RE Investing - A Solution For The Destructive Accumulation Mindset Part2

Introduction The last installment of this series of articles demonstrated that one can produce 19.5% returns from the 4 profit centers of real estate using an example problem and conservative assumptions.  Our exploration of how to utilize real estate to gain financial freedom left off with gains that were largely a function of appreciation.  The trick is to now translate these gains into spendable cash flow to design a cash flow machine to incrementally strive toward financial freedom.              Financial Freedom There are various definitions of financial freedom.  For the purposes of our discussion financial freedom will be the point at which all of one’s monthly expenses are accounted for by passive income from portfolio properties.  There could be securities and other items that contribute toward this freedom as well, but in order to keep the discussion simple we will just assume that we are solely using real estate to achieve our goal of financial independence.              Return on Equity As properties appreciate and the debt is amortized the equity value of one’s portfolio grows.  For the purpose of this article the return on equity (ROE) is defined as:            Cash Flow After Taxes / Equity in Property            Note that the equity component should increase over time assuming that the property appreciates and the loan is amortized.  So if the cash flow from the property remains relatively level or increases slower than the growth in equity the ROE will eventually decrease.  Many of the projects I model have ROE that increases for several years and then decreases at some threshold point in the future.   A detailed analysis of this phenomenon is beyond the scope of this article.  The point I would like for readers to understand is that ROE is generally optimized with some optimal leverage ratio.  If a property suddenly is underleveraged because of equity buildup then it is often wise to exchange the property for a new one or a new set , releverage, and translate paper equity into cash flow.            Trade Little Green Houses For Big Red Properties Most readers are familiar with the board game Monopoly.  After acquiring a Monopoly the player builds little green houses, charges rent, and later trades up for bigger buildings.  The bigger buildings are hotels in the game, but really could represent any property type that takes advantage of economies of scale to produce tangible cash flows.              For our example we are going to use apartment complexes because they are easily comparable to single-family properties discussed in the first volume of this series.  Apartment complexes have one roof, one foundation, shared maintenance expenses, common property management, and a whole set of items that decrease the pro-rata expenses for each door.  The appraisal method is also completely reliant on setting a price for a stream of cash flows instead of bidding with owner-occupants who are rationally willing to pay more for an asset than someone using a discounted cash flow analysis.  Consequently, commercial buildings almost always have better cash yields than single-family properties.            A Quick and Dirty Analysis of Apartment Complex Returns In our prior article we explored the four profit centers for real estate.  We relied heavily on an appreciation component to produce returns that are high relative to alternative investment vehicles.  In order to evaluate apartment complexes it is necessary to define a few terms that some readers may be unfamiliar with.  The first of these terms is a cap rate, or capitalization rate.  The capitalization rate is defined as:            Cap Rate = NOI / Sales Price            If you inspect this ratio you will find that the cap rate is the return one would receive in the absence of debt financing, or what one would receive if they paid all cash for the investment.  The cap rate can also be compared to a level annuity where one would receive an unchanged series of cash flows for a cash investment that occur in perpetuity.            NOI above refers to net operating income.  NOI is simply operating revenue less operating expenses and is generally annualized on income statements.  In the industry NOI, cash flow, and various other financial metrics are tossed around rather loosely.  In the “long run” an apartment complex will consume around 45% of gross rents as operating expenses, capital expenses, etc.  So a loose definition to approximate NOI is:            “NOI” = Gross Rents / 2            Note that NOI in the grossly-simplified definition above includes capex and other items that do not consume cash each year.  Note additionally that we are dividing by two to keep the math simple instead of using a 45% expense ratio.            Armed with these definitions and assumptions we can now do a rough job of analyzing a stream of cash flows from an apartment complex.  Let’s assume that the following apartment complex is available for sale at a bargain price in our depressed economy:            -10 units -Rents = $1k/door -Asking/Contract Price = $600k                       In the example above we can calculate the NOI as:   NOI = Gross Rents / 2 NOI (annualized) = ($1k/door *10 doors*12months) / 2 = $120k / 2 = $60k            Note additionally that the cap rate is:   Cap Rate = NOI / Sale Price = $60k / $600k = 10%            It is not unusual to see cap rates north of 10% in today’s distressed environment.  Cash is dear to investors and is scarce in general.  Consequently, fewer bidders mean better deals for investors.  A 10% return on a large cash investment is pretty good.  However, we will later see that this 10% relative return can be increased dramatically with the use of leverage.              The Impact of Leverage Placing debt on a project is a recipe for greater relative returns if the project returns an amount in excess of the cost of debt.  The cost of debt is the amount of interest charged by a lender.  A project will also produce positive cash flow if the loan-to-value (LTV) ratio multiplied by the annual loan constant yields a figure lower than the project’s capitalization rate.            The loan constant is the sum of all annual mortgage payments divided by the mortgage balance.  Note that this figure includes principal and interest for all debt products except for interest-only loans.    Shorter amortization periods decrease the amount of time that a loan is repaid and increase the loan constant.  Longer amortization periods amortize less of the loan annually and thus cause the loan constant to decrease.  The loan constant is the lender’s return when they place debt against a project.              What is Your Equity Worth? Equity has different prices and is largely a function of what an individual investor’s investment universe looks like.  For instance, some larger investors may own small businesses that produce in excess of 30% annually on money invested.  Others may run hard money businesses where their equity will produce 20% returns annually.  Consequently, the non-debt component of a project’s capitalization will yield a completely unique value for each individual investor.                       Weighted Average Cost of Capital A weighted average of the debt constant and the investor’s specific equity value will yield a rate to capitalize an individual project.  For instance:            -Annual Debt Constant on 30-year debt at 7.25% is 8.14% initially -Equity Constant For Hard Money Lender is 20%            If the debt above was available at 80% loan to cost (LTC), then the WACC calculation would be as follows:            (.80 * .0814) + (.20 * .20) = .1051, or 10.51%            So when an investor underwrites a project they can use a WACC of 10.51% to assess value:            NOI/Sales Price = Cap Rate            =>Sales Price = NOI / Cap Rate = NOI / WACC            Note that the WACC is substituted for the cap rate above because it represents the investor’s equity-weighted capitalization.  Note additionally that this analysis assumes that the project this capitalization is used in needs to be equivalent in risk to the projects that determine the cost of equity.  If the project is an apartment complex and the leases are weak, the neighborhood is poor, or the project in general carries additional risk then the investor may need to adjust the required equity return north and thus move the WACC up as well.              WACC As Debt Amortizes Using WACC highlights that the overall capitalization rate of a project increases as the debt is amortized.  As the years go by the debt in a project decreases and the project may increase in value.  This increases the weighting of the equity component in the WACC calculation, which causes the overall capitalization rate for the project to increase.  Investors generally pull cash out of projects or trade up to larger projects to re-leverage and increase relative returns.  Note that the higher relative returns will produce lower absolute returns.  If an investor’s goal is to increase cash flow over time care should be taken to balance absolute and relative returns when he trades up to bigger projects.  More money down will produce more cash at the end of each month and will lower the cost of debt.  Less money down will increase relative returns, reduce cash flow, increase the cost of debt, and lower the margin of safety for the investment.  Leverage certainly cuts both ways.            In our next article we will explore using a 1031 exchange to defer taxes and trade up to larger projects to continue the strive toward financial freedom using real estate as the vehicle of choice.  We will also explore the tradeoffs of leverage, cash flow, and relative returns in more detail.