Want to get rich in investment real estate? Let me explain a simple concept.
I read an interesting article in Forbes magazine recently, “How The World’s Billionaires Got So Rich.” Not surprisingly, business ownership and real estate are at the top of the list.
If you’re a business owner, you need to expand your business, maximize profits and invest strategically.
What if you don’t own a business?
I know quite a few people who don’t own a business, but purchased rental and commercial real estate and have done exceptionally well. That is especially true for those who bought investment real estate in the past 10 years, in particular, those who purchased during or just after the depth of the 2008 recession.
I also know many people who are interested in getting into investment real estate and are looking for pointers on the what and how.
You’re interested in getting into investment real estate.
Where do you start?
I wanted to share with you a simple but often misunderstood concept that is the first thing you need to know when moving into the investment real estate market. Now, don’t get me wrong, finding an amazing income-producing property and then negotiating the financing and purchase of it takes a lot of work and skill, but before you begin the hunt, you need to understand this one thing.
At the heart of investment in real estate is a concept called CAP (capitalization rate).
For those who have read my book, “The Kickass Entrepreneur’s Guide to Investing,” I cover this in some detail, so you’re likely already familiar with CAP rate. For those who haven’t, I cover the basics of CAP rate below. NOTE, some of the information below is copied verbatim from my book, but I go into it in much greater detail there.
Follow along with some of my calculations; I’m going to show you how an improvement of $1 in profit in your property can produce a $25 increase in your net wealth.
The CAP rate is the building’s profit, before taxes and building depreciation, divided by the purchase price of the building.
Here’s the formula: CAP rate=Net Operating Income (NOI) /Building value (BV).
For example, say the real estate value of a building is $1 million. After expenses, the NOI, not including mortgage, debt repayment or interest charges, but before taxes, is $60,000. The property’s CAP rate therefore is 6%: $60,000/$1 million=6%.
Why is this number so important?
All rental property trades on the CAP rate, so that’s the first thing a discerning buyer should look at when buying or selling a building.
CAP rates vary by city, neighborhood, pockets within a neighborhood and current market conditions. A building in one section of a city can trade at a 4% CAP rate, while at the other end of the city a similar building can trade at 7%. Two blocks over, and you might be trading at 6%. So, although there is some subjectivity associated with the CAP rate, it’s quite defined.
At the moment, the average CAP rate of a multi-unit residential (MUR) building in North America is about 5.5%. The average CAP rate of a MUR in Toronto is approximately 4.5%, however, I’ve seen many properties trade in the 3% range (and even lower).
Now let’s do some backward math. If I told you a building’s NOI is $100,000 and the building has a CAP rate of 5%, we could determine the value as follows:
Although there are many ways to make money in investment real estate, here’s an example of how some creative math can make big dollars.
Let’s say you were able to increase your building’s revenue by $1(by raising rents), or lowering expenses by $1. Your net operating income for your building has now increased by $1. At a 5% CAP rate, for every extra dollar in NOI, you increase the value of your building by $20.
Let me illustrate with a story:
In 2014, I got a call from my insurance company about the 21-unit building I own. It turned out they no longer wanted to insure the property unless we removed all knob and tube electrical wiring from the units. Knob and tube is an older type of electrical wiring that was used up until the 1930s, and insurance companies are reluctant to insure buildings with that wiring because of a perceived increase in risk. I had two months to comply, after which I needed to sign an affidavit confirming the building no longer contained knob and tube. Otherwise, I needed to find a new insurance provider or I was screwed.
Only two of the units had such wiring, so you’d think it wouldn’t be a big issue. The problem is, both were occupied and well below market because of their rent-controlled status. A good deal for the renters, not so much for me. It was going to cost thousands to replace the wiring, patch all of the holes and repaint. At that point, I could spend a few extra dollars to retrofit the units entirely.
The tenants in those two units were paying $900 per month each in rent, and the going rate for a retrofitted unit in the same building commanded a rent of at least $1,500 per month, a difference of $600 per month, or $7,200 per year per unit.
I couldn’t kick the tenants out. I had the option of asking them to leave for two months while I retrofitted the unit, but once done, because of rent control I would have to give them their units back at the same rent. It just didn’t make sound financial sense.
I ended up paying the tenants thousands each to leave their units. All in, including the fees to vacate the units and the upgrade costs, I spent at least $45,000 per unit and rented the renovated units at $1,500 per unit per month. Though it felt like a hit at first, when I was done, the units were gorgeous.
On the surface, I had a 6¼-year payback:
Let’s look at the math: $45,000 in upgrades/$7,200 per year in rent increase=6.25 years.
At a 3.5% CAP rate, which this particular building is currently valued at, the $7,200 per year rent increase amounted to an increase or more than $205,000 in the building’s worth. Multiply that by 2 (there were two units) and in the end, I spent $90,000 and increased the building’s value by more than $400,000.
If I put the building on the market two days after construction completion and re-rental of the units, and the buyer would calculate the NOI based on the new rent roll.
Although there are many more mechanics involved in creating wealth in investment real estate, I wanted to share this simple formula. I will cover more details in future blogs, or you can read more about this in my book: “The Kickass Entrepreneur’s Guide to Investing.“
#entrepreneur #CAP Rate # Creating Wealth