So today we're going to talk about real estate investors.
Blind spot number two with a hopefully saw video.
Number one, if you haven't, please go look at that because there are some things
I'm going to be talking about and referring to in video two
that I don't want you to be confused about that are very important
for what I'm about to say.
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So what our blind spots, we talked about this in video.
One has a difference between smart and wise.
So a smart person solves a problem, a wise person, they avoid a problem.
This is very different kind of investing.
So I'm not saying there's not a lot of people that are smart,
but a lot of times you just don't know what you don't know.
So some of you saw these at the first video.
These are blind spots that I had when I first started in the industry.
So the first blind spot is rent growth or price growth.
And you see this a lot where people are projecting what happened last year
to next year without being realistic with other market conditions.
The second blind spot is vacancy and we see this all the time.
The lower the vacancy, the more the income.
You have to be realistic on the vacancy factor, specifically
with turnover vacancy.
The third blind spot, of course, is expense projection.
And we're seeing property taxes go up, insurance go up,
labor go up, supplies go up, all these things are going up.
So if you're not budgeting correctly, your numbers are going to be
off the fourth blind spot or stabilized interest rate.
And as we know, the Fed just raised .75 percent,
the federal funds rate, and they're about ready to raise it again.
The fifth are the exit cap rates, the six blind spot, and what most real estate
investors do not pay attention to is debt service coverage or DC.
But for today, we're going to talk about exit cap rates and why they're important
because most people have not done this right and last week, of course,
we talked about debt service coverages which are very important.
So blind spot number two, which is actually five on the list, is the
entry cap rate versus the exit cap rate and why assumptions matter.
Now, the entry cap rate is what it is.
It's what you bought it for.
The value divided by the A.I.
or the net up or income based on whatever you paid.
The exit cap rate is what we're going to talk about here.
And that assumption and that assumption alone
can make a massive difference on what you're actually going to do when you exit.
So here we are with the exact same deal that we talked about in video one
you can see here, we have 100 unit value add, 125,000
a unit times 12 is 150,000.
You go for your and a Y from 400 to 500
and your cap rate at acquisition was 4%.
And since we're talking about the entry cap rate, it's simply the 4%
divided into the 400,000, which gives you your 10 million.
So that's how you calculate your cap rate from the entry point.
So now we're going to look at this exact same deal that we looked at in
video one as a sale as opposed to a refinance,
because a lot of people in video one are going to see
that they might not be able to refinance their money out.
And so that general partner or the limited partners might put pressure
on the general partner to say,
hey, we're not going to get our money back, let's sell so we can get it back.
For purposes of this video, we're going to assume that in 2021
you had an interest rate of 3% and you've done all your value add,
and now you're sitting in 2023 where rates are close to 6%.
Now, here's the reality.
A seller is now looking at your deal
and they're looking at the 550 K and a Y,
but they're also looking at what their payment is going to be.
And in the last video, we determined that whether you're a cash out refi
or a buyer, you're still going to have a debt service coverage issue.
You're still going to have a loan payment issue based on the 550.
So whether you're doing a cash out refi and you're still the owner
or you're a buyer, you're still have the same issue
with the lender, only one is a refi and one is a sale.
The lender is going to look at this as the source of payment.
They're going to be looking at the 550 to cover their loan payment.
The reason that this is important is because the 6% interest rate has jumped
so much that a seller is now going to be solving to their own cash on cash return.
And having a higher interest rate means
they're going to have a higher payment, which is going to lower their cash flow.
So now let's jump straight to cap rates and we're going to assume that we went
from a 4% to a 5% cap rate.
As a buyer, we're seeing 7 to 10 deals a week
and we are starting to see cap rates rise as the sale prices
and the values go down because the interest rates have gone up.
This number here
determines cash flow, which determines, of course, how much you're going to pay.
And this is not that far fetched because we're starting to see cap rates
go up already in 2022 to almost 5%.
So now you just do the simple math.
You take 5% divided into the net operating
income to find out what your value is.
Even though you've done a great job growing your value, add two
four 400 to 550, you take 5% divided into the 550,
and that gives you about $11 million value
in video, one where you're trying to do a cash out refinance.
You saw that the loan
barely covered the debt that you used when you originally bought it.
In this scenario, you can see that the value with these rising cap rates
is barely above what you originally paid for the property.
In this scenario, you're probably going to hold
because you do have $150,000 more per year to be able
to give to your limited partners, which is always good,
but you're not going to have a sale as an exit.
This is precisely why I invest for the long term and invest
for the tax benefits, because these things do happen from year to year.
And this is precisely why I try to lock in my interest rates
and have a sum of all loans if I ever need them.
Now, let me summarize all this up.
So the entry cap rate we already know is for the exit
cap rate, of course, we've assumed is five.
If we take the A.I.
from 400000 to 550000, then you can see
the 10 million would have had a 4% cap,
been a 13.75 million value add.
But because cap rates went up by 20% or
1% more, we're now at $11 million value.
So that is why the blind spot number two is your exit cap rate.