Passive Investor Tips is a weekly series hosted by full-time passive investor and Best Ever Show host, Travis Watts. In each bite-sized episode, Travis breaks down passive investor topics, simplifying the philosophy and mindset while providing tactical, valuable information on how to be a passive investor.
In this episode, Travis discusses whether you can make money in an economic environment where interest rates are higher than cap rates. Does it make sense to pay more for your debt than the property is actually producing? He shares two case studies of a value-add multifamily property and a brand new class A property to help illustrate why it does.
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Travis Watts: Welcome back, Best Ever listeners, to another episode of Passive Investor Tips. I'm your host, Travis Watts. I have an exciting episode for you here today. We are talking about negative leverage and can you still make money today in commercial real estate. Very relevant to 2023, interest rates and what we're seeing in the environment. Real quick, disclaimers is always, never financial advice, not telling you or anyone else what to do with your money; not a financial adviser, CPA, attorney etc. so please seek licensed financial advice.
With that top of mind, let's quickly begin by defining what negative leverage is. And what it simply means is when you're in an environment like we see ourselves in today, and interest rates are actually higher than cap rates. Now, what we've seen in recent years is the opposite of this, where we had historically low interest rates and the average cap rate in America was hovering somewhere around 5% before the interest rates started to skyrocket in 2022.
So let's quickly review what a cap rate and interest rate is, for sake of this discussion. A cap rate is simply the amount of income that a property produces without considering any loan costs. So in other words, if you were to pay all cash for a deal, this would be your ROI, or your return on investment.
A simple example to think about - if you have a million-dollar property, and after factoring in expenses, such as property tax, insurance, maintenance, property management, it cash-flowed $50,000 per year - again, remembering, no loan on the property - then you would effectively have a 5% cap rate. You simply take $50,000 in net operating income and divide by the purchase price, which in this example is $1 million, and that's how you land at 5%.
An interest rate is what you're charged to borrow money. It's that simple. So in the example that you have a mortgage with a six and a half percent interest rate. So on the surface, you might be thinking, "Maybe it doesn't make sense to invest in a real estate deal if I'm paying more for my debt than what the property is actually producing." And this gets a lot of headlines, but it's yet another reason why I love value-add real estate. And value-add is referring to a property that is pre-existing, that may be outdated, that lacks modern amenities and technology and appliances, and because of these factors, the rent on a property like that is usually below the market level. And that makes sense, right?
Think about you being a renter, you're shopping for An apartment community that you're hoping to move into, and you stumble across this 1980s apartment community, and the clubhouse is outdated, and the units are outdated, and quite frankly, it looks like the 1980s, and it lacks modern amenities and modern technology; let's say the rent on a property like that is $1,500 per month. When compared to a brand newly-built community, that was, say, built-in 2023, and it's got all the bells and whistles, all the latest and greatest - well, the rents on that property could be $2,000 per month. So there's a good reason that there's a $500 gap in rents, because that newer property is just creating a better lifestyle for the residents, and it has a lot more to offer.
So back to the big question, "Can you make money in a negative leverage environment?" and the answer is "It depends." And I hate that answer. So I want to dissect two quick case studies for you to examine the difference between a nicer, newer Class A apartment community and a value-add community. So case study number one, you buy the brand new community; built-in 2023. You are going to pay top dollar. And if there's nothing you can do to add value or additional revenue streams, then you're subject to what the market dictates in terms of rent. And by the way, here's the market rents according to Yardi Matrix in the United States as of April 2023. They're hovering around $1,700 per month right now.
So here's three scenarios to consider with a newly-built luxury high-end apartment community where there isn't a value-add component. Number one, rents in the market tend to tick upward over the next five years, in which case you're lucky. That's great, and you've got a chance at making some money in a negative leverage environment.
Travis Watts: Number two, what if the rents stay stagnant, and they don't move from here? We just plateau for five years. Well, remember, the negative leverage situation can work against you in that scenario. And number three, if the market dictates that rents need to soften or reduce a bit, that could be a very unfavorable scenario for investors.
Now, case study number two, we decide we're going to buy a value-add apartment community that's older and outdated, and we're gonna fix it up. Now we're not just subject to what the market dictates in terms of rent; remembering, if average rents are $1,700 per month in this particular community, to use the example from a few minutes ago, it's $1,500 per month. Then we've got a little bit of margin there. So if we're able to go into this property, make strategic improvements and increase the rents over time, that's what I want to break down for you.
Now, in this example we'll say that you're buying or you're investing in a syndication, which is buying an apartment community that's valued at $100 million. And we'll say that the cap rate in that local market is 5%, and we'll say that your mortgage interest is six and a half percent. So we find ourselves in the negative leverage scenario.
So a cap rate of 5% on a $100 million property would suggest that the net operating income is around $5 million per year. And you can know this by just running the simple math of $5 million divided by $100 million equals 5%. Now, if you can raise the rents after making your strategic improvements at the property by let's say 5% a year, and you intend on holding this asset for five years just for example purposes, then that would mean that by the fifth year, the net operating income would have increased to around $6.4 million, compared to where you started, at $5 million.
So right here is why I love multifamily commercial real estate. It's why I stopped investing in single family homes years ago; this was my lightbulb moment. To find the new valuation, if you were able to execute that business plan, you would simply take the new net operating income, which would be 6.4 million, and divide by the cap rate. We'll still use the 5% example, assuming the cap rate stayed the same through those five years - and you come up with a new valuation of $128 million. So effectively, that property just increased by $28 million over a five-year timeframe. And that is why I love value-add apartment deals.
Now, obviously, this is a simple example here; there's a lot of factors to consider. I just wanted to paint the picture from a high level of how value-add works, and how you might potentially be able to make money in a negative leverage environment like many investors find themselves in today. And this example doesn't even dive into the tax advantages that may be available to you as an investor, or an individual owner, doesn't even dive into amortization, which is the loan getting paid down over the timeframe in which you hold the property... And it also doesn't include negative factors, like rising wages, or rising insurance costs, or rising property taxes.
So the deal that you buy or invest in could have different numbers, obviously, and would have different numbers, and it could be more favorable than what we're describing here, or it could be less favorable, depending on the specific circumstances. So this is just a simple analysis, and something to consider here for the week as we find ourselves in a crazy environment here in 2023.
You're listening to Passive Investor Tips. I'm your host, Travis Watts. Always happy to be a resource or mentor for you in the passive income investing space. Reach out to me - Instagram, Facebook, BiggerPockets, LinkedIn, Travis Watts, or @PassiveInvestorTips. Like, share, subscribe; feel free to share these episodes with anyone you think could find value. Have a Best Ever week, everyone. See you in the next episode.
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