- If you’ve already gotten your feet wet with real estate investing, maybe you’re starting to think higher – like several stories higher. A multi-unit apartment building or commercial investment may be your next money-making move. Even if they’re no taller than ground level, they’ll still be a step up.Once you have a building with the potential for multiple rentals, you have the opportunity to generate real wealth. Passive income kind of wealth – the kind that lets you quit your job and maybe travel the world, even oversee your investment from afar.
Here are a few reasons to take it to the next level:
• House flipping is a great way to potentially make more money than you’ll ever make in a 9-5 job. If you invest wisely and flip timely, the profits can be terrific. But there’s a limit to it: once you’ve sold that fix & flip property, the money is done coming in. House flipping does not generate passive income.
• House flipping takes concentrated focus, and can feel like a merry-go-round. When the property has sold, you have to get on it to find another one. Then you have to go through the same process again. And again. This can be a lot of fun, but eventually you may want off that ride.
• Fixing up properties can be hard work, physically. It can keep you on your game, but also be exhausting. Passive income allows you to get your fitness in on your terms, not the house’s.
• Homes purchased to be used as rental properties do generate passive income. But it’s not big time money. The expenses related to rental homes keep the income generation lower, unless of course you have a whole block-full of rental houses. And if you’re up to that many houses, you’re working as hard on upkeep as you were fixing and flipping. One larger building, be it units for dwellings or businesses, is just easier to handle.
Before you make your move, zero in on the three main ratios for estimating the value of a piece of commercial real estate: the “cap” rate (market capitalization rate), cash on cash return, and debt service coverage ratio (DSCR).
• Cap Rate – the building’s NOI (net operating income) divided by it’s price (or value in price terms) equals the cap rate. Example: if the property generates an annual NOI of $1M, and the value of the building is placed at $10M for sale (based on a cash sale), the cash on cash return on that building is 10%, which is the cap rate.
• To determine the cap rate, find a commercial real estate broker and/or appraiser knowledgeable of the area. They can give you sale prices and NOIs of similar properties so that you can compare. In a higher priced area, you’ll find cap rates will be lower. Look for a cap rate of 8% or above.
• Cash On Cash Return – how much you receive monthly based on the investment. This is the return after deducting all expenses – ALL – then dividing by the total cash invested. Once you’ve stabilized the property you’ve invested in (meaning, have it functioning at 90% occupancy), a rule of thumb is to receive a12% cash on cash return. It’s valuable to think in the long term. Your first year of the investment may yield a lower percentage of cash on cash return because the building is still not fully occupied. That’s okay as long as the goal is to reach 12% over time. It’s a doable figure to work toward.
• Debt Service Coverage Ratio – the factor banks use in determining a building’s risk level. The ratio between NOI and the amount of annual debt service you’ll need to pay in ownership is the DSCR. A good DSCR is at least 1.25, but a deal where the DSCR lands at 1.5 is even better.
If you take all of these factors into consideration, you will have success in determining the right commercial property to invest in. It’s a great way to bump up the overall income your properties can generate, and it sets you as a solid pro in the real estate investment game.