As an investor, we are often assaulted by countless adages and rules of thumb — The stock market averages 6% annual returns. Bonds are safer than equities. Cash flow is king. And the Federal Reserve has killed returns for savers! While many of these sayings have kernels of truth in them, most of them are designed to comfort investors to the point where they don’t dig into the math of their investments beyond the superficial. If I could re-write a lot of marketing material, the catch phrase would be “compounding is good, don’t look to closely at what we do or other options.” At Westland, we take a different approach. It is crucial to us that our partners understand what we are doing, and more importantly, why it works.
Cash Flow IS King
In real estate there are four major components to our returns: cash flow, appreciation, depreciation, and leverage. In our world view cash flow comes first on the list, and for a very good reason. We consider this the foundational concept for our investing. Let’s run through the basics, using an apartment property as an example.
Apartment A — Constructing a proforma (Building Block 1)
100 Units, all 2 bedrooms, renting for $1,000 per month each.
The first thing we look at with apartment investments is the net operating income (NOI). NOI is the gross revenue a property generates in a calendar year, less the expenses that a property incurs during the same period of time. Notice we do not factor debt in at this level. Debt is a business decision that will change based on the needs and decisions of the venture.
To establish gross rents we take the amount of rental income generated monthly ($1,000 X 100 units) and multiply it by 12 months ($100,000 X 12 = $1,200,000) to yield the gross scheduled rents.
The next step is to include a vacancy factor appropriate for the marketplace. Most of our underwriting in the Pacific Northwest includes a 5% vacancy factor that typically encompasses not only vacancy, but also bad debt, and loss to lease.
In this case, we would take 5% of the gross scheduled rents ($1,200,000 X .05) to achieve an annual vacancy cost of $60,000. We deduct the annual vacancy cost ($60,000) from the gross scheduled rents ($1,200,000) to achieve gross effective income. In some cases we may add in other expected revenues such as laundry income, late fees, or utility billback revenue, but let’s leave that out for simplicity sake.
$1,200,000 — $60,000 = $1,140,000
We can expect gross annual incomes of gross incomes of $1,140,000 by the end of the year.
Now that we have underwritten how much revenue the complex is likely to generate over a years time, the next step is to tackle the expense side of the ledger. Expenses vary from place to place and property to property. However, the categories stay relatively the same. At Westland we always go through the process of dividing fixed expenses (expenses under which we have little to no control) from variable expenses (the places where we have a lot of influence).
In the fixed expense category we include property taxes, property insurance, utilities paid by the property, and interim utilities paid while units are vacant or in the process of renovation.
Real Estate Taxes $110,000
Interim Utilities $10,000
Fixed Cost Sub Total $220,000
The next category to underwrite is the operating costs. To operate a complex of this size, there will be payroll for on site managers, fee management expense, maintenance staff, repairs and maintenance work including materials, unit turnover cost, and compliance fees (eviction cost, administrative, miscellaneous)
On Site Manager $50,000
Fee Management $45,000
Maintenance Staff $45,000
Unit Turnover Cost $30,000
Repairs & Maintenance $50,000
Compliance Fees $10,000
Variable Cost Sub Total $230,000
Total Annual Operating Expenses $550,000
The next step in our process of getting Net Operating Income (NOI) is to subtract the total annual operating expenses from the gross effective income ($1,140,000 — $550,000 = $590,000).
Now that we have an NOI of $590,000, we have a solid concept of what net income the property will generate after a year of operations, the question is how do we value what the building is worth? We haven’t seen the building, we don’t know how nice the building is, we don’t even know what the neighborhood is like. So how can we value the building? This is where a crucial concept comes in and why cash flow is king! Real estate is valued by how much income the property can generate. Let me emphasize this again: Value is derived from how much income the property can sustainably produce!
We call this valuation method a capitalization rate. The market values investment real estate based on a ratio of that income. When we capitalize the net operating income, it means that investors divide the net operating income by the ratio that is acceptable to them. If they want a 5% return on the NOI of the property, then they would take the NOI ($590,000) and divide it by the capitalization rate (5%).
$590,000 / 0.05 = $11,800,000
now the mechanism for how the market values a property has been laid out. There are always a couple of questions that arise. First, where where does a 5% capitalization rate come from? The truth is that they are an approximation for risk in a certain neighborhood for the investment. The market sets them because that is the rate at which a willing seller and willing buyer come into transact. Oftentimes a high cap rate means that there is a lot of risk embedded in a property, while a low cap rate indicates that the asset is very safe and attractive.
How does Westland Generate Profits?
At the core of what we do at Westland is math. We accept that we cannot control what the market deems an attractive cap rate, and we do not underwrite our ventures with the intention of “selling to a sucker.” That is horribly unethical, and frankly, it’s a recipe to fail at real estate investing. Instead, we focus all of our efforts on identifying properties that are under utilized, and often have physical defects that we can fix. Why would we undertake this strategy? Let’s walk through the math together.
The key to our investment strategy is the ability to raise the net operating income of properties. In that equation there are two levers: revenue, and expenses. Both have an equal effect on net operating income, but in the long term, focusing on revenue is the path that yields a significantly higher return to investors. Let’s start with expense reduction. What happens if we reduce our expenses by 30%:
Our expenses started at $550,000 per year. What if we magically found a way to shrink them by 30% without bleeding the complex.
$550,000 X .70 = $385,000
Next let’s take the original gross effective income of $1,140,000 and subtract the reduced operating expenses from the number to achieve the new NOI.
$1,140,000 — $385,000 = $755,000
That increases our NOI by $165,000, which is excellent! To establish the value, let’s take the new NOI ($755,000) and capitalize it at a 5%.
$755,000 / 0.05 = $15,100,000
As you can see this is a material increase in value. As you can see the value increased by $3,300,000, which is a very strong return on an investment. What is surprising is that even though we decreased expenses on the NOI by 30%, we did not see an exact analogue in the growth of the property value. In fact, the property value grew by just less than 28%.
Now that we examined expense reduction, let’s do the same exercise for revenue increases. In similar fashion, assume we raised our rents by 30%. Not a bad year. Let’s run through the math and see how it plays out.
$1,300 X 100 X 12 = $1,560,000 GSI
Less vacancy of 5% ($1,560,000 X .05 = $78,000)
Subtract Vacancy from GSI ($1,560,000 — $78,000 = $1,482,000)
Assuming we kept expenses the same, this becomes a huge win. In the example above expenses ran $550,000 per year, so let’s deduct that from the gross revenue.
$1,482,000 — $550,000 = $932,000
This is a significant change in the net operating income. While we increased our gross revenue by 30%, we increased our NOI by substantially more. When we compare the original NOI of $550,000 against the new NOI of $932,000 we have grown the bottom line by almost 58%. What a significant increase in cash flow.
Next, let’s value that increase in net operating income assuming the market will pay the same capitalization rate (5%). Let’s divide the NOI ($932,000) by the cap rate (5%).
$932,000 / .05 = $18,640,000
As you can see we had a huge increase in value on such a seemingly modest increase in gross revenue and NOI.
There are some lessons that can be taken away from this that give insight into how we think. First, the small changes in NOI lead to huge increases in value. It is a power law. At a 5% cap rate, each dollar of increase in NOI is worth 20X in value. Our ability to add value comes from the ability to grow the NOI. The most powerful lever to increase NOI is by focusing on revenue growth. Small percentage gains in revenue lead to disproportionate NOI and value increases.
Now you have some insight into the lens in which we view all of our projects. Understanding the power laws of increasing revenues and net operating income is at the core of our underwriting of our investments. While our partners don’t need to be experts, we do require that they understand the basic principles that we apply to our business ventures.
If you have any questions about any of the math, or why we view our investment opportunities this way, I’m always available to discuss our investment philosophy. Drop me a line at firstname.lastname@example.org or give me a call at (503) 297–2575