How to Invest in Commercial Real Estate

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Episode #007 - Understanding Net Operating Income (NOI), Cap Rate, and Cash on Cash (CoC).

by Criterion, Braden Cheek, Brian Duck
December 29th 2020

In today's episode we have Brian Duck and Braden Cheek from The Criterion Fund, and Joel Thompson from Precision Equity taking a deep dive into three terms you MUST know when you start investing in... More

the more of the bank's money you can put in at a lower interest rate, the higher your returns go. Mhm. Master. Hey guys what's up and welcome to episode seven of how to invest in commercial real estate. My name is Brandon Cheek and I'm joined by my um co host Joel Thompson and brian Duck with precision equity in the criterion fund. Thanks for joining us again. And today we are diving deep into a few terms that I think could change a lot of people's lives and a lot of um manipulation can go on in them. The three terms are net operating income capitalization rate and cash on cash. And if you can get a good grasp on these three terms, um I think you can start underwriting most deals. You can start learning the fundamentals of where these properties are making money, how you can leverage them with debt and how you end up paying your investors at the end of the day. Well importantly we gotta go really slow as we're talking through these because yeah, I have a few really smart college educated friends and and I'll throw these terms out and and try to tell them you know, cash on cash returns and leveraged returns and in a y and and the concepts are not hard but you have to really know the basics and what's behind him.

So let's let's go into that today. I think one of the biggest ones is capitalization rate or the cap rate and that's a big one because that's the the base underlying factor in understanding the profitability of that property that you're trying to buy, the cap rate, agree, but I think in order to tell them about cap rate, we're gonna have to use net operating income. And so I think we should start with with what is the net operating income of a real estate deal? So I'll start by saying that you have a property that generates what we'll call revenue. Revenue is just all the money that comes in uh from the from owning that asset, through rents, uh reimbursable expenses and things like that. So you haven't even had a laundry or some laundry. Yeah, So late fees, all of the fees, all the money that brings in, that's top line revenue. And then from revenue, you start to subtract all of the expenses and we won't detail all those today, but main expenses are or what utilities, insurance, taxes, uh management, maintenance, management fees, all of that comes off.

And so whatever you're left with after all expenses have been paid, that is your net operating income, right? Or kind of rough profitability, you know, if you were if you were to run that business, that net operating income or y is what you're going to make before any debt has been paid. You know, that's that's gross profitability. Right? Yeah, fair enough. So in a y sobre and how do we go that, you talked about capitalisation rate. So let's talk about what that means in relation to net operating income. Yeah, So the capitalization rate is really just your unlettered return and I know unlettered. So assuming pick easier words, Assuming you bought that property in cash. Um if you were to buy it on an 8% capitalization rate or an eight cap rate Um that property would make you 8% return cat 8% return on your money. So if it had a $400,000 net operating income, uh you know a gross profitability uh $400,000 and you were to buy that on an 8% capitalization rate.

Um That property's gonna be five million bucks. So you buy a $5 million property in cash, it makes 400,000 in oi you're making 8% In cash. Yeah. So so we have this example of $5 million dollars and I happen to be lucky enough to have not me, but whoever's buying this has five million in cash that they want to buy it for. You don't have any debt on the property after all expenses, what's left in your bank account each year is $400,000. If That's an eight cap deal. So 400,000 in cash flow are sorry and then operating income. Um let's see if there's a way we can say that I think I hope hope that came across well is is all cash deal. Uh if if you get 8% on your money that you have invested, that's that's the the camp raid. Okay. And which is better? I mean, it seems obvious, but when you're buying this property, which is better, a high cap rate or low cap rate, it depends, um, you're gonna get more return from a higher cap rate deal because it's making more money. So a 10% cap rate deal is making you 10% if you bought it in cash versus an 8% cap rate deal Is making you 8%.

Right? So you're nicer deals. The more stable deals are are going to trade at a lower cap rate because they're they're more stable. That's that's kind of how you can judge by stable, you mean the risk profile is different. Right? Right. So the higher the risk or perceived risk, not even maybe actual risk, the higher the yield, people will need the return, people will need in order to invest their money in it. And so the more secure, the more stable and the more consistent the cash flow that you can get from the investment than the more people are gonna be willing to pay for that? And that brings that can break down. Okay? So, are you saying that when you buy a property, um, they tend to, similar properties tend to trade at the same cap rate. Is that right? I mean? So if, if you're buying, uh, multi family and its class B and it's located in this most of the properties in that area of the country or whatever, we're gonna trade it a similar cooperate, is that right? Yeah, they'll be similar and and the student investor will know the differences between the slight differences between cooperating and which one is more valuable.

But yeah, generally they're going to be the same for asset class. So a cap rate is a good way for a novice uh investor of commercial real estate to go in to a certain area and know about what he or she should pay for that property. Is that accurate? Yeah, absolutely. You need, you need to start at the end when you're when you're evaluating a deal and you need to decide the bare minimum you want to make on your money. So you can use a cap right to do that because We'll get under this a little later. But you know that you can leverage an 8% cap rate deal um with some additional debt and make more money on. Yeah, but the thing is if if I'm buying and I know in the future I'm gonna sell, I need to, I need to be at a certain cap rate because if I weigh over pay for this property when it comes time to sell, then uh someone who's knowledgeable that's going to be buying from, he's not gonna buy at a wildly different cap rate than the market right? There's market cap rates for sure in in different regions, in different markets, you know, you have the primary secondary tertiary markets and then you have the different asset classes that we discussed um in a previous episode and each one of those asset class and each one of those markets is going to have a market cap rate based on the age and location and everything like that.

Absolutely right. A lot of different factors in the properties will change the cap rate. So, okay, so now that we've got the cap rate, which is the percent return on our money if we paid all cash, uh the great thing about real estate is that we get to leverage it or uh borrow money from the bank to help us buy it. So we don't have to use all of our cash. So brian your the stock guy. Um how often do you get to borrow money to buy stocks? Well actually, uh most people can open a margin account and a margin account with with stocks. Um I don't think anybody is going to let you borrow more than 50%, but those are highly risky because now all of a sudden if you go buy a stock and it moves against you, then you're losing twice as much as uh of what you put in basically. Right? So if you go buy a stock for $100 and you put in $50 and on your margin account there's another 50 and it starts dropping and it's dropping twice as much as as what you really put in. So uh twice as fast.

So um, margin accounts uh typically aren't, aren't recommended now uh if the stock goes up, then obviously you're making, you're making quite a bit, but you're you're also going to pay interest on that margin just like you would alone. So you're paying that, you're paying some commission fees. And so most people don't recommend that you that you open up a margin account in stocks. That's that's highly risky. Yeah. So I think we've talked about the power of debt and commercial real estate and the advantages of of using it. So how are we taking this 8% cap rate deal? It's a it's a $5 million deal. It makes 400,000 and net operating income. So it's an eight cap deal that we're buying. How do we take that 400,000 return over our five million and make it better with debt. How do we do that? Yeah. Banks um surprisingly well loan up to 8085% in some cases against that asset. So let's take our $5 million 80% of that amount with their money.

Uh and that's a $4 million dollar loan. Well, so what happens is I have my 400,000 and that operating income, but now I've got a mortgage payment to pay, right. And so we have that number here. The the if I went out and I got a $4 million 4% interest, which is kind of a going rate today. And we got it on a 25 year amortization. And so for those that don't know that's how long we're going to pay it back. Um so your your house is typically on a 30 year am But commercial real estate uh outside of Fannie Freddie in the multi family world is generally 25 years. So that's what we did in the payment that the yearly payment for that $4 million 4% is 253,000 361. Got you. So you're you're taking the 400,000, you had a net operating income. And then below that you're going to say we're going to go get alone a partner to help us with the purchase price on this. And in exchange for their $4 million dollars On the $5 million 253 out of the 400,000.

So then after We pay that were left with about $146,000. 146,000 roughly. And that number we call in real estate is cash flow. Right? So that's the the cash that you have after all of your expenses and your debt, right? So you take your net operating income or your your gross profitability, you subtract any debt, principal and interest. Um And that's your net cash flow. And that's really what you can distribute to your investors or yourself at the end of the year. That's that's the net cash you have at the end of the year. That's what you made. And the beauty about this is I don't know if the viewers of the watchers have done the math yet, but Um a $400,000 return on a $5 million eight 146,000. Which is our new net cash flow because we got that 80% loan. Um And our down payment was only a million because the bank covered the other four million. Now we're making 14.5% return, right?

You almost on this particular example you almost double the return just because of the leverage you can get from the bank. Right? So in other words, the reason the the um uh the reason that you're using leverage is because you're getting the same net operating income, but you're putting less money into the deal. And so and then you have to pay your debt. But but overall that's increasing your return is that essentially what's going on. absolutely. It's just it's it's a spread game. So this property we decided makes eight without any debt. It's an 8% capitalization rate. And we're borrowing money at 4%. So the property makes eight, we're borrowing the majority of the money at four. That delta we get to keep and add on to the eight with our original. So our million was still going to make that 8%. And then we add the delta between what the property makes and the interest rate. And then we get to add that onto our return as well. Okay, so the so the cash flow number that how do we get to cash on cash?

Uh because that's one of the three numbers that we we wanted to tell people today. We wanted to talk about net operating income as we've done. We want to talk about cap rate. And then now we want to talk about cash on cash because that's really uh one of the most important metrics for us as syndicators is what is that cash on cash number? Yes. So when I think of cash on cash, I think of cash and then I think of a line like a division line and then I think of cash below it. So the cash on top is the cash you made in the year, that's your net cash flow. And cash on bottom is the cash it took you to get that cash flow. That's how much you invested in the deal. That's that's your capital balance are we wrote $1 million 146,000 and net cash flow that's on top and then you just do the math problem. You made 14.5% cash on cash. I was trying to explain this to my kids the other day and they're 10 12 and 13. And they were having a hard concept, hard time with the concept. So I came up with this idea, I said hey you're buying think about commercial property as a money money generating machine.

You know like a golden goose that lays lays the eggs. This money machine I tell them is if I put $100 in Uh it spits me back eight. So I made my return the return money is 8% of the 100 I gave it. And so then in our example what if you could go borrow money and feed it to the money generating machine and it keeps spitting you back eight but but you're only paying 4% a year to borrow that money. And so that's how we get the leverage is the more of the bank's money you can put in at a lower interest rate the higher your returns go. And so uh so we have 14.5% cash on cash just for getting a loan from the bank. What if how I'm gonna show you how important leverage is what if we go with an 85% loan. Someone say that's just a little bit different 85%. So you're just getting a touch more debt and you're putting a touch less down payment in. Yeah. So if you're if you're listening, think about, well how much could a 5% loan alter my returns? Because we already had our show about returns and how drastic even a few points of compounded return over time Benefits you.

So in this example, if I go and I say, Okay, I'm gonna get an 85% loan. That means I'm getting a $4.25 million $269,200. So my cash flow goes goes down 230,000. And so you're like, well why would you want to do that? Your cash flow went down, Well, I only had to put in 750,000 in this example. And so then my cash on cash is 17.5%. So I just went up 33% on my return just for increasing my leverage a little bit. But uh one other thing I want to point out is this is a mortgage. So you're paying part of the payment that you're paying is paying the interest and part of it is paying the actual principal amount. And so it's paying that money back that's paying that money down. So the longer you own that that commercial asset right, the balance of that mortgage is coming down. And if as long as the value holds, uh and you sell, you're going to get all that money just like your house, just like your house. Yeah, but on a much larger scale.

So I mean just the principal pay down could be, you know, 5-7% a year. Well, let's look at, I calculated that for us. So in our first example of 80% leverage, we had a 14.5% cash on cash return at an at an eight cap deal 4% interest on the debt. Well if you add back the principal to that return, the theoretical return it bumps your, your cash on cash is fortune and a half. But your total returns 24 a half, wow or almost 24 a half. So uh there's your earning, you know, a 10% return on you invested capital just from the principal payments. So when you are going to a bank for a loan on commercial real estate, are they going to give you different terms for, there are different interest rate for different uh maybe lTV loan amount or and so if so do you need to, I guess you just go analyze the two or three terms that a bank might give you, Is that right? Yeah, I'll tell you man, a bank will change the interest rate by the day. I mean bank changes interest rates with everything. Um by the way the wind blows.

So you know, you need to be in in the market shopping debt talking to your lenders who are underwriting the deal and and ask them what the rates are and you need to be talking to other people. I would say generally speaking when we go into a deal um you know, we're putting in a rough number and probably You know 20 to 30% higher um just so we have a little buffer and then we hope we can negotiate that rate down. But I mean just a quarter of a percentage point or a half a percentage point on the debt savings could save you hundreds of thousands of dollars over the course of that loan Because if you're getting a $4 million 1% cheaper interest rate that's 40,000 a year. That could be a 10 year loan, that could be $400,000 an extra interest on the debt. So paying attention to that rate and negotiating it and having good lenders are are very Important. Well and as the, as the LTV adjust you may get, if you let's say I want to reduce the bank's risk and only borrow 70%.

Uh the interest rate may be lower for that than the 80% because there's less risk from the bank's perspective. Um And another thing I'll say on on leverages, obviously we can get really good returns, getting 80% LTV deal, but obviously it's not as safe as buying in cash because uh swings in the net operating income now affect your returns drastically because you have that debt payment. And so that's something to keep in mind when you're buying deals. Is that the debt, the more debt you add, the more perceived risk it adds to the deal. Although my experience in the last 10 years is we've been able to find a really good stable deals and put 75 to 85% dead on them and there was still enough cash flow to contend with the swings throughout throughout the year. Right. Right. Yeah. Well um I think these three terms are super important. I think if you can understand how the property is making money, the net operating income and then how to um take that net operating income or the profitability of the property and apply it to a purchase price because you want to buy it.

So hey it makes this much in Ny and I want to make this much on my money. I know if I can get around an 8% cap in cash And then I can go find a good lender, get some good debt and then that 8% deal turned into almost double and if you include the principal pay down it could be almost triple Well, so I want to go uh we got a little bit more time. I just want to give another example about how powerful that cap rate is when you're buying and selling. So let's uh let's say um And uh and also increases in Ny so we have we have the ny the net operating income Part of real estate and manufacturing value there is being able to increase that that Ny so let's say on this example that we were able over a few years to increase the net operating income by just 10%. And real quick. You're doing that through rental increases. You know the you're doing it through occupancy. People are paying you more money in that year. That's how you're getting that increase.

Yeah. It could be that that we're raising rents, it could be that were maybe fixing up units and being able to charge more for the same unit. And it could be that we least vacant space if the apartment complex had vacancy or the retail center had vacancy will lease that up. So that's how you might get uh you know an increase in Ny I'm taking a pretty modest increase of 10%. You know if you if you said, hey the rents are going to go up 2% a year, you can get to 10% in less than five years. And so what does that do to our return if we assume that we sell at the same cap rate that we bought at On this example then a 10% increase in Ny would be $40,000. And so the value that that adds at an eight cap is a half a million dollars in value to the property. Now remember that 80% example we only put in a million dollars. So not only are we getting double digit cash on cash returns and if you add the principle we're up to 24% Combined return. But now if I can increase that, you know I when I sell I get I get another 50% on my money just for just for 10% increase in in Ny well during the ownership period that's less than inflation.

So create crazy when you when you get into capri it's crazy how much return is in both an ability to increase the N. O. I. Than that operating into the property. And one other thing is is that for us we're always trying to find opportunities to buy deals at a slightly higher cap rate and be able to sell them at a lower cap rate. Yeah and that was to your point earlier on market cap rates. And and finding a deal if you can go into a market and and know that hey in this market a good retail asset is trading for an 8% cap rate and this one's a 9 9.5% cap rate. You know there's a value to be had there. Yeah. So um I just looked at what if I could buy at an eight cap uh and I could sell the same income. I didn't even increase the you know I just I re marketed or I I he was a little bit more desperate to sell. And I'm gonna use a better broker to get a national platform and I'm gonna I'm gonna sell it a 7.5 cap versus an 8.5 cap. Or sorry in eight cap. So I'm only getting a half a point on the cap rate.

That doesn't sound like that much. But on our example uh just a half a point in cap rate increases the purchase price over $330,000 on the same on the same income didn't didn't increase the income at all. I just basically re marketed it at a slightly lower cap over 330,000 and uh in purchase price. So that's over a 33% return on our invested money without even moving the. Ny in the point I think we're talking about these things to, we wanted to define them to make them easy to understand. But also the show just small swings and cooperate and an N. O. I. And in in in leverage point can drastically drive strong returns for for you or uh investors. Yeah. Absolutely. Um Finding cap rates and being able to understand them in the market and and make money there is a lot, being able to um place good debt on a property and no good debt, no good debt. And have those relationships. You can make a lot of money there and then being able to bump up the income on an asset and sell it for the exact same cap rate.

It's the exact same cooperate, you're just getting a little, you know, 12% every year. You hold it for five years. The N. O. I went up, you know 10% over that time. And just that money is hundreds of thousands of dollars. That's a lot. Well in that example it was 10% equaled 50% return on your invested equity on that first example of with an 80% loan. So it's amazing how just little tweaks here and there can make so much more money. But that's because you're talking about a 5 10 $20 million property, Right? So just little bitty increases can really help you. And the probability of you getting more than one of these on the same deal, like the probability of you getting good debt, you being able to increase the income of that property and then fix it up and extend the leases and make it a more attractive investment. So you can offer it at a lower capitalization rate. You can convince somebody else to make less on their money than you did on yours when you bought it, essentially what it is because you took care of it. You proved the asset and you proved that you could make it make more money.

That's a believable story and somebody else can come along and by that and then bang, that's a lot of money, man. Well, and this is an assumptions game. So if you're listening, there's all what makes a good syndicator makes a good commercial real estate investor is, is making a bunch of assumptions about what future cash flows are going to be, what the risks are. Uh, but any event, even if, if we don't, we don't make any aggressive assumptions on commercial real estate, it's still a good investment. Let's say there's no N. O I increase. That's not going to happen. But let's say there's none. And let's say I'm going to sell out the same cap rate. I'm not going to be able to improve on that at all. Ah, If it's a finance herbal deal, you can still get consistent 15% cash on cash returns. I mean, an a cap deal in a 4% loan, like we've talked about those deals are available to people. So I just think it's a good, good thing to remember that we don't have to make wild assumptions to make really good returns. And then obviously we have somewhere we do hit it out of the park and cap rates do move in our favor and the Ny does move up and then then the returns are really big.

You know, I want to have a really important point of clarity here that we're not saying that you have to go and do this by yourself, right? Because our investors are investing with us on the deals were buying the three of us, you know, you're buying tons of deals with precision were buying deals with criterion and our investors are investing alongside of us to get all of these benefits with us and they're getting those same returns, they're getting 12, 13, 14, 15, way more percent return when it's sold. Right? So you don't have to go just find a $5 million property and say, hey guys, I want to buy this. You know, I've been watching this podcast. These three guys make it interesting, you know, do a deal with somebody else. Sign up on our email list, get involved with a deal. Figure out how it works, get comfortable with it, study on these terms and understand how you can manipulate net operating income and capitalization rates to your advantage because there's a lot of money to be had there. And if you can you can route this with some knowledge and motivation and ambition. It doesn't have to be your full time job.

You don't have to be full time in commercial real estate. You don't have to be a lender, a real estate broker. You don't have to be anything, you have to have a little bit of money and the willingness to learn and partner with somebody else. If you have apprehensions about what we're saying the terms, it seems scary. Let knowledge be your guide. The knowledge will combat that fear over time and the more knowledge you get, the more comfortable you'll get with commercial real estate as a potential avenue for you. Absolutely. Brandon what you said, that's how I started. Just as a passive investor still had a full time job, but just by investing and paying attention and and um the syndicators sending me information, financial information and studying that. That's how I that's how I learned. Yeah. Well, all right guys uh that I think that wraps it up for today. Um make sure to go to our website. I think that's the easiest place to watch and listen. It's how to invest in CRE dot com. Like subscribe, Check us out and we'll be back in a few days, mm. Yeah. Mhm.

Episode #007 - Understanding Net Operating Income (NOI), Cap Rate, and Cash on Cash (CoC).
Episode #007 - Understanding Net Operating Income (NOI), Cap Rate, and Cash on Cash (CoC).
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