When people ask me why I prefer commercial property — specifically apartments — to residential SFR, my answer typically goes something like this:
The value-setting mechanism in the single family marketplace is a function of something called Comparative Market Analysis (CMA). The fundamental logic of CMA aims to estimate value of subject property by comparing and contrasting it to like-properties that have sold.
This is to say, if 10 3/2 houses in this neighborhood have sold in the past six months in the range of $225,000 and $245,000, then most likely the subject will fit somewhere within this range. And from here, by looking more specifically at age, condition, and amenity package, we are able to narrow the projected value even further.
CMA is not what this article is about, and the only reason I am telling you this is to emphasize the fact that the controlling ingredient of value-setting is the marketplace; it is what people are willing to pay and have paid for this type of house in this location, and there is nothing much that you as an individual investor can do to drive the value. Indeed, all you can do is buy below the intrinsic value and then drive toward that value.
By contrast, as it relates to income property, the value is a function of income, on some level at least. It is generally thought that the reason we buy income property is to benefit from the income. Therefore, it seems as though the more income the income property is capable of producing, the more the property should be worth.
Such is the common wisdom, and in a lot of ways this is not wrong. However, there is one large caveat — let’s examine.
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Value of Income
Understand, all investors do not value income in the same way. All of us have differing opportunity cost that revenue streams are discounted by.
If you are willing to deploy capital for a fourplex generating NOI of $10,000/annum, so long as you achieve at least a 10% return, then at least in principle, you would be willing to pay $100,000. In your world, 10% return is acceptable means of compensation for the effort of underwriting, procuring financing, closing, and overall ownership of said fourplex.
However, if you asked my friend Brian Burke, he’d tell you that while 10% may be respectable, the fact that the end result is a mere $4,000 of cash flow (if you’re lucky) renders this deal worthless to him. You see, Brian has much more efficient ways of creating $10,000 of value in his life than messing around with a fourplex, and therefore he is not at all interested — at any price. In other words, he needs another fourplex about as much as a dog needs five legs, and therefore this opportunity capitalizes for Brian to exactly $0. Not worth anything.
Note: This doesn’t make it a worthless project intrinsically. But it is worthless to Burke. That 10% return you need more than anything, Burke discounts to less than zero. Must be nice (don’t hate him).
If you talk to Serge Shukhat, he’ll tell you that he’ll buy it for half price. (I think I know Serge pretty well, and I’m pretty sure that’s exactly what he’ll say.) He is not quite as diversified as Brian in terms of businesses and real estate across several states, but he has long reached the point of diminishing returns on average deals nonetheless.
As such, in order to get Serge out of bed in the morning — get him to go pee and wash his hands, get him to turn on his computer, and get him to use two of the many available curvatures of his brain to consider your proposal — you’ll have to do a whole lot better than 10%.
As for me, I am known for doing few deals because even when I was really, really hungry, I was still lazy (you believe that?). Seriously, I do few deals because I pick the absolute best deals since my expertise is in creative finance and 100% finance, and there are very few assets out there that can support what I do.
Besides, while I have much respect for real estate, I just don’t like it that much unless it makes money and saves me from paying taxes. So unless it’s pretty much a guarantee that it can do that, I don’t buy. Well, a fourplex with $10,000 of NOI and $4,000 of cash flow on a good day just don’t get me excited.
Though, having said this, I am closer to Serge than Brian — I’ll buy it for the right price.
Your best bet is my dear friend Brandon Turner, the guy you know as a real estate extraordinaire, author, and all around good guy. I simply know him as the dude that buys Waldos, so this fourples is right up his alley. :).
Besides, with his first-born on the way (congratulate him if you haven’t yet), he sure needs the money. He absolutely needs to trade in his Toyota Prius for a nice Tesla. He’ll buy the fourplex and use the cash flow to make a third of his payment!
On second thought, Brandon’s been hanging around me for too long, so forget it.
Do you see my point? All of us see the same income stream, but all of us discount it differently. So, exactly what is the cap rate good for? 🙂 (This last statement was profound indeed. Ponder it!)
I just said that we all see the same income. I lied. What I meant to say is that you see pie in the sky, while the four of us see something else.
I am intimately familiar with the underwriting models of everyone I listed above. Well, with Brain’s and Serge’s anyway, since Brandon’s underwriting model corresponds to my number in his speed dial. 🙂
Brian, from a vantage point of virtually unlimited perspective, which I have come to respect immensely, will more than likely consider your $10,000 of NOI and disagree with you to a tune of about 30%, and that’s if all of the OpEx numbers you’ve got are correct. The 40% margin are those numbers that exist in real world, but not yet in you intellectual worth.
I will likely come in 5% lower than Brian (at least that’s what happens most times we underwrite the same deal). What can I say? I keep telling you guys that underwriting is storytelling. Well, Brian has been around longer and seen more than I, so he is able to zero in on the story with a bit more precision. Food for thought. Of course, being 5% lower is being $1.2 million lower on some of these deals.
Serge will probably come in higher than both Brian and me, and he’ll probably be wrong, but it doesn’t matter — he’ll just charge tenants more and squeeze more out of the investment to compensate for certain lack of foresight. I literally have no idea how he gets away with it every time, but he sure as hell does. That guy generates an additional 15% on the top line Monday through Friday, and a 5% bonus on Sunday! (He takes Saturday off.)
So, if the forced appreciation is supposed to net you some money on the sale, then it’s all about who you are selling to, guys.
Are You Selling?
If you are, then look for a young, inexperienced buyer who is willing to pay lots for income and who is inexperienced at underwriting realistic numbers. In this case, forced appreciation really does work. In other words, in this case you’ve found a buyer willing to pay you for your forced value. Fortunately, the marketplace is full of idiots and 1031 buyers.
Are You Buying?
Underwrite like Brian Burke. Or at least like Ben Leybovich. Or become the most efficient operator the world has ever seen, like Serge Shukhat.
If not, you might need to write a book or two. 😉
I killed it on this one, don’t you agree?
Investors: What’s your view on forced appreciation? Do you agree with my assessment?
Let me know with a comment!