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 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.

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