The best real estate investments have economies of scale that allow you to make money in real estate while accelerating your financial growth. In part I of this post on economies of scale (EOS), I showed you how residential real estate is riskier than commercial multifamily real estate. Now let me show you how economies of scale can create financial freedom and early retirement.
I have two growing boys and my wife and I shop at Costco and Sam’s Club to feed them. Buying in bulk is a great example of economies of scale. The price per unit is less when you buy a large quantity and that concept remains true for multifamily investments as well. It is far less expensive per unit to build, operate, and maintain larger properties than it is for smaller residential properties.
First, let’s discuss how residential real estate is valued. Residential real estate is appraised using the comparison or comp model. Simply put, your property is worth what comparable properties in size and location are selling for. The comp model can be dramatically affected by the different phases of the residential real estate cycle.
On the other hand, commercial real estate derives its value based on the income it produces. This is a business model that can be summarized by the following formula:
Value = Net Operating Income (NOI) / Cap Rate
In the above formula, NOI is the income left over after paying all expenses but before servicing the debt (paying the mortgage). The capitalization rate or cap rate is the percent return expected for a property acquired for all cash (unleveraged).
For the purposes of our discussion, we will again compare a two unit duplex with a 200 unit multifamily apartment building. We will also assume 100% occupancy for both properties.
What happens to the value of our properties if rents are raised $20 a month across the board?
The duplex will experience a $40 a month or $480 a year increase in cash-flow. Unfortunately, rent raises do not impact the comp appraisal model. Depending on where an MSA is in the residential real estate cycle, it is possible to raise rents and experience a decrease in value. Unfortunately, value is largely out of your control with residential real estate.
In contrast, a $20 rent raise in a 200 unit building increases cash flow $4,000 a month or $48,000 a year. Economies of scale provides for 100 times more income. However, this is just the beginning. Next, let’s see how appreciation is impacted.
While a $20 a month rent raise has little to no effect on value with residential real estate, look at what it does to the value of the commercial property in an 8% cap rate market.
NOI / Cap Rate = Value $48,000 / 0.08 = $600,000
This is the massive wealth building power of EOS. A $20 rent raise leads to over half a million dollars in increased value. This is how the commercial multifamily investor can make money in real estate and enjoy rapidly expanding financial growth. Let’s now focus on how EOS can work in our favor on the expense side of things.
The effects of EOS are multiple and far-reaching. In our continuing example, let’s say both owners pay utilities including water. They have both been able to achieve $20 a unit per month in savings on their water bills utilizing various water saving devices.
The owner of the duplex again gets an extra $40 a month or $480 a year in positive cash-flow. As we saw before, this increase in cash-flow has no effect on the value of the property.
By contrast, this $20 savings in expense yields the owner of the 200 unit property an extra $4,000 a month or $48,000 a year in positive cash-flow. That $48,000 a year in extra cash-flow raises the value of the property another $600,000.
NOI / Cap Rate = Value $48,000 / 0.08 = $600,000
Utilities are just one of several expenses in which a small savings per unit can add up to a great deal of cash flow and even a greater amount of appreciation.
Economies of scale is the magic that makes commercial real estate far superior to residential real estate. The best real estate investments utilize EOS to allow for less risk with greater returns and accelerated appreciation. For brevity’s sake, I didn’t touch on how EOS give greater tax benefits and higher principal pay-down than residential properties. Suffice it to say, those effects are similar to the above examples and unrivaled by residential real estate.
Far too many physicians buy residential properties due to their lower price point. Most will burn out from the management headaches coupled with little to no returns. After years of suffering, several will sell and swear off real estate forever.
While you can make money in residential real estate, it’s stressful always living on the edge. The real money lies in going bigger. By utilizing economies of scale, you can achieve your goal of financial freedom much quicker, and with less risk and stress.
To Your Wealth!
Dennis Bethel, M.D.
P.S. The best real estate investments utilize economies of scale for financial growth and to make money in real estate.