Episode #094 - 4 Simple Steps to Evaluate Any Deal in Commercial Real Estate!

Today hosts Braden Cheek, Brian Duck and Joel Thompson discuss 4 simple tools that you can use to evaluate any commercial real estate deal.

And so that's the, that's the power of getting a higher rate of return. And we've done, we've done podcast on that is if you can increase the rate of return, then you reduce the amount of money you need to live the lifestyle that you want, which allows you to quit whatever job you don't like sooner. Welcome back to how to invest in commercial real estate. And we are back with another super exciting episode on evaluating commercial real estate. But before we get into the fun stuff, um, interest rates just got a lot more expensive, didn't they boys? Yeah, sort of a point. Not a lot more expensive, but it was in line with expectation. My expectation was not in line with race. You wanted to decrease. I'm optimistic. You know what I mean? I actually met with a lot of optimism and the, and the tenure as a result came down under 3.5, which is over a point down from its high. So we say that, but I don't find a lot of people land over the tenure. I mean it's not necessarily a common practice. Well, like Fannie Freddie and most non recourse debt do loan on the tenure, but also the 10 year coming down, most likely means the five year came down and a lot of our five year retail loans are based on that index.

So You know, to 25 over the five year, let's say Chris Myers is an example of stride or wherever he works now is that would be a metric he would use. So, Um, you know, if if five years to 75 then I don't know what it is today and you got to 25 over your at 5% rate. So we're getting down into reasonable. Yeah. And I I just wanna you know remind people that if you're getting debt, you know what a quarter over prime is is a reasonable average. So what is that 8% now that means to get neutral leverage, you've got to buy an eight cap, absolutely neutral leverage. And yeah, I mean if I wouldn't be getting data at at a quarter plus prime at the moment but it's just anyway it's getting high getting high. What do we think coming down next year? Yeah. I think by the end of this year, beginning of next year they may start cutting rates. Yeah. I talked to someone last week who really looks into it and has a big group of people and they felt like it's gonna be next year until it starts coming down.

I was hoping maybe the end of of 2023 he and his group think it's gonna be more like 2020 for before starts dropping some. So it seems like all of the big institutional players in this space have have pretty much cleared out from from my understanding. And it seems like the deals that are getting done are just like the the dirty gritty guys going in and getting a deal done. I mean there's no easy, clean cut, you know, good looking properties for sale. You know, you can get that cheap. A seller maximizing on value. I mean there's a lot of weird stuff out there if you're just looking at existing stuff, like why would somebody sell right now? That's the first question you have to ask. Yeah, I mean I've seen some clean stuff, a lot of single tenant stuff that's being marketed at 6, 6.5 and there's some 10 31 money that maybe needs placed. The single 10ant deals aren't worth as much money, right? So a lot of smaller people can but anything, anything that has any type of hair on it that those cap rates are not high enough and so they're not getting put on the market.

We don't see a lot of stuff right now. I think people are just holding, don't you? Yeah, everybody wants to know what what the Feds are ultimately gonna do when they're gonna stop cutting rates. Everybody's like, oh I'm gonna wait another two months. I'm gonna wait another three months. Yeah, buyers and sellers are just waiting on the sidelines. Well, still deals are getting done, it's just slowing down obviously with rates continually going up, it will probably slow down even more, but we were able to go down to the red River iCSC not last week, couple weeks ago and a surprising amount of activity is still being done. I mean the retailers are still showing up, they're still looking to open locations. We've done several new retail developments in the past quarter. I mean, it seems like there's still activity on the side of the economy is good enough, that retailers are, certain retailers are wanting space and so they have to absorb existing space or they've got to find new developments to put their stores in developments don't seem like they've slowed down, at least. Maybe that's maybe that's our perspective because we've really pivoted into those. So, um, in general doesn't seem like they have because like you're saying, retailers are still wanting to expand and um, the current interest rates don't impact the development as as much as they do on buying a long term project.

Right, right. Well, I think that's a decent segue into the topic for today because today we, we have, you know, we talk about cap rates a lot, we did it just in the intro, we're evaluating deals and, and just our small talk and and how we internally discussed deals, a lot of it is the cap rate. What is, what is the cap rate? Because for us, that's kind of a starting point. You know, if we can stay started a decent return, we know we can probably go up from there. It's worth digging into enough, but at the same time, cap rate doesn't evaluate everything, it doesn't tell you the whole story. It it doesn't assume a lot of things. So you have to evaluate more than the cap rate, you've got to look at something else. So today we're gonna go into several topics or or several metrics and how you would evaluate a commercial real estate deal. Um Like we would, well the first one is always cooperate because it's an easy comparison with a similar similar vintage, similar uh you're not baiting me into that ship again. What am I trying to say? Similar properties in the same asset class, similar asset class in the same market.

The cap rate is the easiest one to be able to try to compare. Uh And so we we gain a lot of knowledge off the cap rate. Uh So that's the first one we used to say, okay, is this deal a good deal or is it not a good deal? Okay and here's the question. What is cap, right, is it a yield on cost uh expressed as a percentage of the purchase price? I mean is that accurate to say? I think a cap rate is technically a value on an asset class in a sub market someone no one, no one's gonna like that. That definition. But I, the one I always want people to hear me say is it's the return you get if you paid all cash for the property, the day one return not the future value, not the appraised value. It's if I paid all cash, what is my expected year one return that that is going to be close to the cap rate. Okay. So I think my yield on cost might be accurate. Uh The downside of a cap break though from what I've seen is uh is shaking his head. No it's not it's not a cabaret is not a return, technically speaking.

No, I have to distinguish that. Even though I agree with what you guys are saying it's an I just said it's an expected year one return if you paid all cash. That's what Okay. Yeah, it's not a return. Okay. But sometimes when we look at some operating memorandum and we see a cap rate, sometimes don't people kind of fudge that number and they say, oh well this cap rate is based on you know, future, they want the best of both worlds. They want the best. So selling a cap rate on a performer is basically looking at a discount rate instead or an R. R. Instead because there's assumptions built into that. So how we want to look at it and how you should look at it is when you're evaluating a deal, you find the net operating income and then you put the market sub market asset class cap rate on that net operating income. So if you pull up costar, if you pull up whatever database you have, there's going to be a cap rate for each asset class in each market and sub market in that market. So you may look up and say a retail center in the northern part of Tulsa Oklahoma. The market cap rate for that today is 8.5.

And then you would divide that by your net operating income. And that would yield an estimated value. Yes. The negatives on a cap rate. It's just a day one. Look, it's a picture. Yeah, it's not a net operating income. You can calculate using the cap rate based on today's, you know, financials. Yeah. Just a one day snapshot basically. Right. Yeah. But how many times have you bought a $5 million commercial deal known it for a day? Never. Never. Right. So you got to look at more. You gotta look at what the property is gonna do the rest of the year. What it's gonna do in year two, year, three, year four, year five doesn't go down. Does it go up? You know, nothing doesn't do is take into account leverage doesn't and we buy with leverage. And so that doesn't tell you anything about your returns. If you're gonna leverage that property. Right? Yeah. It's like looking at, you know, a car value, you know, if somebody said, do you want a 2,019 used car or do you want a 2,016 used car? You would inherently put more value on the newer car. Similar.

Okay. So we have to operate. It's usable, but it's not the only metrical and look at what's the next one? Cash? Cash, cash. Why is this so important? What is it? Let's go. What is cash on cash? What's the amount of money you put in your pocket? Right? Every year? Every year, Cash on cash. Is the cash flow, the net cash flow coming out of the investment divided by the down payment or the total equity that you put into the deal. So I got $100 million dollar building. If we put down 20%, it's 200,000. So I have to take whatever cash flow I have after servicing the debt, after paying all my expenses. Uh, let's say it's, you know, 50,000 have to put that over the 200,000, uh, to get my, my cash on cash return in that case would be 25% Cash flow usually changes every year though. Right? The percentage a little bit either based on if every quarter Capex or yeah, every quarter. If there was some, some Capex expenditure that hadn't been accounted for or you know, increases in in other costs?

Right. So I, yeah, Well, I mean, the next question for me is why do, why is this an important metric? And why do, why do we like cash flow? Does that sound dumb? Why do we like cash flow? Not all investments have cash flow. If you're doing a development deal or something, you may not have any cash flow. But for us, we love buying cash flow deals because it puts money back in our pocket and our investors pocket every quarter. And the higher that cash flow number or that cash on cash percentage uh you know, it kind of lets you know how much flexibility you have in your expenses going up or down. If your if your cash on cash is 6% a year, you can't have much change before you, your risk of zero or negative having to put cash into the deal to supplement it. But if your cash on cash going into the deal with your assumptions is 20%. Well now you have a lot of room that you can you can maneuver a little bit with if something breaks, you've got some cash flow to cover it. Well, also we love taking that cash flow and putting it into new deals and leveraging the rate of return on on new deals, right? So I love cash flow because it keeps my phone from ringing, my phone rings when the cash flow stops.

Alright, so negative about a cash flow. What are some of those? Well, it doesn't tell you that the the total doesn't tell you the total return doesn't take into account equity. Pay down, Doesn't assume a purchase price. Uh An exit, you know, an exit cap doesn't do any of that. It's just telling you what the castle you're getting out of it is and what percentage that is divided by your total equity for most people, that's a great number, right? Like for most people that don't understand commercial real estate for most people that are getting into commercial real estate for our first time investor. If, if I can, if I can get them hooked on the idea that I'm gonna pay them 12% a year in cash, flow. You know, 10% a year in cash flow, let's call it. If I can pay you 10% a year in cash loan, you don't understand anything else. But you believe you'll get those checks, you know, can we, can we work something out? We're going to pay down debt. You know, that's a fact. That's more than 10%. Think about That. You'd love to get 12% on any investment per year. Right? But that doesn't take into account, paying down the debt increases in rents doesn't mean the investments ultimately gonna hit the numbers you projected, but, And it does reduce your risk if every year you're getting paid 10, now, four years later, you could have 50, of your original investment in your pocket.

So if something goes wrong, you're not out the entire amount. So I just go to like other popular things like Rolexes, Lamborghinis, Bitcoins, you know, the Robin Hood app when's the last time you put 10, 20 100,000 into anything. And it and it gave you a 10% return in the next year, we have people that do that all the time every day, every Day. Yeah. Most investments in order to get a return, you have to sell it. And so cash flow allows you to enjoy the return and you still own the asset. That's appreciating. That's the key that we love about cash flow. All right. # three equity multiple Equity multiple. Yeah. So we see this a lot with private equity groups. Family offices. Uh, they want to, they kind of go on equity multiple. They're they're not as concerned on when they get their money back, but they're they're concerned with my doubling my money and my tripling my money. And we typically see a minimum desire of uh, you know, two times equity multiple after five years as a minimum 2-3 times cash as they call it.

And a five year window is preferred. Yeah. So I mean what is that? A two X equity multiple in five years 20% right approximately. That's a that's a great return. That's a great return. You have to think about these institutional players right? Like their purpose in life is to invest money and make money on that investment. But if you give it back to them that that creates more work for them. So they're just like I want to make money, let's keep it in that deal. But I only need money back after I get to two times what I gave. You don't give me anything before that just give me my two times and then we'll reallocate it in the next deal. And the equity multiple is basically uh, your investment plus total cash returned divided by the initial investment. Is that right? Yeah. Your negatives, the negatives with equity multiples. It doesn't take into account time value of money. So it's just you could have a two X multiple, but you may get zero cash flow and then you get a dump at the end of five years.

That's not gonna be as good is let's say year one, you get 80% return and the next four years you get 5% return and then you get nothing at the end of five years that that you'd much rather have the money earlier. There's still, you know, two X multiple the same equal on the equity multiple front. But they're very different in terms of total return or uh, total average yearly return. Yeah, I want to be clear. We're not suggesting that use one or the other. We're suggesting that you use all of them. Right? And here's a perfect example why just like you just said, you can see cash on cash number of, you know, year one cash on cash, 10% year to cash on cash, 20% year, three cash on cash, 40%. Like man, the cash on cash just keeps going up so much. This is amazing. Well, it's because they're giving you your money back, right? So they're paying out the same cash flow maybe less cash flow but it's divided by a smaller number and your equity multiple. You would see that and you'd be like okay, you know I'm not really making much money here. You're just giving me a higher percentage return because you're giving me my money back.

I don't want my money back actually. I want I want my money invest in commercial real estate, that's why I gave it to you. So there's all of these things that kind of make up what investment you like. And and I would suggest you have general parameters for each one of these things. You know when we're looking at I. R. R. I want and I are are high teens. We look at equity multiple. I want I want a two X. And in five years when we look at cash flow I want 10 12% year over year. And you can start to see man, this is this deal is checking all my boxes. This is satisfying all my needs. We look at all these parameters all these metrics on every deal. Right? I mean we don't just look at one and a good model is gonna immediately do that for you. You're gonna have your inputs page, shove everything in and then you're out At one time. Exactly. Okay, so then we got one more we want to talk about and that's I. R. R. Which you kind of just alluded to. And so what internal rate of return. It's complicated but what's the positive about internal rate of return. So how I would reference it just right off the bat is we said cap rate is like a snapshot or a picture of the return.

And I are are I like to think of is a movie like it's the life cycle of the deal from the first time you bought it the day you close to the day you sold it. This includes everything, this includes time, this includes profit, this includes cash flow, this includes principal pay down. This includes everything from front to back. It's it's also the most difficult to get to because it includes everything. There's a lot of assumptions. You have to do a lot of work to put an accurate numbers or else you're just gonna get a garbage I. R. R. That doesn't help anybody. You got to know how long you're going to keep it, You gotta know what you're gonna sell it for or at least make those assumptions. And these last two, both equity multiple and I are both need to know how long you're gonna keep it and then they need to know what you're selling it for or assuming an exit cap. But what I would say is it's taking that total return and it's it's giving it to you in an average yearly compounding return form. Uh So where the equity multiple is the total amount of money that you're making.

I doubled my money. I tripled my money. The I. R. R. Is hey you essentially made an average compounding yearly return of 18%. Whoa. That or whatever it is, that's what that's what this is going to tell you. You get an I. R. Of 18%. It doesn't mean that you got 18% each year. It just means when you take the cash flows cash on cash principle pay down sale of the property exit cap assumption whenever you got that takes into account time value of money and it puts it into a nice neat average compounding yearly return. I know I got distracted there a little bit. I know but I think sometimes people listen to this and hear us say 18% return and they're like man these guys are just picking a number like 18% return is so achievable for us. It's not even funny we could we could put together a track record of deals we bought and exited that hit at least an 18% ir And and it would just blow people's minds, most people have never gotten an 18% return in their life and they and and they wonder why they don't have access to these investments When we used to back when the rates were lower if we weren't in excess of 20% ir we were disappointed and We've done we've done we've exited multiple deals that 40% of our our 50.70.

Uh so these these are not when we say 18, I mean that's that's kind of the single single double on an investment, it's not the home run. Next episode. I just came up the idea, we're gonna hit it live really quick. You know, you go to a traditional like life insurance planner and they factor in inflation and like some 7% return in a mutual fund and it tells you how much you need to invest to have your $3 million at retirement or whatever it is. And it just seems so overwhelming. Let's use that same calculator. I've got it and we'll put 18% on the return instead of this, you know seven garbage mutual fund that your life insurance company is selling And we'll see how much money you have to invest and and and it will blow your mind guys if you are investing and you're not getting 18% call, call us please shoot us an email we've got investments for you. Call us. Well let's do that example really quick. I got a calculator on my phone. So let's say that uh I'm gonna pick a number $1 million 65 or whatever.

Okay and so if you can get 18% return. Uh sorry I'm gonna I'm gonna back up let's say you need uh $100,000 of income in retirement. Alright. Starting at age 65. Yeah or whatever. Okay and so then $100,000 of income. Then I have to divide that by what.18 that's 555,000. I'd have to have in savings in order to give myself $100,000 in perpetual income if I could make 18%. Okay? But if I want that same 100,000 and I'm only gonna make 6% on my money in a safe mutual fund. You need you need a million uh 666,000 so you need more than triple the amount. And so that's a daunting task to say well I can't retire until I have a million six. But what if we could show you a way to retire when you got to a half a million? Well now you're thinking okay I'm not waiting till I'm 65 I might be able to do it 50 53.

And so that's the that's the power of getting a higher rate of return. And we've done, we've done podcast on that is if you can increase the rate of return and you reduce the amount of money you need to live the lifestyle that you want which allows you to quit whatever job you don't like sooner, clip that Aaron, you know, good idea. Brighton, clip that. Aaron, I love that. What else you want us to do? Brandon come on, keep it coming. I think that's it for today. Yeah. We will catch you next time on how to invest in commercial real estate. Make sure to go to the website, the criterion fun dot com join the investor list and you'll get all of our investment opportunities. We'll see you guys next week. Thanks guys.