In 2005 I wrote an introductory course on commercial real estate investment. This 5-part course was received via email in daily installments. Here is Part 3.
Commercial Real Estate: How To Invest Like The Rich
Part 3: The Day I Made $100,000
It’s hard to talk about returns without mentioning the word “risk”. When people ask me “where can I get the highest returns?” I answer: “In a casino”. But that’s not for me. I’m a naturally careful person, and I like to keep my risks to a minimum.
People complain to me that making money in property is slow. Sure, it builds wealth, but you have to wait for property values to go up. So a lot of people run around looking for things which work quicker. I see them invest (or gamble) in other, riskier things, looking for that quick return. But you know what? If you buy well, building wealth in property is not slow. In fact, I don’t know of anything that beats it, in terms of high returns and low risk.
Let me give you an example.
I was looking to buy a high-yielding income stream, in the form of a commercial property. I talked to an agent who was based in a town that depended almost purely on mining. Let me tell you more about this town.
It was hot, dusty, and no-one wanted to live there for pleasure. People only lived there for the work. Now, resource prices depend heavily on the world economy. Prices go up, and prices go down. Mines open, and mines close. A town like this depended heavily on the mines. The town was used to booms, and it was used to quiet periods. It was not exactly stable.
However, it was the major town in the area. It had a major port, through which all the resources would pass on their way out. Although it was at the effect of resources, it was much more stable than all the smaller towns around it. In quiet times, the smaller towns would almost disappear - but this town would just go a bit quiet for a few years. It’s been doing that for the last half-century.
3.1 Cap rate is related to risk
The reason I was looking in this town is not because I like heat, or dust, or instability.
The reason I was looking in this town is because it offered high returns.
Why did it offer high returns? Because of the instability I’ve talked about. If you bought a property here, and it went empty during a quiet time, you might have to carry it vacant for years. And it would be hard to sell. I don’t want to be stuck with a property which loses me money each month.
Going back to Cap Rate, which we talked about in part 2: one of the main things that affects Cap Rate is the level of risk, giving this rule of thumb:
The higher the risk, the higher the Cap Rate should be
Let’s look at this statement. Say I want to buy a $100,000 property. I’m looking at two shops, deciding which to buy:
- Shop A is in the middle of a busy city. The city has been steadily growing for decades, and retail space is scarce. If I lose my tenant, there will be a long line of people wanting to rent my shop.
- Shop B is on a quiet street in a small town that is heavily dependent on one industry. The industry has ups and downs. If I lose my tenant, the shop could be vacant for 12 months.
The shops both rent for $10,000 per year. All other things being equal, which would I buy?
Hopefully you said Shop A. After all, if they give me the same return, wouldn’t I go for the one which seems safer? Of course.
OK, let’s make it more interesting. What if:
- Shop A rents for $5,000 per year
- Shop B rents for $20,000 per year
Now we’ve got a real choice to make. Do we go for the lower rent with greater stability? Or do we go for the sky-high rent, but take the greater risk?
It depends on your own situation, and your own goals, but this does illustrate the relationship between Cap Rate and Risk.
Remember from last lesson, that
CAP RATE = --------------
In this example, Shop A is being valued using a Cap Rate of 5%:
ANNUAL INCOME $5,000
Shop A CAP RATE = -------------- = -------- = 5%
PURCHASE PRICE $100,000
Shop B is being valued using a Cap Rate of 20%:
ANNUAL INCOME $20,000
Shop B CAP RATE = -------------- = -------- = 20%
PURCHASE PRICE $100,000
So, because of its apparent risk, Shop B is being valued with a higher Cap Rate, meaning that a buyer would want a higher return, to be compensated for the greater risk.
Going back to my situation, this explains why I was looking to buy in this higher-risk town. I’m relatively young, I don’t have children, I’m still establishing myself. I figure if there’s ever a time to have a higher risk profile, it’s now. So I was looking for a higher return, and was prepared to accept higher risk. That’s why I was looking for property in a mining town. Notice that I still wanted to limit my risk - I was still looking in the big regional centre, not the smaller surrounding towns.
I don’t want to go into a big discussion about risk vs reward here. But the trend I’ve observed looking at other more established investors is that they tend to lower their risk profile over time. Initially, they maximize their borrowing, their profit, and their risk, to grow quickly. Once they’re wealthy enough, there’s no need to do deals with the risk they once considered quite acceptable. They lower their borrowing ratios, and they might look for lower returns, if it means getting really solid properties with a great location. They do this even if it means slightly lowering their profit on each deal.
I don’t advise you to go into risky deals. But if you’re interested in commercial property, you have to be able to deal with a certain level of risk. My best advice is to get educated as quickly as you can. Once you know the risks, you can decide whether the expected returns are worthwhile. The most dangerous risks are the ones you’re not even aware of.
3.2 What is a Fair Market Value?
Let’s go back to the story.
We phoned the agent in a mining town. We talked about what we wanted. We were looking for something which would give at least a 10% return, at a time when interest rates were about 5%.
Less than a week later, the agent rang us up and said ‘I might have something for you’.
I got out my pen and paper, and said ‘go ahead’.
He said: ‘There’s a sale that has fallen through. There’s a really nice pair of shops on the main street which are for sale. They rent pretty high, they’ve got good long leases, and I think they could be perfect for you.’
He gave me some more information:
‘Each shop rents for $700 per week. They have 5 year leases. The tenant also pays all outgoings.’
I pulled out my calculator did some quick sums. Two shops, that’s $1,400 per week. Over a 52 week year, that makes $72,800. And there are practically no other costs, because the tenant pays everything: insurance, rates, water, power, taxes, everything.
I came to the point: ‘What are they asking?’
‘Well, they’re asking $400,000. They just want to get out. They’ve done well out of the place, and that’s how much they need to build their dream house on the coast. They just want an easy sale, they don’t want a hassle, and they don’t want another sale that falls through.’
By now my feet had started dancing a jig under my desk - I hoped it was not to loud.
‘I might be interested. Can I get back to you tomorrow?’
‘Sure, get back to me tomorrow, but don’t take any longer because this will sell quickly,’ he said.
3.2.1 I Knew It Was Worth More Than They Were Asking
Now, I didn’t know exactly what the prevailing Cap Rate was in this mining town. But, this property was yielding 18.2% (72,800/400,000), and I knew the Cap Rate would be lower than that.
Did you get that?
They had priced the property as though the Cap rate was 18.2%. But I felt that the cap rate should have been lower than that. The result is, I felt the property was being sold under market value.
To cut a long story short, I decided to purchase the property, using a bank to get finance. The bank needed a valuation done.
The valuer said that prevailing Cap Rates for this sort of property, in this town, were 12%-15%. This was great news!
Using a 12% Cap Rate, the property value was:
ANNUAL INCOME 72,800
PURCHASE PRICE = ------------- = ------ = $606,667
CAP RATE 0.12
Using a conservative 15% Cap Rate, the property value was:
ANNUAL INCOME 72,800
PURCHASE PRICE = ------------- = ------ = $485,333
CAP RATE 0.15
So I knew the valuer (and therefore, the bank) would consider the property worth somewhere between $485,000 and $607,000.
The valuer came back with a value of $500,000.
Yet I was buying it for $400,000.
The day I bought that property, I made $100,000.
3.3 Stick a fork in me, I’m done
Now, if you think I was a bad guy, and that I ripped off the sellers, I can’t help you. You should get out of the property game.
Here’s how I look at it:
- The sellers were really happy to sell the property for the price they did. They made a lot of money. It allowed them to retire and build their dream home.
- No-one else was offering them more
- I paid as much as I was willing to pay for it.
- I took the risk. The town could have gone quiet, and left me with a vacant property.
This is truly a case of win-win, in my opinion. Some people think that there is no such thing as win-win. They think: for someone to win, someone else must lose. I’m the opposite - I believe that if someone loses, nobody wins.
Now there are many reasons why it is good to buy a commercial property significantly under market value.
The most important, is that it means I can get my money back out quickly, so I can purchase another property. The whole point (apart from the stream of cash a property like this provides) is that I can keep my Loan-Value-Ratio (LVR) low enough to buy another property.
I talk about this a bit more in part 4.
Also in part 4, I will give my take on the difference between investing for capital gain, and investing for cashflow. In the above example, the $100,000 is only on paper. It is not yet money in my pocket. As I’ll explain in part 4 - cashflow is extremely important. It is your lifeblood.
By the time I finish that, you will be ready for part 5, where the rubber hits the road. It will be time to see how YOU can start doing this.
3.4 UPDATE - 5 years later
Now, in 2008, that mining town has boomed. It’s because of worldwide demand for resources. I didn’t predict this - I just got lucky. Over the years, the rent has hardly changed. It’s now around $80,000 per year. But because the property is now more desirable, and considered much less risky, the valuer used an 8.8% cap rate for my last valuation. This gave a valuation over $900,000. ($80000/0.088)
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