3 reasons why commercial real estate is the most profitable investment
“95% of Americans fail to retire by 65, they are either dead, or dead broke. The 5% that do retire managed to do it because they have a second source of income– or third, or fourth,” and the best alternative out there is the real estate market (and commercial real estate, in particular). Stephen J. Davis, founder and lead consultant at Total Wealth Academy, is very straightforward about investing. And he finished his webinar at Real Estate IQ with this compelling argument about why it’s critical to invest and to do so in the real estate market.
From his point of view, real estate is the best vehicle to invest in, outpacing the stock market. And he doesn’t just believe in it. He has eight reasons to choose it over Wall Street. In his webinar “Moving from single-family to commercial and apartments,” he discussed three particular motives to illustrate his point. And here, we bring you the highlights.
Why investing in commercial real estate?
Davis focused his presentation on the many aspects that made the real estate market substantially more profitable than the stock market. Even if you invest in single-family homes, you’ll be able to see a higher revenue every year. However, somewhere along the way, you’ll be in a position to make the jump to commercial real estate. And he encouraged attendees not to miss that opportunity.
So, without further ado, here are the three main reasons why you must invest in commercial real estate.
1. Real estate makes you money in four different ways
The first reason in this shortened list is the versatility of the real estate market. And these four different ways in which real estate makes money apply to residential and commercial real estate. To explain it, Davis shared the following example: an average single-family with an all-in price of $170,000, an ARV of $200,000, and only $20,000 out of pocket.
The first way in which real estate makes you money is cash flow. In the example, when you take the rent ($1750) and subtract the maintenance and vacancy costs, plus the principal interest taxes and insurance, you end up with a cash flow of $350 per month ($4200 per year). When you divide the yearly profit by the amount of money out of the pocket, you get a 21% rate of return. “The stock market average rate of return for the last 75 years is 7%, while I have made 20% of return rate for the last 25 to 30 years, every year,” he assured.
The second reason is equity pickup, understood as the difference between what you paid for the property and what it’s worth. In this case, it’s $30,000 that goes straight to your net worth the moment you purchase the home. Considering the $20,000 put in cash, it’s a 150% rate of return.
The third reason is principle reduction. In this particular case, it’s not much ($1,800), but divided into the amount of money out of the pocket, it’s a 9% rate of return, which beats the stock market again. And the last one is appreciation, which is about 3% annually. However, 3% of the example property is $6,000. If we divide it by the $20,000, it’s a 30% rate of return.
When you add all this together, the first year you own a single-family home, the total rate of return is 210%. The second year forward, it’s about 60% because there’s no equity pickup in the second year. Nonetheless, do this 20 times over the next ten years, and you’ll have $120,000 a year in cash flow for the rest of your life. You’ll have 6 million dollars in real estate and 3 million in equity. This is why people invest in single-family.Stephen J. Davis, founder and lead consultant at Total Wealth Academy
But according to the expert, owning about 20 single-family properties might be an indicator to transition into commercial real estate. And why would anyone that gets $120,000 yearly do that? Well, because of the following reasons.
2. Forced appreciation
“You move from single-family to apartments because you’re in control,” summarized Davis. And by that, he means that you no longer depend on comps to establish the property value. “Simply put, forced appreciation means that you control the value of your commercial real estate,” he mentioned. In single-family properties, it’s safe to say that the neighborhood regulates the home price, so it’s easier to lose money if, for instance, you overspend in rehabs.
But commercial real estate is different. “You can have two identical apartment complexes side by side, and one can be worth 2 million while the other is worth 4 million. This is because commercial property is valued based on net operating income or NOI,” the lead consultant explained.
To know how much commercial real estate is worth, you divide the NOI by the capitalization rate – which the bank ultimately determines since they decide whether an investment has a high or low risk. Davis offered the following example: you purchase a 30 unit for 1.5 million dollars, and with rehabs and closing costs, the all-in price is 2 million dollars. However, the total out-of-pocket is about 30%, $600,000 – which can be obtained in multiple ways: using personal funds, IRA or 401k with no tax, friends, relatives, partners, and so on.
Because of the state of the property, the bank considers it’s a high-risk deal and determines an 8% capitalization rate. So, the value of the property ends up being $2,000,000. But 18 months later, after fixing and renting it, the NOI increased to 2.4 million dollars, while the bank decreased the capital rate to 6% because it no longer considers it a high-risk investment. Therefore, the property has a new and improved value.
“If you divide the numbers, the new value is $4 million. As a full owner, you’d obtain a 167% rate of return. But let’s say that you opted to do it with other five people. The rate of return as a passive investor in this deal is 125%. And there’s no tax due because it’s a loan. So the total impact is $1.6 million equity in property and $1 million in your pocket,” Davis analyzed.
As the investor indicated, the magic formula to appraise commercial real estate is that for every dollar you increase the NOI, you increase the value of your property by $17.
3. Tax advantage
Davis assured that real estate investors pay the lowest taxes of any for-profit group in the United States. And that’s because of reasons like depreciation, and the 1031 exchange, which allows you to pay no tax if you sell your properties and reinvest the profits into other ones.
Investing in real estate is a smart move in the long run. It has the potential to provide you with impressive profits if you do it wisely. And those benefits can go even higher if you dive into commercial real estate – which includes self-storage and hotels, to mixed-use and mobile home parts.
What is more, “we make money in both the up and down market. However, you need to be cautious right now because there’s an exuberance in the marketplace. People are overpaying for single-family and commercial. It’s still a good time, but you’d better know what you’re doing. So, if you can’t find the deal, skip it. It’s more important to do the right deal than do the first thing that comes across your plate,” Davis concluded.
And how to be cautious and avoid overpaying for properties? Well, of course, by subscribing to our Off Market Leads! They’ll get you the best off market properties in Texas, Florida, Georgia, and Utah with the deepest discounts. And the best part is that we can guarantee you’ll find a deal within 90 days!
Disclaimer: The blog articles are intended for educational and informational purposes only. Nothing in the content is designed to be legal or financial advice.