Commercial Real Estate

Commercial Real Estate

How are we looking for the future?

 

People ask me all the time what I think commercial real estate is going to do in the next 6 months, 3 years, etc. I don’t blame them, it’s a great question. But the answer depends on you and what you’re bringing to the table. I recently just sold roughly $300 million worth of property in late 2018 and early 2019. Why? Because we analyzed our situation and acted on it. I went to my management company and asked them questions. In order to make a sound judgement call, you have to ask the tough questions: is our net operating income growing? Is the need for renting still growing or has it reached a peak? What are our expenses and how are they growing? How is our cash flow and what is it going to look like in the next year, 3 years, 5 years?

Once you have a grasp and understanding of where you stand, you can start to estimate where things are going to be. I knew that in that time period what the cap rates were, so I asked my company what they thought they would be down the road based on the investors.

After figuring out those projections, I made the call. We sold the properties to people who believed they could run them better or get better cash flow. But we did our homework and already figured those numbers out.

I was recently at a meeting with Goldman Sachs and the whole discussion revolved around exit cap rates and projections. Let’s say that you purchase a property with a 4.4 cap rate and ii goes to 5.4, this means you will need to increase your net operating income growth by 25% just to break even and get what the property is worth. Exit cap rates are extremely important. This is one of the biggest mistakes I see when it comes to investing, people not paying attention to the exit cap rates.

If you don’t know what a capitalization (cap) rate is, it’s simply the ratio of a property’s Net Operating Income (NOI), divided by its purchase price. For example, an asset with an NOI of $100,000 that costs $2 million has a 5% cap rate ($100,000 divided by $2,000,000). You can also use this formula in reverse to find a property’s market value. If a property has an annual NOI of $70,000 and market cap rates are 7% for properties with similar characteristics, then the value of the property would be $1 million ($70,000 divided by .07).

You can find the value of a property using a cap rate because in theory, cash flow extends forever. You take the Net Operating Income and divide that by the cap rate. If you owned a property that is expected to produce $50,000 of NOI each year and market cap rates are 7%, then the property would be valued at $714,285.71 ($50,000 divided by .07). It seems simple, but there are so many people who overlook using these formulas to estimate their property value.

So where are we now with these market changes? I think we’ve got about 10 years of expansion in the future. Interest rates are starting to go down again. People should always focus on cash flow and analyze their exit cap rates. I’m a big proponent of that and have done it myself with great success.

If you have any doubts about being a real estate investor, you need to read my latest book: Return to Orchard Canyon. This book captures the feelings that too many people have today. Too many people are stuck working for a paycheck, giving up their lives to make a living, and throwing any dreams they may have had aside. But I pick apart these myths. Living doesn’t always mean sacrificing your dreams. On the contrary, our nation was built on the backs of dreamers who took risks.

Sometimes the best thing you can do in business and in life is to reinvent yourself.

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Original publish date: November 13, 2019