Mixed use

Underwriting Mixed Use: Shops Below, Flats Above

CREMODEL · underwriting notes

Two income streams that behave nothing alike, priced by the market at two different rates, financed by one loan. Averaging them is how mixed use gets mispriced.

The retail runs on a rent roll: leases, terms, escalations, recoveries, allowances at rollover. The residential runs on a unit mix: units, monthly rents, turnover, make-ready, per-unit operating expenses. They share a roof, a tax bill and a mortgage, and almost nothing else.

Two cap rates, not one

A buyer will not price the whole building at one rate. Flats in a decent location trade near multifamily pricing, transactional cap rates have sat around 5.6% to 5.7% for a long stretch, while the ground floor retail prices as retail, wider, depending on the covenant. Value each stream at its own rate and add them. Averaging the two rates and applying the result to the total income gives a different, wrong answer, and it is wrong in the seller’s favor more often than not.

The expenses do not share a basis either

Retail operating costs are quoted per square foot and largely recovered from tenants under net leases. Residential costs are quoted per unit per year and recovered from nobody, you pay the taxes, the insurance, the water, the payroll and the turnover, and you recover a slice through billbacks at best. Charging the residential floors a per-square-foot retail expense load, or the retail a per-unit residential one, quietly double counts the tax bill.

One loan, two coverage stories

The lender sizes against the whole building’s net operating income, so the stable residential income supports the retail and the higher retail rents support the residential. That is genuinely useful. It also means a retail vacancy shows up in a coverage test that the apartments are carrying, which is worth seeing before it happens.

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