“He is not a full man who does not own a piece of land.” – Proverb
As today’s quote implies, the aspiration of owning land (which I’ll happily extrapolate to include home ownership) is nothing new. But is it a good or right objective to hold in such high regard? As David Bahnsen recently opined, owning a home can certainly have positive implications if done so “under the right financial circumstances.” However, since US housing affordability has diminished significantly over the past 60 years – not even accounting for the current higher-rate environment in which we find ourselves – the notion that home ownership is a realistic goal for everyone is far-fetched at best. Instead, we should ask ourselves, “Is home ownership necessary for peace of mind, long-term wealth generation, or a truly fulfilling life?” That answer is a resounding “no,” as a house is but another possession, and “stuff” doesn’t create long-term happiness. The wise person would trade home ownership for perpetual peace of mind in a heartbeat.
In addition, substantial peace of mind may come from renting and not being on the hook for inevitable repairs and maintenance included in “the joys” of ownership. And, if a person were to wisely invest the funds that would otherwise be needed for down payments, maintenance, taxes, and monthly mortgage obligations that are potentially higher than rent, they may find themselves wealthier over the long term. In multiple cases, I’ve witnessed long-awaited “downsizing” moves cost more than the home equity accumulated over time. So, even retirees with a mortgage-free home may again face a new mortgage payment or be forced to rent (financially speaking) when relocating. That is not to say that real estate hasn’t created significant wealth for some people, but – as with stock trading in our FOMO culture – success stories are likely shared far more than the cases where a given real estate deal failed miserably.
IOU
As promised in the last edition, we’ll wrap up this series with a brief overview of ways to value commercial real estate. There are various methods to do this, but they’re essentially all ways of doing the same thing: decomposing a property into ratios or unit costs to allow for more of an “apples to apples” comparison. Though it’s a less-common approach on the residential side, it makes perfect sense to me to consider how much each bedroom, bathroom, or square foot of living space costs from one house to the next. On the commercial side, these “per unit” measures are standard practice. And, since commercial properties are intended to generate income, we can look at the cost per unit and revenue per unit, along with other methods. Here are a few examples:
- Hotels or multifamily: how much cost or income “per door” or “per key” (jargon for each hotel room or apartment unit) am I incurring or generating?
- Cost/income per rentable square foot
- Replacement cost: if I’m paying less than what it would cost to buy the land and rebuild the entire property, I may feel good about that.
NOI and Cap Rates
It’s all well and good to know what you’re paying or generating per foot, as these can help to juxtapose properties with one another, but I believe both things are important simultaneously. With that in mind, it’s worth learning about Net Operating Income (NOI) and Capitalization Rate (cap rate).
NOI is a simple calculation that subtracts expenses from revenues to determine how much cash flow a property generates. Thus, a property with $100k of revenues and $50k of expenses has an NOI of $50k. Easy, right? The problem with NOI, however, is that it’s all quantity and not quality. If I paid $5 billion for a property that only generates $50k of income, that doesn’t seem very good. However, if I got the place for free, $50k sounds excellent; this is where the cap rate comes into play.
The Capitalization Rate divides the NOI by the property’s market value to determine the amount of income vs. total market value as a percentage (e.g., our same $50k NOI on a $1 million property would mean a cap rate of 5%). You may already be asking yourself, “Isn’t that the same as yield?” Yes and no. The subtle difference between cap rate and yield is simply that yield compares NOI against the cost of the property, while cap rate reflects NOI vs. the property’s market value. I’m usually more interested in yield, but – if you want to be cool – you talk cap rates. Real estate professionals like to talk about how they bought a property at an “8-cap” and sold it at a “4-cap.” Math will tell you that if cashflows stayed the same during the holding period, they sold it for more than it was purchased for (but it ignores the amount of money they may have invested along the way). But math will also tell you that buying at an 8-cap and selling at an 8-cap could be even better if the NOI and market value both increased substantially, but the cap-rate ratio remained the same. That’s a long-winded way of encouraging you not to be fooled by cap-rate conversations.
One last thing on cap rates: Inverting the cap rate indicates how many years it will take for the income to generate an amount equivalent to the property’s value. Again, it’s even more helpful with yield if we’re assuming “yield” inherently reflects the cost of the investment. A 10% yield means recouping the cost in 10 years (1 divided by 10%), while a 5% yield means recouping the cost over 20 years (1 divided by 5%).
The above are but some of the ways we can compare, assess, and justify real estate values.
Valuing The Office: putting our knowledge to good use
If my wife, Katie, is doing a repetitive task (let’s call it “folding laundry”) and wants to watch something guaranteed to bring her joy, she’ll put on reruns of The Office, which seem to play endlessly on various TV channels over the weekends. Michael Scott, Jim, Pam, Dwight, and the rest of the team make for good entertainment in what appears to be a suburban, low-rise office space. But would their building be a good real estate investment? The honest answer is, “It’s impossible to know because it’s fake and actually filmed in LA – not Scranton,” but bear with me. If we pretend The Office was real for a moment: Would I want to buy the office of The Office – i.e., a two or three-story mixed-use building, with outdated office space upstairs and warehouse space on the ground level? My answer is “I don’t think so,” but here are some reasons why or why not that may be the case:
- Demographics: Scranton isn’t a large market (about 75,000 people in the city or 375,000 in the metro area, and population growth seems to be zero or slightly negative. Not what I’d deem to be generally favorable demographics.
- Additional Costs: The office space needs a lot of upgrading. It could be mainly cosmetic or more involved, but we really can’t tell as viewers of the show. My guess is that the improvements are more complicated than just some new paint, furniture, and fixtures. And that’s before getting into deferred maintenance issues like the structure, roof, parking lot, etc. On the one hand, these items could pose a great opportunity (significant “value-add” project), but – on the other hand – will those enhancements bring us the return on investment (or NOI increase) we’d need to drive a successful outcome?
- Price: As with any project, the purchase price is an essential component of this underwriting calculation. If someone gives me the building for free, I’m all ears. But the cost of the property and my interest level are very much negatively correlated (which is probably true of any property, ever).
- Occupancy: One of the main concerns is – if I don’t have Dunder Mifflin locked into a long-term lease with guaranteed rent increases – who would be the next natural occupant of that type of property in an area like Scranton? You likely need a mid-size company that requires both office and warehouse space (unless the two areas can be leased separately). I don’t know how many companies in Scranton are in the market for warehouse space with the capabilities we can offer (square footage, ceiling height, loading dock access, etc.), BUT I assure you it’s a smaller number than the number of companies looking only for office space. From another perspective, perhaps the number of warehouses is limited (i.e., low supply), demand is very high, and Scranton has a law that no more warehouses can be built within city limits (limited competition). I’m obviously fabricating all of this, but that could a) make warehouse space very valuable, b) introduce legislative/permitting risk into the equation, and c) imply we’d have to pay a lot more for the property in the first place…which could undermine the entire investment thesis.
Wasn’t that fun?
As for The Office TV-show franchise itself, I don’t know what it’s worth, but NBC was willing to pay $100 million per year for five years (of real money) for streaming rights, thus rendering our fictional real estate deal a drop in the bucket by comparison.
There is plenty more to cover in the world of real estate, and we’ll be sure to revisit it. As they say in the entertainment industry, that’s a wrap!
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
