How to Invest in Commercial Real Estate

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Episode #036 - The Power of 3%-4% annual RENT GROWTH in Commercial Real Estate

by Criterion, Braden Cheek, Brian Duck
July 22nd 2021

Have you ever wondered how to make an easy $1,000,000 in commercial real estate? Today our hosts Brian Duck, Braden Cheek & Joel Thompson from The Criterion Fund how you can make millions of do... More

So we so we increased the revenue you know just by having $200,700 a month apartments and we increased at 4%. That's an extra $767,000 a year just in free cash flow just income and and not really for doing anything besides just keeping up with inflation on the market. Right? And and so then you just take, what does that equal in value? Well you just take what somebody's gonna buy that income on you know to cooperate right? And so apartments are hot and most apartments are selling at around a six cap. In this market, newer ones lower really old ones may be slightly higher. And so that times us 60.6 to put it at a six cap value Is $1.1 million dollars wow. And so you have your tuner unit apartment complex increased in value. Uh $1.1 million if you got 4% rent growth in that year. That's one year. Hello. Hello what is up and welcome back to how to invest in commercial real estate today is all about the power of rent growth.

So unlike traditional home or something like that where the values appreciating based off the inherent value of the real estate, a lot of commercial real estate is bought not off the value of the real estate at all. But if the value of the income and the income that property produces. And and that's what we're going to be explained today is how that can appreciate how you're gonna make money outfit. Yeah I'm excited to talk about it, because I think most people, uh they think commercial real estate is really complicated and they're like, how do I, how am I gonna make money at this? And what they're doing is they're evaluating to what, you know, the income is that is producing today and getting those numbers and I don't think people appreciate the power of building in rent growth to your model. Uh and so we're just going to kind of mention some examples today and let people know kind of what they're missing out on if they're not considering the rent growth. Yeah, that's that's a fundamental point in real estate modeling is you've got a forecast, not only what the property is doing, what it did before you bought it, what it's going to do after you bought it, you know, you're probably hold it for 57, 10 years and and you shouldn't be assuming that the income is going to stay flat or, or go down, you know, you should probably saying, hey, this is a desirable piece of real estate.

People are eventually going to pay more for it over a period of time. And what does that actually do to your returns? I mean, most people don't even think about it, so they can't even fathom what it could do, but it could be the difference of, of millions of dollars by, by, you know, I don't even think about it, So let's give an example because if you're in real estate you're gonna already know about the power of rent growth and you're going to have a model that takes all that into account. So we're not really speaking to you were speaking to people that want to get into it, we want to show them how powerful it is um with things they haven't thought about before. So let's start with an example. Um you've got you've got an apartment complex. Yeah, so let's let's take a 200 unit apartment complex in a market like Tulsa, right? And let's just say that the rents are $700 a month, workforce housing, affordable middle of the road deal. Yeah. And you know, let's say the apartment market is pretty hot right now and we expect inflation to be in rent, wrote to be on the higher side And it certainly is in in markets like Austin and Phoenix and others probably getting way, more than let's just say we were able to achieve a 4% increase that's high, but it's but it's not out of the question, so 4% increase on a $700 a month, $700 times 12 is 8400, take that times 4% it's $336 a year in rent growth per apartment.

Right, okay, so then you take that times your 200 units and uh that's like 67,000, 67,000 and then I'm gonna take that on a six cap because right now apartments are well Hold on. So we so we increased the revenue, you know, just by having $200,700 a month apartments and we increased at 4%. That's an extra $767,000 a year. Just in free cash flow, just just an income. And and not really for doing anything besides just keeping up with inflation on the market. Right? And and so then you just take, what does that equal in value? Well, you just take what somebody's gonna buy that income on, you know, to cooperate, right? And so apartments are hot and most apartments are selling at around a six cap in this market, newer ones lower, really old ones may be slightly higher. And so that times us 60.6 to put it at a six cap value Is $1.1 million. And so you have your tune into an apartment complex increased in value. Uh $1.1 million if you got 4% rent growth in that year, that's one year.

That's another example of when we talk to people about who are doing rent houses right here, you're multiplying that increase by 200 instead of, okay, you've got five or 6 rent houses. And the other thing is if your rent house goes up, let's say over the course of five or six years or 10 years it goes up 20% what you're selling that house at 20% more here. Your net operating income is on a multiply, right? Or you know a cap rate which is essentially a multiplier. So you're you're multiplying that increase in income by this cap rate. So it's so the value is going way up, not just the extra uh inflationary increase in your in your home that you were renting and uh eventually sell every dollar of income on a six cap and that example differences worth $16 in value. So somebody's gonna pay me $16 for every $1 in revenue I make that business make. So you can think by taking this $700 apartment and just increasing at 20 or $30 a month. Right? You're gonna hit that 4% mark. Pretty easy.

The tenant is gonna say 20 or $30 a month. That's nothing. I'm gonna have to go move out, find a new apartment, put a deposit down, utilities, everything like that. Most most of your multi family tenants are just going to take that if it's kind of in line, if they can't go get a comparable apartment drastically cheaper for the same price most people are just going to stay and and just renew Even 3%. I did the math where you guys were talking, it's 840,000 in value now uh in just one year and that's at 3%. Um So what I'd like to say is, okay, let's let's think about it in terms of what is the return on equity or the turn on value? I mean a million dollars, but how much does it cost me? Even if we took a 200 apartment complex times 50,000 unit, which is about what you might pay for something that rents for 700. Now you're at a $10 million $2 million 4% a year, that's a 50% return on your down payment in year one.

And I'm gonna say honestly, I have failed to buy uh multi family that I should have purchased because I wasn't taking into account rent growth, you know, and maybe because we were coming out of the recession when I bought my first multi family, so I was building a much more conservative numbers, which was keeping me from paying a little bit more to get these deals and now all the values are skyrocketing, inflation is taking hold and rent going up and people are seeing the value of their property shoot up through the roof. So, you know, it's a, it's a game of modeling, you know, these people are coming in and buying, you know, thousands of doors or tens of thousands of doors, they may be able to do it strictly off of appreciation. Like what we're saying. They may not be cash long at all. Right, Because maybe instead of just annual rent growth that they get for free, they have to put in a new washer and dryer package or or some sort of um new windows throughout the property and new roof, you know the all the wood rot. They have to put some money in before they realize that income growth. Right? But you can still justify it. You can 100% still justify. And many models will, will take that into account where they use Capex to improve the property to justify rent growth.

Not driven by inflation but driven by improvements, nicer appliances, you know, uh remodeling of the units and there you may be saying, well it's going to cost me a million dollars uh to uh to renovate this, but I'm not gonna get $28 in rent increases, I'm gonna get $75 I'm gonna go from 775 $775 in rent. And you can you can see that would be, you know, maybe three million. So you spent one million to get three million. So that's how these models kind of kind of work. So when you're doing, when you're doing the modeling, I've seen some of these models, don't they? When you project Ir rs and that sort of thing out in the future, aren't you putting in some sort of rent growth in these models Absolutely, you have to be multi family today. Like Joel said it's extremely competitive. It's 100% of modeling game. Whoever can model the best and make the most, you know, the best assumptions and be comfortable with that risk is gonna win that deal because they can say, You know, I feel confident about the appreciation. So I don't really care what the cash flow is going to be like the next couple of years.

I know that that rent growth is going to compound, I know that we're gonna buy an asset. Um that's going to appreciate, and then that's where they're making their money is, it's 100% seems like an appreciation game. So when you think about it, when you run a model on a retail center, some of those leases are pretty long, right? So you can't Uh you can't model in as quickly on the rent growth as you could multi family because most multi families are anywhere from 6 to 12 months. And that's about it, Right? So you can see it's a great point. Uh and so some retail, like we put in 3% compounding uh annual rent growth in our most, all of our leases. Uh but others may have different kind of schedules of increases. So maybe they have an increase every three years Or 10% increase in five years. So how I model, I'll put all those actual values in. And then if you if I can't increase the rent for four years until they released the news, I'm definitely putting in a bump, a decent sized bump when they do okay. And so we had a retail example as well uh Like you know take a multi tenant shopping center and you know the revenue maybe $700,000.

And so what I did was I took 4% a year. Or maybe I took three, I took 3% a year on the retail maybe a little less. And I compounded that for five years and got the income to 800,000. And so then I had $100,000 of increased in a y. Over that period. And then I took a took it out on a cap. And that was also $1 million. So not as aggressive as the multi family. But if you if you you can think about, well I just buy this building, I just manage it and let my rents go up. And I. I have I'm a million dollars richer in four years, five years. Most people aren't thinking about that. They're uh not appreciating how much just little rent increases over time. Really add to the value of your property. Well and there are there other ways to increase the N. O. I mean other than the increasing the least rates because there's really not right. I mean the only other ways to cut costs and there's just so much you can do there, right, It's way easier to make more money than spend less um From what I found. But yeah I mean it's it's making more spend less like it's here and why?

So it's really just rent growth. I mean whether you're getting that through through Capex or just um you know market, you know people moving in and becoming more of a demand, you've got to get the rent growth for. Sure. Yeah I would think so. And yeah I'll just give one last example when we've talked about a little bit before. But uh especially in retail you may find that you're under market. Uh And they're also his apartments that are under market an apartment deal that would be under market is someone that developed the property 30 years ago. It's been in the family, they haven't renovated it. And so their their their basis in the property is super low and they're just comfortable with whatever the rents are and keeping tenants and not you know forcing to move out because they're scared if we ask for too much people move out there. Just comfortable. That's that's a great opportunity to say hey these could be $100 under market, same same thing which just I mean the same apartment, right? But once got a washer and dryer package and one doesn't me personally I'm gonna pay at least, I mean probably $100 extra a month just for the washer and dryer.

So I don't have to go to the laundromat and wash it. So if you find an apartment complex and it has everything, checks all the boxes, it just doesn't have a washer and dryer. If you can figure out how to do that, you know, it's, it's probably three grand, four grand for Washington dryer set and you get $100 a unit. There was, I mean apartment complexes all over the country that were renovated to have washer and dryers and then because somebody figured out in a model and it worked on tons of assets anywhere in the country, you could just go in and say, I know, I know what to do here. I figured This out $100 a month for a renovated, you know, with the washer and dryer, $1,200 year. If it costs you 3000 or 3500 to, to make the upgrades, you're getting 35% of your money. Uh, so that's, that's great. Yeah, the two biggest things from my perspective when you're exiting or assuming an exit in the model is what are you doing with your income, how is it growing or not growing or what they can see or whatever and then what cap rate or value of that income are you using. So a lot of times you want to see the cap rates stay very close to your original cap rate, you want to consider the income going out almost the same value as the income you bought it just because that's For a slightly higher exit cap, correct?

Because you know, the thinking is if you buy a newer retail deal at a seven cab that, and let's say that during that time, you could have bought an older retail deal for an eight cab within 10 years from now when you sell it, it'll be older, you should put 7.5, 7 and three quarters a cap on that exit income, correct? Your biggest variables, your net operating income, that's what you have to play with, that's what you have to increase and yeah, you can go in and separate that out between income and expenses. But generally speaking of that, you know, I need to be going up every year and that, and that is, that's what driving, that's what's driving the appreciation at the, at the back end. When you said the person with the best model wins the deal. And that's true, doesn't mean that the model was right. It means he wins the deal. Uh, and so right now, what we have is whoever has been the most aggressive has one ultimately, because the market has, has followed all of their assumptions, the ones, the people that were more aggressive and their underwriting bought the deal, but then they, the market actually performed, you know, and so they are now getting paid for being more aggressive and there'll be times when you're going into a down cycle where the aggressive ones will get caught.

Uh, and, and the conservative ones will be more right. But yeah, it's the warren Buffett quote, I like you, you find out who is swimming naked when the tide goes out. It's, it's 100 thing, 100% of the thing with multi family modeling because all of these, you know, multi family prices were driven up like crazy and you're really gonna see who over leveraged the crap of themselves and over modeled that income growth and they're not going to have it. And it will be, so you take that the downturn until interest rates rise right now. I think we're gonna still see a bunch of money flowing into commercial real estate. The trillions of dollars that have been pumped into the market will, will push inflation, which will drive rents up. So it's a good time to be an owner of commercial real estate. We'll just see how long this cycle lasts anyway. I think that is a really good point. People have to be focused on the annual rent growth. It's something easy to just like, oh, I'll just renew the lease for another year. Oh, I'll just keep a month a month, but that is probably your most profitable activity as a property owner is what you're doing in the lease renewals. I mean, and that maybe the motivator that causes you to buy the property is if, if you really realize what that rent increase rent increases are going to do for your value, it may motivate you to say, okay, I'm gonna buy this because I know what it's going to do in the future.

Yeah. Anyway, hopefully it helped make sure to like and subscribe and chair, um, checks out on the interweb were on how to invest in syria dot com and we'll catch you next week. Thanks guys. Yeah, Yeah.

Episode #036 - The Power of 3%-4% annual RENT GROWTH in Commercial Real Estate
Episode #036 - The Power of 3%-4% annual RENT GROWTH in Commercial Real Estate
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