There are several questions that need to be answered before investing in real estate. How? What? Where? When? And Why???
I will attempt to share my thought process and try to answer these questions. This will probably be a 5-part series. Today, let me give my answer to the first question…How?
First of all, let’s take the term real estate investment and look at what I think that really means. Let me break that term down into two parts: 1) Real Estate and 2) Investment
Real Estate can mean different things to different people depending on what their background is. It could be anything from vacant land or vacation rentals to a high-rise office building and everything in between. For the sake of this article, we will be talking about “income producing” real estate. So, we will look only at real estate opportunities that have a monthly income being paid by a tenant.
To me, the term INVESTMENT means just that…INVEST…not speculate. We are not building houses (or apartments for that matter) “betting” on appreciation. We are not flipping houses and “betting” on the price we think we can get for our property based on how it “compares” to another property (single family home values are based on comps or comparables). Those are all strategies but to me, that is not investing. That is speculation.
So how do we “invest” in real estate? I think we must dig into two very different parts to the investment equation: CASHFLOW and APPRECIATION. That means that there must be a real PLAN in place as to what we are going to accomplish with both of these as it pertains to the property.
For me, investing in real estate means that we are going to buy an asset that is already an established business that is bringing in income and already has planned expenses. If the income is sufficient to cover the expenses, then it will create a Net Operating Income (NOI) and after those expenses are paid, loans are paid and money is placed into reserves for future expenses, then we have CASHFLOW. The value of a commercial real estate asset is a multiple of that NOI. In plain English, this means that we buy an apartment complex (self-storage or mobile home parks work too) that has tenants that pay rent every month. And every month, that apartment complex has expenses like water/sewer, electricity, insurance, property taxes, property management, repairs and maintenance and reserves. We can then take the income from the rent and subtract the expenses and we get a monthly net operating income. You see, we buy properties that we can see this income and these expenses for the past 1-3 years so we have a really good handle on what they will be going forward…SO, we aren’t speculating or betting…we are buying an ongoing business concern that we can then put a plan in place to increase income, reduce expenses or both. If we can do that, 1) we make a profit every month and 2) we can increase the value of the apartment complex since that value is derived as a multiple of the Net Operating Income (NOI).
Here is a quick example:
Let’s say we have a 100-unit apartment complex and the average rent is 700. If we do our research of the market and determine that most of the apartment complexes that are close are getting an average rent of 800, we will look to see why. Maybe they have nicer finishes and lighting inside. Maybe they have larger apartments. We then decide that if we purchase this 100 unit complex and put money that we have reserved into it to renovate the interiors and put in new cabinets, lighting fixtures, plumbing fixtures, counter tops, paint and flooring, we can then charge the 800 that our competitors are getting. After a period of time to renovate and lease up, we have increased the income by $10,000 per month/$120,000 per year. Since there will be some increased expenses associated with property management, etc., let assume that of this $120,000 increase in income that 75% of that ($90,000) gets added to the existing Net Operating Income. Depending on the market, we have just increased the value of the apartment complex by $1,125,000 to $1,800,000.
90,000/.08 = $1,125,000 (8% market cap rate)
90,000/.05 = $1,800,000 (5% market cap rate)
This is a simplified example of how to take an apartment community and by renovating and increasing rents, you can increase the NOI, which not only should increase the monthly cashflow but since the NOI is tied to the value of the property, it increased the value of the property.
Next time, we will look at the question…What?