How to Project the Profitability of a Property
As an investor when looking at any potential real estate opportunity, there are a myriad of metrics and theories behind what makes a viable investment and what does not. But at the end of the day, you’re simply trying to answer the question: Am I going to make money from this venture? While, yes this is a loaded question, below we walk you through how School of Whales answers this to select our investment properties.
Jump Ahead to
Are you the kind of person that when in a crowded room you check where the exits are just in case you were to need to get out fast? Maybe you’re a little on the paranoid side and make a hypothetical “Plan b” exist strategy. Well, that’s the kind of energy you should bring to the evaluation of any potential illiquid investment: What are the ways to get your money out? There should be at least two options.
Here are the most common exit strategies in commercial real estate:
Refinancing of the Property
Once a commercial property is stabilized (in other words, is operating and has reached its net operating income targets) you can refinance existing loans and use the funds from a new loan to pay off your existing commercial mortgage, as well as pay back equity investors. The best part for you as investors? You get to de-risk by getting some of your money back, while still being a property owner. Commercial property owners might also refinance to lower their monthly payments, change their loan terms or tap into their property’s equity to add new commercial properties to a growing portfolio.
Feasible Sale of the Property
Everything is for sale, right? But you must make sure it is feasible to sell your investment property for more than what was put into it. A commercial property’s net operating income (NOI) directly correlates to its market value. That means the end game is to always maximize this, so you can increase the value of your property and sell for a profit!
Mathematically, NOI looks like this: Gross Operating Income – Operational Expenses
If you’re not math person, NOI is simply money generated through operations (such as tenant rent) minus the cost of operating the building.
Evaluating the market conditions of where you are investing is also critical. You do not want to buy into a hot market and over-pay. This is where experience and ability to analyze data and market trends is critical.
Internal Rate of Return
IRR represents the percentage rate earned on each dollar invested for each period it is invested. IRR uses the concept of the time value of money, aka the money an investor has now is more valuable than money an investor has later. The internal rate of return is a key metric when it comes to defining the relationship between time and yield on a commercial real estate investment. You want your projected IRR to be at least 20%.
Developer Track Record
The developer is a key player in the viability of your investment. In fact, the developer is just as important as the property itself. This is your guy in the front lines actually doing the thing and making sure all these projected metrics become a reality.
When evaluating a developer, first and foremost, make sure they have proven success in the type of property in which you are investing. In our case we are looking for developers that have a proven track record in value add and opportunistic properties because these are the types of commercial real estate in which we invest.
Once you have researched past performance, you want to make sure your values and vision align. Think of it like a marriage. You do not want to be financially tied to a person or entity who does not share your vision.
There are many hurdles a developer must jump through when constructing or renovating a commercial building. We’re talking permits, municipality approval, and with historic building, local preservation laws. Sometimes these permits or approvals cause major delays, while you wait for word from your local government.
In life, timing is everything, and this extends to investing. The key is to get in early enough that significant growth is highly likely, but make sure you have the know how to make sure that the project is viable.
In addition, the market landscape needs to be ready to absorb the supply of whatever the project will be offering. Think: is there enough density or traffic in the area, so that the project has customers?
Capitalization rate or cap rate is the primary metric we use to forecast ROI of any project. Expressed as a percentage, it is calculated by dividing Annual Net Operating Income by Current Market Value.
The perception of a cap rate being good or bad is determined by your expected rate of return and how you plan to get there. In our case, we are specifically looking for the diamond in the rough in an up-and-coming area. Why?—Because these are the types of properties that you can buy at an attractive valuation, renovate, generate attractive rental income, and increase NOI, so that you can sell for a higher market value. This process is called compressing cap rates.
These metrics and guiding principles are part of what goes into our underwriting process and how we go about selecting investment properties for the School of Whales portfolio. But we are not re-inventing the wheel here! These guidelines can be applied to the evaluation of any real estate property—both commercial and residential.