Like many industries, commercial real estate investment comes with its own jargon, lingo, and buzzwords. In casual conversation with real estate investors, lenders, or other real estate professionals, these words and phrases may be used as shorthand for certain aspects of a transaction or investment strategy that they are considering. One phrase that we use frequently, and that we consider to be among the most important in commercial real estate investment, is that “you make your money on the buy.”
What Does “You Make Your Money on the Buy” Mean?
As the saying implies, “you make your money on the buy” means that the success of a commercial property investment is heavily predicated upon the price paid to acquire the asset. In other words, it is possible to acquire a fantastic investment property in a great real estate market with high occupancy, strong leasing activity, significant cash flows, but if the price is too high relative to market value, the overall return is going to suffer.
So, this phrase begs the question, how does an investor determine how much to pay for a property? The short answer is that the price will vary by individual and their risk tolerance, time horizon, economic outlook, and return requirements. But, there are a number of ways that investors can get “in the ballpark” of a fair price for a property.
Perhaps one of the most influential factors in determining a fair purchase price is an investor’s individual return requirements, or how much they need to earn on their money to take the risk of acquiring the asset. For many investors, there are three major components to their required return.
The Risk Free Rate
The first is the so-called “risk free rate” which is the interest rate on a 10-Year United States Treasury Bond. It is called the risk free rate because payments on the bond are backed by the full faith and credit of the United States Government, which is as safe as an investment can get. This factors into an investor’s return requirements because they can look at the risk free rate and say to themselves, “I can take zero risk and achieve X% return, so if I take some risk, I need to earn at least Y% more to compensate.” To illustrate this point, it is helpful to provide an example.
As of this writing, the interest rate on the 10-Year Treasury is .78%. A commercial real estate investment carries more risk than a 10-year treasury so it follows that the next logical question for the investor to ask themselves is “how much more do I need to be paid for taking on the additional risk of purchasing a real estate asset?” This is the so-called “Risk Premium” and it varies by individual because each investor perceives risk differently. However, one tool used to measure this is the property’s Capitalization or “Cap” Rate.
The Cap Rate
Cap rate real estate is the rate of return that could be expected, assuming an all cash purchase. The formula used to calculate it is:
However, if an investor is trying to determine the value of the property/purchase price, they would need to rearrange the formula to solve for it. It looks like this:
Here is where an investor’s perception of risk comes into play. Two investors could look at the exact same property and one of them could conclude that it is a high quality, stable asset so they are willing to pay more for it. The other could look at it and see potential issues, which causes them to conclude that there is more risk and they are willing to pay less for it. For example, assume that the property under consideration has Net Operating Income (“NOI”) of $100,000. The investor who sees less risk would theoretically require a lower return, say 6%, so they would be willing to pay $1.6M for it ($100,000 / 6%). The investor who sees more risk would require a higher return to compensate, say 7.5%, so they would be willing to pay $1.3M ($100,000 / 7.5%).
The point is this, one of the data points in the “how much is the property worth” calculation is the cap rate and it can vary by investor based on the perceived risk associated with the property, projected cash flows and expected future performance. To determine a fair purchase price, each investor has to decide for themselves what cap rate they require. It should be noted that it can also vary by market (e.g. New York vs. Charlotte), asset class/property type (e.g. Multifamily vs. Office Buildings), and
Internal Rate of Return
A property’s Internal Rate of Return (“IRR”) is a metric that measures the compound return on investment earned on each dollar invested, for each time period it is invested in. The actual formula used to calculate it is fairly complex so most investors use the “IRR” spreadsheet function. But this function requires a series of cash flows as inputs and these come from the property’s proforma.
A proforma is a financial projection of a property’s income and expenses over a defined investment holding period. It is used to calculate the property’s annual Net Operating Income which, along with the purchase price, are the inputs needed to calculate the Internal Rate of Return. To illustrate this point, assume that a property produces the same series of cash flows, but there are two different purchase prices. The differences in the internal rate of return can be seen in the table below:
In the first property, the purchase price of $1M (shown as negative because it represents a cash outflow) results in an Internal Rate of Return of 10.98%. In the second property, the higher purchase price of $1.25M results in a lower IRR of 5.23%.
The point is, if an investor knows what IRR they need to earn, they can model the cash flows and then solve for the purchase price needed to achieve it. In some cases, there can be a substantial difference between this result and the asking price for the property, which is where price negotiations can begin. However, if the difference is so large it may mean that the investor passes on the deal and moves to the next one.
Finally, a property’s Equity Multiple is a measure of the relationship between the total cash flows received and the total cash paid. The exact formula is below:
If the purchase is made in cash, the total cash outflow represents the purchase price. If the acquisition includes a loan, the total cash outflow represents the total equity invested. The result of the calculation represents the return multiple earned on the money invested. To illustrate how it works, assume the same set of cash flows as above, the Equity Multiple is calculated as follows:
With the first property, the lower purchase price leads to an Equity Multiple of 1.56X, which means that the investor would earn 1.56X their money on this series of cash flows. In the second property, the higher purchase price leads to a lower Equity Multiple of 1.24X.
The point is the same as the IRR, a real estate investor can establish their required Equity Multiple (often >2.0X) and back into the purchase price required to achieve it.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
Before making a purchase, we invest a significant amount of time and resources in due diligence and financial modeling to ensure that our acquisition cost/purchase price (including closing costs) allows us to meet our return requirements. These are critical aspects of a typical real estate transaction. Underwriting the property conservatively and making sure we arrive at a fair valuation allows us to “make our money on the buy.”
If you would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.