Capitalization Rate and Commercial Real Estate

The Mike Everitt Method

How can you buy a property then get your initial capital back within a short period of time without relying on market appreciation? This sounds too good to be true, but it isn’t. As with all real estate investing with this method requires knowledge and skill.

I had the pleasure of having a lunch with a practitioner of just the precise method. I learned of this method from an investor named Mike Everitt. In our conversation Mike had told me that he only buys a property that will get him to his next property. Naturally I was intrigued. I hope you are too.

To understand the method he employs, you first must understand what Capitalization Rate (Cap. Rate) is, so I will start there. The explanation of Cap. Rate may be a little dry, but it is worth it to gain the understanding of this method.

Cap. Rate is the ratio of net yearly income (Of the property) to its purchase price. That sounds like a mouthful; but stick with it and I will break it down to explain it further.

CAVEAT: This method is based on capitalization rate and its ability to calculate value of a property. This doesn’t work for residential properties because their value is based on personal use and not as an investment. This method is for commercial properties. (A commercial property is a multi family, retail building, office building or otherwise)

Simple basic Cap. rate calculation:
$100 000 net yearly income ÷ $1 000 000 purchase price = 10% cap rate.
$12 000 net yearly income ÷ $500 000 purchase price = 2.4% cap rate.

When calculating your net yearly income take your income and subtract your expenses such as insurance, taxes, utilities and other operating costs. These are costs attributed to operating the property, but not for financing the property (ie. Not the mortgage).

Another piece of the cap. rate puzzle is that the number means nothing unless you know how to apply it. I will explain the basic application of cap. rate. Cap. rates will be different in different areas, but in a given area they will be relatively the same. I will clarify that statement. In area A, the cap rates might average 5% while area B might average out at 7.5%. If you know the cap. rate of the area, and you can calculate the yearly income of a property, then with the formula, you can calculate what the purchase/sale price should be.

Using the example above if you know your net yearly income ($100 000) and that the average cap. rate (10%) you can calculate the properties value to be $1 000 000. Once you have calculated the value you know if you are getting a good deal or not.

OK, now that I have explained the basic capitalization rate calculation and how it is used to calculate the value of the property, how can you use it to buy a property with say $250 000 down and very soon be able to get your $250 000 back so you can buy your next property? The magic is in the net yearly income. If you can increase income OR reduce your costs you will increase the NET yearly income. Now think about how that can affect the value of the property. If your cap. rate is 5%, then every dollar that you increase your net yearly income (Reduced $1 of cost or increased income by $1), the you increase the value by $20.

 

WAKE UP….This is where the magic is.

If you have made it this far I can now give you the answer to the initial question. For the example I will give you I will use numbers that are easy just for illustration purposes.

Using the above property ($100 000 net yearly income, $1 000 000 purchase price, 10% cap rate.). To buy this property you would need a down payment say 25% ($250 000). You need to finance $750 000. If you can reduce your yearly costs by $13 000 and increase your income by $12 000 totalling an increase in your NET yearly income of $25 000, then your value calculation has just changed.
$125K ($100K + $25K new) net yearly income ÷ 10% Cap. rate now gives you a value of $1 250 000.

You just increased your value by $250 000

 

By increasing your net income, you have increased the value of the property and this means that you have more equity so your LTV has changed and you can now refinance and take out your newly created equity…….Then buy the next one.

$1 250 000 x 75% LTV = $937 500 that you can now finance the property to.
$937 500 – $750 000 = $187 500 in equity you can refinance to.

Use that to buy your next property.

Voila. I am going to call this the Mike Everitt Method….and yes, I know he is not the only one employing this strategy and the name is not very clever, but I am going with it for me for now.

This method is my end goal. I want to work my way into commercial properties for a couple of reasons. I will keep you POSTED on my progress. If you want to know more or have something to add as always lets start a conversation.