How to Invest in Commercial Real Estate

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Episode #079 - Poker and Commercial Real Estate: Understanding Implied Value in CRE!

by Criterion, Braden Cheek, Brian Duck
September 26th 2022

Today hosts Braden Cheek, Brian Duck and Joel Thompson from The Criterion Fund use a poker analogy to educate investors on the nature of implied value in Commercial Real Estate!

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in those moments, I'm trying to calculate expected value. I'm saying, okay, what's the likelihood that I'm gonna make three million? What's the likelihood that I'm gonna make, I'm gonna lose one million because both their real possibilities and a lot of people get scared about losing the million, but they don't understand that the three million, how real that potential is. Yeah. All right. Welcome back to how to invest in commercial real estate. This is episode 79. And We're back talking about another cool investing topic. Um so before we get into that, um it's a little bit in the weeds. It's a it's a it's a hairy one, so to speak. But before we get into that, there's been a lot of interesting things going on in the market by interesting. I mean suck. Um so yesterday September 21, the Fed raised the interest rates another three quarters of a point. That sucks. Yeah, it's been it's been painful. A lot of investments, doesn't. Yeah, briefly. Let's get into why? That sucks. I mean just as as simple as you can, why is the average cost of of debt being more expensive hurt us right now.

Why does it so? Well, it hurts us because we have to borrow at a higher rate. We still seem the um sellers still seem to be selling at the same cap rates and so there's just not enough in between the cap rate and the bar Right to make much money. 100 percent. That's a perfect example. So at the beginning of the year, I think we were talking about this earlier when we were buying Plaza West and some of the stuff in ST louis our cost of capital was sub for right around 4%. We were buying roughly 8 to 8.5 cap deals that left us left us a 4 to 4.5% spread. Now the average cost of capital and that same deal and it's not total cost of capital, average cost of the debt is probably low sixes. And you're still buying it on, like you said, probably a very similar cap rate. So your margin is cut in half on that deal. So it's gonna take a little bit for the seller to soften the pricing and and kind of get back going. You'll see a lot of stagnation I think in things trading. Yeah, for sure, sellers are not going to adjust their prices that quickly because I mean we are in a really hot economy one that's in hyperinflation, that means a lot of money is out there and so that money needs to go into investments.

People are selling if they do sell to take advantage of high prices, they have to turn around and 10 31 trade into another deal. And so the deal, the amount of money chasing deals hasn't gone down, it's still super high, what makes it, so that's keeping, you know, seller's price is low, but the debt picture for us cash flow buyers is really a challenging picture right now And we're doing some new developments and uh not only on the criterion building, we have a floating interest rate uh but also a lot of projects are gonna stall because the debt coverage ratio is changing with the higher debt. And it limits the amount of money that people can borrow against a certain project. And normally that would be fine because, you know, rents arising values are increasing, but it's the speed at which the feds are changing or raising their rates. You know, if they're doing a quarter point every quarter, you may get a point in a year and that allows the, that allows everybody to adjust a little bit better, but real estate projects, especially developments take two years to to finish.

And so when you were getting this is the, is this the third three quarter point or second? I think it was a half a quarter and a half, then three quarter than three quarters and they added another half hour. And so they're just changing it too fast for the market to adjust. And so we're gonna, we're gonna have a harder time finding the deals that cash flow the way we want them to in the short term. Yeah, it's it's also, I mean, it's not all doom and gloom, right, We're we're a week away from one of the best times of the year and its distribution time. So that's amazing because what have we seen in the market, I mean market values have gone down. Um I mean I think it's like 20% or a third of of stocks on the new york stock exchange pay a dividend. That average dividend is like 3.5%. So not only is your value plummeted and you can't sell it, but your dividend is non existent and our value hasn't plummeted right? Because we don't have to trade, we can wait this out and we're still paying out double digit cash on cash returns. So it's times like these that people really appreciate the power of commercial real estate and and want to get involved.

I can tell you for my personal investments, I'm watching my stock value go down so much uh and the real estate value, I consider the same practically, I mean maybe some of the values are dropping a little bit, There could be made a case made for that, but like you said, we don't have to sell right now. Um we can wait until you know the market's better. So I don't consider that my real estate value has gone down. But my stocks are plummeting reason stocks go down. Well, one reason as they're raising interest rates now, the companies can't borrow to improve their uh assets and and um the amount of money that that you know they're trying to make your crypto crypto mind sucks. It's the worst actually, out of those three states. Okay stocks are down, Crypto tank kryptos in the garbage. Alright, so let's talk about what we're going to discuss today and it's a little bit of an abstract concept that I wanted to go over. Um, and I'm gonna call it expected value or implied value when making investment decisions and we'll get into a little bit about what that means.

But as you get into your real estate investing career, you're, you're always going to be faced with, uh, you know, is this going to make money? How much money is it gonna make? What are the risk, What is the downside? And sometimes you're not gonna ever know exactly how an investment is gonna perform. And so one of that's one of the things that I ran into early on, I was forced to make a decision do I want to buy this property? I think you can make money, but I also think I could lose money. How do, how do you go about evaluating that decision? And it can't just be, you know, I, I think it's gonna do this like you need some type of meth methodology that you're using some logic and common sense to, to help, you know, you and guide you in, in which, you know, investments, you should steer towards, if you have some numbers that you can stick by sort of with every investment, then investment after investment after year after year, then more likely you are to succeed. If you kind of have a feel for what it is that, you know, the chances are, you can't analyze an investment without looking at the full picture.

And I think that's what we're talking about a little bit before the show is, is so many people just get hung up on the downside of, well, it could lose half a million dollars. Well, you, it's not a fair statement because what if it could make a billion dollars, you know, uh, that that loss compared to the upside is nothing, right? That's a bet you would probably want to take and that's, that hits at the core of what we're talking about today because most people run from risk and you can't get away from risk in this game. And so what if I said that kind of a thought experiment that, hey, I got this investment for you and you say, what is it? And it's like, well, it's, it's a real estate. And You know, and then you ask me, is it gonna make any money? I'm like, well, actually it's gonna lose money 80% of the time, 80% of these types of investment lose money, are you gonna take the deal? Most people are like, no, I'm never gonna take that deal. It loses 80% of the time. But the thing is you, You have not, you have to open your mind and you have to ask better questions and you don't have enough information to decide if you're gonna buy that deal now.

What if I said that this investment loses 80% of the time and when it does lose, you're gonna lose $100,000. Would you would you take it then? Yeah. Most people that are thinking hell no, I'm not taking that, he loses 80% of the time. And every time I lose I lose $100,000. And so but what if we told you when it when it hits, you're gonna make $2 million 80% of the time? Uh You you lose you lose 100,000 and when it wins you make two million, you still may be asking yourself. I don't know if that makes sense. But we were gonna break it down in a poker example because I like to play no limit hold'em poker. And so if you have never played this is not gonna make a lot of sense to you. So you specifically play no limit just because you're such a high better now. No limit is that's what everybody plays now. You know, it's just it's just there's limit poker and there's no limit poker. No limit poker is that you can bet any any amount of chips that are on the table at any given time. We'll show you how much I know about poker.

Yeah. So here we go. We need to play poker some time. Yeah this guy, we're gonna play poker with him. Okay so those of you that do know how to play poker. Here we go, let's say you have four to the flush and uh you're waiting for the river to come out. Okay. Which means you have four cards. Thank you. I was lost in the first. So if you play no limit poker, we've had the flop and we've had the turn and we're waiting for the fifth card that's gonna come out on the table. I have to hold cards. Okay? And let's say two of those are hearts, and two of the ones out here heart. So now I have 45 hearts makes a flash, which is a really Dominant hand. And most likely a winning hand, especially if I have, let's say in my hand, the ace of hearts. Then if I it would be an unbeatable hand unless there's a pair on the board and someone can make a full house. So how do we go about deciding whether we should call a bet on the river if I'm holding forward to the flush. And so here we go, I'll try to explain this as easy as possible. Uh in poker there's 13 cards in every suit, there's 13 hearts.

You didn't know that, I didn't know that. So I have I have four of them two in my hand, and two are showing on the board. So that means there's nine out there left. So what that means is that there's nine cards uh that can win me the hand. Now uh there's there's four cards out here and then I have the two. So that's six. You take 52 -6 is 46. Okay. That's how many cards are out there that I don't know what they are. nine of those make me a winner. So we're doing this live on the fly at the table. I am doing well. Yeah, this is how you play poker if you didn't know. So uh 99 times I'm gonna win out of 46 cards. Okay that is basically a one in five shot to win or 20%. I have a 20% chance of winning that hand. Okay so let's say that there is $1000 in the pot and someone bets $400. Okay they bet $200. Now I have to call $400.

And by calling 400 I have a chance to win the whole thing. Which would be 1800. Okay because they bet four, so it's 1400 I have to put another 418 $100. And uh you need to know should I call that bet any guesses? If I should call that bet 800 to win 14, You put you pay 400 to win, Okay 400 to win 1800. You have a 20% chance of winning. So yeah I wouldn't do that because if you play out the odds, if you play five times, right, you have a 20% chance of winning. If you play five times, it's gonna cost you 1600 bucks, right? Or $2000? Five times 400. But you can only win 1800. Okay. See I just learned how to play poker. There you go. Uh And so that's a little bit of it. So let's say that someone bet $200 into the $1000 pot, or let's even make it easier, let's say it's $100 bet into $1000 pot, and I have to pay 100 to win. So that means I can I bet $100 to win 1200 that's a bet I have to take, right?

And what you have to keep in mind, I'm tracking better now. I'm glad, I'm glad I got the point of understanding while we're live and you only Have to you have to play 12 times to get your money back. But the odds are one in nine. So the odds are One, it's actually I was wrong before it's 20%. So you're gonna win one out of every five times. Okay? And it's it's not a guarantee that if you play it five times, it's just the odds are you have 20%, you're playing math at that point. And you're saying over time, does this bet, does it have an expected value or an implied value. Uh that's positive because you you can have an implied value, an expected value that's negative. The more I play, you know if I call that $400 bet We've already established that I'm gonna I'm gonna pay 400 to try to win 800, but I'm only gonna win 20% of the time over time. The more I placed that bet, the more money I'm gonna lose. It's like it's like gambling in Vegas, it's like playing roulette or or whatever. Like you're you're the more you play roulette, the more you will lose. C. And they do this at the roulette table to they give you the implied they give you the odds on the screen even though it's not relevant, Right?

Because you have the you have the same odds every single time. It doesn't matter that 70% of the time it actually hit red. Well here's the same odds of hitting read every single time. Yeah roulette is is unique. Now they have two green spaces. Okay? And so uh if you put money on one number or let's say you put it on red, uh you and they're only going to pay you, there's 50 50% black and 50% red. And then the two green that to green is your expected value and it's negative right? That's what's costing you because they only pay out 1 to 1 on your bed about $100. You win $100 but you're not gonna win half the time because there's two green spaces on there, you're gonna you're gonna win 46% of the time or 44% of the time. So casinos, they don't really care uh if you win or lose, all they care about is the amount of money bet because over time they just get a percentage of the money bet. But anyway that's a little bit off the topic. So how do we take the poker example and we apply it to real life, commercial real estate.

There were there are deals and I'll give you an example. One was an auction that we were bidding on an apartment complex in north Carolina. I had never been to the state of north Carolina and I had to make the decision whether I was going to buy that property during the auction and I had very little information to go by. So right there, 99% of the people are out okay. Never been to the state of North Carolina tight timeline and a difficult of understanding getting all of the information kind of gathering it, 99 out of 100. Now of course I had some experience with apartments and so I tried to use all of my experience in running B and C. Class apartments to come up with an expected value for the deal. And basically what I came out with is that the price was 30,000 adore approximately. Uh, 66, 16, maybe 14, 15, 16. And uh, so I tried to say, Okay, what if this investment really works and I'm able to turn it around and I'm able to fill it up. What's it worth? And I calculated that I could make potentially two or $3 million.

And then I I try to also ascertain if the deal doesn't work out the way I think it is, I think and I have to sell it. What is my potential loss? And these aren't exact numbers. But for me, I was trying to come up with that value and I thought that, okay, 250 units approximately. I thought my downside was a million dollars, maybe million three, something like that, $45,000 a door. If things didn't go well. And so in those moments I'm trying to calculate expected value. I'm saying, okay, what's the likelihood that I'm gonna make? Three million? What's the likelihood that I'm gonna make? I'm gonna lose one million because both are real possibilities. And a lot of people get scared about losing the million, But they don't understand that the three million how real that potential is. And so for me, I thought, well, I don't, I give myself a 5050 shot here. I haven't been to North Carolina. And so I said, Okay, I think it's probably 50% chance I make money and 50% chance I lose money. But for me. but the 50% chance making was three million, this is the, in your mind, the loss was a million at 50 50.

So that means you gotta take the bet even though you could lose a million and a lot of people get frozen when they're evaluating commercial real estate because of the fear of losing. And, and what, the only reason we're talking about this exercise today is to help you guys understand how your mind needs to work and approaching investments. You need to try to evaluate your downside. You need to try to evaluate your upside and then you try to put, put some type of odds on how likely it is that, that it goes well and how likely it is that it doesn't go well and that allows you to, it will give you the confidence to move ahead because you know that, well that downside case might happen, but it's not likely to happen. So in that specific example, I'm remembering now the downside was the improvements and the upside is hey, if we spend this million dollars and improvements are 45 $6000 a door, we should be able to get $20 a door and rent increases And if we get $20 a door and rent increases and sell it on the exact same cap rate we bought it. That's $3 million.

Something like that. That's kind of how the exercise. So it's not like we're pulling these numbers arbitrarily out of nowhere, you know, they're, they're backed by something. But The thought was, Hey, if I just put all brand new roofs, if I put all brand new windows, I could at least sell it for, for what I bought it for minus the improvements. But the possibility of just getting a $20 rent bump Or whatever, $50 or whatever could make millions. Yeah. And so let's, let's talk about another example. Um, we do a lot of multi tenant retail and we have one center in south Tulsa Village, south and it's got a huge gym and that was the risk when we evaluated that deal is okay. This deal looks great. We're gonna make, you know, half a million dollars a year on this thing cash flow. It's gonna be awesome. But what if the gym leaves? And first of all, if you're not asking that question, you're wrong, you've got to ask the question. You've got to look at it. And, and for me, I grew up next to the center. I used to drive by there. I knew that the gym was busy with people and so I felt like that the chances of that Jim going out in the near future was 10% actually belong to that gym.

Yeah, I go there too. So, uh, and so if, if the gym moves out, it's gonna hurt that investment is not going to make money and we may lose some money until we're able to fill it, which could be years. But if they do stay, which I give it 80 90% chance they stay, we're gonna be making a half a million dollars a year and so half a million dollars a year under 90% of the circumstances versus maybe losing a million dollars a year. Uh, 10% of the time where these deals that now, man, can I get one of these? Well, hey there and, and there's another example I'll tell everybody is we bought a deal in Vegas that had a big uh, Big lots. It was in 30, square feet. This is a good example. And guess what? I did the same exercise. I said they're probably not gonna leave. This is gonna make me several 100,000 year. And I bet $3 million on it. Uh, and bought it. And what did big lots do a year later, they moved out and they've been out for the last three years, it's been vacant and that's a $450,000 hit to the cash flow every year right out of my pocket, luckily the rest of the property had leased up.

And so I'm basically at break even. So even though I'm technically losing money by not having a tenant in there, I'm not actually having to come out of pocket with a half a million. But that's an example of a deal that, that didn't go my way. Uh, as painful as that is. But the thing is, nobody's gonna buy it, nobody's gonna buy those centers that listen to this ever again. Just because you said that, uh, well I think the important thing to know is you're gonna play those odds and you don't have to stress about, let's say village south. The tenant did move out even though it was a low chance. The next eight centers you buy your, they may not move out. It's a numbers game. And so you can't worry about that one off where you got bad luck and someone moved out. Uh, don't let that stop you from taking a good bet. Just like in the poker example, you may call the bed Of $100 or $200, whatever. And so there's gonna be plenty of times that you make that bed and you don't get, you don't get the hard on the river and you're out that 100 you're out that $200.

That doesn't mean it was a bad bet. Professional poker players, they will take that bet every time and they won't think twice about losing that money. An amateur will make that bet. He'll get piste off that he didn't get the heart. And the next time it comes around, he's like, no, I'm not, I'm not doing that. And then you've ruined all your odds. You've ruined your odds and, and all because you're trying to avoid the risk of loss, not understanding implied odds or expected value. And I don't know that we've done a great job of explaining it today, but at least maybe it got your mind thinking that you need to think in terms of not this one investment, but how does, how does this investment work if, if I had to buy it 10 times in a row, what is, what is it the expected value there? And that will help give you the confidence on that first one to say, is this a good bet? Well if I did it 10 times or 100 times and it came out with a positive expected value then I should, I should make the bad, I should buy the investment and and not worry if you know big lots moves out because over time enough of those deals, they're not gonna move out.

The likelihood that I'm all moving out is not gonna happen and you're gonna be money ahead. Have you bought any more big lot steals yet? No, I haven't. But we did buy uh, we did buy in slidell, they had some big tenants but we like the traffic counts. We like the tenants, we didn't think they were going to move out, but there's a chance, there's a chance of them moving out and you know, so many people in this game, they, we do it as human nature. We're always trying to avoid pain more than we're trying to get pleasure for the most part. And so people will be afraid to make what is a prudent investment decision to avoid loss or to avoid embarrassment or to avoid failure. And we're trying to tell you, hey, there's another way to look at that. Bring in all the information, look at multiple investments and how you know, tons of them will play out over time and that will help you make a decision today. Well, I think, I think that will help. I mean it certainly helped me not lose as much money on poker and and make some better educated decisions.

You've got to get out there and play the odds and yeah, there's always a risk of failure. But if there's a greater overwhelming chance of of you winning, that's probably that you should take right. That's probably a deal you should look into. That's probably a deal you should buy or get some more data. And again, all of these numbers are pulled from something. They're not arbitrary numbers that were just picking up. Oh well, worst case scenario as I could probably lose a million dollars. No go in and ask yourself questions. What's the big biggest risk facing that deal? And how much would that cost me? Okay, what's the best benefit this deal could have? How much does that make me and start from there and hone it in, right? It's all educated assumptions. There's so many assumptions in real estate and this is this is one of them? I'll remind people of a couple of things first is you don't want to go into a deal, even if it's the the expected value is positive, but you're gonna lose a million dollars and you can't stomach a million dollars. Like that'll wipe you out. You can't take that bet. That's not a bet. You can take. Someone else can take it but you cannot take it.

You have to be able to sustain whatever the odds. Say, let's say you're gonna lose 100,000 80% of the time. Well you gotta, you shouldn't take that bet unless you're able to lose $100,000 several times before you hit that million dollar winner. That's number one. Number two, I want to remind everybody is this game. You have to get comfortable with being uncomfortable. There's so many assumptions, There's so much risk in every deal and most of the time it's gonna work out. But sometimes it doesn't and you're never gonna be able to just sit back and be comfortable. I made the best investment. Nothing's gonna go wrong. This is all gonna work out. That's never the case. Uh And that's something I had to get comfortable with early on is I just felt at risk all the time. I always felt like what if this deal doesn't go, what if this tenant moves out. What if I miss something that's the nature of this is you have to get comfortable with being uncomfortable with not knowing all the answers and with taking risks and making bets so Well, that was a good one. Aaron will have to edit all my worthiness. I think that's fine. Anyway, catch us next time on how to invest in commercial real estate.

We will be back next week with another episode. Thanks guys. Thanks.

Episode #079 - Poker and Commercial Real Estate: Understanding Implied Value in CRE!
Episode #079 - Poker and Commercial Real Estate: Understanding Implied Value in CRE!
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