When NOT to Use the Cap Rate | Just Ask Jesse
In this week’s Just Ask Jesse we received a question on the limitation of using cap rates for analyzing real estate. I run through four scenarios where I think they are not as useful and don’t tell the whole story about a property. To Just Ask Jesse contact: Email: email@example.com Instagram: jessefragale Website: www.workingcapitalpodcast.com Transcriptions: Jesse (0s): Welcome to the working capital real estate podcast. My name is Jesper galley. And on this show, we discuss all things real estate with investors and experts in a variety of industries that impact real estate. Whether you're looking at your first investment or raising your first fund, join me and let's build that portfolio one square foot at a time. All right, ladies and gentlemen, welcome to working capital the real estate podcasts. We have a another just ask Jesse this week. And for those that don't know that's anybody that is interested in getting a real estate question, commercial real estate question answered. You can reach out to me either on Instagram or you can directly email me for emails. You can just type in firstname.lastname@example.org or check me out on Instagram. You can direct message me there. Jesse, J E S S E for galley, F R a G a L E so either or so this week I was asked a question that was related to cap rates, and it was talking about when to use a cap rate or scenarios that a cap rate isn't useful. And the way I framed that question was, I thought what I'd look at is the limitations of the cap rate, because oftentimes, you know, in real estate, we see the cap rate all over the place and to recap, no pun intended in terms of the calculation that's net operating income divided by the value or purchase price. And that'll give you a percentage. So for instance, a hundred thousand dollars divided by 1 million. So a hundred thousand and NOI divided by 1 million, say that's the purchase price that would equal 10%. And that would be a 10% cap rate. Now, in terms of understanding when or when not to use it, I thought I'd go over four limitations that we have when using cap rate to keep in mind. You know, ultimately the positive aspect of the cap rate is it's a very quick way to figure out what the yield is on a property, what the percentage return is on a property compared to another property. And the best time to use them is when you're comparing two very similar assets. And in that case, you can do a quick test. And really what it will allow you to do is figure out if further analysis is required now, in terms of the limitations of the cap rate, or just some things to keep in mind. Number one, I think it's important to understand that it does not include debt. Doesn't include the mortgage. So firms or individuals with different capital structures that is that they have different leverage or they're using different types of financing at different rates. It's really difficult to compare those two in general, but when you're using the cap rate, it's silent about those two things. So how you finance a deal is silent. So you got to keep that in mind because when you're looking at the properties, gross income minus expenses, that will include everything, the gross expenses, but not the mortgage payments themselves. So as we know, in commercial real estate and residential real estate investors put debt on commercial property during the whole period. So the fact that the cap rate doesn't include debt financing will limit its useful usefulness. When you're looking at two deals or multiple deals that are leveraged differently now in terms of number two, the variations in calculation and the time period that's used. So what I mean by that is investors, brokers, sellers will all use different metrics or different time periods when calculating the net operating income, not all the time, I shouldn't say always, but oftentimes. So for instance, what we call the T 12 or the trailing 12 months, some investors might use the past 12 months of net operating income to derive the cap rate. It's probably what I would do. It's probably what most investors do now, sellers or brokers. When you see the offering memorandum, you might have the potential NOI. So they're using a figure. That's not necessarily what is the actuality, but maybe what the market rents are and ideal vacancy and maybe no vacancy at all. So keep that in mind when you're taking a look at cap rates and whether they're coming from investors or they're coming from people trying to sell the asset. Now there's also the different schools of thought, whether items like what we call replacement reserves, whether they should be included or not in the calculation. And I use a replacement in reserves as just an example, but for those that don't know, a replacement reserve is when you put money aside monthly or annually for items that are large ticket items like the roof boiler window replacements. And we know those items are expensive and they're a large amount of money, but it usually happens in one year. And in order to smooth that over, we put a little bit aside every year. Now that little bit we put aside brings in the debate of whether replacement reserves should be calculated as part of expenses for the cap rate or they shouldn't. Now, if you can think about that, if they aren't calculated. So what we say is replacement reserves are below the line below the NOI line that would have a big effect on the percentage cap rate that we derive, right? Because we're not putting it into the gross operating expenses expenses. Conversely, if you put them above the line and you include them, that's going to have another hit on what that yield looks like. So ultimately these variations do matter when you're trying to drive the cap rate and it's something that you just need to pay attention of when you are using it. Now, the other one I like is that when you're doing value, add properties, the cap rate can be misleading. And that's why they're so useful when comparing like unkind assets, you know, when you have to assets that can be compared fairly easy, that's the time you would use a cap rate, alternatively value add properties that offer oftentimes have significant vacancy reduces the effectiveness of the cap rate, for example, a property that has great fundamentals, but it's poorly managed may have a 30% vacancy in a market that, you know, the average vacancy based on your research is 5%. So immediately this vacancy will drastically and artificially reduce the cap rate because of the lower NOI. And it's really easy to think about that because you could have cap rates that really don't make sense in a market 1%, 2%, because a building is poorly managed and maybe has much more vacancy than it really should, or, or that it would compare to the market. So that's another thing that you definitely want to look at when using cap rates on the other end, you want to look at properties. Like I said earlier, that are similar, similar in age, similar in area, but also similar in that they're representing what the market is in a particular area. So in this example, that'd be vacancy rates. The last one I'll mention that I find really doesn't get mentioned that often is that they ignore the lease expiring risk. And perhaps it's not mentioned as much because it may affect commercial deals a little bit more, but you could easily see it in an apartment deal in an apartment deal leases are typically one year in length or month to month. So in that case, we don't really see the lease expired profile as, as having a huge issue. On the other hand, if you look at office industrial and retail deals, the leases can be five years, 10 years, 15 years in some cases, 20 years. So the cap rate does not illustrate the risk of key tenants coming up to expiring. The, this is a major problem as there may be substantial vacancy losses and expenditures required for Lisa. So for instance, if you have a, a tenant that has a 20 year lease, that might have the exact same cap rate as if you had a not so great tenant with a three-year lease. And I remember this a couple of years ago when we work was, was IPO going can't believe that I think it's been a couple of years now, we would see in our area, the cap rates change, depending on, depending on if we work was in the building. So they would capitalize instead of doing the NOI divided by the value of the building, in order to figure out the value of the building, the little algebra, you have to capitalize the NOI. So you take the net operating income and you divide into that, the cap rate. So what they would do is they would use a different cap rate, a higher cap rate to make up for the fact that they saw we work as potentially a riskier tenant. So definitely you want to look at the leases and go into depth as to the quality of the tenants, but also the length of the leases. So those are four things that you should look at when using cap rates and understand their limitation. At the end of the day, the cap rate for me is a quick test of whether you should be doing a further inquiry. And it's something that 100%, if you're comparing very, very similar buildings, it's a good way to have a high level overview of whether those buildings, whether you prefer one or the other, but obviously more analysis is required for any deal that you look at. Cap rate is just one tool. So hopefully that answers that question just shows a little bit of the limitation on the cap rate. And anyways, I hope you enjoyed it. If you have any questions, like I said, Jesse, at working capital podcast.com or just reach out to me directly on Instagram. Thanks so much. Thank you so much for listening to working capital the real estate podcast. I'm your host, Jesse for galley. If you liked the episode, head on to iTunes and leave us a five-star review and share on social media, it really helps us out. If you have any questions, feel free to reach out to me on Instagram, Jesse for galley, F R a G a L E, have a good one take care.