How to Invest in Commercial Real Estate

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Episode #019 - What to watch out for when using Cap Rates to purchase Commercial Real Estate!

by Criterion, Braden Cheek, Brian Duck
February 9th 2021

On this Episode of How to Invest in Commercial Real Estate we have Brian Duck and Braden Cheek from The Criterion Fund, & Joel Thompson from Precision Equity going over what you should watch ou... More

because this property's potential, let's say is to make a million dollars here. It's only making half a million a year. Now I I can buy that on a seven cap because I know even if I sell it in an eight cap and double the revenue, I'm killing it. Mhm. Yeah. How's it going guys welcome back to how to invest in commercial real estate. Um What's up? Welcome back. Yeah. What's up? Um We've talked a ton about evaluating deals and and cap rates and how you should look at them. And today we just wanted to give you know, a full disclosure or warning about what cap rates don't include. And maybe some things you need to look out for when you're evaluating deals on a cooperate because there's a lot of things that you know, cooperate doesn't include. And if you're not asking the right questions, you may get caught. Yeah. It's a general, it's a good general guide to give you a baseline for a property's value and it can indicate a predicted first year return if you paid all cash for the property. But it's not just the return on from cash flow isn't the only return that you get from real estate. There's a lot of other things going on. And today we want to kind of dive into what the cap rates missing. And we'll mention another tool that we use, it's our preferred uh tool to evaluating the returns.

Yes, I would say, you know, for you know, just generally speaking, a cap rate is used to measure the cash flow from that property or mainly the cash flow from the profit and loss. So the profit from the property. But there's other things that's not on the P. And L. Maybe on the balance sheet, you know that's being capitalized, that's not going to be included in that cap rate and you could, you know, you can get stuck with that. Right brian, what's the first big thing that the cap rate doesn't take into account? Well I'd say it doesn't it doesn't account for the debt that you have on the property on the asset, right? It's probably the biggest one. It's purely in, Oh I uh that that over divided by the purchase price, that's all it's taken into account. So then you've got to take into account debt. So people think of debt as positive leverage and and that's where you're you're getting a higher cap rate and a lower interest rate on your debt and you're making a yield on that money and it uses the returns. But is there a situation where you could be in a negative leverage situation? Absolutely.

Absolutely. Where you're where you're paying more, paying more or you're paying more on your death than than the cash flow on the property, right? Yeah. You're paying more for the debt than the property is paying you in cash flow, right? So you you just end up upside down, how that would happen is if you bought on some, you know stupid low cooperate deal the property is not cash flowing but the debt is still there every single month. Is that isn't necessarily a bad thing. I mean in the first year or two. I mean could you, are there situations where maybe that's not a bad thing? Maybe you've got a property that you expect to um appraise or increase in value a lot or is it always a bad always a bad thing if your underwriting it? Uh you know it's not a bad thing if you're expecting it I would say. But you know a negative leverage situation just to define negative leverage. It's that when you have um the debt payment on the property is more than the net operating income it produces your upside down month of Vermont. Yeah you could run into that with let's say about a six cap deal and your interest rate is 4.5 on a 25 or 30 year. And that that would produce a negative leverage situation now that the interest rate is still lower and so you're still essentially making money but any any profit that you're making is going to pay down that debt.

It's the principle abortion that payment but your debt payment as a nature of cash flow is going to be higher than that. Ny so let's talk about why somebody would do that. Yeah. Uh We've done it. Uh you take a really skinny cashflow deal because the property was 60% occupied at the time you purchased it and there's real upside and bring those documents e up tomorrow is a good example of that. Yeah. Tamarac was apart apartment property that precision bought, it was 30 or 40% occupied and we had a hard time even getting alone because it didn't cash flow. You didn't get alone, you paid for in cash, didn't you? We ended up we got a we got a small, we got like a 50% loan lTV loan to value on that um because it wasn't cash flowing when we bought it, but we showed the lender hey, we're getting it at a low purchase price. It's worth the negative leverage the negative cash flow from the debt in order to give us time to fix it up and to get it rented. And of course it's been a really good asset for us. So there are reasons why people might might take on a negative leverage property. Okay. Um Yeah, going going back to it um that apartment complex and kind of the capital expenses that might not be included in a net operating income.

You know, when you're buying an apartment complex, the the remodel or the make ready typically isn't always included on your P and L. They may be capitalizing appliances or carpet or flooring or you know some drywall or some big capital expenses in that apartment complex. And so you're already in a negative leverage situation because your debt is costing you more money than the property is producing. And then now you're having to go into that same apartment complex and take additional dollars that the property isn't producing and inject it back into the property to try to get it to make more money, Right? So you're not in a negative leverage situation, but that costs even more money. Yeah. And it could even happen on a higher cap. Great deal. A lot of times people will see a high cap great deal and they'll think this is great. I'm getting eight cap, a nine cap, but typically higher cap, great deal is not that they may be in a tougher area, but it may be because they have an old roof. The parking lot is torn up. Uh the overall condition of the property is run down. So you're getting it at a higher cap, but you're immediately going to have to spend more money in order to stabilize that asset and that will bring your, your returns down.

So you gotta know that capital expenditures are not included in that cap rate. Yeah, it doesn't include deferred maintenance. Right? So you may have gotten that at a 10 cap, but you're gonna have, you know, 56 $700,000 maybe that first year in repairs. And you need to make sure your underwriting that. So I think the biggest theme of that is, you can't just rely on the net operating income. You've actually got to know the deferred maintenance, you've got to inspect it, you know, we talked about that and and underwriting, you go in and you hire somebody that does the physical inspections, make sure it's not upside down anyway. You've you've got a plan for that. Well, you might have to um you might have to account for some tenant improvements to, right? I mean, you might have some lease is running out where people that are either um renewing the lease, but they want some tea i with that. Or maybe you've uh someone's moving out and you've got a new tenant that's gonna want some T. I. And so that's not that's not included, is that right? Very, very good point on retail. Especially because one thing we do and we're evaluating retail is we're looking at the rent roll and seeing who's who's leases coming due in the next 1 to 3 years because that that's gonna mean expenses capital expenses in our mind both to renew that tenant or if they move out to cover that rent and to provide uh tenant improvement for a new tenant.

And that can really hurt your your cash cash flow and therefore your return. So Yeah, that's in almost every asset class, you know, retail, single 10ant, quick, quick service, retail, industrial can be a really expensive one with tenant improvements because they're so specialized. Um I mean you can you can get into the weeds on that quite a bit. But yeah, there's not only to the improvements, but leasing commissions. I don't know if we touched on that, you're gonna have to pay somebody to potentially back fill the space if they leave. So those are typically not in the cabaret now evaluation, they're not in the cap rates. So you can't just go out and say, hey, there's this 10 cap deal, it makes $100,000 and you're just planning on distributing, you know, whatever you don't pay in debt to your investors, there's other things you have to underwrite that go back into the property, their reserves, they're leasing commissions there, tenant improvement dollars. And you can't, you know, you can't just save all the money at some point. You gotta reinvest back in, you know what I mean? So the next one, uh so brian the next one has to do with market growth.

So why is someone willing to buy five cap deals? And let's say hot markets, what would be the advantage to them doing that? Well, you've got rent growth, right? So you've got a hot market and so the, the rent growth that could happen in those markets can go up quite a bit, What, 34, 5% a year maybe depending on how hot it is. And so that's going to improve your property value quite a bit. Absolutely. So you're saying that you may get more rent growth on a property that has a lower cap rate, The property has a lower cooperate because it's probably in a better market, a better location, a better asset. Um, and you know, a better market, maybe Austin, you know, Austin is getting a ton of new people. People are moving into Austin and hordes, They can't build houses fast enough, they can build apartment complexes fast enough jobs and companies are moving into that company. So you're getting massive amounts of job growth. There's new jobs created in Austin all the time, All the time. There's no apartments created there.

So you can go into that market and you can say, hey, it's a five cap, it's skinny. We may not make money for the first couple years. We may end up in a negative leverage situation depending on your interest only how you get the loan and everything, but we know that we can get way more rent growth in Austin than we can another market. Let's say, you know, ST louis or Tulsa or something like that. Yeah, the demand for well and multi family, the demand for space for people who live that's going to go up um, the retail because there's so many people in that they are needing to buy things and and go shopping and go to restaurants and that sort of thing because of the high growth in that area, then those property values are going to go up to. Yeah. So you know, going back to usual, why, why are these investors, why would they rather go by a five cap in Austin than a 10 cap apartment deal or a cap apartment deal or seven cap apartment deal in Tulsa or another market. Uh, you know, just like what we're talking about, they, they are looking at it from the standpoint of, yes, the day to day cash flow is going to start low or maybe even be non existent or maybe their cash on cash is 5% pretty low, but that rent growth grows that faster.

But the compounding of that additional income growth compounded at a five cap in that market is going to supersize their sale price. And so not only is there less risk, but they have a higher potential for the back end, uh, when that, with that rent growth. So that's why someone would do that. Uh, Now you're kind of betting that the situation remains, that rent growth is there year after year. Uh, but all, all of real estate is risks on some form or another. You know, if you're buying an eight cap deal in a market that doesn't have rent growth, that doesn't have job growth. Uh, population moving in The cash on cash. Day one is going to be better. And so maybe that that's, that's a secure position for you then, but you may be missing out on the back end upside depending on on that, uh, that cash on cash to the total return, you may make maybe less than that five cap in Austin, it just depends on the circumstances. Yeah, I think that's a good segue to the next point is talking about the exit, you know what I mean? When you go in and you increase a 10 cap deal or, you know, a cap deal, you know, if you're gonna go buy an apartment complex in Tulsa, you're probably gonna buy it on, you know, a seven cap around there, let's just say, right, so increasing that income, you're going to sell that income for a seven cap.

Whereas if you increase that income in Austin on a five cap deal, then that income that you're increasing is worth more. It's just worth more. So that may be another reason people are going to those markets is because um, you know, you can, you can measure the rent growth better, but at the same time they can, it's, it's just worth more in the back end. So to put a cap rates do not take into account the sale prices. So that's a, that's a negative for a cap rate is that you're getting a day one picture on on yearly in a why that, that's it. So, so on the sale price, all of these factors will impact the sales price, but on the one we're talking about rent growth, that's maximizing sales price, but also the market can change. So let's say you're you get into a market that's emerging and the cap rates are seven today, uh five years from now, things in that market are selling at a six cap or 5.5 cap. You you've won that game because you're gonna make huge returns. Where if you're you're going into a declining market, you may buy at a seven and you you may have to sell it at 8.5.

You didn't, you didn't let you know uh that where the future of that particular market was going and so you may be uh anticipated making a certain return. But if you have to say if you have to exit at an 8.5 versus the seven that you bought, you're gonna you're gonna get hurt now, what what you hope is that rents did improve somewhat over that time and you waited long enough where inflation helped you and you didn't lose money, you just didn't make any money because you're paying down that debt. So maybe you can get out of it, but it wasn't as good as an investment. Yeah, I I think that was a great point because um Of of cap rates, I don't remember 100% where I was going to them because I was trying to listen. that's okay. I got the next, the next one. And I think maybe the last one we're gonna talk about is cap rates don't measure uh where the rents are per market for the deal that you're buying. So all it says is day one. This is the Ny, but what if I have an apartment complex that hasn't been updated in 20 years and the rents are $200 below market. There's a big chance that I can go in and we've done this in our north Carolina facility in our Indianapolis and we've done it here in Tulsa, uh, where they were lower and we go and we fixed the exterior up and we, we redo the interiors and now we're getting $200 pops.

And that, that really, really inflates the Ny uh, and the cap rate doesn't tell me that at all. Um, so that's another good, good one to remember. Um, is being able to increase those rents to market. Well, can you, and you, can, you do that on retail too. I mean, maybe not to the extent. Uh, because you can't raise the rents, uh, percentage wise, as high as you can maybe on multi family if you really fixed things up. But, but you could do that on retail too. Right theoretically, you can do it on any asset class, retail is not as dynamic as multi family because multifamily just have people moving in and out every month. But I'll give an example on our, on our, we have a local deal here in Tulsa village South, We bought that at a really low per square foot price because the rents were really low, They were carried forward from the recession, Uh, you know, the, the owner got hurt and so he was just trying to fill stuff and he put people in at $10 a foot. Well this in this area, rents should be $15-$20 a foot and so that's 50 to 100% increase. The thing is I can't just go in and do that arbitrarily year one because these are long leases.

There may be a five year lease, but as they've rolled, we've taken tenants from $10 to 14 15 $16 and it's, it's blown the returns through the roof on that deal when your underwriting that it gives you more confidence to buy the lower cap rate it, you know, because you're, you're assuming, hey, these rents are so under market, I can grow them the copper, it's not going to tell you that, but it will give you the confidence to say, man, I know I can make this thing crank out a lot more money. I can buy it at a stronger cap rate because it's kind of irrelevant now because this properties potential, let's say is to make a million dollars here, it's only making half a million a year. Now, I, I can buy that on seven cap because I know even if I sell it in an eight cap and double the revenue, I'm killing it. Yeah, that's a good point. So those are all, there's a lot of nuances in and uh evaluating the returns in real estate and like we talked about the returns are increasing rents, the returns are paying down debt. The returns are an increased sales price uh market caps moving in a different market. And the initial capri is just the starting point. Uh in any discussion on uh potential returns needs to involve all of these factors.

And for each one of these factors unfortunately there's assumptions. Uh And so real estate is just one big uh one big risk based on your experience and knowledge. I'm gonna bet that I can increase these rents 3% a year. I'm gonna bet that the exit cap on this deal in this market five years from now is going to be this uh I bet I can get this interest rate on on this deal. And so all of that's factoring in. But now we're going to tell you about what we use and what most people use to fully evaluate all these returns. And it's the I. R. R. The internal rate of return and it's it's kind of a complicated formula to get to a NPV of the streams of income. But in essence you can think about it as it's the given when I get the money yearly cash flow, potential sale price Capex expenditures put in that the flow of those and the timing of those all average to give you an average yearly compounding return. That's what the I. R. Is. And it helps take into account all of those different cash flows.

I just know there's the I. R. S. Can be a difficult subject, right? So just if you've got a different opinion on I. R. R. A different way, we should maybe say it, uh feel free to leave in the comments once. Yeah, but we're gonna do a show, we'll do a show on I. R. R. And we're gonna have a sample property and we'll show you kind of all those assumptions that you put in to get to what your projected compounded nearly return is the I. R. You know, right now, I would say, uh on a multi family deal, they're they're typically trying to hit mid teens. Um, In the past we've we've hit some higher ones. Just because there was some rehab. You know, plays in the market are retail deals are typically Upper teens to to low 20s. Um, just because they can be bought at a slightly higher cap rate. Yeah. And 11 other thing I wanted to come back to real quick when I blanked earlier is cap rate compression. Right? So your investors are gonna ask this and it's really important that you can't get all of your money, all of your profit. The entire business plan is predicated on buying something at an A cap.

And then in five years we're going to sell that same income for a six cap. You can't do that, your investors are gonna catch it. The people, you're pitching the deal too. It's one of the most common questions we get all the time is what cap, right are you buying at? And what cap rate are you ending at? Because you can you can just fluff all the return by putting in some ridiculous exit cap rate. Yeah, the market's gonna go nuts, is going to be the most desirable asset class in the world, and I'm gonna sell this on a five cap. It's like, well the asset isn't producing any cash flow along the way. I don't want to just hitch a ride based on your hunch. I would say I've invested in some online syndicators. And and so I have a little experience with looking at how they do things that things to look out for uh for online syndicators. And even us, it keep us honest, is the two things. One is you you mentioned, what exit cap are they putting in because that can determine uh kind of the final return numbers for you? But almost more importantly, is the the annual rent growth. What do they, is it, is it believable annual rent growth because that's going to drive your I. R. R. More than pretty much anything else.

And if they if they get too anxious there, then you won't find out uh For 10 years that they made the wrong assumption, you'll get in the investment thinking this is a 25% ir deal, but they're never going to get there because they just they just put in too aggressive of rent growth uh and and that could cost you. So Yeah, and the second, you know, there's two things and I are like you explained its its money and time and time is equally as important as money, right? Because if you make $1 million 40 years, but if I made a million dollars and it took me a year, there's a percentage there, right? I mean, time is an equal component in that. Well, um you know, cap rates can hide a lot of crazy crap. Um You can't just believe him. It's it's basic profitability, you've got to dig in. You got to know what questions to ask. You gotta know where to look where the money might be going. That's that's not a cap rate. You gotta know how to increase the money, you gotta know how to underwrite cap rates and in the beginning and in the end. Um But it is a great tool still, even with all these problems, you just gotta know, hey, before I go on this cooperate, I've gotta double check my list so to speak and make sure I'm not going to fall on one of these hidden traps, but if you do it, it's gonna help, it's going to save you some problems.

It saved us. Mhm. I think that's it. All right. Thanks guys. Thanks, mm. Yeah. Yeah.

Episode #019 - What to watch out for when using Cap Rates to purchase Commercial Real Estate!
Episode #019 - What to watch out for when using Cap Rates to purchase Commercial Real Estate!
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