Friday, January 13, 2012

Capitalization Rates

I've taught this so many times - I decided to write a quick tutorial on capitalization rates here so anyone can access this information easily.

Income (i.e. Rents)
Less Operating Expenses - real estate taxes, insurance, maintenance (all expenses except personal income taxes)
Equals: Net Operating Income

This is the cash flow you would get if you bought a property for cash before paying your personal income taxes.  Ideally you'd be smart enough to buy the property in a IRA or Roth IRA and not have any personal income taxes.

Net Operating Income divided by Total Investment equals your Cap Rate.  Total investment includes the acquisition of a property plus renovations.   A high cap rate is better than a low cap rate assuming all other things are equal.

But there are many other things we can use cap rates for.

You can use cap rates to "see" where a market is.   A market that has 25% cap rates and very low interest rates (cost of money) is a market that is emotionally in FEAR.  That market just got through with a major devaluing of real estate and investors have a sick/visceral feeling in their guts that prevent them from taking advantage of amazing opportunities.

A market that has 6% cap rates and the cost of borrowing is running at 10% is a market that has been going up and investors are cocky- they think the market will go up indefinitely despite the fact that it doesn't make economic sense.     This is a market you should be selling it despite the GREED factor of thinking "this thing is going up every day - I'd hate to get out too early."

You might want to make a BIG NOTE that most investment decisions are made in the GUT not in the head but by using cap rates you can possibly make better decisions with your head.

You can also use cap rates to make a better decision.  If an investment/improvement in your property costs $1,000 and saves $500/year, is it a good deal?  Well, using a 10% cap rate that improvement will raise the value of your property $5,000!!!!  Sounds like an amazing deal to me.   But without using that analysis it might not look like such a good deal.  $500/.1 = $5,000.

As a practical matter there is no sense in calculating an exact cap rate.  When I am standing in front of a building that I am evaluating I run the numbers quickly in my head.

$1,000 Rent (brain says $12,000 in income IF everything goes right)
Tenants pays utilities (brain says expenses will be between 30% of gross and 50% of gross depending on the answer to this question, the local real estate taxes and the condition of the property).  Say $4,000 for the sake of this conversation.
(brains says $8,000 Net Operating Income)
Real estate broker says: $50,000.  (Brain says maybe buy for $45 plus $5 in improvements)

Calculate:  $8,000/$50,000 - 16% Cap Rate

If my cost of money (borrowing) is 10% this might be a deal.

If my cost of money is 18% I know I would lose money every month.


Friday, January 6, 2012

The Roller Coaster

What your perspective on the likelihood of an economic/real estate recover is probably very indicative of the fact that you are a human being. When the markets are up 99% of people think it will NEVER go down. And when the markets are down most people think it will NEVER recover. But if you look at any graph of any market you'll see something very different. Extremely low prices ALWAYS eventually stimulate buying. And the momentum almost ALWAYS goes too far. And the cycle completes itself.

Human beings have a very very short and myopic memory. The fact of the matter is, if you use a financial model it is always very obvious where the market is. I use Capitalization Rates. When "cap rates" are high (i.e. prices are low) I can buy and hold and make money regardless of what the market does or how long it takes to recover. When cap rates are low and don't make any sense it is good time to sell but I don't have to sell - I still continue to profit from the day to day cash flow of the property. 

In the end, for most people though it is like riding a roller coaster. Most people only know where they have been and the visceral feeling of where they have been is their emotional governor and they literally have no choice but to yield to their feelings. A financial model is a "theory" and the visceral feeling of falling (or rising) is way more "real" and overrides good judgment. But you do not need an MBA from Harvard to know that it is a good idea to buy when yields are 20% plus and sell when prices are so high that the same asset is yielding 5%. Yet most people respond just the opposite because of the visceral effect.

Now lets see how you good your choices and thinking are. Time will definitely tell!


Thursday, February 3, 2011

Out of Town Investors - Beware

We recently visited with an investment promotor that was making a lot of money. Their offer to out of state investors looked amazing on paper. The only problem is, the investors they were selling to were doomed to losing money.

This promotor was purchasing $10,000 homes in rough neighborhoods with much gravity. (See my previous article on gravity.) He then did a cosmetic renovation for about $5,000 and found a tenant for the property. A fresh coat of paint can make a eye sore go away - but it doesn't remedy the rot on the other side of the paint. Based on capitalization rates/yield he then sold the property for about $40,000 to an investor from out of town and agreed to manage the property on their behalf.

Where are the problems? The homes were in neighborhoods with many many homes for sale and much deferred maintenance. In short the neighborhoods were imploding. Couple that with the fact that after the deal had closed, the promotor had made all their profits and had no incentives to insure that the property remained rented, maintained and cash flowing. It is just a question of time before management issues surface - the properties were not entirely renovated properly, the neighborhoods decaying, and attracting and keeping good tenants will soon be impossible. And finally, when those management issues do surface, the investor is from far away and has very few options to solve their problems that don't involve losing a lot of money.

Wednesday, February 2, 2011

Speculation Vs. Investments

Speculation: engagement in business transactions involving considerable risk but offering the chance of large gains, esp. trading in commodities, stocks, etc., in the hope of profit from changes in the market price.

How many variables effect the price of a stock? Management? Economies? Product competitiveness? Competition? Patents? International factors? Distribution channels? Product life? Efficiencies?

Honestly, wouldn't you have to be brilliant just to be able to identify all the variables, not to mention assess each one and how they relate to one another?

Investment: he investing of money or capital in order to gain profitable returns, as interest, income, or appreciation in value. A devoting, using, or giving of time, talent, emotional energy, etc., as for a purpose or to achieve something.

When a business owner invests in a piece of equipment, they have the benefit of a) huge expertise in their venture, b) all the incentives to make it work, c) skin in the game. Although there is certainly a element of risk, the number of variables are far "tighter" than that of a speculation.

My investment strategy is not to speculate. Rather, it is to invest giving the right individual (i.e. someone who has a tried and proven track record) the right incentives (i.e. profits subject to me making my money first).

Saturday, January 22, 2011

Turds!!!

When I meet with a realtor for the first time and they ask me what I am looking for, I tell them "turds".

Yes, their reaction is probably not a lot different than yours - but it does make an impression.


The wonderful thing about turds is they are yucky and smelly and no one wants to be around one - but soap and water fixes turds.

Real estate that has been mismanaged creates opportunities:

- It can almost always be bought at a higher capitalization rate (lower price) than "perfect" real estate, even when considering the additional investment required to bring it up to speed

- The cosmetic renovations "turds" require give an investor the opportunity to add disproportionate value to the property. for example skuffed up "ugly" walls can be painted with colors and trim that make the room more special than a "perfect" white box room that sells for top dollar.

- Sometimes the problems that make a property a "turd" require specialized knowledge or creativity that prevents competing investors from even participating in the opportunity.

One of my wisest teachers, Peter Fortunato taught me, "use what you've got to get what you need to get what you want". Looking for investments that you can craft into investments that meet your criteria instead of those that directly do so, will open many opportunities that you would otherwise never see.

Gravity of Neighborhoods


Over the past 6 months I have spent at least one week a month scouring the Mid West for specific neighborhoods to invest in.    I have been investing in real estate in one form or another for the past 30 years.  This is the first time I have amazing investment opportunities in single family homes.


In the course of driving through many neighborhoods in many cities I had an observation & insight that, for me, is quite useful.   Neighborhoods that consist of architecturally ornate homes seem destined to one of two extreme plights.   The fortunate ornate home neighborhoods retain high net worth owners and, at a very great cost, are maintained and often improved.  On the other hand, the architecturally ornate neighborhoods that lose their wealthy benefactors all seemed to have fallen to being or fast becoming slums.     The weight of gravity - i.e. the cost of maintaining those significantly ornate properties, is beyond their economic means.    And after gravity begins the process of pulling them down, the process is, I believe, irreversible.

What does this insight afford me in terms of making investment decisions?  First, if I find a property that "works" from an financial perspective in a gravity laden  neighborhood, I need to strongly consider whether I can maintain it moving forward, but more importantly can my neighbors maintain their properties.  If they can't, I will get sucked into the hole that depression will make.    Secondly, there are neighborhoods that have housing stock that is not highly ornate - homes that are far more practical from a maintenance and upkeep perspective.   All other things equal, I feel that they present a fundamentally much better investment venue.   

Wednesday, January 19, 2011

The 2 Best Predicators of Investment Success

If you could pick the best two predicators of an investment's success what would they be?

I would choose track record & incentives - give the right manager/promotor the right incentives.

Who is the right manager/promotor? Someone who has a proven track record in a specific niche investment arena and I trust after having met them. It is that simple.

What are the right incentives?

If you did compensate the promotor before the investment created profits, what incentives would you be giving that promotor?

An investment in which you pay fees, profits and costs from the initial investment (i.e. before the investment creates any profits) is called "front loading" ((http://www.investopedia.com/terms/f/front-endload.asp)).

How much does a "front loaded" investment have to make just so the investor can break even?

It is my opinion, and I think just good common sense, that an investor should always evaluate:

1) How much front loading is built into an investment? Keep in mind that promotors use very "creative" and often very deceptive names and accounting methods to hide those front loaded fees. That is one of the biggest challenges of reading and digging through legalese laden information to even get to what the real fees are.

2) How exactly does the promotor get compensated? Taking a monthly percentage of managed funds does give the promotor the incentives to keep the investors happy over the long term but it provides an immediate incentive to sell more investments irrespective of performance.

3) What is the promotor's track record? If you can't get direct and substantiated answers to this question, what is that telling you?

An ideal investment would have a promotor that has a very strong proven track record and a investment structure that compensates subject to performance.