"The Man, The Mission, The Passion" Husband, Father, Attorney, CPA, Steward Leader, Entrepreneur, MBA, Author, Builder, HBS OPM 25 Class, Mentor, Teacher

Ways to Analyze Real Estate Deals

real estate numbers

What metrics do you use when analyzing a real estate deal? 

There are many ways to look at deals; which deal is best varies with economic conditions, resources and goals of the investors plus you can only buy what the market has to offer which isn’t always what you prefer to buy.  Below are two ways to look at real estate investing plus 3 metrics explained (Cap Rate, Cash on Cash, and IRR).

– Opportunity to Generate Cash Flow:  

Possible when the spread between the Cap Rate and your cost of funds is sufficient. We bought a nice deal several years ago with a family office as a 50% partner: 5.9 Cap rate over 4% 10-year fixed debt with 3 years of interest only. Nice spread, right? However, when the i/o ended and the mortgage constant got closer to the Cap Rate, the cash flow dropped precipitously and our partner wanted to exit even though the remaining cash flow + principal pay down equaled a solid 8%+ return on equity invested. We were able to get an excellent mid teen IRR (pre-tax!) even though we had to pay close to a couple million in defeasance (pre-payment penalty on loan). Personally, I would’ve held the community, at least till maturity, but you try to keep your partners happy.    

– Opportunity to Create Equity:  

Often called value add. Is there something to be fixed? Can you fix it? Will fixing generate sufficient rewards? The trouble is true value add is a minority (20%?) of the market yet the majority of the funds (80%?) out there say they are value add investors. Sorting the wheat from the chaff is what makes a good investor. Plus being able to execute once the deal is done.

Capitalization Rate:

A measure of unleveraged return on real estate, cap rate is similar to interest rates on bonds. If the current cap rate demanded by the market is 5%, then a real estate investment that returns $100,000 a year in NOI (Net Operating Income i.e. Revenue less Expenses) is worth $20,000,000.  

$100,000/5% = $20,000,000   i.e. NOI/Cap Rate = Value

Or  

$20,000,000 x 5% = $100,000  i.e.  Value x Cap Rate = NOI

Cash on Cash (Equity in Investment/Cash Flow of Investment):

A measure of current (usually LEVERAGED i.e. with debt) return on a community, cash on cash is simply the cash flow of a community divided by the amount of equity the investor has in a community. Since most real estate investments carry debt, cash on cash is also a measure of leveraged return. Cash on Cash return should be higher than the interest rate, the mortgage constant, and the cap rate otherwise negative leverage is occurring which is a bad thing. An investor who has invested $30,000,000 and expects an 8% cash on cash is looking for $2,400,000 a year or $200,000 a month.  

Internal rate of return (IRR):

The interest rate at which the net present value (NPV) of all the cash flows (both positive and negative) from a project or investment equal zero. You will see 10 year pro formas (projects of income, expenses and eventual sales price) with projected IRR’s to the 2nd decimal place designed to guide investment. Personally, I’m challenged to come up with a decent financial plan one year out, much less 10 years. Then to project a cap rate on a sale 5, 7 or 10 years out? Smoke and mirrors; nothing but wild guesses dressed up with fancy math! But folks want a number, a sense of certainty…

Issues with IRR:

1. Not a measure of Absolute Return: Big difference in absolute terms between a 20% IRR on $10,000 versus $1,000,000 ($2K v. $200K). Great to make a 20% IRR but on what dollar amount? It’s a lot easier to get eye popping returns on small dollar amounts.

2. VERY Time Sensitive: Invest $1,000,000 – make $100,000. Good? Excellent? So-so? If it took 30 days, 120% IRR. But if it took a year, only 10% IRR. 

3. Contains No Measure of Risk: Evaluates outcomes, NOT their probability.   

4. Not Designed to Measure Liquidity Costs: Assumes that you can re-invest at same return; i.e. terrific if you can continuously do back to back investments. More realistically, you have to sit on cash in between investments.

5. Pre-Tax Measure of Return: However, what you keep, have to re-invest, is post taxes. This is an issue common to most metrics.

As always, I share what I most want and need to learn. – Nathan S. Collier

Real Estate Thoughts

real estate growth

Happy New Year Mr. Collier,

I hope this year brings you more peace, joy, prosperity and fulfillment than last year as you grow in more wisdom and understanding! When you have some time could you please answer the below questions?

What are your thoughts on capital gains?
If by capital gains, you mean the equity created by entrepreneurial effort, I’m all in favor of it. If you mean paying capital gain taxes, well, every time you sell and pay Uncle Sam 25% or so, your next deal has to be at least 25% greater than your last for you to just break even. Personally, I find that hard. Plus, all the time and effort it takes to find a seller, to put up with all the tire kickers and close but no deal negotiations. Then you have to turn around put the same time and effort to find your next deal. I’d rather put that time and effort into running and improving my existing deals, creating tax free equity I can pull out via refinancing and re-invest.

Most real estate churns because it’s bought through a fund and the owners are not hands-on and the only way to be sure of the value created is via a sale. A hands-on owner knows their real estate and does not need a sale to validate value creation. Also, most funds make their profit as a combination of fees and promote (a share of investors profits); the big fees lie in the buying and selling process i.e. there is a major incentive to turn the portfolio. Plus REITs tend to have a stated target average portfolio age that they must hold to in order to maintain credibility with market analysts and investors, this requires they sell their older communities on an ongoing basis and acquire newer either by development or purchase or both.

Communities do tend to require more capital investment and Sr. Mgt. TLC as they age, thus creating “value add” possibilities for the opportunistic investor.

What do you think would have made your growth faster in the early days? How do I take my current residential rehab business to $1M+ a year in revenue?
Same answer to both:
1) Scaling up as rapidly as possible i.e. larger and larger projects
2) Delegate; Build a Team

How many people would be part of a self-sustaining management team?
There is no absolute number and a lot depends on turnover/retention/commitment to organization and the level of team member i.e. the higher the level, the more challenging it can be to replace. Short answer is to apply the Mack Truck philosophy: If the #1 in any position got hit by a Mack Truck, their #2 should be capable of keeping things running smoothly. At the top level, I would suggest a three, a triad i.e. 3-legged stool.

Who was the first person you hired?
Combination receptionist/leasing agent.

How would you define retained earnings?
Retained earnings: Earnings (or cash flow after debt payments) retained to be reinvested i.e. not distributed to owners. More technically: on a balance sheet, the figure represents the sum of all profits retained since the company’s inception. In plain English, for the small investor, retained earnings is how much do you chose to re-invest v. how much do you take to live on.

As always, I share what I most want and need to learn. – Nathan S. Collier

 

The Wisdom…and Challenge…of Asking for and Accepting Help

ask for help

Many of us have a fierce streak of independence that makes it challenging to ask for help, heck even to accept help when it is offered. We all want to appear capable and strong, we all have fears of being vulnerable or dependent or a burden. A script runs through our heads, often programing that exists at a subconscious level: “If I ask for help, I am not enough. If I ask for help, I’m weak.”

The truth is we can never do it all ourselves and we ALL need help at times. By refusing to ask for help or by declining help when offered in good faith, we perpetuate a false persona and we teach others that it is not acceptable to ask for help.

Asking for help is a sign of emotional strength for often it takes courage to ask for assistance.

Closing Quotes:

“Most people don’t get those experiences because they never ask. I’ve never found anybody that didn’t want to help if asked.” – Steve Jobs, 1994

“We’re all imperfect and we all have needs. The weak usually do not ask for help, so they stay weak.” – John Wooden

“It isn’t so much the act of asking that paralyzes us–it’s what lies beneath: the fear of being vulnerable, the fear of rejection, the fear of looking needy or weak. The fear of being seen as a burdensome member of the community instead of a productive one. It points, fundamentally, to our separation from one another.” – Amanda Palmer, The Art of Asking; or, How I Learned to Stop Worrying and Let People Help

 

A BLOG ON PERSONAL LEADERSHIP BY THE FOUNDER OF THE COLLIER COMPANIES
LARGEST PRIVATE PROVIDER OF STUDENT HOUSING