Last week’s podcast episode on how to fire an employee was one of the most popular episodes I’ve released. Check it out on Youtube or Spotify.
If you are one of the 200+ folks who joined my newsletter recently and are looking for the risk management assessment tool, click here. It is a free section from my real estate masterclass.
Lets dive in:
Now let me tell you about the wealthiest guy I know – Ryan.
He lives with his family in small town Georgia and owns a series of companies. One is a real estate private equity company and the other is a construction company.
He builds nursing homes and assisted living facilities from the ground up and that’s what he’s been doing for 40 years. How did he make so much money and what is his competitive advantage?
Way before he builds a nursing home, he goes to a nursing home operator and has a meeting. They want 80,000 SF and 80 beds. He figures out what they want, works with their team, and presents a concept to them…
Then It is time to make a deal on how much they are going to pay in rent. Ryan tells the operator that the market rent to build this building is $185 per SF. He says he needs a 9% return on his money (A 9 cap) to make his numbers work and to compensate for the risk associated with the development.
So they settle on a construction budget of $14.8MM and a rent of $1.33MM a year.
But not just any lease, It is a 20 year lease. At $17 per square foot per year. In a building they plan to move into two years later when It is done.
Not a bad deal. Ryan has to do the work to permit, build, and finance the construction. But he gets a good return.
–
We’re about to start discussing cap rates and how they work. Take this free quiz if you aren’t sure and want to understand the rest of this email.
–
Under normal circumstances Ryan builds the building for $14.8MM. Gets it open. Starts collecting rent, and goes. But the 9% return he got is better than the market, because he took the risk to build the building (and the construction costs that go with that).
It’s worth a 6 cap now that it’s producing NOI and the risk is off the table. This is how developers make money and are compensated for their risk. Built to a 9 cap and sell for a 6. Or build to a 6 and sell at a 4.
$1.33MM (NOI) / .06 (CAP rate) = $22.2MM.
So the building he spent $14.8MM to build is now worth $22.2MM the day it gets finished, certificate of occupancy is acquired and the tenant moves in and starts paying rent.
Whammy! A profit of over $7 million.
But wait, that’s not all. Those are expected returns for a developer. Remember how Ryan has a competitive advantage?
He owns the construction company that manages the project.
He has a much different budget for what it costs him to build a nursing home because he’s good at what he does. It’s actually only $125 per square foot. So the cost, for him to construct the 80,000 SF nursing home, is $10MM.
So instead of spending $14.8MM and having a building worth $22.2MM when it’s done, he spent $10MM and has a structure worth $22.2MM when it’s done.
So what’s better than earning a great return on the money you invested in a project? Earning a great return on the money you didn’t even need to invest in a project.
So on this deal, he just cleared $12MM out of thin air.
And he does this 5x a year all over the southeastern United States. And he’s done it every year for 40 years.
And he has never sold one. He still owns them all. A lot of them outright with no debt at this point. He refinances them at the new valuation and pulls out capital and uses it to build more buildings and grow.
So what happens now?
There is less risk on his portfolio.
The less risky an asset is and the larger an asset is, the more cap rates compress, and everything gets even more valuable.
For a free mini course on risk and debt, click here.
Instead of a 6 cap, his portfolio experiences something investors call “cap compression.” And It is worth a 5 cap.
This compression happens because investors look at the portfolio and see less risk and more size. Instead of one operator at one location paying rent, we have a lot of different operators in different cities all paying Ryan rent. If one of them stops paying or goes bankrupt, the game isn’t over. So there is less risk. So they’re willing to accept lower returns because the risk-adjusted returns are the same. So they’ll pay more.
A few other dynamics happen when you reach this kind of scale that further compress cap rates and make everything more valuable.
The potential buyer for a small, one off, $14 million nursing home is different than the buyer for a portfolio of 20 or 30 of these buildings totaling well over $200 million.
Institutional money (big players like private equity funds and endowments) enters the game, and the yield needed to make the deal work goes down. The cost of capital and debt gets cheaper for these larger scale investors, so the cash return is higher or the same on their investment even though they pay more money as a purchase price.
So back to Ryan.
Each building, alone, is worth $22MM at a 6 cap with $12MM in profit. But at a 5 cap, it is now worth $26MM, another 4 million in profit per building on 150 buildings. 150 x 4 = $600MM. $600MM in extra value created by reaching scale. My friend Ryan is a billionaire using this method.
A similar “scale” effect happens in other industries too. A single self storage facility might trade at a 6 cap. But if I have 42 of them, with less risk and more customers and more scale, the value goes up and the cap rates go down to maybe a 5.5 or 5 cap.
This is called a “rollup” strategy. More properties -> bigger buyers and less risk -> more value and more profit.
There are three ways to make money in real estate:
- Take a lot of risk
- Deploy a lot of capital
- Develop an operational advantage
Every single wealthy real estate investor does 1 or more of those things. Ryan does a bit of all three. Development is risky (#1). He is spending millions (#2). He owns a construction company that is insanely good at building buildings at a low cost (#3).
I am doing mostly #3 – we’re operating real estate in a way (remote self storage management) that most people can’t or don’t do well.
Far too many investors don’t understand the risk aspect of real estate and have been bailed out by a hot market too many times.
How do I think about risk?
How many levers are outside of your control?
The more levers – the more risk.
A house flipper has a lot of levers he can’t control. The timeline for permits with a municipality. The surprises during remodel. The debt service on their hard money loan. What somebody is willing to pay for the property when it hits the market 9 months later.
Any of those things go wrong and they lose big. So it’s tremendous risk that, in this environment, is tough to justify.
The entire real estate game is balancing risk factors with upside. What can go wrong? How bad would it hurt? What are the odds? How much cash could I need and do I have it?
That’s all for now – talk soon.
Nick