Breaking Down Commercial Real Estate For Beginners

Happy Saturday and welcome to another addition of The Sophisticated Investor. This week I'm demystifying commercial real estate for new investors looking to learn more about investing. As someone who started in residential real estate and has over 5 years as a licensed professionals there was a lot I did not know. Today I'll cover some of the basics without all of the fluff.

• The BIGGEST difference between residential and commercial real estate is the way they are valued.

In any real estate transaction the bank is always going to be your largest partner in the deal since they typically provide at a minimum 50%+ of the funds. In residential, a reason a house is worth what someone is willing to pay for it is because the bank underwrites the person(s) who will be paying the loan. They look at the persons gross income, debt to income (DTI), and a few other variables to underwrite the persons ability to repay the loan. However, in commercial real estate the banks look at the asset, the building itself, because it is the thing producing income to replay the loan weather it is rents from apartments, the $/sqft in a retail shopping center, self storage, industrial warehouse space, lot rent from a mobile home park, and so on depending on the type of commercial real estate.

The simple formula for calculating income for CRE is....

Gross Income (GI) - Expenses = Net Operating Income (NOI)

To calculate the yield or otherwise know as the capitalization rate (CAP rate) of a potential investment you would take the NOI and divide it by the purchase price.

NOI / Purchase Price = Cap Rate

If you include any costs associated with purchasing and renovating this will provide you with your yield on cost (YOC).

NOI / (Purchase Price + Costs) = Yield On Cost

YOC tends to be a metric used by more sophisticated investors because it's more inclusive and a better predicting of investment returns. This is especially true when the real estate is not "turn key" and needs to be renovated, otherwise know as a "value add" project.

Many investors like myself start within the residential sector learning the basics of value add projects to maximize the value by renovating bathrooms, kitchens, flooring, painting, replacing fixtures and installing new appliances. Even the less thrilling tasks like plumbing, roofing, and electrical which tend to have less of an impact on a buyer have an effect on the ability to market a home to buyers as they tend to search for homes with less unexpected costs that can occur. However in commercial real estate there are other ways to also add value without renovating, we call these "operational value add" opportunities. For example, in a multifamily apartment we can increase the NOI in two way, by adding additional income outside of rents like valet trash services. $30 * 100 units = $3000/month in additional income. We tent to look at things on an annual basis like a bank though so that's really $36,000/year! Another example might be cost efficiencies, by reducing expenses like property management fees, we can increase the NOI.

How can you determine how much value this adds to the property though? Well that becomes very easy now that you know how to calculate your cap rate. Let's assume for this example you have a 5% cap rate.

$36,000/ 5% = $720,000

That's right, by adding something as simple as trash service you have added $720,000 worth of value to the property.

To take it a step further though Cap rates change overtime due to interest rates. If rates are expected to go higher in the future, it stands to reason your mortgage payments would be larger when you go to sell the property, which means the NOI will fall. When you calculate what that does to the value added, it can significantly increase or decrease your properties value. Let's runt the same calculation again but apply it to different times.

Example:

It's 2021 and the average Cap rate is 4%. We know rates are on the rise and you plan to exit with a 6% cap rate.

$36,000/6% = $600,000.

Verses...

It's 2024 and average cap rates are 6% and we expect rates to fall and Cap rates to drop to 4.5%

$36,000/4.5% = $800,000

Conclusion: There is a $200,000 difference between the value adding trash valet at the sale of this project. This is what makes or breaks so many deals and it's important to look at the entry and exit cap rate assumptions. This is the biggest variable to look for perhaps in someones underwriting, followed by how much they plan to increase the income.

As mentioned, assumptions in increasing rent is one of the largest drivers of NOI. To this day I will look at the property on Zillow to determine in real time what other similar units with similar amenities in the area are asking for rent. Does it seem realistic to increase rents $150/unit on renewal? If other rents are asking way higher, then yes. If other units are listing for less then maybe not. Remember though, real estate is local and it's all about location, location, location and it can change block by block.

If you have never invested in commercial real estate it can be daunting, time consuming and it's easy to make a mistake and overpay for a good deal turning it into a bad deal very quickly even though it comes with so many benefits like diversification, economies of scale and steady streams of income compared to residential real estate. If your looking to leverage these CRE projects in a more passive way there are groups like mine known as "syndications" where we work with multiple investors to poll capital together to buy larger projects together to leverage these economies of scale to increase returns. However, because there is an element of raising capital from private investing partners the Securities and Exchange Commission (SEC) regulates theses private placements.

It's important to consult an investor relations professional like myself who can help you navigate which option is best suited for your situation and help answer questions.

Author: Nicholas Abraham - Multifamily Syndicator