NOV 27, 2021
I find it kinda weird how we’ve been taught to think about money. In the course of conversation with others, a common life outcome is monetary gain. A dollar amount salary, bonus, valuation, etc. and of course ‘passive income’ that we’re aiming for. I’ve noticed a pattern in my own life too; whenever ‘more money’ is a big motivation, I can’t reach a point where I say “yup, that’s good, I have all I need.” It’s never enough.
Don’t get me wrong, I enjoy making (& spending!) money, but I don’t find myself coveting it as much as I used to; I use it to empower myself to do what makes me happy. Money morphed into a means to an end, vs. being the actual end. Leveraging other people’s money in real estate is the best way to scale faster, and have a larger impact through the Why & Just Causes you have for yourself (see one of my last posts).
A few weeks ago I wrote about how the world of CRE was like the wild west. There’s virtually no regulations when it comes to how you want to structure a deal:
You get the drift.
Compared to residential markets, the CRE space is more creative. It took me a while to wrap my mind around on how investors were actually generating profits, there’s a few different mechanisms people use. I’ll talk about 3 ways I could profit by allocating $1,000,000 to a hypothetical deal.
The most common, and slowest, way to realize a profit in my $1M investment is: do nothing. Real estate will appreciate over the lifetime you hold it. There’s a finite amount of land, and a growing population; it’s a supply & demand thing. Let’s assume I bought the property for $1M in cash in 2021. By 2023, it may be worth $1.2M.
That’s $100K in return every year by just sitting on my ass (20% total return).
Imagine if I financed the purchase. If I put in only $200k into the investment while borrowing $800k:
2021 - $1M: debt $800k, equity $200k
2023 - $1.2M: debt $750k, equity $450k ($200k equity + $200k appreciation + $50 pay-down).
I’m not going to count the $50k debt pay-down as a profit, because I’ve had to deduct that cash from an account somewhere to make my payments.
I actually made a higher return by financing than if I were to buy in all cash: $200k (profit) / $200k (input) = 100% Cash on Cash return vs. 20% paying all cash. That’s pretty sexy.
(2) Cap Rate & Value Add
All RE nerds will talk about this across any asset type. Cap Rate = Net Operating Income / Sales Price. The cap rate is the return you expect from your asset based on the net income it generates. Net income is your gross income with all deductions (expenses, taxes, etc.) accounted - it’s your take home monies.
Let’s assume my $1M property has a cap rate of 7% to start, that means NOI = $70k. A 7% cap rate isn’t bad, or good - it depends on what my investment thesis is. A 7% cap-rate on an apartment building in a great neighborhood might be fantastic; a 7% cap on a shopping mall in a rundown area may be horrible — you decide.
I’m also going to assume I like the 7% cap rate deal because it has potential. I’ve reviewed the property and feel that the $70k NOI is due to poor management. A property runs only as good as its management. I like ‘value-add’ properties with low cap rates because it means if I can squeeze out a larger NOI, I can resell them for a higher price.
E.g. I purchase the building for $1M (7% cap, $70k NOI) and get to work - I paint the exterior, clean the insides and raise rents to match market values. NOI jumps to $90k.
Now plug in the formula for Sales Price = (NOI/cap rate) = $90k/7% = $1,285,714. That’s a $285k profit on a deal by tweaking the management & increasing NOI by $20k.
(3) The 1031 Exchange
This is the holy grail of all commercial real estate profiting mechanisms. It allows investors to reinvest all of their profits from a sale into a ‘like kind’ property without having to pay any capital gains tax.
Going back to my $1M acquisition, If I had made a $200k profit on the deal, I’m allowed to use the 1031 exchange to take my full $1.2M and purchase another apartment building/hotel/shopping mall etc. and pay $0 in taxes. There are a few restrictions: you must be purchasing another ‘like kind’ property AND complete the purchase within 180 months, so you’re not allowed to keep the profit sitting in your bank account earning interest indefinitely.
The 1031 is a perfect example of how libertarian and capitalistic values can work together with government. For a while after the Biden administration took over, there was a lot of talk about the 1031 being severely limited/removed. I found comfort in the fact that the bigger players wouldn’t allow something like this to go through to the President’s table. For now, it seems like discussions around tabling the 1031 removal have been sunset!
Talking about money as a tool to help achieve life values gets me excited vs. talking about money in terms of how much more you can make by doing XYZ; I find the latter off-putting because it’s like pulling the cart before the horse. I’ve learnt through my own experiences that if my priority was chasing money then I’m always looking for the next big hit — you can’t really commit & build anything without sacrificing all other alternatives.