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32 Part I:Getting to Know Commercial Real Estate Investing
U When is it the best time to go bottom-fishing? If you aren’t a bold risk taker, you may find this advice uncomfortable (so consider yourself fore-warned!). Maverick investors buy at the bottom phase or at the front end of the recovery phase. This is called “bottom-fishing” for deals. This is where the big, big money is made. Maverick investors are brave and courageous trendsetters. They’re usually the first investors in the worst part of town, and they’re usually banking on the area to come back big time. If they play their cards right, they come out on top, and if they don’t, they simply walk away with an “aw, shucks.” Now that’s bravery!
Trends are your friends
True friends are always around when you call on them, and they won’t ever let you down. And economic and demographic trends are your true friends in commercial real estate investing. And best of all, these trends aren’t terribly complex or difficult to determine. Here are the three trends that are plainly fundamental when investing in any commercial real estate:
U Job growth: This trend makes perfect sense: Where the jobs are, people are. And where the people are, demand exists for apartment rentals, office space, and consumer goods. Job growth is an excellent indicator of a healthy real estate market.
The best place to start in researching job growth is to contact your local economic development department or chamber of commerce and ask for historical and current job growth data.
U Development: This trend is all about supply and demand. After all, if a shortage of office space or apartment housing is evident, you clearly have a demand for new development. On the other hand, if you see that the city is overbuilding, it’s an indication for you hold off and reassess.
U In the path of progress: It isn’t too difficult to spot this trend with your own eyes. Whenever new building and development is either coming your way or surrounds your property, you’re in the thankful path of eco-nomic development. You can feel the “buzz” of prosperity around you.
Chapter 3
Evaluating Commercial Real Estate
In This Chapter
© Familiarizing yourself with important lingo © Determining a property’s worth
© Examining a few analysis examples
© Valuing properties the professional way © Surveying those things that create value
© Knowing the difference between a good deal and a bad one
here’s a myth going around town that you need to be an accountant with an Ivy League degree to evaluate and analyze office buildings, retail cen-
ters, and apartment complexes. Don’t believe the hype. If you can count and do some basic math, you’ll have no problem figuring out what your cash flow and return on investment are for any piece of commercial property. In fact, we guarantee that after you read this chapter and follow along with the exam-ples, you’ll be able to figure out what a commercial property is worth just like those sophisticated investor guys you see with their pocket protectors and fancy spreadsheets.
This chapter explains what creates value in a property, shows you how to ana-lyze an apartment building and a shopping center like a pro, explains how to know a good deal from a bad deal, and provides invaluable guiding principles of investment that will keep bad properties out of your portfolio — guaranteed.
Talking the Talk: Terms You Need to Know
Throughout this chapter, we use some terminology that you need to be famil-iar with. Having these terms under your belt is crucial on two fronts:
34 Part I:Getting to Know Commercial Real Estate Investing
U We presume you’re reading this book because you want to invest in com-mercial real estate. Most likely, you’ll be using a real estate broker to help you locate and close the deal. Real estate brokers know — and use — most of the terms mentioned here. Gaining thorough understanding of the terms levels the playing field. If you can speak their language, you gain instant credibility and a relationship advantage over someone with-out your knowledge and understanding.
U Just by increasing your word power, you gain increased confidence, which enables you to make sound, efficient investment decisions, and gives you an increased ability to hold your position, especially in negotiations.
Here are the words you need to know to navigate this chapter and talk the talk:
U Capitalization rate: Your capitalization rate is your net operating income divided by the sales price. Also known as the cap rate, it’s the measure of profitability of an investment. Cap rates tell you how much you’d make on an investment if you paid all cash for it; financing and taxation aren’t included:
Cap rate = net operating income ÷ sales price
U Cash flow: Your annual cash flow is net operating income minus debt service. You can also figure monthly cash flow by dividing your annual cash flow by 12:
Annual cash flow = net operating income – debt service
Monthly cash flow = annual cash flow ÷ 12
U Cash-on-cash return: To find your cash-on-cash return, divide your annual cash flow by the down payment amount:
Cash-on-cash return = annual cash flow ÷ down payment
U Debt service: Debt service is calculated by multiplying your monthly mortgage amount by 12 months:
Debt service = monthly mortgage amount ´ 12
U Effective gross income: You can find your effective gross income by sub-tracting vacancy from gross income:
Effective gross income = income – (vacancy rate % ´ income)
U Gross income: Gross income is all of your income, including rents, laun-dry or vending machine income, and late fees. It can be monthly or annual.
U Net operating income (NOI): Your net operating income is your effective gross income minus operating expenses:
Net operating income = effective gross income – operating expenses
Chapter 3: Evaluating Commercial Real Estate 35
U Operating expenses: Your annual operating expenses of the property typically include taxes, insurance, utilities, management fees, payroll, landscaping, maintenance, supplies, and repairs. This category doesn’t include mortgage payments or interest expense.
U Vacancy: A vacancy is any unit that’s left unoccupied and isn’t producing income. Remember: A unit that’s vacated and rerented in the same month isn’t considered a vacancy; it’s considered a turnover.
U Vacancy rate: Your vacancy rate is the number of vacancies divided by the number of units:
Vacancy rate = number of vacancies ÷ number of units
Figuring Out What a Property Is Worth
When you first hear the word analysis, you may freak out — especially if you aren’t a spreadsheet guru. We were intimidated by that word when we first started out, too. But through the years, we’ve come to look at property analy-sis more simply. The dictionary definition of the word analysis is “a separa-tion of the whole into its component parts.” So, we break down any property analysis into its component parts: income, expense, and debt. That’s it. We take a look at the income information. Then we take a look at the expenses. And finally, we add a loan or mortgage to the overall picture. We combine them to come to a conclusion as to whether this deal makes money. Analysis made simple.
The size or complexity of the deal doesn’t matter. Separate the deal into its three component parts: Analyze and compile the income part; analyze and compile the expense part; and analyze and compile the debt part. Any deal can be broken up into these parts. When you have these parts, you can calcu-late the net operating income, cash flow, cash-on-cash return, and cap rate. It’s that simple.
Before you can figure out what a property is worth, you have to decide what you really want from the property. You may want a stream of passive income every month. Or you may want to hold a property long term to build your wealth. Or you may want to buy it, rehab it, and sell it for a profit.
Not-so-obvious tips on analyzing When you’re analyzing any property, keep the following in mind:
U Be leery of broker proformas. Proformas are brokers’ presentations of data on the property that reflect a best-case scenario or even a perfect-world situation. For example, even though the property may have eight
36 Part I:Getting to Know Commercial Real Estate Investing
The technical meaning behind the numbers
Cap rate, cash flow, cash-on-cash return, and net operating incomeare investment terms that we show you how to use in this chapter, but what do they really meanto you as an investor? Here’s the in-depth explanation:
U Capitalization rate: A cap rate is used as a measure of a property’s performance with-out considering the mortgage financing. If you paid all cash for the investment, how much money would it make? What’s the return on your cash outlay? Cap rate is a standard used industrywide, and it’s used many different ways. For example, a high cap rate usually typifies a higher risk invest-ment and a low sales price. High cap rate investments are typically found in poor, low-income regions. A low cap rate usually typ-ifies a Iower-risk investment and a high sales price. Low cap rates are typically found in middle-class to upper income regions. Therefore, neighborhoods within cities have “stamped” on them their assigned cap rates.
That said, if you know what the NOI is, and you know the given cap rate, you can esti-mate what the sales price should be: sales price = NOI ÷ cap rate. For example, if the NOI is $57,230 and you want to make invest-ments into 9 percent cap properties, the price you’ll offer will be $635,889 (57,230 ÷9 percent). This is a good way to come up with your first offer price — at the very least, it’s a starting point.
U Cash flow: Positive cash flow is king, and it’s one of your primary objectives in invest-ing. Positive cash flow creates and main-tains your investments’ momentum. When purchasing an apartment building contain-ing more than five units (considered com-mercial), a bank’s basis for lending is the property’s cash-flow capabilities. Your
credit score is a lower priority than the cash-flow potential. An apartment building with poor cash flow will almost always appraise much lower than its comparables for the area. Finally, positive cash flow keeps you sleeping at night when property values drop, because your bills and mort-gage will still be paid.
U Cash-on-cash return: This is the velocity of your money. In other words, how long does it take for your down payment to come back to you? If your down payment were $20,000, how soon would your monthly cash flow add up to $20,000? If your cash flow added up to $20,000 in one year, your cash-on-cash return would be 100 percent. If it takes two years, your cash-on-cash would be 50 percent. If it takes three years, it would be 33 percent.
Commercial real estate investing can pro-duce phenomenal returns. Cash-on-cash returns of over 100 percent aren’t uncom-mon. Now, if you were to go to your local bank and deposit $20,000 into its most aggressive CD investment for one to three years, what type of cash-on-cash return could you expect? Maybe 2 percent or 4 percent? You need to put an emphasis on cash-on-cash return when you invest simply because you need to know how fast you can get your down payment back so you can invest it again — and again.
U Net operating income (NOI): This term is one of the most important ones when ana-lyzing any deal. The net operating income is the dollar amount that’s left over after you collect all your income and pay out your operating expenses. This amount is what’s used to pay the mortgage with. And what’s left after you pay the mortgage is what goes into your pocket — your cash flow.
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