All Forum Posts by: Jaden George

The most fundamental metric in the commercial real estate space is, without a doubt, the capitalization rate or cap rate. It is calculated by dividing a property's net operating income (NOI) by the purchase price (NOI ÷ purchase price). There are a variety of uses for cap rates, including gauging market appetite for a particular asset, evaluating a deal at a specific purchase price, and estimating a future exit price. Here I will focus on evaluating and comparing deals.

I argue that cap rate as a return metric fails to tell us the entire story. In fact, it tells us very little about the asset and its potential. This becomes more and more true the further the asset is from a stabilized state (e.g., the heavier the value-add). Take a 100-unit property with current average rents at $1000/mo. running at a 50% expense ratio (operating expenses equal 50% of income). This property generates $600,000 in net operating income ([$1,000 x 100 x 12] x 0.5). If the asking price for this property were $12,000,000, the cap going-in cap rate would be 5% ($600,000 ÷ $12,000,000). If the going market cap rate for assets like this one is 6%, then this asset seems way overpriced on the surface. But what if you learn that the property is experiencing a very high loss to lease (LTL), meaning their leases are severely under market rates? Similar units in the area are renting for $1,300/mo. and the subject property will only require about $1,000/unit in capital expenditures to compete with comparable properties. In addition, we also learn that the property has been run very inefficiently, and new ownership will have no problem running this particular asset at a 40% expense ratio. This is where the cap rate leaves us high and dry, and yield on cost comes in to give us a way to evaluate and fairly compare this value-add opportunity to others.

The yield on cost (YOC) is calculated by dividing stabilized NOI by total project costs (stabilized NOI ÷ total project cost). Here, the denominator will include purchase price, capital expenditures, sponsor fees, and acquisition/financing costs. Assuming $500,000 for closing costs, this investment's YOC would be 7.4%. This number is much more helpful when comparing two investment opportunities as it tells a much fuller story than the cap rate. This is because it includes the stabilized performance of the property and the costs associated with executing the business plan. In contrast, the cap rate considers the current NOI and purchase price alone.

Taking it a step further, we can calculate something called a development spread. A development spread is the difference between the YOC and the market cap rate. It quantifies the value the business plan will add to the asset in the current market context. In our example above, the opportunity provides a 1.4% development spread (7.4% - 6%). Further, dividing the development spread by the market cap rate gives us the development lift, which indicates the value added as a percentage of the market cap rate. The example above shows a 23.3% development lift (1.4% ÷ 6%). This metric is helpful when comparing two opportunities in different markets or across asset classes (or any situation where market cap rates vary between assets).

While the cap rate certainly has its utility, I hope you can see that YOC and development lift tell a much more valuable story when evaluating and comparing two or more value-add opportunities.

Investment Info:

Small multi-family (2-4 units) buy & hold investment.

Purchase price: $450,000
Cash invested: $25,000

The property is a quadplex built in 2004 just miles away from TN Tech campus which is where I go to school. Each unit is a 2/1 and about 750 sq. ft. The rent roll when I bought it was $2,525. I knew that market rents, if marketed towards students and relatively updated, are $1000 a month. I am using this property as a house hack and living in one of the units with my roommate.

What made you interested in investing in this type of deal?

Ever since educating myself on real estate investing and first hearing about house hacking, I knew that would be the first thing I did. Being able to drastically reduce my housing expense while also building equity and getting tax benefits while in college is going to be huge for my earning and saving potential, helping me finish putting myself through college - or invest again in the next couple of years.

How did you find this deal and how did you negotiate it?

I found this deal directly on the MLS from a realtor. My dad drove out and we went to see it the day after it was listed. The sellers wanted $350k for the quadplex and the small bit of land it was on, or $440k for the quadplex plus the 6 acres of land (with no zoning restrictions as it is just outside Cookeville city limits) behind it. We ended up getting the quad plus land under contract the next day at $450k.

How did you finance this deal?

I was told that I would have to get a commercial loan on the property*yes-even though it's a quad, I'll have to address this in another forum post due to character limit here* and was given 2 choices: 30-yr amortized & 5-yr balloon or 15-yr fully amortized. I chose option 2 at 4.15% interest, 15% down. The loan term took away much of my cash flow (still almost rent-free) but built in incredible equity buildup ($1,500 in the first payment) while also keeping me from having to refi in 5 years.

How did you add value to the deal?

How did you finance this deal? Cont. -- This financing was not ideal considering I only had about $25k to invest with and the cash required to close was close to $69k. So, being about $45k short of making this happen I turned to my dad and not-too optimistically asked for a $50k loan at 6% with no monthly payments due in 7 years. Expecting to be laughed at and given a counter offer closer to "interest-only payments and 8% at least", I was very surprised when he accepted the terms.

What was the outcome?

As of right now, I am living in one of the units with my roommate. One unit has been updated and is at market rent, the other two are still occupied by inherited tenants but will be updated and brought up to market rents with new tenants (almost a 50% increase to what they were paying) by mid-August. Once that happens I will be living rent-free before property maintenance.

Lessons learned? Challenges?

Challenges ahead include learning more about real estate development and seeing what is possible with the 6 acres of land behind my property. I have been reaching out to friends who I know have experience in that field - please reach out if you can help!
Looking back, I realize that I should have taken a closer look at financing. Instead of accepting being told that I would need a commercial loan, I should have dug in to find out why I was being told that - and if it was the truth.

Did you work with any real estate professionals (agents, lenders, etc.) that you'd recommend to others?

Trey Bolin is an excellent real estate agent the Cookeville, TN area!

@Kirbi Campbell

$50k net worth before age 19. I am at $28k excluding my quickly depreciating car. To do this, I will have to find a way to increase my earned income and also rely on my stock account comprised of mostly undervalued stock from last spring to do as well as it is projected.

I am 17 years old and trying to do everything possible to get ready to jump into REI by age 20 with a small multi family property (3-4 units) in my college town that would allow me to house-hack. My main problem is preparing for the financing on the property. The FHA loan seems like a good choice for me though I could likely afford the down payment on a 85-90% LTV loan from a portfolio lender if the FHA is too strict.

Assuming that I will be a 20 year old student with a standard w2 job, I doubt that lenders will jump at the opportunity to lend to me.

What can I start doing and thinking about to create the best chances of obtaining a loan from a lender at age 20 with less than ideal income?

Thanks guys!

@Dan Sheeks That is seriously everything I needed, I appreciate it!

@Jess White That’s what I found in my research as well. Thanks!

@Bill F. Thanks Bill!

@Brett Goldsmith Thank you Brett!

@Juan Deshon Thank you Juan!

@John Morgan Thanks!

-So you can take out the principle tax-free after 5 years!? I need to do more research!