Wednesday, November 5, 2008

A Next Shoe to Drop

There are two ways to make money in commercial real estate. The first is to increase income and decrease expenses. The second is appreciation to your building based on the market's desire to own your property. Seems easy right. It is. But what I've found in my last few years of study is that commercial real estate is very similar to texas hold-em. It is very easy to learn, but it takes a lifetime to master. Similar to a no limit high stakes game of poker, the smallest mistakes can wipe out your stack in an instant.

For example, let's say that the annual income on your building is $200,000 and your expenses are $100,000. That leaves you with $100,000; this is called your Net Operating Income.

$200,000 (Income)
(-)$100,000 (Expenses not including mortgage costs)
=$100,000 (Net Operating Income)

All you have to know at this point to understand what a building is worth is to know what rate of return an investor is willing to pay for that $100,000 in Net Operating Income. If an investor is willing to accept a 10% return on their investment, then your building is worth $1,000,000.

$100,000 / 10% = $1,000,000

The 10% is called a cap rate. Cap rate and Net Operating Income are the two most important terms in commercial real estate. They are similar to "implied pot odds" and "number of outs" in texas hold-em.

What if you could increase your expenses by $10,000 by raising rents, and what if you could decrease your expenses by $10,000 by having more efficient management on your property? This gives you:

$210,000 (Income)
(-) $90,000 (Expenses not including mortgage costs)
= $120,000 (Net Operating Income)

If the cap rate is still at 10%, then your building is now worth $1,200,000.

$120,000 / 10% = $1,200,000

This means you just created $200,000 in value into your building with a small change in operations. Now here's the fun part. What if you didn't even change anything in your building, but investors were willing to take a lower return for your $100,000 Net Operating Income? (Original Example) What if the cap rates in the area were lowered to 9% because commercial real estate is a hot investment in your area/country?

$100,000 (Net Operating Income) / 9% (Cap rate) = $1,110,000

Your building just increased in value by $110,000 just because investors were willing to take a lower return. This is what happened between 2002-2007 as commercial real estate was smoking hot. Investors were paying a 2-3% return for the Net Operating Income, which created huge paper gains on the buildings.

I only take the time to explain this because over the next six months you are going to begin hearing about commercial real estate as one of the next major problems in the market. Right now cap rates are rising, which is causing building values to fall. Investors over the past five years purchased buildings with short term debt just like homeowners. They are now going back to the banks to refinance only to find out that they cannot. (Because of something called a debt cover ratio that would take too long to explain)

Over the next 48 months commercial buildings are going to flood the market in a manner not seen since 1990, only this time I believe it will be much worse. There is no Fannie Mae or Freddie Mac that the government can socialize to create new loans for commercial real estate. Lending restrictions will severely tighten up, creating massive losses for banks that purchased these mortgages, and enormous bargains for investors entering the market.

I prepare every day for this coming opportunity. To prepare I work on my ability to increase income/lower expenses on a building, understand the direction of cap rates/capital movement, and align myself with investors who will have the capital to make purchases when the time is correct.

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