Cap rates (as a measure of value) change based on risk, upside, trends and investor appetite for a certain type of asset.
But the bottom line is this:
Commercial real estate is valued based on how much money it makes (Net Operating Income)
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Increase NOI --> increase value
Decrease NOI --> decrease value
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Back to my friend.
He's looking at a distressed asset. Half vacant. So there is some upside potential. That potential is baked into the cap rate he can buy it at.
So he makes an offer to buy at an in-place 6 cap.
The NOI = 1.2MM
Cap rate is 6
A quiz -> what is the value?
- $1.2MM * 6 = $7.2MM18.8%
- $1.2MM / 6 = $200k16.5%
- $1.2MM / .06 = $20MM64.7%
13,403 votesFinal results
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You guessed it. $20MM.
So my friend gets the property under contract for $20MM.
And while its under contract, before he buys it, he pulls an ace out of his sleeve.
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You see my friend owns several LA Fitness franchises and also several trampoline park franchises.
So he prepares his plans to sign long term leases with both of these businesses the day he closes on the property.
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And the day he closes he does so and they both move in.
And now the retail center is 100% full.
Bringing in $2.4MM a year in NOI.
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So now what cap rate would we use to value this full retail center with long term leases in place across the board?
The upside is gone, so the cap rate will go up slightly, and my friend generally achieves an 8 cap valuation here.
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So with $2.4MM in NOI, what is the new value at an 8 cap?
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So with $2.4MM in NOI, what is the new value at an 8 cap?
- $2.4MM / 8 = $300k1%
- $2.4MM / .08 = $30MM95.4%
- $2.4MM * 8 = $19.2MM3.6%
10,792 votesFinal results
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You guessed it. $30MM.
So my friend just bought a building for $20MM, signed two leases, and now its worth $30MM.
So he created $10MM of value out of thin air.
And he does this to two or three retail plazas a year.
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Have friends who do the same thing with medical buildings. Such a sick play.
Does he hold them permanently? Or keep for a year to get LTCG tax treatment?
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He holds them all at least 1 year to make the gains taxable at long term capital gains, but he does sell some occasionally!
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Awesome breakdown. There's a retail plaza right by me that needs this done.
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But first for you to pull this trick you have to own the Fitness franchise 😉