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Equity is NOT the only way to make money in real estate

Thomas Beyer

Thomas Beyer

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Equity upside is always desired. Often the only way to make money in single family houses, raw land or condos realistically is through equity upside, as cash-flow is poor to negative. Hence the focus on strong markets. Let`s face it though: not every market is an up market, and certainly not all the time. Many prices in UK, Ontario, Australia, BC or Alberta have risen to a point where affordability is seriously eroded, possibly for a long long time .. hence significant, fast equity upside it tough to get .. Hence, are there ways to make money in flat to even declining markets ?

Yes, there are, in commercial real estate, strorage or multi-family/apartment buildings. These assets are essentially income producers and are usually measured as a multiple of annual cash-flow, also referred to as CAP rates or yield. The CAP rate is the net operating income divided over the price - also referred to as going-in yield. It is the inverse of the P/E ratio used for the stock market. So, in a declining market like Windsor, ON or a flat market like GTA, let`s assume you can get a 10% CAP rate, i.e. 10% yield after operating expenses and realistic vacancy assumptions if you paid in cash. Of course you don`t pay all cash, so let`s assume you get an 80% mortgage (with CMHC usually), so 20% cash down. This is 24% ROI on the cash invested in a flat market and 9% in a -3% negative market !

>>> You do NOT need equity upside in multi-family (or storage or commercial) to make money !

Just the going in price has to be attractive enough / the going-in yield has to be appropriate and the vacancies have to be managed ! The higher the (anticipated) equity upside the lower the CAP rate usually (like AB or BC right now ..) but excellent cash-on-cash ROI can be achieved in flat or even declining markets - if the yield (or CAP rate) is appropriate - see chart below !!

We don`t really care where we make 25% to 70% cash-on-cash !! Do you ?

Conclusion: buy in Windsor (or GTA or London or Calgary or Texas or Detroit or Ottawa or ..) : at the right price/yield .. and manage the vacancies / rents / expenses .. you`ll be amazed ... of course, the higher the expectation for future negative growth the lower the price / the better the yield has to be !!

Cash-on-cash ROI + equity upside using leverage

in 3 different growth markets: + 4%, flat and -3%


Left most column is yield (i.e. CAP rate) .. top line is various leverage level

Equity Upside 4.00% - "Normal" Market


Leverage: 0% 50.00% 60.00% 70.00% 75.00% 80.00% 85.00%


6.00% 10.00% 13.50% 15.25% 18.17% 20.50% 24.00% 29.83%

u>8.00% 12.00% 17.50% 20.25% 24.83% 28.50% 34.00% 43.17% 10.00% 14.00% 21.50% 25.25% 31.50% 36.50% 44.00% 56.50% 12.00% 16.00% 25.50% 30.25% 38.17% 44.50% 54.00% 69.83%
15.00% 19.00% 31.50% 37.75% 48.17% 56.50% 69.00% 89.83%

20.00% 24.00% 41.50% 50.25% 64.83% 76.50% 94.00% 123.17%

25.00% 29.00% 51.50% 62.75% 81.50% 96.50% 119.00% 156.50%





Equity Upside 0.00% - Flat Market



Leverage: 0% 50.00% 60.00% 70.00% 75.00% 80.00% 85.00%

6.00% 6.00% 5.50% 5.25% 4.83% 4.50% 4.00% 3.17%

8.00% 8.00% 9.50% 10.25% 11.50% 12.50% 14.00% 16.50%

10.00% 10.00% 13.50% 15.25% 18.17% 20.50% 24.00% 29.83%

12.00% 12.00% 17.50% 20.25% 24.83% 28.50% 34.00% 43.17%

15.00% 15.00% 23.50% 27.75% 34.83% 40.50% 49.00% 63.17%

20.00% 20.00% 33.50% 40.25% 51.50% 60.50% 74.00% 96.50%

25.00% 25.00% 43.50% 52.75% 68.17% 80.50% 99.00% 129.83%





Equity Upside -3.00% - Declining Market



Leverage: 0% 50.00% 60.00% 70.00% 75.00% 80.00% 85.00%

6.00% 3.00% -0.50% -2.25% -5.17% -7.50% -11.00% -16.83%

8.00% 5.00% 3.50% 2.75% 1.50% 0.50% -1.00% -3.50%

10.00% 7.00% 7.50% 7.75% 8.17% 8.50% 9.00% 9.83%

12.00% 9.00% 11.50% 12.75% 14.83% 16.50% 19.00% 23.17%

15.00% 12.00% 17.50% 20.25% 24.83% 28.50% 34.00% 43.17%

20.00% 17.00% 27.50% 32.75% 41.50% 48.50% 59.00% 76.50%

25.00% 22.00% 37.50% 45.25% 58.17% 68.50% 84.00% 109.83%

Left most column is yield (i.e. CAP rate) .. top line is leverage level

One reason why we see CAP rates rise in AB or BC right now (Nov. 2007) is the fact the the future equity upside is lower than the last few years .. so anticipated rent growth is related to yield going in .. or as Tim Johnston puts it "sell into the boom" .. i.e. it has the lowest CAP rates !! (but why sell if you can make money in ANY market with cash-flow buildings ??) True wealth is built by holding .. with cash-flow !
 
Hi Thomas - just to make sure I understand.....

A 200k property with rent of 1250/mo and 250/mo of expense (vacancy allowance, ins, maint, tax, condo fee etc) gives net income of 1000 x 12 mos =12000 per year net, or 6% CAP

Correct so far?

I get lost in then trying to figure out cash to cash ROI from here - would it be 12k(income)/40k (orig investment)? Somehow doesn`t seem right to me - chart says 4% on flat growth

Help!

Thanks
 
Generally speaking as an investor you should look at makeing your profit when you buy (below market) and not when they sell (appreciation). Or by having a positive cash flow at time of purchase. When making cash flow calculations, on properties to be held long term, expences should be based on 45% to 50% of rental income. This is a much better real world number which leaves about 50% for debt service (calculated on 100% financing) and profit. If after all costs you can see $100 per unit per month profit you are doing OK. This is much simpler system and safer for the novice investor to ensure success I believe as opposed to seeing it as, and calculating, cap rates.
 
QUOTE (neill @ Nov 16 2007, 02:30 AM) Hi Thomas - just to make sure I understand.....

A 200k property with rent of 1250/mo and 250/mo of expense (vacancy allowance, ins, maint, tax, condo fee etc) gives net income of 1000 x 12 mos =12000 per year net, or 6% CAP

Correct so far?

I get lost in then trying to figure out cash to cash ROI from here - would it be 12k(income)/40k (orig investment)? Somehow doesn`t seem right to me - chart says 4% on flat growth

Help!

Thanks

correct .. cash-on-cash also takes into consideration the MORTGAGE payemnt which the CAP rate doesn`t .. it assume "all cash" .. and since the mortgage payment usually also involves a principal paydown .. the cash-on-cash is LOWER than the ROE or retrun on equity .. since the cash-on-cash PLUS your principal paydown is really teh profit you made that year .. plus hopefully any equity appreciation ..
 
QUOTE (invst4profit @ Nov 16 2007, 09:39 AM) Generally speaking as an investor you should look at makeing your profit when you buy (below market) and not when they sell (appreciation). Or by having a positive cash flow at time of purchase. When making cash flow calculations, on properties to be held long term, expences should be based on 45% to 50% of rental income. This is a much better real world number which leaves about 50% for debt service (calculated on 100% financing) and profit. If after all costs you can see $100 per unit per month profit you are doing OK. This is much simpler system and safer for the novice investor to ensure success I believe as opposed to seeing it as, and calculating, cap rates.

True enough .. and yes 45-50% is an accurate "rule of thumb" figure .. or $3200 to $3400 per suite per year in expenses. Also, if CAP rates rise .. which they are now in some markets .. you may get less per door than you paid for even if rents go up slightly ..

So yes, you make money on the day you buy .. but you realize it the day you sell !
 
QUOTE (neill @ Nov 16 2007, 04:30 AM) Hi Thomas - just to make sure I understand.....

A 200k property with rent of 1250/mo and 250/mo of expense (vacancy allowance, ins, maint, tax, condo fee etc) gives net income of 1000 x 12 mos =12000 per year net, or 6% CAP

Correct so far?

I get lost in then trying to figure out cash to cash ROI from here - would it be 12k(income)/40k (orig investment)? Somehow doesn`t seem right to me - chart says 4% on flat growth

Help!

Thanks

correct so far, although expenses such as taxes, condo fees and vacancies alone are usually MUCH higher than $250/month .. we use at least $300 for a tightly managed apartment building and probably $400 or more for a condo .. higher the more high-end the property is !
 
Excellent topic Thomas. I like the way you think.

The only concern I have about this is that rents can drop in declining markets. I don`t believe you`ve factored that variable into your equations. In some cases, rents can drop dramatically, though in such markets, the potential for lower rental income is usually reflected in the property`s list price. A good example of this is in Windsor, where some multi-family properties are going for very attractive prices. You just have to be aware of all the factors.

w

PS: By no means do I suggest that I have any expertise in this area, I just like numbers.
 
QUOTE (willy @ Apr 7 2008, 12:58 AM) Excellent topic Thomas. I like the way you think.

The only concern I have about this is that rents can drop in declining markets. I don`t believe you`ve factored that variable into your equations. In some cases, rents can drop dramatically, though in such markets, the potential for lower rental income is usually reflected in the property`s list price. A good example of this is in Windsor, where some multi-family properties are going for very attractive prices. You just have to be aware of all the factors.

w

PS: By no means do I suggest that I have any expertise in this area, I just like numbers.

of course, I too like cash-flow AND equity upside !

but: even in a completely FLAT market for 25 years, with 0 rent growth, and 0 cash-flow .. you can quadruple your money when putting 25% down and paying the mortgage to 0 in 25 years !

or: even if the market drops in half, you`d double your money !!

the trick is to "hang in there" long enough with positive or at LEAST break even cash-flow !! you`ll come out OK, in ANY market .. (assuming not too high vacancies and thus, at least break even cash-flow )
 
QUOTE (thomasbeyer2000 @ Nov 15 2007, 08:55 PM) Equity Upside 4.00% - "Normal" MarketLeverage: 0% 50.00% 60.00% 70.00% 75.00% 80.00% 85.00% 6.00% 10.00% 13.50% 15.25% 18.17% 20.50% 24.00% 29.83%

8.00% 12.00% 17.50% 20.25% 24.83% 28.50% 34.00% 43.17%

10.00% 14.00% 21.50% 25.25% 31.50% 36.50% 44.00% 56.50%

12.00% 16.00% 25.50% 30.25% 38.17% 44.50% 54.00% 69.83%

15.00% 19.00% 31.50% 37.75% 48.17% 56.50% 69.00% 89.83%

20.00% 24.00% 41.50% 50.25% 64.83% 76.50% 94.00% 123.17%

25.00% 29.00% 51.50% 62.75% 81.50% 96.50% 119.00% 156.50%





Equity Upside 0.00% - Flat Market



Leverage: 0% 50.00% 60.00% 70.00% 75.00% 80.00% 85.00%

6.00% 6.00% 5.50% 5.25% 4.83% 4.50% 4.00% 3.17%

8.00% 8.00% 9.50% 10.25% 11.50% 12.50% 14.00% 16.50%

10.00% 10.00% 13.50% 15.25% 18.17% 20.50% 24.00% 29.83%

12.00% 12.00% 17.50% 20.25% 24.83% 28.50% 34.00% 43.17%

15.00% 15.00% 23.50% 27.75% 34.83% 40.50% 49.00% 63.17%

20.00% 20.00% 33.50% 40.25% 51.50% 60.50% 74.00% 96.50%

25.00% 25.00% 43.50% 52.75% 68.17% 80.50% 99.00% 129.83%



n style="font-size:10pt;line-height:100%">
Equity Upside -3.00% - Declining Market



Leverage: 0% 50.00% 60.00% 70.00% 75.00% 80.00% 85.00%

6.00% 3.00% -0.50% -2.25% -5.17% -7.50% -11.00% -16.83%

8.00% 5.00% 3.50% 2.75% 1.50% 0.50% -1.00% -3.50%

10.00% 7.00% 7.50% 7.75% 8.17% 8.50% 9.00% 9.83%

12.00% 9.00% 11.50% 12.75% 14.83% 16.50% 19.00% 23.17%

15.00% 12.00% 17.50% 20.25% 24.83% 28.50% 34.00% 43.17%

20.00% 17.00% 27.50% 32.75% 41.50% 48.50% 59.00% 76.50%

25.00% 22.00% 37.50% 45.25% 58.17% 68.50% 84.00% 109.83%

Left most column is yield (i.e. CAP rate) .. top line is leverage level

One reason why we see CAP rates rise in AB or BC right now (Nov. 2007) is the fact the the future equity upside is lower than the last few years .. so anticipated rent growth is related to yield going in .. or as Tim Johnston puts it "sell into the boom" .. i.e. it has the lowest CAP rates !! (but why sell if you can make money in ANY market with cash-flow buildings ??) True wealth is built by holding .. with cash-flow !




Hi Thomas,

This is an awesome post! How did you calculate these cash-on-cash returns in the charts?

Thanks,
Paul.
 
QUOTE (pmeikle @ Oct 23 2009, 11:50 AM) This is an awesome post! How did you calculate these cash-on-cash returns in the charts?

[CAP Rate + Expected Value Growth] / [1 - leverage + 5% reserve]

Example 1: 6% CAP rate + 4% growth = 10%

using 60% leverage: divide 10% by [1-0.6+0.05] = 0.1 / 0.45 = 22.2% annual ROI

Example 2: 10% CAP rate + no growth = 10%

using 70% leverage: divide 10% by [1-0.7+0.05] = 0.1 / 0.35 = 28.5% annual ROI

Low CAP rates usually do not allow high leverage as banks don`t lend that high .. whereas in a high CAP rate but flat market higher leverage can be obtained allowing for a HIGHER cash-on-cash ROI than in a booming (low CAP rate) market !

Thus in low to no growth areas the CAP rates are usually higher to allow for a decent ROI .. thus in a fast growing market like Alberta from 2002 to 2007 low CAP rates were common, thus huge value growth .. since 2007 rent growth is slower to flat thus CAP rates have risen meaning prices have predictably fallen .. thus: sell into the boom (with low CAP rates). Now is probably a time to buy again in Alberta as CAP rates have risen to a point where they make sense again !
 
QUOTE (thomasbeyer2000 @ Oct 28 2009, 02:43 AM) [CAP Rate + Expected Value Growth] / [1 - leverage + 5% reserve]

Example 1: 6% CAP rate + 4% growth = 10%

using 60% leverage: divide 10% by [1-0.6+0.05] = 0.1 / 0.45 = 22.2% annual ROI

Example 2: 10% CAP rate + no growth = 10%

using 70% leverage: divide 10% by [1-0.7+0.05] = 0.1 / 0.35 = 28.5% annual ROI

Low CAP rates usually do not allow high leverage as banks don`t lend that high .. whereas in a high CAP rate but flat market higher leverage can be obtained allowing for a HIGHER cash-on-cash ROI than in a booming (low CAP rate) market !

Thus in low to no growth areas the CAP rates are usually higher to allow for a decent ROI .. thus in a fast growing market like Alberta from 2002 to 2007 low CAP rates were common, thus huge value growth .. since 2007 rent growth is slower to flat thus CAP rates have risen meaning prices have predictably fallen .. thus: sell into the boom (with low CAP rates). Now is probably a time to buy again in Alberta as CAP rates have risen to a point where they make sense again !

That answers my questions perfectly.

Thanks, Thomas!

Kind Regards,
Paul.
 
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