Oct 7, 2021
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.
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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
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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
jesse@workingcapitalpodcast.com 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
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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.