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. 

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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 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 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 wh