there, then cap rates are going to be very high. Risk and liquidity. You can give me a building that has apartments on top and retail on the bottom and depending on its design, location, and specific tenancy, Ill tell you the retail has , more or less risk, more or less liquidity. So it’s not a universal answer. You actually have to think, risk and liquidity, and how does it stack up.
Bruce Kirsch: I try to explain cap rates to my students as it is really a reflection of the attractiveness of the nature of that particular cash flow stream.
Dr. Peter Linneman: Thats it. Its not one in another location, in another building, with another lease, with another tenant. That one.
Bruce Kirsch: Exactly. So it gets down to the actual physical location granularity.
Dr. Peter Linneman: Absolutely. And quite honestly that is what makes it a profession, if you think about it. If it was as simple as go to a website, cap.com, and it would tell you, then it would be formula rather than a profession. It’s a profession because you are constantly making and revising those judgments.
