Making Money With Commercial Real Estate!

 If I knew then what I know now, twenty-years ago I would have purchased a building for my advertising agency.  I was expanding my agency and getting into a serious lease but had no idea what it took to evaluate a building and how it could possibly make money for me as an investment. 

So let’s look at what knowledgeable real estate investors have been doing, making money on commercial real estate in both good and bad economies.  They know the three primary ways to make money in commercial real estate, cash flow, appreciation and principal buildup through paying down a loan.  If I had only known this, my wife would be much happier with our investment strategy and we would have fared much better when the stock market took its downturns.  A Commercial Real Estate investment can offer only one of these or all three ways to make money and if I had purchased a building and my company leased it from me I could have had all three. 

Which investment is right for you depend on the investor’s criteria and needs, which may change over time and his resulting emphasis on these three factors.  But to understand how these three works there are other concepts that must be discussed.

Concepts:

1. The first term that an investor needs to understand is “net operating income”.  This is the income that remains once all the operating expenses have been paid but before mortgage payments are made.
2.  The second is “capitalization rate.”  This is a measure of risk that fluctuates with various factors such as interest rate, location, leases, etc.  The riskier the investment the higher the capitalization rate should be.  A property leased to the government or a fortune 500 company will have a significantly lower capitalization rate than a property in a poor location and leased to a recently formed company.  This term can also be interpreted as the return an investor would receive if he paid cash for a property.  Thus an 8% capitalization rate would result if an investor received $80,000 net operating income on a $1,000,000 investment.  In reverse an investor should be willing to pay $1,000,000 on a property with an $80,000 net operating income.
3. Most people understand cash flow.  It is the money left from rental income after the investor pays his mortgage and expenses.  Investors often refer to the term “cash-on-cash return.”  This is the cash flow divided by the down payment the investor needed to make.  So a property that cost $1,000,000 would have a 12% cash-on-cash return if the investor put down $200,000 and had cash flow of $24,000.  But, many investors do not realize that the cash-on-cash return is different than the capitalization rate and greatly impacted by the loan terms they are able to negotiate.

If an investor purchased a building for $1,000,000, paid cash for the property and received $100,000 in cash flow he would have a 10% capitalization rate and a 10% cash-on-cash return.  On the other hand, if the investor leveraged his money by putting only $200,000 down and borrowing the other $800,000 he would make a better cash-on-cash return.  For example, if he is able to borrow the money at 7% interest and a 20 year amortization, his annual mortgage payments will be $73,997.  Thus his cash flow is $26,003 and his cash-on-cash return is 13%.  He has invested less money but gotten a higher rate of return.  In addition, at the end of the 20 years he will have no debt.  He has paid off the $800,000 through the income he received.  This shows that leverage through debt can greatly increase the return he receives.  If he wishes to fully leverage the initial $1,000,000 he could purchase $5,000,000 in real estate instead of only $1,000,000.  His cash flow would be $130,015 per year, or an additional $30,015 per year.  In addition, he would have paid off the entire $5,000,000 at the end of the loan.  This shows the power of leverage.  But, leverage increases an investor’s risk.  If the income stops the cash buyer simply has no income, but he does not have to fund the mortgage out of other funds.  The more leverage used the greater the potential risk to cash flow.

The above shows the power of leverage to increase cash flow.  It also shows that leverage can greatly increase the equity that can be built by letting the lessee pay down a mortgage.  In the cash example there was significantly less risk, but at the end of 20 years he still has a property worth $1,000,000 ignoring appreciation.  In the highly leveraged example the investor has property worth $5,000,000 fully paid off.  The investor must weigh the risk of the additional debt versus the increased equity.

The third primary way to generate wealth from real estate is through appreciation.  Most commercial real estate will appreciate over time provided the property is maintained and the surrounding area does not decline.  In a pro forma most people assume an annual appreciation rate of 2-3%.  Thus in the above examples, a $1,000,000 building would become worth $1,806,000 over 20 years at 3% annual appreciation.  The $5,000,000 building would become worth $9,030,000.  Thus leverage again is a major factor in wealth accumulation.  At the end of 20 years in the difference in the total return is very significant.  Most investors therefore leverage their properties.

What willingness of the investor to take risk and his desire for cash flow, appreciation and/or loan reduction will determine which property is best for him.  Younger investors with other income streams often wish to build a real estate portfolio and will take a riskier approach.  As investors mature they may take a more conservative approach and feel a greater need for cash flow.  Once an investor determines the best route for himself he can evaluate an investment wisely and best meet his economic goals.

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