Scaling in Commercial Real EstateMay 25, 2022
What's up guys, today's video is all about commercial real estate. I hope you enjoy this overview and I hope it makes sense. Commercial real estate can seem very scary. A lot of people think it is out of reach, it is too big, there is too much risk, or they just plain do not understand it. Even for most real estate investors, a lot of them have a hard time going from single-family homes to commercial real estate. So, the questions are:
Is it scary?
Is it dangerous?
Is it somehow worse than investing in single-family homes or other products?
In this article, we are going to cover a lot of things about commercial real estate. Everything from value to how we find deals, how that looks, and risk. In short, commercial real estate is a much more efficient way to scale and reduce risk at the same time so we are going to cover this. We are going to talk about it. I own over 2 million square feet at this point of commercial real estate and a lot of my preconceived notions on how real estate investing in the commercial real estate space would be, were wrong and it ended up being my primary business which is exciting for me. I love the commercial real estate space and I have questioned why so many people are not talking about it. There's so much information and content out there on single-family homes, but so little on commercial real estate. That does not make any sense to me because you don't need to start investing in single-family homes. You do not need millions of dollars. It is not riskier, and I am going to cover why and how it works.
So, the first place we need to start with commercial real estate is in value. The reason is that value dictates why they are sold. Why people are buying it dictates risk and everything else. Value in commercial real estate is what I love about it. The reason is that with other investments I have a really hard time understanding everything. From stocks to single-family homes, the prices seem erratic and illogical, but with commercial real estate, it is relatively simple. Value is derived on only two things value is derived first from revenue. In commercial real estate, we have lingo like “cap rates” that a lot of people may not understand. All the financial lingo around commercial real estate is really to discuss and talk about the revenue. Is it going up? How much money am I going to get to keep in my pocket?
Commercial real estate is nothing but an investment so when you buy and trade it is on how much that investment will return to you. That is all a cap rate is. When you are looking at a cap rate, a cap rate is simply trying to describe how much you will make if you buy this investment. We exclude debt here, so if I pay X amount for this property and it returns X amount, which is the cap rate, so to speak.
Now, let me give you an example. High cap rates generally mean I am making a larger return, so think about a cap rate that's zero is theoretically breaking even. You are not making any money, so the lower the cap rate goes, the lower that investor will receive on their overall return. The higher it goes, the more cash flow they will receive at first. It seems very simple. Okay well, then I will simply just try to buy high cap rates since low cap rates are bad but that's not exactly true because cap rates are derived purely from revenue and that is our number one point of value.
But we also include the second point risk or safety. I think of it as stability. The stability of that revenue coming in and the likelihood that that revenue will come in five to ten years, so when we look at assets, investors are looking for a return, and safety cap rates are supposed to represent these two things combined. A low cap rate should theoretically mean that it is a more secure investment that is going to deliver that return for a long time. As an investor, if I think that the cash flow from this asset is going to be very risky and they may not be around for the next year or the year after I am not going to pay a high price. That means I need a high cap rate so I can make as much money as I can because that revenue is unstable and inconsistent or because I do not believe it may have a good future. Maybe that revenue will drop so I need to offset that on the purchase price because I need a higher return to make my money back quicker to offset for risk. If I think that an asset is really stable and will deliver a great safe return for years and years to come and I also believe that revenue will go up for years and years to come, I’ll pay a really high price and a low cap rate because I know that over time my income and my return off that asset will be going up. So, in 10 years what I purchased at a low cap will be a much, much higher cap rate based on what I paid for it because the revenue is increasing therefore my overall return is increasing year after year. The reason this is important is that this is how we evaluate and how we find opportunities in commercial real estate.
Not all investors see things the same way. I know we did not when we started out. When we started, we were buying storage facilities in smaller markets and we were paying 12, 14, 15 caps. At the time, storage facilities were not a very good investment. They were not perceived as a good investment. Let us say banks didn't even like to lend on it. They thought that it was a riskier asset that fundamentally made no sense. In fact, we thought the economics behind storage benefited storage. We thought that it was more secure.
People never thought that an individual would default on their home before they defaulted on a storage unit. To which we thought, “Of course, they would!” You need to pay 1500 bucks a month as opposed to a mortgage. They are thinking,
“If I lose my home, where do I put my stuff?”
So, we looked at this as almost a kind of weird arbitrage in the market. We had to get over hurdles with financing and terms because that was a lot harder to justify. Instead, we would do “owner carry” or “owner financing” – we would make the owner of the facility we were buying carry that debt and we made it non-recourse so that we were buying high cash flowing assets with really low risk. That was a wonderful time for us in our business because we felt like we had found this magical misunderstanding and inefficiency in the market, and it was derived from the fact that we believed that the revenue would increase but we also believe that it was stable.
So, how did the market miss this? why did the market miss this? It missed it for two reasons: the first reason was that self-storage was so new that few people really understood it, but more importantly, self-storage had never gone through a credit cycle. It had never gone through a big credit downturn, and no one knew what would happen to this asset class. The thinking was,
“Alright, what is going to happen? I don't know, it's a new asset class.”
It really came around in the seventies and really came about in the 90s. Now it is the belle of the ball. Everybody wants to know it, but I think of self-storage as a teenager. It is inevitable. I am a teenager, and this is America, it is an adolescent. It is not fully grown at this time when we were buying other commercial assets like office buildings. They were secured by long-term contracts. You would have someone that would lease an office, or I could have retail that I could lease to a Kmart or Sears for years and these were the biggest companies in the world. Of course, they were going to pay. They would never end and never default. They were super secure, and people were buying them at really, really low cap rates. Well as we in hindsight, a lot of those things turned out very, very poorly. What turned out good for us is the technology started to change how much revenue you could get, but also the stability from it as people were doing this massive shift that has occurred over the next 20 years – What I call this “new era” of real estate investing. The perception of how much revenue you can get from retail office space or from hotels has changed dramatically due to the great recession and due to Covid-19. But it has really put into question the stability of the cash flows from this asset class.
Now I know I am going in-depth, and I know you may even be saying,
“A.J., this is kind of confusing!”
I am giving you context to boil it down to the simplest thing. In commercial real estate, the only thing that matters is cash flow – just revenue and when we got into the real estate game, I did not understand real estate. I did not get equity. My friends and people I knew were becoming millionaires through buying and flipping and doing things with single-family houses, which did not make sense to me because I didn't understand where value was coming from since there wasn't cash flow. It was just mystical stuff, and I was just too dumb to understand the equity game at all. I needed something that was very straightforward. I was in a cash business, and I needed to look at a cash flow. How much am I going to make from it? So, because of that I skipped all the other assets and went straight to commercial real estate. My business partner (my father) and I needed depreciation. We needed all those benefits and advantages of real estate, but I needed to know the value. I am not a gambler. I needed an easy, predictable, logical way to underwrite and value what I am investing in commercial real estate offers.
That is a much simpler way for you to decide whether you should be buying it or not and understand exactly the income you are going to make from it. When we got started, I had to keep things simple because that is how I operate, and I needed things that were very safe and predictable. I wanted to compound my returns because I wanted to build an empire. You don't build an empire off a 1.4 cut of a 15-cent hamburger and I couldn't do that unless I could project out and know how much my money was going to return, how I could get it out, and how I could re-deploy it and at what rate I was going to make money after I deployed it. I wanted to map it out on a piece of paper so that when we looked at finding value in commercial real estate, we looked, and I created basically two philosophies.
We have two types of value that I am trying to buy or trying to find. Let us put it this way – in the market, we have given value then we have earned value (or value you create). Let me touch on these two things because it sets the stage for why this is important to understand. Moving forward here in this conversation, “given value” is discrepancies in markets due to owners. Normally, this is found in discrepancies in rates. So, let us say that I buy an office building where all the tenants are paying fifteen dollars per square foot. Now, in this exact same market and like-minded assets, other office buildings are charging 20 to 25 dollars per square foot.
When you look at this and say, “Why?” it may not have anything to do with the marketplace. It may have a lot more to do with the owner of that asset. Lots of owners do not like to give rate increases or they are so hands-off and they're so passive they don't even pay attention to it. They are just bad operators, so you can buy that asset at $15 per square foot and then you can increase it to normal market rates. So, I am going to look at the term of the contracts when they come up. Fifty percent of the building is going to come up in the next two years. That means in the next two years, fifty percent of my revenue will be able to increase by thirty percent. If I go in and I pay a low cap for that in the next three years, then my net income will explode. This place is about to explode and in return, my value explodes and grows massively. We are going to talk more about that when we come to financing. The point is that it is measurable, and it is easy for me to understand. When I was buying storage facilities, some operators were operating at 50-cents per square foot and others were operating at a dollar. The product was the same. There was no difference, and they were right down the street from each other. It made no sense to me. It was like arbitrage. That was the value that the market just gave to me. I just bought it and put the rates at where the market should be. There are other ways to find a given value that we will talk about in other videos, but that gives you the idea of what a given value is. It is already there the market did all the work for you – you just buy it and take it. That is how I started out. I wanted a sure thing. I already knew the demand was high. I knew rates were at that spread between that asset in the overall marketplace and what it achieves was my given value.
Number two: created earned value. Earned value is different. Earned value is the thing you need to do to make that revenue go up. Now, remember when we are talking about given value and earned value? The whole focus is on improving revenue and therefore improving the overall return you get and the overall value of the property. Now, the earned value came a little later for me. This came as we built out operations. This came as we found out ways that we could do intense revenue management with assets. This came as we started to do expansions and we would start to remodel buildings. The clearest and most noticeable earned value in commercial real estate is developed.
In development, there is nothing there and I need to build something that is new and a lot of times that may not even exist. I am trying to capture a higher value that exists in the marketplace. Therefore, most people view development as speculative because there's not a lot to measure and at the end of the day, you're kind of making up numbers that you think are achievable. It does not mean that it is not true. I am a developer.
I develop but let me give you a clear example of this. Malls are dying right, so across America we all know that malls are dying. I live in a metropolitan area that has a mall that has vacancies all over the place. We heard that a developer was coming in and developing a massive mall, which at first glance that makes no sense. Why are you developing a retail center? Revenues are going down and they are not stable at all. That is a poor asset. What they did though was they changed the offering. They made it an outdoor mall. They added more amenities that people would gather to. The actual retail side of selling goods to customers was the sideline. They made it outdoors. They made it beautiful. They put in housing over the top and they created something that everyone wanted to be around. Customers wanted to go to it. They attracted the people and the people bought things. There were movie theaters, there was restaurants. It was a beautiful location for the community. It was still a mall, but it was not perceived as the same thing at all. The rates that they could demand from it were higher than the other mall and people were clamoring to get in. It was a place where people gathered. That is a perfect example of earned or created value. They gave something to the marketplace that they knew was needed and they could do it at a much higher price.
Now that we have talked about commercial real estate, how we get value, what we look for, and how people in commercial real estate generally create or earn value…now we're going to look at what I call the Commercial Real Estate Wealth Cycle. This is a process that we have used to build, buy, and create a portfolio of over 150 million dollars in assets. This wealth cycle is very simple: we buy assets that we have given value in so I can measure how much that revenue will increase. There we increase through both given value and earned value. We put our operations and we may do certain things to increase it. We increase the overall revenues. We go out and we find it, we buy it, we put our model over it, and we increase the revenue. Okay? Nothing special here at all. Once we have increased that revenue many times, we've increased the value of that at multiples more than what we had to put in.
Now, this is where things get interesting. It is important that we talk about risk and risk is coming up, but I wanted to give the context of the cycle before we dive deep into it because at this point in the cycle, I’m going to reduce my risk as well as get all my money out and redeploy it. We pull our money out. We put a new loan on it, we take all our money plus a profit out then we do it again in single-family houses. This is called the BRRR Strategy that Brandon Turner from Bigger Pockets coined. The BRRR Strategy works in commercial real estate, but it works even better, and therefore lowering risk is one of the things that I love most about commercial real estate. It is this aspect of risk after I’ve improved my property not only do I get all my money out plus profit and I still own a cash-flowing asset that makes good money, but I also then put it into a new loan structure and that loan structure is called non-recourse. That means the asset backs the loan but not me. That loan is not personally guaranteed. If things go to pot, it goes under, and I give the keys back to the bank and I just keep doing what I am doing. They do not get to come after my home, they don't get to come after my bank account, and they don't get to come after my property at all. That means I have now gotten all my money back that I had put into a new loan which I’m no longer personally guaranteed for, and it still pays me infinite returns. Of course, it could go down to nothing and people say, “well you lose your investment.” but I have already got my investment out. I am protected against unknown events that I can't predict. That happens, we know it happens because life happens. So, the capital extraction plus the reduced liability allows me to do the next thing that I love about commercial real estate.
Scale commercial real estate is wonderful. The reason being is in scale we have two parts of the scale. The first one is volume. You can scale by volume, I can sell more products, I can buy more houses, and the more that I do, the more I am scaling up. My business is growing. This is a volume game and I need more. We need to do more. I have never liked volume games.
The next part of the scale is magnitude. That means you do one and you sell another that is even bigger and then you go bigger and bigger and you may not be doing as much. You may not be selling as much, but the total amount or the magnitude of that cell, the magnitude of that transaction has grown in commercial real estate. I get both. I can start small, and I can grow big while never losing even the first one that I did.
So, your scale curve looks like this, and it very much follows a compounding curve. Commercial real estate is specifically designed for this. The reason being is because the cash flows that pay you getting your money out reducing risk, but your ability to move forward in magnitude is limited. What I mean by this is, when we started out, we were buying facilities that were a few hundred thousand dollars. They were very small in rural towns. Now we are building 20 plus million-dollar properties in major cities. Our investment style has not changed at all. Our overall structure or management, the lending practice, the way we do business has not changed, but instead of a $400,000 property, I have a 40-million-dollar property. I am still doing the exact same thing here that I’m doing there, and you can do this quickly. We started small and after about our first five small facilities we went up. We went up, then we went up again and we just kept growing larger. As large as we could sustain it and we were comfortable with it.
Commercial real estate, my favorite part about it is your ability to scale. People view growth and having more assets as having more debt and liability but remember I am shedding liability as I grow today with over 150 million dollars in assets. I have less liability than when we first started with those few facilities that were worth hundreds of thousands of dollars. This is exceptional in business. It allows you to grow even more, do more, and get bigger sellers banks that will give you better terms. They work with you more. You get more deals as you grow so it compounds in every single aspect. The tougher you are the more people respect you.
The next side of this is, “why get started in commercial real estate?” Obviously, for all the reasons that I have already stated, but the idea that I cannot or that I need a lot of money, this is where I think the opportunity in commercial real estate is. Commercial real estate as of right now for most of the players that are in commercial real estate, these are funds institutions. These are big guys and exactly that's why I’m not getting into it, and I say, “No! You're missing the opportunity in commercial real estate.” The amount of assets that are under five million dollars is staggering. They are everywhere. You have them all over your town and all over America. Thousands of them all over America, yet for myself as well as other institutions and funds and people that get great terms on debt and they are not buying them. It is not worth their time for them to go buy a two-million-dollar asset. I cannot do it because it's a poor use of my capital and my resources that's part of my scale. It does not make sense to trade a 40-million-dollar asset and work in time and effort to do a 2-million-dollar asset. My returns drop, efficiencies drop, so we do not do it.
However, for individuals starting out, they can get it all. Not only can they get it all, but for me there's opportunity. There is less competition, and this is the next part about it: Ownership. The people that own those assets are usually mom and pops. Remember when we talked about value at the beginning? You can grow value through growing revenue or stabilizing the revenue. Mom and pops are notorious for having stagnant revenue and not being hands-on. There is a much greater opportunity to grow the revenue from a mom and pop and stabilize it than there is in an institution because they're already doing a good job.
So, what does that mean? Starting small you have higher yields. anyone that is starting in commercial real estate today is probably going to get much higher yields on their investment than I am today doing big ones. Now, this is hard to understand because it does not seem to make sense or it's counterintuitive, but it's true. When I started, my deals yielded higher returns than they do today because I deal in magnitude not volume. Getting into commercial real estate is a better opportunity than getting into the stock market, single-family homes, or other assets where everybody is going after the same thing. They are all fighting for it, and they all want it. This is untouched for the most part and I think for an investor, especially in real estate, it offers the best opportunity to create wealth and income over any other asset class out there.