Putting My Money Where My Mouth Is. Me doing what I suggest

How comfortable are you following advice from or investing with someone who says all the right things, but hasn’t been executing on their own advice?  When you go to a bank and the advisor suggests a mutual fund; Are they invested in it themselves?  I struggle with that question being someone who is discussing joint venture real estate and pumping up being a capital investor and letting a (skilled) managing partner (Me) do all the work.  I am open and honest in this scenario as I am not someone with the financial means to be the capital investor (yet) and I have dedicated years to educating myself to being the managing partner. 

I do truly believe in real estate as a great investment for a number of reasons; I do think real estate is an investment that carries a lot of risk; and I do believe that the majority of this risk can be managed with some education and hard work.  I believe the risk in real estate can be mitigated to the point where for a comparable return the risk is significantly lower than anything else.

So where does that leave me.  I want to help people invest, but I have not been the capital investor before, so considering my first point of view of this post who would invest with me?  I say all the right things, but I am not currently a capital investor and yet that is what I put forth as a great investment to be in.  I have also written about the positives of investing in commercial real estate, yet I am currently invested in single family doors.

Well…I have now.  October of 2019 I closed on a deal on 16 unit apartment building in Saskatchewan with a couple other investors.  I am a capital ivestor in a commercial building.

After a lot of brainstorming sessions, accountability calls, research, deal analyses and more; I wanted my next property to be heavier on the cashflow.  To find a property that has great cashflow, you either need to put down a greater percentage (Which I didn’t have) or you need to leave the lower mainland.  I am sure there are a few gems out there, but working out of town, I didn’t have the time to spend searching too many deals to find one.  I chose to spend time with my family as I was already missing out on a lot at home.  Sound familiar?

So, what worked for me was out of town cashflow.  This meant I would not be able to property manage.  Now I was going to be in the same scenario I have talked about before.  I was going to be the capital investor. 

I didn’t have much cash to invest, so how could I do it?  I have been fortunate that the investment property that I purchased had increased in equity (early) enough that I could get a HELOC.  I used that HELOC to purchase the Saskatchewan property.  This had so many positives for me in this scenario.

  1. Because I was using a line of credit to purchase the property, the interest charged to the LOC is fully tax deductable.
  2. The cost of borrowing (HELOC interest) is covered by the cashflow.
  3. We purchased a commercial property that is valued by using cap. rate.  This means that as we increase the net income (Increase income and/or decrease expenses), we increase the value of the building.  We have more control over the value of our investment.  See my previous post “The Mike Everitt Method”.
  4. I have invested with other investors, so I am not alone with this investment.
  5. The building was purchased undervalued and with lower than current market rents.  As the building has turnover we are able to increase rents and therefore increase value.  By purchasing the property at a discount we have some built in security to start. 
  6. I do nothing but collect and watch it grow.  A little simplistic, but I really just monitor what happens.  I am not involved in any of the day to day.

The moral of this story is I put my money where my mouth is.  It is working.  I am on both sides of a deal and it feels great.  I would love to be simply a capital investor in the future.

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.