In this series I am giving you an up-close look into a case study of Pete’s commercial real estate investment decision.
My client Pete purchased his office building 10 years ago for $450,000, which was at the height of the market for the time.
He has had the property continuously leased at market rent. His loan at the time of purchase was $250,000 at 6.5 percent interest, but it was refinanced after five years for $190,000 at 5 percent.
In my last article we examined Pete’s current cash flow as well as how loan amortization is paying off his loan at the same time increasing equity. Let’s examine how Pete can increase market value as a means of becoming a millionaire.
Increasing market value
There are two ways to increase equity: loan amortization and increasing the market value.
How do you increase market value?
Market value is what someone is willing to pay for Pete’s office building if he were to place it on the market for sale today.
If he holds onto his property he is not getting cash for the extra value created unless he sells or refinances the loan and takes equity (cash) out of the property. More on that later.
Market value is really a perceived value until you actually sell. There are four ways to increase market value in Pete’s case study:
1. Increase the rent.
The value of Pete’s investment property is essentially tied to the NOI (Net Operating Income) we discussed earlier. Increasing the rent will therefore increase the NOI, which directly increases the market value. This is an important concept to understand because the inverse will directly affect you if you are a tenant — an increase in the perceived market value allows for an increase in the rent.
2. Improve the property.
Pete could add amenities such as a kitchenette, wheelchair lift or improved energy efficiency. He could also update the building to standards office users look for today such as high-quality finishes, ADA compliance, solar panels and network infrastructure/Wi-Fi.
3. Re-tenant or gain additional uses.
Pete could pursue a higher-quality tenant when the current lease expires or capitalize on potential zoning allowances such as gaining approval to add a second story.
4. The economics.
In Pete’s case, supply and demand plays a big part in the value of his office building today.
In Napa we have a short supply of office buildings for sale with a high demand. Unfortunately, this is one of Pete’s dilemmas: he is having difficulty finding a tenant, but has had several inquiries into purchasing.
With Pete’s property being worth approximately $1.1 million he is on his way to being a millionaire if he were to sell.
As I mentioned earlier, he could refinance his property taking the maximum cash-out potentially of 75 percent of value less his current loan and use this as a down payment on the purchase of a $2.5 million property.
Whoa! What just happened there? You will have to wait for part three.