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The Real Estate God

@TheRealEstateG6

Aug 11

What's the relationship between cap rate, return on cost, and stabilized yield?

This is arguably the most important relationship in real estate and most people don’t understand it at all

It’s actually really simple

Let’s start with the basics:

- The cap rate is the NOI divided by the purchase price. When you buy a deal, you buy it for an in-place cap rate

- The return on cost is the NOI increase of a specific action (usually a renovation) divided by the cost of that renovation

- The stabilized yield is the new NOI divided by all the costs in the deal

Stabilized yield is an extension of the cap rate through the duration of the deal by adding the NOI changes to the numerator and by adding the additional costs to the denominator of the formula

For example, if a property was purchased for $1MM and the NOI was $100k, the *cap rate* would be 10% ($100k NOI / $1MM PP)

If you executed a $100k renovation and that increased the rents and therefore the NOI by $20k, the *return on cost* of that specific renovation would be 20%

($20k NOI increase / $100k renovation cost)

Then you add the NOI increase to the numerator ($100k + $20k = $120k) and the cost increase to the denominator ($1MM + $100k = $1.1MM)

Which leads to the *stabilized yield* being 10.9% ($120k new NOI / $1.1MM total costs in the deal)

So you take the initial cap rate and add in each return on cost action (the new revenue gets added to the numerator and the new costs get added to the denominator) to get to the stabilized yield

It’s that simple. People try and complicate RE a lot but it’s literally division

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The Real Estate God

@TheRealEstateG6

Jul 31

1. Go to tertiary market
2. Find a product type that’s profitable to build
3. Check zoning code and figure out the zoning that allows for that product type
4. Reach out to every property zoned for that use but currently operating as a *different* use
5. Buy, profit

// THREAD //

This takes the “off-market property” strategy one step further

The issue with most off-market strategies is that the owner actually has some idea of the value of the property

For example, most owners know approximately what a multifamily property should be worth in the area

That’s because of three reasons

1. They can base the value off the in-place cashflow
2. They can base the value off comps (and there’s always a ton of multifamily comps)
3. They can call up a broker to tell them what the value should be (and the broker will actually know)

This isn’t to say you can’t get multifamily properties for a discount off-market (you absolutely can)

Just that it’s harder to get a steep discount on them because the market for them is so transparent

The brilliance of the strategy laid out above, however, is that the market becomes a black hole when you switch uses (ex from industrial to self storage)

It works so well because the owner legitimately has no idea what the value of their land should be once you change uses

The valuation methods used above no longer work

1. The owner can’t base the new value off the in-place cashflow because the cashflow obviously changes when you change uses

2. There are barely any comps for switching uses and the ones that exist are almost impossible to look up

Anyone can look up a multifamily sale, how many unsophisticated owners can look at sales in their market and ascertain which properties have switched uses?

My guess is literally zero

3. Brokers (especially in tertiary markets) have no clue how to value a property when you switch uses so the off-market seller can’t even go to them for advice

For example, a property I’m prospecting off-market is currently operating as 3,000 SF owner-occupied industrial facility

But it sits on 10 acres and can accommodate ~200k SF of self-storage. The owner has no idea

Read 5 tweets

The Real Estate God

@TheRealEstateG6

Jul 22

I get asked all the time “how do you choose a market” & to be honest it’s pretty simple

Instead of approaching it from the statistical jargon perspective, I approach it from the “can I actually find a deal in this market” perspective

Here’s how I choose a market to invest in:

First let’s talk about how institutions look at deals & why it doesn’t make sense to look at deals that way as a smaller investor

Way I see it, there’re 2 strategies when choosing a market

1. “rising tide lifts all boats”
2. search for dislocations/discounts

Strategy 1 is used by institutions who need to deploy a lot of capital

This involves them playing “economist”. They need to find markets with high population growth, rent growth & appreciation

They operate in a competitive segment of the mkt ($20MM+) & it’s difficult to pick up assets for a “discount” in that range

So instead, they have to find mkts where competitors are underpricing future growth

This is dangerous since if you guess wrong, it could be a disaster. But institutions are built for this as they have analysts & data they can use to correctly pick the next high-growth mkt

As a smaller investor, you don’t. You have no edge over large firms. It’s not a smart place to compete

But as a smaller investor you don’t need to deploy a lot of capital

So you can use strategy #2

Instead of playing economist, you search for the least competitive mkts, where there’re the most pricing dislocations &, therefore the most discounts

Basically I look for the market with the least competition that’s stable

// Choosing a Market //

Ignore the data & focus on making money (finding markets where you can stabilize over the market cap rate)

A 4 step process:

Step 1: Look for cities/towns under 250k pop
Step 2: Vet supply
Step 3: Vet demand
Step 4: Make sure there’re mispricings

(Assuming shorter term holds)

Read 7 tweets

The Real Estate God

@TheRealEstateG6

Jun 12

You want to start your own real estate private equity firm but you don’t know how much it’ll cost

Here’s how to think about start-up costs:

There are basically 2 ways to set up a real estate private equity firm

1. First way is to start a fund. This means you raise the money first and find the deals later

2. The second way is to operate deal-by-deal, which means you only raise money for specific deals as you need it

Starting a fund involves a ton of legal costs, compliance costs, administrative costs

Wouldn’t recommend even thinking about this path unless you’re planning on raising a lot of money ($50MM+)

It involves a ton of startup costs and a ton that can go wrong

So I’d recommend option 2 instead: operating deal-by-deal

It allows you way more flexibility with how you operate

It also involves minimal startup costs. Why’s this? Because all the “startup costs” are layered on the deals themselves (which investors pay for), not your firm

Legal costs are registered as “deal costs” for the specific deal

“Administrative costs” are the asset management fees you receive yearly

You’re able to off-load your startup costs onto each deal, meaning that your actual startup costs are very low (sub $25k if you do it right)

This means that the hardest part isn’t the startup costs. It’s the *ongoing costs*

Real estate is a long game. It takes years for a deal to pan out (even a great deal)

How’re you going to put food on the table in the mean time?

That’s the main question you have to answer

You can’t eat IRR - you need money to live off of before your first deals sell

And you need money to invest as a co-invest into any new deals (REPE GPs usually contribute ~10% of the equity). So you have to get creative

You basically have 4 options to “navigate” this tricky initial period

Read 9 tweets

The Real Estate God

@TheRealEstateG6

Jun 10

There are 3 main debt metrics in real estate:

1. Debt Service Coverage Ratio (DSCR)
2. Loan to Value (LTV)
3. Debt Yield

Here’s how to view each from both a buyer’s perspective & a lender’s perspective:

// DSCR //

Definition: The DSCR is the ratio between the net operating income (NOI) from the property & the debt service associated with the loan

Formula: NOI / Debt Service

Example: A property has an NOI of $100k/yr & a debt service (inclusive of principal and interest) of $65k/yr. $100k / $65k = 1.67. So we would say the DSCR is 1.67x which is healthy - the property can easily service its debt

Buyer Perspective: This metric is probably the most helpful to understand how risky your deal is. It essentially asks the question: can the cashflow from the property satisfy the debt payments? If the answer is no & the DSCR is below 1x, you’ll need to come out of pocket to pay the loan, which is obviously a disaster. A deal like that inherently carries quite a bit of risk & you can lose more than just your initial investment

Lender Perspective: A traditional bank will likely not be interested in providing a loan unless the DSCR is at least 1.25x. Remember, the DSCR is inclusive of the principal payment, so even if you’re in an interest only period, the lender will calculate the DSCR as if the loan is amortizing. If you know the DSCR will be below 1.25x you will likely need to find a bridge, or hard money lender who specializes in transitional properties to give you a loan (or lower the leverage).

// Loan to Value (LTV) //

Definition: The LTV is the ratio between the total loan amount and the purchase price.

Formula: Total Loan Amount / Purchase Price

Example: A property valued at $2MM currently has a $1MM loan. $1MM / $2MM = 50%. So the LTV would be 50%

Buyer Perspective: LTV can serve as a proxy for how much additional risk you want added to the deal. More leverage will amplify the return (both positively & negatively). Below 50% leverage is seen as conservative, 50% to 70% as moderate, & anything over 70% is aggressive. This only applies, however, if the appraised value is accurate at the time the loan is made. Often, the appraised value simply matches the purchase price even when the buyer has secured an above or below market price. When a property is worth more or less than the appraised value the LTV can be a “fake metric” that overstates or understates the risk

Lender Perspective: Lenders heavily anchor the amount they are willing to lend on the LTV. During good times, traditional banks are generally open to lending roughly 75% of the appraised value (whether for an acquisition or refinancing). More recently, banks have pulled back and achieving leverage this high is more difficult (although the main constraint these days is usually from a DSCR perspective rather than an LTV perspective). Like with the DSCR, if you want higher leverage than a traditional bank is willing to offer, you will most likely have to find a bridge or hard money lender

Read 5 tweets

The Real Estate God

@TheRealEstateG6

Jun 9

“How are real estate properties valued?”

There seems to be a lot of confusion around this topic when it’s actually really simple

The #1 myth you’ll hear is "Properties are sold based on their in-place income"

This is dead wrong. Let's walk through why this isn’t how it works:

Easiest way to think about why this is false is by imagining a vacant 4 unit property. Vacant properties have no income. So if properties were actually sold based on the in-place cap rate, vacant properties would have a 0% cap rate and be sold for $0 dollars

That's obviously not the case. Vacant properties are generally worth more than $0 (there are some exceptions)

Why is this?

Because properties are sold based on the stabilized yield, not based on the in-place cap rate

Let's walk through an example. You have a vacant 4 unit property, how would you value it?

Assumptions are that the market rent is $1,200, lease-up costs are $60k ($10k per unit * 4 units + $20k in reserves), the market occupancy is 95%, the market NOI margin is 65%, & the market cap rate is 5%

First thing you need to do to value the property is to find out the stabilized NOI

Income: $1,200 market rent * 4 units * 12 months * 95% occupancy = $54,720
Expenses: The market NOI margin is 65%, which means that expenses are 35% of income

$54,720 * 65% NOI margin = $35,568 NOI

Now that you have the stabilized NOI, you can calculate the stabilized value

Stabilized Value: $35,568 / 5% market cap rate = $711,360

The next step in valuing the property is accounting for the costs to "get there" (to stabilization)

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