Real Estate Investing, with Tony John

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 the final part.

Commercial Real Estate: How To Invest Like The Rich
Part 5: How Can YOU Get Started?
There’s such a difference between understanding something and living it. So, how do you start being a commercial real estate investor?

5.1 The Importance Of Prompt Action
I once spent a great weekend with about 400 people in a real estate course. The presenter kept drilling home the point: “You’ve got to get excited about it! You’ve got to open the paper, find interesting properties, and get on the phone. Start making calls!”

The course ended on a Sunday night. Afterwards, I flew home to the other side of the country, and looked at the local paper that evening. I had made an offer on a property by Tuesday morning. Within three months, I had purchased two properties (one residential, and one commercial - my first).

I would love to know what percentage of people at the course went home and actually put all their new knowledge into action. I suspect that it’s pretty low. A lot of people like to arm themselves with all the facts, all the knowledge, but then STILL DON’T ACT!

I tell you - I learnt a lot at that real estate course, but it was only the basics. You get to a certain point where the best way to learn is by doing it yourself. That is where the real lessons start.

I can’t stress how important it is to act on your new knowledge. Otherwise, it all becomes a memory, and you gradually talk yourself out of taking any action (or worse, allow other people to talk you out of it!)

5.2 Things That Will Stop You
When I began investing in commercial property, there were a lot of people around me who tried to talk me out of it.

My family, my friends, even some of my fellow investors, could all see ‘problems’ with the deals I found. The most common things I heard? “Why would you buy that?”, “You have to be careful”, “Do you know what you’re doing?”, and “That sounds risky”.

The thing is, I had very little personal experience to support my beliefs. I mean, everyone has to start somewhere. I was sure that the deals were good, but I couldn’t prove it. It really took courage to go against what well-intentioned people around me were advising.

Now, after investing in commercial property for a while, it is much easier. I haven’t gone bankrupt, I have money flowing into my accounts, and I continue to buy commercial property. Now, friends and family are more likely to say things like “well, you seem to know what you’re doing,” which is big difference, when you think about it!

But it’s really interesting to see how the human minds work. A lot of people just aren’t prepared to take action. Their reasons may change, but their actions don’t.

Take the shops I talked about back in Part 3. I’ve got a friend who, back then, said “There’s got to be something wrong with them. I wouldn’t buy those. There’s got to be a catch.”

Now, years later, when it’s easy to see that the shops turned out to be great deal, he says “Well, if I could find a property as good as those shops, of course I’d buy it. But you have to be lucky to find those. That’s why I havn’t bought anything yet.”

Now, what he’s telling himself is not actually true. These deals do come along, regularly. But when they do, he’s gripped by doubt and fear. In hindsight, when he’s missed the deal, he can see it was great. But put a great deal in front of him, and he can’t see it. Doubt and fear arise, and all he can see are the things that might go wrong.

Do you know anyone like this?

Are you like this?

If so, are you interested in breaking through this?

5.3 Learn To Talk The Talk
One of the most valuable things I can tell you is that you should learn how to ‘talk the talk’. This is not so you can sound like a big shot, it’s so you can converse with a seller and ask the right questions, and understand the replies.

My wife is a doctor. When we sit down and watch a medical show such as “ER” on TV, I’m always struck by how she understands much more of what’s going on than I do. She hears a doctor speak, and it makes sense. She picks up a lot of details that I don’t even notice. It’s because she’s trained in the field, she knows the jargon, so she can process the information as it comes in.

It’s the same with commercial property. As you get more and more familiar with it, you get better at spotting interesting details, that might go straight over other people’s heads. And spotting these might make the difference between seeing the bargain and completely missing it.

Gradually, you get to know the numbers. For example, if someone on the phone tells you the building rents for $15 per foot, it might not mean much to you. But if you know that all the similar buildings nearby are leased at $30 per foot, you might start to get excited about the chance to buy a property at half-price. That’s a possible bargain you wouldn’t be able to see if you were not familiar with the numbers. And you learn the numbers by making calls, and getting experience.

Here’s what I recommend you do in the next 24 hours: find the commercial section in your local paper, spot an interesting property, and get on the phone about it. See what the seller can tell you about it. Decide whether it sounds like a good deal, a bad deal, or a mediocre deal. I’m not asking you to go and see the property, I’m not asking you to make an offer. I’m asking you to take an action which will have you learn something new, leaving you more experienced than you are right now.

You see, something magic happens when you phone up about a property. You start hearing details that did not fit into the ad. The seller has a new job on the other side of the country, and is getting desperate; the seller is willing to lease back the building; the seller will do $20,000 of work on the building as part of the settlement; the seller is willing to help finance the property; the seller will defer settlement for 18 months; you start to get a feel about whether there’s a deal to be done. Your creative juices start flowing.

You’ll find that commercial property can actually be exciting!

5.4 Where To Now?
This is the fifth and final part of the course.

I certainly don’t expect everyone who has followed along for the last five parts to rush out and buy a commercial property by next Tuesday.

I once spent a fascinating evening talking to a guy who concentrated on doing property ‘wraps’. He told me that each week he put in more than 100 offers on residential properties, and usually bought several properties each month, way under market price.

While I could see that he made a lot of money using this approach, I decided that I was not interested in investing that way. Apart from the fact that estate agents got completely sick of him and his constant low-ball offers, it was practically a full-time job for him, and I did not want an approach which took that much time. So it was not for me.

Similarly, commercial real estate investment may or may not be for you.

But you should now be at a position where you can either say:

• “OK, I see how commercial real estate works - but it’s not for me”, or
• “OK, I get it, I’m excited - let’s get started!”

5.5 The Importance Of Education
If you’re serious about investing in commercial real estate, I recommend education, education, education. After all, a commercial property is a big purchase, so it is worth making the effort to educate yourself. I’m not talking about ‘analysis paralysis’, where you learn more and more and act less and less. But arming yourself with knowledge about commercial real estate is a smart thing to do.

I believe the best way to learn something, apart from doing it yourself, is to listen to and observe other people who have done it, or who are doing it. If I consider the people who have taught me the most, they are active and seriously wealthy commercial property investors. In general, they have come from ordinary families, and their fortunes are entirely self-made. That is what makes them so inspiring to me.

Actually, I believe the absolute best way to learn is to do it yourself. But in a serious venture like commercial real estate investment, it’s good to learn as much as you can before getting started.

5.6 It’s Important to Control Your Own Destiny
I want to tell you about an older couple I know. They retired a couple of years ago. They both worked really, really hard all their lives. They were very careful with their money - they have lived modestly, within their means, and they have carefully saved money all through their working lives.

In the last couple of years of their working life, they enlisted the help of a financial planner, to help them manage their money into retirement. Naturally, all of their savings quickly went into the Stockmarket.

Within two years, their savings were cut in half. Unfortunately, their financial planner put their money in some IT stocks, just before the IT bubble burst. Also, he put a lot of their money into “blue chip” stocks. But one of these had an accounting scandal, and halved in value overnight. And another blue chip stock put out a profit warning, and lost significant value. In fact, if you saw the list of the stocks they were in, it was a list of what not to own in the late 90s. Of course, that’s with hindsight - their financial planner was no fortune teller.

Half of their savings represented many years of working hard and saving carefully. And they lost that within about two years.

They recently nearly missed an important family funeral, because they simply couldn’t afford to travel to it. The rest of the family had to pitch together to help them attend.

As their financial planner told them: over the long run, the stock market generally goes up - any financial planner can tell you to ’stick with it for the long run.’ But that doesn’t help them in this case. The husband has developed some health problems, and needs expensive care. They’ve had to pull a lot of their remaining funds out of the market. With their money out of the market, they can’t recover the massive losses they took. They are going to live out their remaining years with very little money. In fact, the wife now bursts into tears whenever they talk about finances. And that’s after an entire lifetime of hard work, responsible saving, and using professional advice. It makes me feel very sad, and not a little outraged. How can good, responsible, hard-working people end up in this situation? It doesn’t seem fair.

I really want to encourage you to take full control of your financial future, so that for your family’s sake, you are not able to be completely sunk by outside forces. I believe commercial real estate is a very safe, secure investment - it’s what I’m banking on.

5.7 Stick a fork in me, I’m done
Well, we’ve covered a lot of information in this 5-part course. I really hope you’ve got some valuable information which will help you look at commercial property in a new light.

If you’ve followed along, congratulations! Remember, what we’ve covered so far is just the starting point of a journey which never really finishes. But you have to start somewhere, right?

I hope that you are inspired to build wealth in commercial real estate, and your financial future is improved because of it.

Until next time, then, remember: EDUCATION, AND TAKE ACTION!

Good luck!

Add to Del.icio.us

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 4.

Commercial Real Estate: How To Invest Like The Rich
Part 4: Cashflow or Capital Growth?
Some people think you have to invest either for capital growth, or cashflow. As though you can’t get both, so you have to choose.

With a lot of properties, particularly residential, this is largely true. If I look at my own residential properties, I have certainly got much larger capital growth on the low-yielding properties, than the high-yielding ones. Although I would point out that if you buy particularly well, you can get both.

One of the things I particularly like about commercial property is that it’s possible to get both.

4.1 Why Is Cashflow So Important?
Imagine you own a house, and it literally doubles in value overnight. Next morning, you walk into the kitchen for breakfast, a far wealthier person. But what actually has changed? Do you have nicer food in the fridge? Is there more money in your bank account? In your wallet?

Can you make your mortgage payment more easily?

While there’s no doubt that you are more wealthy, it’s purely on paper. You may well feel happier, but I’m asserting that it makes absolutely no tangible (ie real, physical, measurable) difference, until you ‘cash it out’, either by:

• selling the house, or
• refinancing the house

Until you get the cash in your account, your new wealth is purely on paper.

There are a lot of people out there (especially older, retired people who own their own home) who are sitting on enormous wealth but feel poor.

And no wonder - because unless you have the available cash to spend, you may as well be. If you can’t afford your groceries, you are living the life of a poor person - even if you own a nice house!

That belief drives my approach.

I use cashflow to experience wealth now, in the present. Not in 10 years, or 20 years, but this month. I have money pouring into my account every month, which is available for me to use as I see fit.

I don’t want to be sinking money into some big pit, hoping for a big payoff in the future. I’ve got my government-mandated retirement fund for that!

I want cash returns now.

There’s another very important reason I want cashflow: to pay my interest bill! As I said way back in part 1, my personal salary cannot pay for the properties I own. This salary limitation is what prevents most property investors from continually growing their portfolio. They invest in cash-losing properties, chasing capital growth, but there are only so many of these that they can afford to pay for each month!

Now, some people get uncomfortable about this. “What if you lose your tenant?” they ask. Well, if I just had one tenant, this would be risky. But the more properties, the more different tenants, the less important any individual tenant becomes. I could lose any tenant tomorrow, and still meet all my interest payments. Excess cashflow gives additional safety, when things go wrong. Excessive cashflow has me sleep well at night.

4.2 Why Is Capital Growth So Critical?
Now, after raving on about cashflow, you might think that I don’t care so much about capital growth.

In fact, I care about it a great deal. Capital growth is critical for me to keep growing my portfolio at the rate I want.

I use capital growth to “jack up” my cashflow. Look at the following example.

My bank will generally lend me 70% of the value of commercial properties. To keep the numbers neat, pick some example numbers. Imagine I own $1,000,000 of commercial property, and the bank has lent me 70%, that is $700,000. I have $300,000 equity.

Now, imagine I want to buy another $500,000 commercial property. The bank will lend me 70% ($350,000), but that still means I need to come up with $150,000.

Where does that money come from? How do I buy this new property?

Well, there are lots of possibilities of where that $150,000 could come from. But ignoring anything too creative, let’s just consider that I have to come up with $150,000 that I don’t have. I decide that I want to get it out of the existing portfolio.

Then there are two possible ways to do it:

• Cashflow: I save up $150,000 from my existing rental income
• Capital Growth: My property grows 15% (from 1 to 1.15 million).

Of course, I can use a combination of these sources.

It would take me too long to save up the $150,000 from excess rental cashflow. Especially when I was planning to use a lot of that cashflow to fund my lifestyle.

But 15% capital growth is not too hard to get. Therefore, I use capital growth to fund future purchases, making sure that each purchase brings in additional cashflow, to make my position safer.

I’ve found that holding some well-selected residential properties can also be a good way to get capital growth. But my approach is different from a lot of other people’s. When the property goes up in value, I refinance it. But rather than take out all that tax-free money and putting it in my pocket, I put most of it back into another property - usually a commercial property. Sure, I pocket a bit of it - that’s my reward for investing wisely. But most of it goes as equity to fund my next commercial property.

The new commercial property gives me:

• another boost in cashflow.
• an additional property which will appreciate, and give further capital gains.

When I get the additional capital gain, then I refinance again. In this way, I can keep ‘jacking up’ my portfolio, funding it via capital growth. Residential property is not strictly necessary for this strategy, but I find it fun to own some. Maybe I’ve got too much time on my hands.

4.3 How Do I Get Capital Growth With Commercial Property?
The conventional wisdom goes:

• high cashflow properties have low capital growth
• low cashflow properties have high capital growth

This means, when you go to invest, you must decide: am I investing for cashflow, or capital growth?

I also hear people say:

• commercial property gives you cashflow
• residential property gives you capital growth

This is too simplistic. It’s not generally true at all.

Certainly I have seen some spectacular growth in residential properties. But you can get excellent capital growth on commercial property - something a lot of people don’t realize.

Some great ways to get capital growth are:

• buying under value.
• increasing the cashflow from the property.

4.3.1 Buying Under Value
I gave an example of buying under value last time in part 3. This can give you a big capital growth on day 1.

4.3.2 Increasing the Cashflow
There are various ways to increase cashflow from a commercial property. Most commonly, you increase the cashflow by increasing the rent, or finding a new tenant, or subdividing the property into smaller, lettable areas, renting each at a higher rate.

Usually, your lease only allows you to increase the rent a small amount (a few percent), which, provided the Cap Rate stays constant, gives only modest growth. I have some commercial properties whose rent-reviews are tied to the nation’s overall economic growth, which gives me a growth of only a few percent per year in the current low-inflation environment.

But you can make a lot of money by purchasing properties whose rents are below market, then raising the rent to market level at the next review. If you double the rent of a commercial building, you may have doubled its value. It’s pretty rare for residential properties to get this kind of growth. So don’t let people tell you that commercial property doesn’t give any capital growth.

4.4 Stick a fork in me, I’m done
Now I’ve explained how I look at capital growth and cashflow.

As you’ve seen, cashflow if very important to me. It’s like air - I need it to survive. Cashflow is how I pay the bank. It’s how I pay myself. It’s how I pay for unexpected costs. It stops me getting into trouble. It provides a safety buffer.

But I don’t ignore capital growth. But the way I treat capital growth is different to many investors I speak to, so I need to emphasize:

I don’t use capital growth to ‘cash out’ and put in my pocket directly. I use it to purchase additional cashflow-positive property, to increase my cashflow.
Capital growth jacks up cashflow. Cashflow is king. Capital growth is secondary. I get it, I take some of it, and I convert the rest to more cashflow.

In part 5, the final part of this course, we start talking about YOU. How do YOU get started in commercial property. What actions do YOU need to take now? See you then…

Add to Del.icio.us

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

            ANNUAL INCOME
CAP RATE =  --------------
            PURCHASE PRICE

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)

Add to Del.icio.us

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 2.

Commercial Real Estate: How To Invest Like The Rich
Part 2: Capitalization Rate

WARNING: In this part, I will show a formula. A physicist called Steven Hawking once said that each mathematical equation you insert in a text will halve your readership. You may have to work through this part twice.

My promise is that it will be worth the effort.

Understanding capitalization rate gives you a way to quickly tell whether a deal is:

• an exceptional deal
• a mediocre deal
• a dog

The other incentive I’ll give you is that I promise the following part, part 3, will be much lighter. In part 3, I will show you how I used my understanding of capitalization rate to make $100,000 in a single day!

2.1 The Money-making Machine
You walk into a quiet old shop. In the darkest, dustiest corner, you see a little machine, looking a bit like a pump. It probably hasn’t been cleaned for years. It might be a piece of junk. It doesn’t look like something that would be valuable.

Out of curiosity, you ask the owner what it is. He smiles, and says:
“Most people don’t notice that thing. That there is a money-making machine.”

You nearly walk out of the shop right there, but you’re in no hurry, so you let the owner continue.

He starts it up and gives a demonstration. Sure enough, despite some noisy rattling and clanking, dollar bills start flying out of the nozzle.

Picking one up and examining it, it looks real.

The owner shows you a certificate from the government, indicating that this machine complies with all requirements, and that any dollar bill it produces is legal tender. He shows you sworn statements from valuers, saying the same thing. It truly is a money-making machine.

He shows you his records, which show that, after the costs of operating and maintaining the machine are taken into account, it makes a profit of $10,000 each year.

He tells you that the machine is guaranteed for life. And it is for sale.

By now you’re excited by this machine. You ask him how much he is selling it for.

The owner looks at you for a while, smiles and says:
“Make an offer.”

2.2 How much is an income stream worth?
The above story may sound ridiculous. But I want you to know, it’s not far from the truth. They don’t look like I described, but open your real estate section each weekend, and it’s full of money-making machines. You just have to start to see them for what they truly are.

Forget about the details: how much parking it has; what type of carpet it has; whether it needs paint; what business is carried out inside it. What would that property be worth if you looked at it purely as an income stream?

So, I come back to the question, if someone offered you an income stream of $10,000 per year, for the rest of your life, how much would you pay for it?

I don’t want you to get caught up in details, like the time-value of money or whether the money is yours or the banks, or anything else. Assume the income stream goes up in line with inflation. This is not a trick question. I’m just asking you, ignoring other factors, how much would you pay for this income stream?

Would you pay $50,000 for it?
Would you pay $100,000 for it?
Would you pay $200,000 for it?

Now, I don’t really mind what answer you came up with.

At the moment, I just want you to see that there is a direct relationship between what you would pay for it, and the return it would give you. If you paid:

• $50,000, you would get a 20% return on your money each year (10,000/ 50,000 = 0.20)
• $100,000, you would get a 10% return on your money each year (10,000/100,000 = 0.10)
• $200,000, you would get a 5% return on your money each year (10,000/200,000 = 0.05)

The return, also called the yield, changes depending on the purchase price.

The less you pay, the higher (better) the yield.

We’re half-way there.

2.3 Capitalization Rate
We’ve seen how the purchase price directly affects the yield you would get from the income stream.

Put another way, the amount you would be willing to pay for the income stream is directly related to what sort of yield you want to get. If you wanted a:

• 5% yield, you would pay $200,000 for a $10,000 per year income.
• 10% yield, you would pay $100,000 for a $10,000 per year income.
• 20% yield, you would pay $50,000 for a $10,000 per year income.

Well, this brings us to the capitalization rate. There are various definitions of capitalization rate (or Cap Rate, as I will call it from now). Here is one:
“The rate of interest which is considered a reasonable return on the investment.”

Remember I said there would be a formula? Well here it is:

            ANNUAL INCOME
CAP RATE =  --------------
            PURCHASE PRICE

In real terms, it gives a way to value an income stream according to the return you want. Another version of the same formula, which I find more useful, is:

                  ANNUAL INCOME
PURCHASE PRICE =  -------------
                  CAP RATE

This formula allows me to take an income stream, specify what cap rate I want, and come up with an amount I would pay.

So, going back to the $10,000 income stream. If you were prepared to accept a:

• 5% yield, you would value the stream using a 5% cap rate, giving a purchase price of (10,000)/(0.05) = $200,000
• 10% yield, you would value the stream using a 10% cap rate, giving a purchase price of (10,000)/(0.10) = $100,000
• 20% yield, you would value the stream using a 20% cap rate, giving a purchase price of (10,000)/(0.20) = $50,000

And that is how the capitalization rate works.

2.4 So, how much would I offer?
Well, if you’ve absorbed everything up to here, you’ll know that I can come up with a purchase price as long as I can define what cap rate I think is appropriate.

Now, you’re probably wondering, how do I come up with a cap rate? Well, that is the million-dollar question. I briefly touch on this in part 3.

Well, to figure out a cap rate, let’s look at some alternatives I could do with my money.

a) Put it in the bank
Interest rates are always changing, but last time I looked, my bank will pay me 5.45% on my money. I figure my bank is pretty safe. So I want to get at least 5.45% from buying the money-making machine, otherwise I may as well just put my money in the bank.

b) Invest in a mutual fund
My mutual fund is telling me that they’re averaging a 7% return over the last 5 years. But there’s no guarantee of future performance. I figure my money-making machine is safer than my mutual fund.

Let’s say I want a higher return than my mutual fund’s average. I am willing to accept an 8% yield. That way, I have a return which is both higher and safer than my mutual fund.

This means I would be willing to purchase this income stream for

                  ANNUAL INCOME     10,000
PURCHASE PRICE =  -------------  =  ------ = $125,000
                  CAP RATE          0.08

Notice that the higher the cap rate I choose, the cheaper I get the income stream. So why not choose a higher cap rate? Why not choose 25%? Why not choose 100%?

The answer is that the seller has to agree on the purchase price, which is exactly the same as agreeing on a cap rate, even if the seller doesn’t know what a cap rate is.

2.5 Bonus Question to Consider
Why would anyone sell a money-making machine?

2.6 Stick a fork in me, I’m done
So ends part 2 of my 5-part mini-course. You have just seen how a magic number called the cap rate can be used to place a value on a stream of income.

You’ve also seen how this can be a useful basis for working out the value of a commercial property.

What’s next? Well, that’s enough of the dry theory for now! With residential real estate, we’d already be talking about the details - painting, fixing the toilet, ripping up the carpet. Here I’m talking about a strange number called Cap Rate!

I mean, what’s going on? Forget commercial real estate - it’s too hard. And it’s probably for people who are already rich!

If that’s what you’re thinking, I apologize. It’s just that sometimes you need to cover the basics before you get to the interesting stuff. You see - you haven’t been wasting your time. Understanding the Cap Rate can really help you to unearth hidden bargains and make a lot of money.

So next, in part 3, I’m going to give a real-life example - an actual deal I did. I’ll give real numbers, and show how I used knowledge of the Cap Rate to make $100,000 in a single day.

Now, I’m not telling a story like that just to blow my own horn - in fact, I’m worried about mentioning actual amounts, because I don’t want people to think ‘oh I could never do that!’ The fact is, you could.

Later in this course (part 5, to be exact), I’m going to talk about how YOU get started. That’s where the rubber hits the road.

But for now, well done on hanging in there. This has been a tough lesson. Part 3 will show you why we bother learning all this stuff. So, catch you next time.

Add to Del.icio.us

In 2005 I wrote an introductory course on commercial real estate investment. This 5-part course was received via email in daily installments. On re-reading this course, I can see that my thinking has shifted slightly over the last few years. For example, in this course I explain that I like to hold both residential and commercial real estate, whereas today I prefer to hold a pure commercial portfolio. Having said that, I still stand by the contents of this course. Many readers have written to me that they found this course to be a useful starting point with commercial real estate investment. Let’s begin! Here is Part 1.

Commercial Real Estate: How To Invest Like The Rich
Part 1: Why Commercial Property?

There’s a lot of money to be made when you invest in commercial real estate. I believe it is the key to creating streams of cash which automatically flow into your bank account, month after month.

Yet, if you’re like most real estate investors I know (including those of you who are not investing right now, but plan to in the future), you’re looking exclusively at residential housing, and are not considering commercial real estate for yourself.

Later, I will show you just how much money you can make with commercial real estate. But for now, let’s look at:

• why most people don’t invest in commercial real estate
• why YOU should!

1.1 Why don’t people invest in commercial real estate?
I strongly believe that we learn from people around us - our family, our friends, our colleagues, and so on. Truth is, not very many people invest in commercial real estate. This means that the rest of us just don’t get exposed to it.

1.1.1 Pre-conceived Notions
Because we’re not exposed to it, we are stuck with pre-conceived notions about commercial real estate, which prevent us from ever considering the possibility of owning it. Some of these notions (or superstitions) are:

• commercial real estate is only for rich people
• commercial real estate is risky
• commercial real estate is boring (who wants to own a shed, when you can own an apartment with a water view?)
• commercial real estate is complicated

Well, this course will clear up any misconceptions you might have.

1.1.2 Lack of Familiarity
Like I say, we’re just not familiar with commercial real estate. Most of us grew up in a house or an apartment. We know what they are, we are comfortable with them. But we don’t feel the same familiarity with a commercial property.

But in fact, you’re already way more familiar with commercial real estate than you think. Every time you walk into a shop, a mall, an office, or a warehouse, you’re walking into a commercial property.

I promise you, you are going to start noticing commercial property more and more after you finish this 5-part course. You’ll notice when they’re for sale, you’ll notice when they’re for lease, and you’ll find yourself driving past shops and industrial buildings, and wondering who owns them.

1.1.3 Lack of Information
When I go into my local bookshop and go to the investment section, I see a mountain of good, bad, and indifferent books dealing with residential real estate. But there is almost nothing available out there on commercial real estate.

The last time I actually found a book about commercial real estate, I immediately bought it, without even looking inside. But when I took it home, I was very disappointed. It was written by a man who had NEVER purchased or owned a commercial property. His ‘research’ consisted of talking to a few people who had done it. In his conclusion, he said that he was now ‘planning to buy something’.

In one section, he listed a whole lot of ‘rules’ for buying commercial real estate. If I had read his book first, I never would have bought anything! I think I broke all his major rules with the first property I bought. Yet I’m still alive, and making money!

Some expert, huh? The same man had written a book about the stock market. I found myself wondering if he had ever bought any stocks!

So, you have to be careful who you listen to. There aren’t many knowledgeable people talking about commercial real estate. A lot of the people who really know about it are too busy to write about it!

1.1.4 Expensive
A second reason that we’re not familiar with it is that commercial real estate can get expensive very quickly. Now I want to clear up any concern you might have about this straight away.

There’s a big belief out there that commercial real estate is only for the rich. Well, it’s just not true. If I look in my local paper, I find a lot of commercial properties under $100,000. I find some storage sheds for less than $15,000! Given that you should be able to borrow 70% of the purchase price, and there are some creative ways to come up with the other 30%, the entry cost into commercial real estate may be much lower than you think!

I started, and still operate near this lower end of the market. The average value of my commercial properties is around $500,000.

There are people, companies, groups, trusts who regularly purchase properties for $5 million, $10 million, $50 million, and higher. I am not in that category yet. I love Donald Trump - I always find him really interesting to listen to, and also I think he’s a funny guy, whether he means to be or not. I really admire him. But I’m not sure that when he talks about real estate, the average investor can listen without tuning out, and having their eyes glaze over. He talks about deals which are so big that the average investor just shuts down their brain.

So there are not many people at the lower end who are taking the time to talk about what they’re learning, and what they’re doing.

1.1.5 Requires Mental Leap
That’s where I come in. Like most property investors, I started off investing purely in residential real estate, because it was all I knew about. After educating myself some more, I switched (and I believe it took a mental leap) to commercial real estate. Now I invest in both. I find it really useful to hold a mixed portfolio. I talk more about how why I hold both residential and commercial in part 4 (hint: it’s to maximize how quickly I can buy my next property).

1.2 Why should YOU invest in commercial real estate?
There are a number of reasons I think it’s worth considering commercial real estate.
1.2.1 Higher Cashflow
In general, commercial real estate provides higher cashflow.
For example, based on their current valuations, across my portfolio:

• my residential properties yield an average of 6.1%.
• my commercial properties yield an average of 11.5%.

Clearly, my commercial properties return more cash, for the given capital value. Now, the actual returns I’m getting are much higher than that, because I purchased them at lower prices, plus I’m using mortgages to give me more leverage. But I talk about that later in the course.

This is true in general. While actual amounts will vary, commercial real estate generally provides a greater rental for the same purchase price than residential.

That’s more money in your pocket!

1.2.2 Longer Leases
Usually, my residential tenants can leave within a week or two of giving notice, leaving me with an empty property, and the task of finding a new tenant.
Not so with commercial real estate - I’ve locked those guys in for years!

1.2.3 Tenant Pays Costs
For my residential properties, I have to pay a lot of additional costs:

• water
• insurance
• rates & taxes
• maintenance

One of my houses even has a poorly constructed pool. I just got a bill for $7,000! That wiped out most of the income I was due to receive from rent for the entire year. I am regularly paying plumbers, electricians, handymen, to fix all sorts of problems.

With my commercial properties, the leases specify that the tenant pays all outgoings.
Every time I get a bill, I just put it on the fax, straight to the tenant. The only bill I personally pay is the insurance (I don’t want to risk the tenant forgetting to pay it). But I make sure I pass the expense directly onto the tenant.

Also, the tenant has a much greater incentive to keep the property in good shape. If the painting looks poor, a door falls off its hinge, usually the tenant rushes out and fixes it without even telling me. Why? Because:

1. the lease specifies that it is the tenant’s job
2. the tenant is trying to run a successful business, which often includes attracting clients and customers. Having attractive premises is more important to the tenant than to me!

1.2.4 Stronger Legal Position For Landlord
Residential tenants are usually covered by government laws, which cover how long they can avoid paying rent before you can take action. Often, these laws have been written to prevent nasty, greedy landlords from taking advantage of poor battling tenants. After all, you’re dealing with people’s lives.

With commercial properties, your tenant is more often a company, although you may have personal guarantees from individuals involved. Commercial Leases are usually drafted in a way that protects landlords. With my shops, for example, if my tenant falls two weeks behind in rent, I can lock them out of the building, and start selling the contents of the shop! Try doing that with a residential tenant! That would be called stealing.

I can charge penalty interest if rent is otherwise late. If I have to take legal action (eg writing a letter) to recover money, then tenant has to pay my costs. The leases are structured so that the tenant has a huge incentive to stay up-to-date with all his obligations. I recently had a tenant who had to re-mortgage his house so he could continue to pay what he was contracted to pay me.

This might sound nasty, but it’s not. The tenant has entered into a legal contract with me. It is their job to pay what they owe me. It’s nothing personal.

I sleep better at night having a thick lease in my filing cabinet which protects me from tenants who would avoid paying rent.

1.2.5 Easier To Purchase Significantly Undervalue
I give a great example of this in part 3 of this course, where I bought a property for $100,000 less than market value. And the seller was completely happy!

My personal approach is that I always want the seller to be happy with the price I pay. I don’t want to leave them feeling ripped off, or like I’ve stolen from them. I’ve found with residential properties, the seller likes to haggle over every single dollar. On the other hand, with commercial real estate, often the seller has very different concerns. They might not even bother to haggle about tens of thousands of dollars. This may sound unbelievable, but it’s true.

1.2.6 Play A Bigger Game
I found that looking at commercial real estate has changed my relationship to money.

When I used to invest exclusively in residential real estate, at the back of my mind I used to consider whether I, personally, could pay the mortgage.

Now, with commercial real estate, I owe bigger amounts. Each year, my interest bill to the bank is much higher than my personal salary! That means that there is absolutely no way I could pay the interest on these properties myself. I absolutely depend on the rental income each property generates.

When I first had more debt than my salary could pay, something ‘clicked’ in my head. I suddenly realized that there were no more limits to the size of property I could own. I began to realize that I could hold any size property, so long as it reliably generated more income than it cost to hold it.

My game changed from ‘how much property can I afford’ to ‘how much can I get the bank to lend me?’ If you’re not used to debt, and are not comfortable with this idea, don’t start worrying yet. As this course continues, I will keep speaking about it, and you might find yourself getting used to the idea. In fact, you’ll see how the more properties you own, the safer your position becomes.

1.3 Stick a fork in me, I’m done
That’s the end of part 1 of my 5-part mini-course. I have just shown you why I think commercial real estate is worth considering, even if nobody you know is talking about it.

When you start investing in commercial property, it is certainly a different game. But if you’re reading this, you’re up to it.

Next I will talk about a magic little thing called capitalization rate. This little number is the key to finding telling good deals from mediocre deals.

Add to Del.icio.us