Mastering Commercial Real Estate: Cap Rates, Interest Rates, and Positive Leverage

(Transcribed by TurboScribe.ai. Go Unlimited to remove this message.)

If it's 50% occupied, you can go buy it at a 7 cap when you're borrowing at 7% because you're going to grow the NOI so much that it doesn't matter. Yeah. Heard.

I hear you. Yeah. Get it? Yeah.

Don't leave a comment in the YouTube. Yeah. Don't do it.

All right. What is up? And welcome back to How to Invest in Commercial Real Estate, arguably the best podcast in Jinx Oklahoma. What is up? You know, hopefully you guys have been watching the Olympics.

I have. Because I think it's fantastic. I love it.

I mean, I wish it was every year. It's only every four years. Yeah.

It's a lot of fun. Yeah. Would you guys think of the opening ceremony with the river, not necessarily one of my favorites as far as some of the ones I've seen? It was cool.

It was in the rain. That's for sure. Yeah.

I thought it was kind of cool. You know what I thought was really cool was the Olympic Torx. Yeah.

Balloon. That was pretty unique. That was cool.

I'm always fascinated by, you know, superior humans, you know, doing their thing. The feats are amazing. Yeah.

Absolutely amazing. I think it's insane how close all of them are. Most every sport is insanely close outside of Katie Ledecky.

I mean, it's got to be just, it's got to suck swimming in her events. You know, this is kind of off top and we may cut this, I don't know, but Ledecky killed the field, right? Yeah. And we're like, oh, it's because she's such a superior athlete, you know, it's just what she is.

And then, you know, the Chinese swimmer breaks a record, you know, and they're like, they're all doping. They're cheating. And I'm like, I don't think we should go there, right? We don't go there when Americans win by a long, a good amount of time, a good amount of distance, right? Yeah.

So I think we got to be better losers and not start accusing everyone when we lose. In fact, I'd say you're one of the best losers I know, Joel. Yeah.

I try. Do you see the 62 year old ping pong lady won a medal? No. Pretty sick.

Brian, there's hope, bud. The the what is it? The Ukrainian guy in the shooting competition. That's the best.

His pose became famous. You know, just hand in pocket. No idea.

No idea. No sighting. Nothing.

T-shirt shorts. Yeah. You know, he just got back from the war like that day.

He's like, this is how we do it. I want to do it. Did you call him a Ukrainian? I didn't know what country it was from.

What country was it from? It was Turkey? Okay. Well, I'm a little disappointed, though, is we we stopped the game at about half time and USA is losing to Serbia in basketball. So that guy's got this taping.

They got the Joker, though. You know, I know. He doesn't mess.

He's good. I don't know if you know this. Curry had 16 or so first quarter points.

Oh, nice. He has half our points at halftime or something. So we went to CCIM lunch in here in Tulsa yesterday.

We'll plug that a little bit. It's always a fun time. I can't say that there was a plethora of high quality real estate being tossed around there.

You know, some some of us a little bit rough. I got to be honest. There's not a plethora of high quality real estate being sold in Tulsa generally, which is why we find ourselves buying so much real estate out of Tulsa, I think.

Yeah, that's a fair point. But if you want to get plugged in and you actually live here in Tulsa, some really great people, you can get connected, you know, you'll get ideas for new deals. But there's also vendors that will help you help you manage and the maintenance on your deals or all the all the vendors are there.

The brokers are there. So it's a good avenue to get introduced to people. Golf tournaments coming up.

Yeah, that's the end of the year. Guys, you're in Tulsa. You want to go to the golf tournament, CCIM golf tournament.

And it's not Forest Ridge this year, man. Forest Ridge is so freaking hard. Where's it at? I just suck at golf, too.

That doesn't help. Yeah, when I hit it into the forest, it's just gone. I don't even.

Yeah, it's because the forest is there. If it wasn't, I take like I take 10 balls, 12 balls and expect to lose most of them. You remember when Brian made it through the entire Phoenix trip without losing a ball? That was crazy.

I think I was down eight, nine dozen. I don't know what. I hadn't played like that since, unfortunately.

All right. Topic for today. We yeah, we thought we would kind of go back and discuss some of the important metrics on how we quickly evaluate commercial real estate deals.

And so the terms we're going to be talking about today that you need to know and you know how they interact with each other is cap rate. Number one, then we go interest rate. Number two, I think those might be the two most important right there.

If I was going to sum up commercial real estate with two terms, it would be cap rate and interest rate, but then also leverage can play a role and IRR is another one you didn't know. So should we give real brief definitions for the audience on those? Yes. All right.

Cap rate. We've gotten into a lot of heat with cap rate discussion. Here we go.

But let's keep it simple. If you have a million dollar deal and you pay all cash for it, what cash flow can you expect year one? Right. That's pretty easy, right? So if it's an eight cap deal, 8% capitalization rate, that means if it's a 80,000 dollars of cash flow.

Yes, you're you're unleveraged in a Y divided by your purchase price at the time of sale, at the time of the valuation. Right. You could argue in that first 12 months, the NLI is going to go up, but at the time of sale, day one, it's that it's that formula, your purchase price or your NLI divided by your purchase price.

Yeah. And so that that that's a big one. Of course, interest rate is just what what interest rate the bank is charging you to borrow the money.

Leverage point is how much of the deal can you borrow from the bank? So on a million dollar deal, if you have a 70% loan to value, 70% leverage, that's a seven hundred thousand dollar loan. That means you got to come up with 300,000 in equity. You know, I, I think another word we have to add to the list is positive leverage, right? Because that's the beauty of, of real estate is being able to go buy something that makes 10% and, and borrow the majority of the money at 8% or 7%, right? Then you have that Delta, you know, you're making 10% in the seal, but your cost of borrowing the funds to acquire the deals less than the deal makes, right? So you have a positive leverage point there, making you money.

Yeah. And that that's a great point. And then IRR is kind of the number that puts it all together.

It takes into account everything that's going on in the deal. And you assume a sale price in the future and it gives you your average yearly return. Yeah.

The sum of all cash flows divided by the total time period, the dollars were in the deal. Or our internal rate of return. Internal rate of return.

Yeah. It's a little bit complicated, but it's an important one. So, so what we thought we'd do today, because, you know, we have, we've had high interest rates now for, you know, year and a half, two years.

And, you know, kind of slowed down the market a little bit, because just like if you're thinking about purchasing a house, if you're in a house right now and your mortgage is 3%, do you really want to go buy a house and get a 7% mortgage? No, you don't. So what it causes is it causes, you know, people to stay where they're at. Well, same in commercial real estate is they can't get the best price for their deal when they're selling in a market, the interest rates are high.

Cause the cost to borrow the money to buy it is really high. And so, you know, it causes the deals to kind of stagnate. Um, so.

Which is when you should be buying, right? Because nobody's selling in a market where they know they're, they're leaving money on the table unless they have to. So if you're buying in that market, you're immediately, immediately getting a deal. Well, uh, yes.

So your point is accurate. That is a good time to buy, but not at first because, uh, cap rates lag interest rates. Right.

So let's say a deal, a million dollar deal has 80,000 in cash flow. It's an eight cap deal. Uh, and, and you could have purchased that and gotten a 5% loan or a 4% loan.

But if the, if the debt cost of debt goes up to seven or eight. Right. The cap rate, isn't going to move overnight, right? The seller's like, I still want the price I want.

Uh, and so what we've been doing is kind of waiting these last couple of years and cap rates are moving slowly up because people have to sell for whatever reason. And you know, and that's, that's what kind of brings those cap rates up because if you do have to sell, you're going to have to sell at a lower price and a lower price means a higher cap rate. And, and so that's what's caused them to move up.

And right now we're in a situation where rates I think have stopped going up and are about to start coming down. And so we are actively trying to buy as much as we can right now. That's a good time.

Real quick. Rates are going to go down and prices have come down. This is right, Tom.

Did you say if rates go down? I said, if, okay. You think rates are going down, Ryan? I didn't say when. When, when do you think rates are going down? When do you think we're going to see a first rate cut over there, Brian? By the end of the year.

Oh, we got to replay the tape. Yeah, I like it. I hope it's before the end of the year.

By quarter of a point. Interest rates and cap rates do have a correlating relationship, right? Interest rates go up, cap rates go up, but they, they lag a couple of quarters. I would think in a, in a traditional thing, as long as the interest rates aren't immediately corrected, right? We've seen for a year steady now, maybe longer.

Interest rates just continually go up. So as an investor, for sure, if you can wait it out, we found ourselves offering on the same properties over the course of six, nine months, just because it was still on the market and deals would just stagnate and you find nothing is priced, right? And you have to reach out to the broker a lot more because everything is still priced at, Hey, this is the eight cap deal. And right now with the cost of capital just being raised so much.

It's a nine cap deal. I'll, I'll, I'm, I'm still good for the nine. Call me when you're ready to take it.

A lot of people started calling back and adjusting prices and stuff tried started trading six, nine months later. So, uh, we, we have a few numbers that we're going to go over with you just to kind of give you some examples, but, uh, typically like, uh, you were saying positive leverage. Let's say that a million dollar, uh, you wanted to buy a million dollar piece of property and it's making 80,000 a year or 8%.

And, uh, let's say, uh, the bank will loan you money at something less than eight. Well, you're going to, that's how you know, you're going to make money. And how, how the simple way to think about it is what if the bank would loan you a hundred percent of the deal? So you have a million dollar property in the bank will only a million dollars.

And let's say that, uh, you know, the, it's doing 80% or 8% cap rate or 80,000 in cashflow, but the bank's gonna, they're gonna make you borrow it at 6%. Well, that's going to cost me 60,000 in interest. Okay.

And if I can borrow the 100% of the deal, then I make $20,000 for nothing. I didn't put any money in the deal, the bank loan, 100% of it. And so that's the power of positive leverage, uh, in the simplest form.

Now we can't get a hundred percent financing, but at least it, it shows you that borrowing, uh, money to buy a deal at less than the cap rate is the whole ball game in commercial real estate. That's literally what we do best. It's what we focus on is getting a spread between the cap rate and the interest rate.

And you don't always, it's not always that easy of a calculation because you are paying principal back at the exact same time, but yeah, a lot of the time she'll set it up. Um, yeah, but if you've loaned a hundred percent, yeah, I guess you're, you have a principal paid, paid down, um, but that, that money you're going to get back. So it is a little bit complicated.

So in our example, we, we start off, we took a million dollar example because it's just easy. That's our budget. We have a million bucks.

Yeah. I mean, the thing is the numbers are exactly the same on a a hundred thousand dollar deal and on a $10 million deal, right? The numbers don't change, uh, the percentages. So you can really apply these types of returns to any deal that you're looking at.

Um, the main thing is what's my cap rate, what's my interest rate, and what is my leverage point? And from there you can kind of get an idea of what kind of returns you're going to make. Yeah, full disclaimer. Uh, we had an exit assumption of the exact same as our acquisition cap rate.

So if we acquired a nine cap or 90,000 and a Y on the million dollars in purchase price, we assumed we were exiting at a nine cap. Obviously real world scenarios. You're, you're typically not exiting at the same cap rate you're acquiring on.

Um, ideally, you know, in, in the world we're buying in right now, we think we're going to be selling for a lower market cap rate than we bought on because hopefully it'll be a stronger economy, but that can fluctuate. Um, the other thing that can fluctuate in between these deals that we didn't want to mess with for the sake of the example was rent growth disparity. So all of these properties have 3% annual rent growth, um, from our experience and how we underwrite, we feel like that is very achievable generally across the board in retail.

Most asset classes, I would say most asset classes, you're probably getting a lot more. Um, but yeah, right now I think 3% annual rent growth is very achievable. Can't imagine anybody knocking us on that.

Yeah. Okay. Could it be two, you know, could it be 2% sure.

Uh, could it be five? Yeah. So yeah, we, we got to have some, you know, assumptions here to make this easy. Another thing is the loan.

Uh, we talk about a 70% and an 80% leverage point, but we're doing all the loans on a 25 year AM. Yeah. That's very typical for retail.

Uh, obviously you can get a 30 year on some and a 20 year on some. Uh, and that'll change the cash on cash numbers. It won't change the IRR numbers much.

Uh, but so those are kind of the baseline assumptions. Also, these are deal level returns. So we're not considering any, any waterfall, any splits, anything like that.

This is assuming one person buying something themselves or, or a group of people buying something and just splitting the cash flow proportionally. Last assumption, and we'll stop talking, it's a 2% cost of sale. Also very reasonable, right? Yeah.

Okay. All right. Well, Brian, so the first example I think we talked about was, uh, a nine cap deal, which, uh, they are available on the market.

Um, you know, I think retail is probably easier to get a nine cap than multifamily. Multifamily typically is a lower cap rate asset class. Uh, so we're doing a lot of retail.

So that's what we're talking about today. Um, and we assumed a 7% interest rate on the first example. Very real today.

Yeah, today right now you can go out and get a 7% interest rate and you can find a nine cap deal. Uh, and so let's look at a couple of different leverage points. Seven, let's look, let's look at 70% and then 80% uh, on that first example of a nine cap deal with a 7% interest rate.

Okay. So yeah, at 70% LTV, uh, the five year cash on cash average was 12% and the IR was 20%. Yeah.

That's fantastic. Yeah. Right.

I think that's really, really good. So, um, you know, if you think about in simple terms, no matter what deal you're looking at two points of positive leverage cap rate over interest rate produces a 20% compounding, uh, yearly return and, you know, 12% cash on cash. Right.

And at 80% LTV, the cash on cash five year average went to 14% and the IRR went to 25%. Nice. Yeah, that's great.

So we just went to the CCI luncheon yesterday. We talked about that, right? I can't tell you how many people in that room said how slow and boring everything is right now. And, and you know, criterion, we are freaking slammed right now.

Precision. You guys are really busy right now. So, uh, I love talking about this because we just said you can find nine cap deals on the market.

We just said you can get interest rates and borrow money at 7%. And we're going through these returns and these are winners, right? Like, what was that last one? 20 what? 25. 25%.

You put some splits on that as a sponsor and you go figure out how to raise $300,000 you're a happy person. You have happy investors. You're making a great return, right? Today, the worst real estate economy over today.

And once again, the numbers will work. Uh, if you, if you're getting two points of positive leverage and you're getting an 80% loan, uh, and using some of the assumptions we've, we've already talked about, like these are the returns, whether it's a $4 million deal, you know, a $350,000 deal. Right? The math is the math.

And, um, so the math is the math. Like it is, it just is. And you can trust, you can trust it.

Uh, now, obviously there's nuances to all these deals. And we've talked about that in other podcasts, but I'm just talking about quick analyzation of, of a deal. If you're looking at a deal that you think you want to buy and it's at a nine cap and you know, you can borrow it at seven, you know, you're going to make money on that deal.

More importantly, if you know you're going to borrow money at seven, you shouldn't be looking at any, uh, much less than a nine cap. Right. And, and this is where I'm going to get some flack, right? Because people say, well, it's a nine cap because it's got vacancy and so much upside for you to grow the, you know, why I get that.

I hear you, right? That's too complicated for, for, for this podcast right now. I hear you like if, if it's 50% occupied, you can go buy it at a seven cap when you're borrowing at 7% because you're going to grow the NOI so much that it doesn't matter heard. I hear you get it.

Don't leave a comment in the YouTube. Don't do it. We've talked about that stuff in other.

So, uh, and we did this just, just to kind of prove a point we looked at, what if, what if you're looking at an eight cap deal and interest rates have come down some and it's a 6% interest rate? Yeah, we actually looked at five, six and 7% interest rates for a one, two and three point spread. Okay. So, uh, let's go with, uh, let's go with just a, a 1% spread eight cap at 7% at 70% LTV it's eight and a half percent cash on cash and 18% IRR.

So that's just with one point spread. That actually, to be honest, being a professional in the field, that surprised me. It's fantastic.

And 80% LTV is 9% cash on cash and 22%. Okay. So worst case scenario, right? Like S and P 500 over the past 30 years has averaged like nine, nine something percent.

So you're getting that return in cash paid out quarterly, which the S and P 500 doesn't pay out an 8% dividend, right? It's just the value of the stock. Then you have to sell it at some point to actually realize the full 8% versus real estate, you're getting the 8% in cash, but when you sell it, it cumulatively adds up to 18% per year. Again, you do your retirement calculator on 18% per year.

Let's just discount it. Some for risk. Let's call it 15.

Let's call 14. Right? Like don't believe in the system. Be modest.

Sure. But every now and then you're going to hit 18. Every now and then you're going to hit 20, 21, it's going to be nuts.

And then we've, we've done these episodes on, on discounted cash flow calculators, um, at 18%, right? It's millions and millions and millions of dollars. If you keep it up for a few decades. Yeah, for sure.

Okay. Then we did a with 2% spread and eight cap is 6% interest rate. 70% LTV is 10 and a half cash on cash, 19% IRR, 80% LTV, 12% cash on cash, 24% IRR.

And so really what that, what that was showing me is that the two points of positive leverage going, you know, buying at an eight cap and getting 6% interest was very similar to buying at a nine and getting a 7% interest. Right. The, so really, uh, we talked about this before the show.

I, if I could give you one number, uh, one, the most important number is the, is the difference in cap rate over interest rate. That might be the, the number one, uh, thing you need to, to know in order to have the best returns. It's focusing on that, that difference.

And where we made a lot of money, uh, just two or three years ago was buying at eight cap and getting 4% for our quality. Uh, and so now we were, we were getting to the investor, uh, we were, we were getting, you know, 20, 25% IRR and then, and that was on top of the, the promote that we were taking because there was just so much cash flow there because of that four points of leverage. What was this latest stat on Plaza West that we did? Do you guys remember that? It's, uh, I don't, not off the top of my head.

I was working on that. Okay. Say something.

I'm going to, okay. You find that because we also did a 3% spread, eight cap with a 5% interest rate, 70% LTV, 12% cash on cash, 21% IR, 80% LTV, 14 and a half percent cash on cash and 27% IR. So that's, yeah.

So you really start, I mean, if you can get three points, you really get there four points as probably a 30% IRR deal level, uh, and maybe a 16, 18% cash on cash. So, you know, that, that's a pretty easy metric when you're looking at this guys is talk to local lenders. Hey, what's, what, what, what's the going rate on retail? I just had lunch with, uh, Chris Myers, uh, at Stride.

No, he's at Stride. Yeah. And, uh, the poor guy switches so much.

I know right now he's at Stride, but he, he's, he's all over a six and a half to 7% on his interest rate right now. Okay. And, and so we know we can, we can buy good real estate at eight and a half and to nine cap.

Uh, and so that's my, that's my two points that I need in order to make it an efficient investment vehicle. So Plaza West, I just ran an IRR metric because we're about to run this Facebook ad, uh, to date as the end of, uh, as of the end of the second quarter of 2024, we bought it in January of 22. So we've got what, two years and one quarter, nine quarters.

We have a 69% IRR on that shopping center deal because we bought it at an eight cap. We had four points of positive leverage at, at 80% LTV. We sold off the out parcels for like a six and a half cap when we bought it at an eight, made a bunch of money there, paid down some debt.

Anyway, if we were to sell that asset right now, give the investors another equity check back, even though they already got their initial equity check back, they would get another one. They would get a 69% IRR home run, home run on that deal, right? Home run. And just out of curiosity, we did one more example.

We kept the cap rate and the interest rate the same at 7% cap rate, 7% interest rate still at 70% LTV, um, 5% cash on cash and 15% IRR. And I, hopefully you did that right. And we didn't do one at the 80% LTV, but no, it's still, uh, that, that actually was a little bit shocking.

And so what, tell, tell us why, how are you making money when, when your, uh, income and your interest rate are the same? Well, you're not, we're not making a lot. I mean, four or 5% cash on cash. Uh, another, another disclaimer on these is we didn't, uh, we didn't get into the fees.

And so, you know, you could, you know, you could take off a little bit of these numbers. I know we did some, but you're going to have some, some, uh, acquisition costs and some fees associated with buying these properties. It just gets complicated, but you could take off a point or two on these returns if you wanted to pretty easy to, to, to take that into account.

So if you, if you brought in the fees in this, in that deal with equal leverage, uh, I would say you're probably at three, 4%. And the reason is, is you're even leverage on the set, on the 700,000 you're borrowing, let's say in our million dollar example, but the 300,000 you're still making, uh, an effective return on. Yeah.

Uh, and so that's, that's where, uh, you know, that's where your return is coming. Well, and it's, you're getting rent growth, right? Yeah. And you're, and you're getting rent growth and we're taking an average cash on cash.

So year one, uh, you're, you're virtually zero. Uh, but then you, you increase the, the NOI by 3% a year. And so you grow it up to six, seven or eight, and then the average is four or five.

Uh, but still that, that shows you that you can, you could buy an even, uh, leverage deal, uh, cap rate to interest rate. And if you have a path for rent growth, uh, then you still could make money. Yeah.

And the IRR is increased because you're paying down some debt while you're And, and the, and your increase in the, the rent and guys, uh, we, we typically don't try to, uh, to sell at the same cap rate we buy at and, and there's a lot of industry experts that will say, well, as deals age, you need to increase the cap, the exit cap. So if you buy at a nine, you should, you should theoretically put in there, if you're going to hold for five or 10 years, a nine and a half or a 10 on the exit. Maybe in a declining market.

I mean, an increasing market with positive population growth, job growth, uh, good, strong economics, there, there's no reason why that asset would just be worth less in my opinion. Yeah, I think the argument goes, well, if you hold it long enough, uh, it becomes, uh, let's say it goes from a class A to a class B and older asset, and that has to come down and cap rates on, but we're going to do a show, uh, where we address this. That we're buying nine cap deals that I think should be eight caps.

Uh, and in fact, we're going to prove it to you in a, in a future podcast where we're going to show you where the two identical deals are on the market. One's asking an eight cap and one's asking a nine cap. And there, there isn't any reason for the difference other than seller circumstance.

And so we try to look for deals that we think we can reduce, uh, the cap rate on the exit, so maybe we buy at a nine, but we think we're going to be able to sell it at an eight and a half, uh, just because of what we're talking about that we don't know why it was priced at a nine, but it looks really close to ones that are priced at an eight. So yeah, I mean, even the St. Louis deal, right? Uh, we have the ability to spin off the pads. That's easily worth sub 7% cap.

We bought it at a nine. So if we do that and then still sell the big box behind it for a nine, you're effectively an eight and a half. Probably you're winning.

Yep. Well, I think we probably anything else we need to cover on that for today. That's all we do.

Um, but just little things guys, uh, just that difference between cap rate and interest rate, uh, is really a lot of what we try to achieve and more purchasing, what can I, what cap rate can I buy it at? What can I get my debt at positive leverage? I would encourage people to look into other investments where you can generate so much positive leverage. I think that's, I mean, outside of the tax advantage is being able to create so much positive leverage so easily. It's, it's so normal.

Everyone, everyone creates positive leverage when they're buying real estate. Like it's very rare. People are buying in cash and even the people who are super low leverage are generating positive leverage.

That's, that's the name of the game in real estate. So the more comfortable you are with, uh, these levers, you know, in your easier and faster and more deals you'll end up buying. Anyway, we will catch you guys next week on how to invest in commercial real estate.

All right, thanks.

(Transcribed by TurboScribe.ai. Go Unlimited to remove this message.)