What if I told you that you could make one powerful maneuver to double the value of your real estate equity?
Would you call me a snake oil salesman? Contact the SEC? Claim I’ve been eating too much semi-boneless ham?
Well hold on, because I’m going to try my best to prove this claim!
In the past, I posted an article explaining how to use cap rates to determine the value of commercial real estate. In it, I pointed out that a seemingly small swing in cap rate can result in a large swing in value. And when using debt, this can turn into an even larger change in equity.
This was perhaps an understatement, and I’m about to show you why.
No matter how often I do these calculations, I’m amazed at the power of the value formula in increasing asset value and growing the wealth of commercial real estate investors.
I feel a bit like Einstein as I think about this topic. Though he had a lot to be in awe of as he gazed through his telescope and his microscope, he reportedly proclaimed that compound interest was the Eighth Wonder of the World.
This is a pretty huge statement for such a genius to make. And as we look at the power of the value formula in commercial real estate and consider the muscle behind it—the cap rate—we may as well proclaim this formula as the ninth!
Let’s see if you agree.
The Value Formula in Commercial Real Estate
We’re all familiar with how residential real estate is valued. It is primarily based on comparable properties, or “comps.” You may be Chip and Joanna Gaines, Jr., and spend a boatload on beautifying your home. You may have half a million in it. But if the other homes on the street sell for $300,000, it’s unlikely you’ll get your price.
Commercial real estate doesn’t operate in the same manner. The following is important to keep in mind.
Residential real estate is limited by the comps.
Commercial real estate is valued very differently. You can actually force appreciation.
And there are actually multiple ways to force appreciation. Let me explain.
The value formula for commercial real estate is as follows:
Value = Net Operating Income ÷ Cap Rate
The definition of cap rate (aka capitalization rate) is the annual return from operations that an investor would expect to receive for a certain asset in a specific market at the current time, if the asset were to be purchased for all cash.
So, to force appreciation in commercial real estate, we need to either:
- increase net operating income (increase the numerator)
- or compress the cap rate (decrease the denominator)
And if we can do both, that’s even more powerful.
How Do You Pull This Off?
My team and I invest with an operator named Brian who has owned and managed commercial real estate for over four decades. He is one of the most knowledgeable business pros I have ever met.
Now in his early 70s, you’d think he would be enjoying life at his Southern California beach house while others do the hard work on-site. He certainly could afford to do that.
But Brian spends 48 to 50 weeks out in the field. His company owns and operates self-storage facilities and mobile home parks throughout the U.S.
He and his team of V.P.s leave the office midday every Monday to board a private plane. They hop from one asset to another, covering multiple locations almost every day and returning home on Thursday evenings.
I’ve met with many of their employees and visited five of their sites. Their staff is happy and loyal.
Their five core executive team members have been with the company over 30 years. And their facilities are required to meet a standard they call “Disneyland clean.”
One of their smiling managers apologized to me for a handful of leaves that had just blown into the parking lot. It was a windy day, and he had already cleared the leaves off twice—seriously.
Check out this photo from one of their self-storage facilities in Austin. It looks like an artist’s rendering, but it’s really that clean:
If you ask Brian what he’s doing as he travels from site to site, he’ll tell you he’s looking to pick up money everywhere he stops. His goal is to find every conceivable way to add a dollar to revenues—or save a dollar in expenses.
Why a dollar?
The Power of a Dollar in Commercial Real Estate
Imagine you own a commercial real estate asset. It may be a 100-unit apartment complex, or a 300-unit self-storage facility, or a mobile home park. (Three of my favorites.)
And imagine you find a way to raise the net income just $1 per month. That may be by raising revenue by a dollar or decreasing costs by just one dollar.
This dollar per month translates to $12 per year. (My mama always told me I was good in math.)
A measly $12 in annual income may seem like a small thing. But how does that translate to the value of the asset?
Let’s use our value formula and find out.
To reiterate, the value formula is:
Value = Net Operating Income ÷ Cap Rate
Cap rates have been running in the 5 to 7 percent range for typical commercial assets these past few years—sometimes even less (which equates to higher prices). Let’s assume 6 percent for our example.
Increased Value = $12 ÷ .06 = $200
You may be thinking, “Wait, Paul… are you saying that a $1 increase in income could result in a $200 increase in value?”
Yep, that’s exactly what I’m saying.
But it’s even better than that. That’s just the impact on the asset value. But the impact on the equity is even more powerful.
When leveraging an asset at, say, a 60 percent loan-to-value (LTV), the impact on the equity is effectively two and a half times that.
The impact on equity value is calculated like this:
Impact on Equity Value = Asset Value Increase % ÷ (1 – LTV %)
So, X ÷ (1 – 0.6) = 2.5x impact. (I’ll give you an example of this in a moment.)
This is where we get into the Ninth Wonder of the World territory.
So, to clarify, let’s take a brief look at an example based on an amenity at a mobile home park we just invested in. This is only an example, and a few of the details have been changed to simplify the math.
This mobile home park was recently acquired for $5 million. With 60 percent LTV debt, the operator got a $3 million loan, which means that investors put in $2 million in equity.
The park was not well run before. There was a good bit of clutter, extra cars, and some other things that needed to be addressed.
The new operator decided to pave over an acre of weeds toward the front of the park and fenced it in with a nice gate. The residents were informed that they needed to move their third and fourth (any above two per home) vehicles—including cars, boats, RVs, trailers, etc.—to this secure lot.
Of course, this presented an opportunity to introduce new fees. Plus, once all residents have complied, the operator will advertise the leftover space to the community. There is often a need for paid boat and RV storage, especially since many neighborhoods don’t allow it.
The cost of this project was only about $100,000. When full, this lot will rent for about $10,000 per month.
How does this translate to asset value—and more importantly, the value of the equity?
$10,000 per month x 12 months = $120,000 per year
(Note that is a 120 percent annual ROI on the cost of the paved lot.)
$120,000 (Net Income) ÷ .06% (Cap Rate) = $2,000,000
Yes, you read it right. A $100,000 upgrade resulting in $10,000 in monthly income could potentially result in a $2,000,000 increase in asset value.
How Does This Impact Investors?
If this theoretical exercise plays out at the time of sale, the $5 million value just went to $7 million—a 40 percent increase in asset value.
Recalling the impact on equity formula, let’s apply the above numbers.
40% ÷ (1- 0.6) = 2.5x Impact = 100%
So, the equity goes from $2 million to $4 million, or a 100 percent impact on equity, meaning the equity doubled in value.
Do you see why I say the value formula in commercial real estate investing might just be the Ninth Wonder of the World?
Compressing the Cap Rate
I’m dedicating the rest of my career to investing my time, talents, and treasures into the commercial investment arena. It’s a lot easier than beating my head against a wall trying to find the next flip deal or building a single family rental portfolio.
I started this post promising to tell you about the power of compressing the cap rate. But I thought it was important to tell you about the foundation for why this works. Then I got all excited talking about the value formula. (Will you forgive me?)
But now let’s finally do a quick example to demonstrate the power of compressing the cap rate. Please note that I am not saying this is a realistic example or that you could necessarily replicate it. I am simply trying to point out what the movement in the cap rate alone can do to value and equity.
To make this fun, let’s assume you purchase a self-storage facility from a mom-and-pop owner/operator. Assume that this asset is in the path of growth and that you have a relationship with a REIT that is hungry to buy these types of facilities in this specific area.
This REIT knows that Amazon HQ3 will soon be located right across the street, and they are desperate to get a facility like this. (Hey, don’t accuse me of being realistic!)
You buy the storage facility for a 7 percent cap rate, which means based on the current income and price, you expect a 7 percent annual ROI if there was no leverage (which is how the cap rate is calculated).
If you could turn around and sell that facility to a REIT at a 5.5 percent cap rate, what would the asset appreciation be? Maybe higher than you think?!
Let’s say the trailing 12-month net operating income was $300,000. So, at a 7 percent cap rate, you paid $4,285,714 ($300,000 ÷ .07).
Now, without increasing the income, you are selling it to the insider REIT for a 5.5 percent cap rate. Your sales price is $300,000 ÷ .055 = $5,454,545.
This is an increase of $1,168,831, or about 27 percent. This is a nice appreciation at the asset level.
But what if you had this asset leveraged at 75 percent LTV? In this case, you would have a loan of $3,214,286 on the property and your own cash (equity) in at $1,071,429.
You just added $1,168,831 (less any transaction costs) to your equity of $1,071,429. You just doubled your money.
And that didn’t even include the long list of ways that you could increase your income (the numerator in our formula). Some of these strategies might include:
- raising rates
- selling locks, boxes, and tape
- adding truck rentals
- adding insurance and late fees
- adding more rentable storage
- adding cost savings measures, like LED lights
- so much more
That’s the power of a “small” change in cap rate. That’s the power of commercial real estate.
Of course, this cap rate swing can work against you, as well, so it’s imperative to avoid overpaying for an asset.
And beware of the gurus who say, “It’s different this time.” Or those who say, “This cap rate compression has no end in sight.”
Haven’t we heard that all before?
We just talked about two different ways to double your equity using the commercial value formula: through increasing the net operating income or through compressing the cap rate.
Imagine what you could do for your equity by using both strategies to improve one asset!
These are the types of opportunities that professional operators look for. These are the types of deals I look to invest in. Do you see why?
Your children and their children will thank you if you get this right. You could be on the path to generating true multi-generational wealth.
I should have known there was a reason that most of the Forbes 400 invest in commercial real estate!
Have you discovered the power of the value formula in commercial real estate? How have small changes in cap rate impacted your asset value? And your wealth?
Let’s discuss in the comment section!