Commercial Real Estate Course - Part 4
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…