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.
COMP MODEL
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.
BUSINESS MODEL
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).
INCOME
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.
APPRECIATION
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.
EXPENSES
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.
SUMMARY
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.
P.S. The best real estate investments utilize economies of scale for financial growth and to make money in real estate.
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What do you consider the minimum number of units to achieve the EOS? Technically anything above 4 units is considered “commercial” residential, but I’m guessing that you are thinking of numbers much higher than that.
Also, trying to invest in property that has dozens of units (ie, 40, 50, 100, etc etc) is very expensive, as compared to a property that has say 10 or 20 units. In your experience does that mean that you will almost always required business partners to raise the funds for initial investment?
GA…Assuming you have a good property and all things being equal, the bigger you go the better. Once you hit around 80 units (the lowest I like to go) it makes sense to have an onsite maintenance man. Too much below this, and a full time maintenance man won’t make economic sense. This can save you a lot of money.
Lets say you have a 20 unit property that you manage. A toilet needs to be replaced. You hire a plumber who charges you a $75 service fee (upfront money just to set foot on the property). On top of that, he charges $75 an hour with a minimum of one hour. So fixing this toilet is going to cost you $150 in labor in addition to the cost of materials. Your onsite maintenance guy knows how to change toilets. His annual pay may come out to $10 – $20 an hour. So that one hour toilet replacement cost you $20 (at the most) in labor instead of the $150 you would have had to pay. The key is to have enough units to keep him busy and to justify the expense of his salary. The more you can avoid outside contractors, the more money you will save and the more your property will cash-flow and appreciate.
As for the 25% – 30% down you will need to buy these properties…If you are looking to be an active investor, then yes you will need to find some partners unless you are already independently wealthy. On the other hand, you can invest passively using a quality syndicator.
What do you suggest as a good entry strategy into the commercial real estate market? I am hoping to buy a property in 3-4years (after saving money as an attendings) but I would be hard-pressed to jump right into an 80unit property (with other investors), while also being the lead investor.
In the market that I am looking at, properties with this many number of units go for 20-40M.
I read one of your other posts on WCI and you had mentioned one of your early investments was 60K in a large property. At that point, were you involved in any decision making, or were you just going along for the ride?
Thank you.
GA…$250,000 to $500,000 a unit. I assume you are talking about N.Y. City. Perhaps San Francisco. I don’t play in either of those markets. However, keep in mind that the closer the CAP rate gets to current interest rates, the less it will cash-flow. You see, in simple terms, CAP rate is just your unleveraged return. So if you are in an MSA with a market CAP of 4%, for example, you can expect to receive a 4% return on your money if you bought it for all cash.
However, if interest rates are 4.5%, then you will likely have negative cash-flow. So why do people still buy in these CAP rate compressed markets? The answer is APPRECIATION. Some feel that they can weather the negative cash-flow for a short-period while they raise rents and then sell for a large profit. This strategy can work, but I don’t like it. To me, it’s less investing and more speculating. Speculation can be very profitable, but it can also be painful.
I invest in real estate for cash-flow primarily. Appreciation is important, but it is secondary. As such, I am a long-term holder of real estate. As long as I am enjoying cash-flow and can increase NOI annually, I have no intention of selling a property. Because my focus is on yield first and growth second, I stay away from these types of markets. If you feel strongly about your market, then I would advise you to find someone in that market who is successful in doing what you want to do. Most bigger markets have real estate investment clubs / organizations that you can join. Find a mentor and learn a successful system.
You had it right the first time, I was talking about Los Angeles, but SF is on that list too.
Also, I think you should start a book review page on this website, that would be very nice.
Thanks.
Forgot to say thanks. Your answer were very helpful!
GA…My pleasure. Feel free to contact me with any questions you have and also sign-up to the website and enjoy the free interview.