Basics of Real Estate Investing #1

Thesis – Investing in Real Estate Can be boiled down to Net Operating Income and Value

When most people think of investing, they think of investing in traditional assets like stocks, bonds, mutual funds, index funds, target date funds, etc. Some people view purchasing their primary residence, vacation home, or single family rentals as investing. Alternatively, some who consider themselves real estate investors acquire assets and diversify their portfolio through Real Estate Investment Trusts (REITs) or RE Crowdfunding platforms primarily in commercial real estate (CRE). For the purposes of this blog, I’ll focus on investing directly in a commercial real estate asset class, multifamily properties (5-units and larger), as an active or passive investor. There’s a ton of content out there explaining the merits of investing in multifamily real estate over the stock market and I’ll eventually get to that topic but, for this post, I want to outline how investing in apartment buildings is no different than selecting a business that has strong business and operating fundamentals with potential for growth and value creation.

Measuring Business & Operating Fundamentals

There’s nothing more satisfying than purchasing an asset that produces cash and ideally from day 1. It’s a pretty simple concept – Choose to invest a certain amount and expect a target return on your investment. For example, let’s say you decide to passively invest $50k into a multifamily syndication and the sponsor team targets an 8% cash-on-cash return annually. This implies $4,000 worth of passive income that could be distributed quarterly or even monthly. Seems simple enough but where does that $4k of mailbox money come from?

Let’s start with the concept of Net Operating Income, also known within commercial real estate circles as NOI. This key operating metric is purely revenue minus expenses. Typically, a property management company maintains a monthly Profit & Loss statement (or Income Statement) that tracks all revenue and expense items. Total Net Revenue consists of gross rents collected plus other income which can include utility billbacks, laundry income, or additional fees like late fees, application fees, or pent rent. Expenses can be fixed or variable costs but include items like property taxes, insurance, repairs & maintenance, utilities, property management fees, landscaping, snow removal, contract labor, legal & administrative expenses, and marketing. The expense ratio is calculated by taking % of expenses of total net revenue. Plain and simple, we want NOI to grow over time. This can be done by increasing rents to market rates through property enhancements and renovations or cost management through optimization of operations.

Before cash flow is able to be distributed to owners/investors, debt service needs to be accounted for. One of the benefits of real estate is the ability to utilize leverage to stretch the buying power of equity dollars. Financing can come in many forms – commercial lending (banks), agency lending (govt), and private lending (hard money loans). Loans are typically paid on a monthly basis for a specific term. It’s worth pointing out that loan payments are accounted for outside of ordinary operating expenses. Also, there are levers available to lower loan payments to increase cash flow – interest rates, term, amortization, interest-only periods, loan-to-value ratios, etc.

So, in summary…

Cash Flow = NOI minus Debt Service

Probably stating the obvious here but increasing NOI increases Cash Flow.

Measuring Value

There are a number of valuation methodologies for businesses – relative valuations via comps (Revenue & EBITDA Multiples) and Net Present Value of Discounted Cash Flows (DCF Analysis). Residential Real Estate is almost exclusively valued on recent sales comparables and market-dictated pricing. Commercial RE valuations are primarily based on NOI and capitalization rates (aka cap rates). It’s perfectly fine to triangulate with comps such as price per unit or price per square foot but most multifamily investment sales are marketed on the basis of NOI and cap rates.

NOI has already been discussed above, so let’s cover cap rates.

Capitalization Rate = NOI / Property Value

For example, say an investor purchased a 10-unit apartment with $50k NOI for $1M. The cap rate of the property would be 5%. CRE assets in a given market typically trade within a certain cap rate range. Sub-markets and neighborhoods within a Metropolitan Statistical Area (MSA) may see cap rates fluctuate as well.

Putting Your Money to Work

Depending on an investor’s risk profile, there’s a continuum of investments that an individual can make within a particular asset class – core, core plus, value-add, and opportunistic/development. Core assets are typically nicer buildings that are stable and income-producing; development opportunities have some uncertainty around budgets and active operations launch so pose more risk. Value-add deals are a good mix of risk/reward and pose an opportunity to force appreciation. How do you force appreciation? Going back to our 10-unit above, let’s say you increase rents b/c they’re 15-20% below market due to mismanagement. You also find that the previous owner wasn’t charging tenants for owner-paid utilities or pets. These combine for an annual increase of NOI of $10k. Doing the math, the value of the property is now $200k greater and now has an asset value of $1.2M. I’d call that a win!

To summarize, investing in multifamily at the property level is really about sound business operations and creating value through asset management. You can do this actively (direct) or passively (co-investing with an operator / deal sponsor) but the most important thing is getting in the game. Take action and take control of growing your wealth. There’s absolutely nothing wrong with allocating some of your net worth into stocks, mutual funds, or index funds to enjoy the ~10% gains that the market has historically averaged since 1928. However, if you’re looking for some additional benefits around taxes and lower volatility, CRE probably has a place in your portfolio.