Yesterday’s post, The $7million Real-Estate Question(s), was aimed at the first-time investor, perhaps stuck on making their first real-estate investment (not home) purchase decision by the – perhaps too many – factors that they would need to consider.
In essence, what I said is: in a commodity market, buy the commodity at commodity prices … and wait!
Wait for what?
Ideally, forever … but, at least until the values have improved.
But, what kind of real-estate are commodities?
Houses and apartments in most areas are commodities; small multi-units (duplex / triplex / quadraplex) can be, too. Anywhere where there are lots of them near each other …
… preferably lots for sale, and fewer vacant [AJC: Too many vacancies can show an area that’s declining in population and/or jobs (with job growth being, by far, the most important of the two) … we don’t want that!].
Also, for residential property (that you don’t intend to live in) you really need to go for an area that will/can appreciate as it can be very difficult – if not impossible – to get them to cashflow-positive on a reasonable deposit (say, 10% – $20%).
Even so, my first two $7million Questions showed you the right type of market to buy in … which is, right now!
But, when evaluating more complex real-estate transactions, such as: commercial apartments (6 and above); offices and factories of all sizes … surely the The $7million Real-Estate Questions are not enough?
And, surely you are right …
These types of properties are sold as ‘businesses’ in that they have:
a. Income (or rent)
b. Expenses (or outgoings)
c. Taxes (unfortunately)
d. Profit/Loss (or Net Operating Income)
I will run you through how to analyse some of these types of property in future posts; for now, I want to tell you one way to assess these types of Investors’ Real-Estate that is NOT as important as you may be lead to believe, and another way that is MUCH MORE IMPORTANT.
Because commercial property runs at a profit (or loss) and has an Income Statement, people tend to buy (and sell) these types of rel-estate on the basis of their financial statements alone …
… and, not on the sale of comparable buildings around!
This is critical to understand – as it is totally opposite for the types of residential real-estate that most of us are used to.
The second thing to realize is that these buildings sell on a variety of bases, but usually the ‘expert’ real-estate acquirer will assess the Net Operating Income during Due Diligence and buy for a multiple of that … there is usually a multiplier [AJC: that the real-estate books that you read will all say is around 10 … but, these days in many of the hotter markets in the US and overseas, it will be as high as 12 to 16 – or even more when things get crazy].
This is called a Capitalization Rate or simply Cap. Rate.
This is just another way of saying that when you buy the building, it will return 10% of the Purchase Price (for a cap. rate of 10) by way of Net Operating Income (which should improve as you increase rents).
A larger Cap. Rate when you talk “times” (or smaller when you express it as a %) is BAD for purchasing (but, great for selling if you can increase the rents a lot!); here’s why:
A 12 times Cap. Rate means that a $1,000,000 property will only return (NOI or Profit) a little over 8%
A 16 times Cap. Rate means that a $1,000,000 property will only return (NOI or Profit) a little over 6%
So, a serious investor will pull out all the numbers, take a look at the Cap. Rate and make a decision whether to buy (obviously, there will be a lot of other factors … this will drive the financial decision).
How will they typically make that decision?
Well, they’ll compare the % return to what the cost of funds are … if they can make enough to cover the mortgage … then they’re in. So, with a Cap. Rate of 8% and Mortgage Interest rates at, say, 7%, it’s slim … but, they’re in front!
Cap. Rates are really useful, when you can a property for, say, $1,000,000 – add $50,000 of renovations that allow you to increase rents by 10% … all of a sudden, your property is now worth $1,100,000 – a 100% Return on your $50k rehab. investment!
But the Cap. Rate alone doesn’t give you the true picture for the original purchase decision … there’s a MUCH better way to look at the financial decision … first, here’s why:
A. Your investment in real-estate is only the deposit – typically 25% (plus Closing Costs) on commercial
B. The Bank’s investment in real-estate is the mortgage – typically 75%
But, you get the ‘return’ or the Net Operating Income on the entire building …
Because of this wonderful benefit of buy-and-hold, income-producing real-estate, the ‘right’way to value an investment is by it’s return on what YOU put in: it’s called your Cash-on-Cash Return.
So if you put in 25% deposit on a $1,000,000 building with a Cap. Rate that’s returning 1% over the mortgage rate, then you are getting:
1. 8% return for the 25% that you put in, plus
2. A ‘free’ 1% for each matching 25% that the Bank puts in – since they put in the other 75% that’s another 3% effective return.
All of a sudden that ‘small’ 8% return that seems only a little above the bank’s interest rate of 7% swells into a real 11% Return on your money [AJC: most investors will look for a return on their money (in real-estate) in the 10% – 20% range; this requirement will increase as Mortgage Interest Rates increase] … and, we haven’t even counted on any appreciation, yet (!):
i) As Rents increase, so does your return because YOU don’t have to put in any more money … inflation does all the work for you!
Example: if interest rates remain the same (and, they will because you DID fix them, right?), but the rents go up a mere 4% per year over costs (and, they will because you DID put a ratchet clause in the lease, right?), in just three years the building’s 8% return will swell to 9% …
… and your cash-on-cash return will jump to 9% + (3 x 2%) = 15% – try getting thatin CD’s, Bonds or Stock Funds!
ii) As the building appreciates, so does your future return, even though you can’t cash on this right now (unless you refinance, of course).
Example: If cap rates don’t change (that, unfortunately, is up to the market), the 4% increase in rents will ALSO increase the value of the property by 4%. Which sounds great, until you realize that you only put up 25% of that …
… so, YOUR return increases by 16% – try doing that with Stocks!
Now, how does a 30% return (half now, half when you sell) sound to you? And, what happens if you hold for a little longer?
You do the math!
That all sounds great! Sign me up!! I only have one question though. What happens if I can’t rent out the property? Let’s say there’s a local recession or something like that…a totally unexpected one. If I can’t rent out the property but I still have to pay the mortgage, what do I do if I can’t pay for it out of my own cash flow? Wouldn’t I lose the property? Or let’s say something about the local economy changes and I can’t rent it out for enough to cover the mortgage. What happens if I can’t cover the rest from my own income? Couldn’t this risk losing the entire deposit??
I don’t mean to detract from your post. I’m just trying to cover my bases here and make sure I understand where you’re coming from. Other than that, it sounds great!
Thanks for the posts AJC, i am learning a lot, and hope to apply these principles w/in the next few years when i can save up that 25%. I’m have E-myth on hold at the library thanks to you.
Wow Adrian, your posts keep getting better and better, especially these last 2!
@ Bob – what if your savings – if you DON’T take any risks – aren’t enough to sustain you adequately in retirement? Just make sure that you build a buffer against problems, and buy well.
@ Jeremy & Scott – Thanks.
Jeremy, if you want to get started on E-Myth, just go here! 🙂
AJC, What 1 or 2 books would you say are quintessential for learning more about real estate investing?
@ AJC – Ah, so you’re saying in addition to saving for my deposit I should also save up enough to cover expenses for a while just in case something goes wrong? (can’t find a tenant, local depression, etc.) How much would you recommend?
I can see the power of leverage in real estate. That’s the real reason it’s such a good investment. You can’t really find any other investments out there that you can purchase on such a huge margin. (i.e., a margin account at a brokerage firm would only let you purchase $50,000 extra if you put down a $50,000 deposit. With a mortgage, you put down $50,000 and you can purchase an additional $200,000. Major leverage and the interest rates are usually much better and not variable!)
@ Jeremy – I would consider Dave Lindahl an expert in this area – I haven’t met the guy, but I have studied a lot of his material and consider it good-to-great, as is any of John T Reed’s stuff on real-estate in general. At Johntreed.com John is scathing of many RE ‘gurus’ yet I found that one of the books that he recommended was pretty much pure tripe (even recommeding using bonds to secure real-estate … smoke and mirrors)!
@ Bob – exactly; you may even want to consider INSTEAD of putting in, say, a 20% deposit (plus closing costs) putting in only 15% and putting 5% aside as your buffer. If yuo buy a second property (again at 15% deposit) you may find the same 5% buffer is enough to cover contingencies on both, and so on …
Truthfully, it depends on the type of property and how high on the rent scale you are … you can even buy loss-of-tenancy insurance in some countries/locations to assist.
Thanks Scott, i did not know about that, too bad the whole thing isn’t on there.
AJC, I will see if i can get my hands on some of those guy’s stuff as well. thanks.
Fantastic intro to commercial real estate.
The buy and hold strategy is ideal right now if you can afford a loan. Many loan programs for investors or for second residences have dried up or become too unreasonable. Overall it is still the best strategy for building long term wealth.
@ Jeremy – when you do, let me know what you think
@ Adam – you gotta get out more 🙂 But, thanks!
@ Jon – You won’t get any argument from me re ‘buy and hold’. Thanks.
With how long it takes to make money in commercial real estate starting from scratch isn’t this really more of a wealth 301 strategy rather than a 201 one?
@ Andrew – it was a key plank of my $7million7year journey … although, I will talk about commercial real-estate as a Making Money 301 (wealth preservation strategy) in a future post. The key difference will be how much equity you hold …
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Ok AJC, I’ve talked with my mortgage broker and he said he could get me in with a 10% down on an investment property. I have looked at almost every listing in my are and have found a few potential properties, I have even gone out and walked by my top pick properties. I will probably have enough saved for a down payment within 2 months. I also spent the weekend figuring out how to convince my wife to buy into this plan. I live in a college town which will make finding renters a little eaiser. You’ve got me excited about this next step in my investment portfolio…is it time for another Real Estate post yet?
@ Jeremy – it seems you already know the most important piece of investing advice – real-estate or otherwise – that I can give you:
“I also spent the weekend figuring out how to convince my wife to buy into this plan” … good luck with THAT 😉
Just FYI, the cap rate figures are wrong in this post. Cap rate=NOI/Purchase price. It’s simply your return if there was no leverage involved. Buy a property for $1m that generates $80k NOI, then it’s an 8% CAP. Higher caps are better for buyers and worse for sellers, you said it backwards.
@ Brandon – Yes, if you buy a property with a higher cap. rate (expressed as a %) then that means that you are getting a better return on your (unleveraged) money, e.g. an 8% ‘return’ v a 6% ‘return’. It works in reverse if you express the cap. rate as the # times NOI is returned … but, I admit this a less common usage of the term so I have amended the offending statement slightly. Thanks for pointing this out 🙂