Commercial real estate investing 101
Not that I am Donald Trump or anything, but I do get people asking me about how commercial real estate works since they’ve seen me looking for deals. I get lots of questions so I’ll just tell you how it works. You can save yourself an arm and a leg by reading this post and not attending some overpriced real estate seminar.
In fact, I learned most of this from some book that was written in 1980’s by some African American real estate investor out of Detroit who used to be a professional athlete. There are companies and organizations that claim that this knowledge is holy sacred info that they can charge thousands of dollars for so that you can be “certified”. Like the idiots at CCIM and their ridiculous courses that teach you nothing but useless book knowledge. Ask Donald Trump if he took it. It’s like taking “intro to dance” at an Ivy League. Yes you’ll learn a lot about the theories and practices, but will it make you dance like Michael Jackson? Probably not.
By the way, I’ll probably get a lot of shit from (idiot) real estate brokers who’ll bitch and moan at my post but you know what? Screw them bitches!!!*
Anywho, enough ranting… back to the course.
First some terms and definitions:
Gross Potential Income = How much it CAN potentially make if if it were 100% occupied
Gross Operating Income = How much it ACTUALLY makes at current state. Basically, GPI minus losses due to vacancy (because not all units will be rented all the time)
Operating Expense = Or “OpEx”… means expense
Net Operating Income (NOI) = Gross Operating Income MINUS Operating Expense (i.e. how much it makes)
Capitalization Rate (Cap Rate) = NOI / Price.
Say you find a nice 10-unit apartment complex in a decent neighborhood. It’s owned + operated by some old dude who just happened to pay off the mortgage early and is leaving his current wife to elope with a hot 25 year old model from Portugal. The wife is freakin’ pissed off and wants 1/2 of all his assets, which is basically this apartment complex. On top of that, the Brazilian-hottie-concubine has a hefty shopping habit that he has to pay for (and to think she wanted him for his personality). Hmm, I smell a good deal here. Seems motivated to sell. (Yes, this is a true story. Except I never met the Brazilian hottie so the part about her being a hot model might be a made up story from the broker.) And the kicker? The concubine wants her man to get a complete makeover: surgical hair transplant, tummy tuck, AND a Porsche. I’m no doctor but I’m pretty sure plastic surgery doesn’t cure stupid.
You want to buy it because you are a bottom feeding leech like me. So you contact the brokers or the seller. After they scratch their ass (or each others’ balls) for a couple of days for no apparent good reason, they finally send you a piece of paper called “P&L”. This is an yearly profit and loss statement; basically how much they make and how much they spend. Say it looks something like this (i’ll make it super simple so you can understand how it works).
GPI: $250,000
Vacancy: 20% (or 2 units)
GOI or Income: $200,000 (80% of $250,000)
Expense:$100,000
NOI: $100,000
Now, this guy is asking $1,000,000 for it. Well, that’s a hefty price tag ain’t it? Well, is it? What is the cap rate?
Cap Rate = NOI / Price = $100,000 / $1,000, 000 = .10 or 10% (commercial real estate people call this a 10 cap)
What this means is that.. if this property were owned bought with cash (i.e. you have a million bucks stuck in between your sofa cushions and decided to invest into income producing property over throwing a crack party), you would get 10% return on your investment per year. Makes sense, doesn’t it? If you lend me a dollar and I give you 10 cents every year for the rest of your life, you would make your dollar back in 10 years.
Now unless you were sadistic and like having someone kick your nuts, I would say 10% return SUCKS ASS. You’re buying that building to make money, not because it’s pretty. How long is it gonna take for you to have your capital back so that you can do this over again? Besides, who has a million bucks in liquid cash? I’m sure there are some but for vast majority of us, we don’t.
Now that’s where DEBT comes in handy. Remember, the name of the game is LEVERAGE. If you don’t know what leverage means in real estate, well… I’ll write about it another day. Leverage is doing more with less. That’s all.
Before I get into the financing side of it, let’s revisit the deal. Is this a good deal? Maybe. Maybe not. How about this scenario. Let’s say you buy the property and fill up one of the two units that are vacant. Now the P&L looks like this:
GPI: $250,000
Vacancy: 10% (or 1 unit)
GOI or Income: $225,000 (80% of $250,000)
Expense:$100,000
NOI: $125,000
Hmm. Ok, this means you’ll make extra $25 grand a year (assuming no debt). How is this a big deal? Well, suppose you sell this as is at 10 cap to some other guy. HOw does this affect your bottom line? Remember the definition of cap rate:
Cap Rate = NOI / Price
which is same as
Price = NOI / Cap Rate
So… your property at 10 cap is now worth $125,000 / .1 = $1,250,000. You just made $250k by filling up ONE STINKIN’ UNIT! (No pun intended though I have seen shitload of units that stink like poo. Shows like “Flip that House” does no justice because odor cannot be transmitted over airwaves unless that airwave is within 10 meters or so)
Now back to financing on the original scenario with 2 unit vacancy… suppose that you finance the deal. 20% down payment and 80% bank loan. Let’s assume 30 year amortization at 7% interest rate. Your payment would be $4,667/mo or about $56,000/yr. Makes sense… $800,000 x 7% is $56,000. Subtract this amount from your NOI (yes, you do have to pay the bank or they’ll bitch slap you and take your property away), which leaves $44,000 a year.
Your return is now $44,000 / $200,000 = 22% return. Incredible ain’t it?
What if you did 10% down payment (i.e. $100k) ? Your debt payment on a $900k loan is around $63k… and you would end up with $100k - $63k = $37k. Your return is now $37k/$100k = 37%. That’s why leverage is good. The name of the game is… how much loan can you get? The more loan the better.
More to come later.
* Disclaimer: While I’m sure there are brokers who actually give a damn about clients, I’ve found most of the brokers to be life-sucking leeches who only give a damn about their commission. I know they’re very important to the everyday business in commercial real estate, I’ve personally never met anyone who actually provided a service that I was happy with. If you even mention the word “creative deals”, they’ll look at you like they ate something real sour. If you’re a broker and are reading this, please prove me wrong.
