Imagine this scenario: It’s 2021. Everything and everyone around you is the same as when you went to bed last night. But you suddenly realize that prices on everything have reverted a half-century.
But only for you. And only when you buy.
Houses, cars, and chewing gum are selling for 1971 prices. Wrigley’s gum is seven cents a pack. You can buy a new luxury car for $9,000. A grand home in the country sells for $100,000. Flip houses cost you $8,000—but can be resold for $150,000 as usual.
As a real estate investor, you would have a field day buying low, selling high, and making a fortune.
Sorry, it’s time to wake up from this dream. Come back to 2021 and ask yourself, “Am I living in a dream trying to buy low and sell high right now? Is it a fantasy to attempt to get a great deal in this overheated market?”
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I speak with a lot of real estate investors in my investor relations role at my firm. I host a BiggerPockets show where I interact with dozens of real estate investors at all levels weekly. And I can tell you with confidence that it’s very hard to find a good deal right now!
And there’s no sign of it letting up. This time last year (in the second month of COVID-19) I predicted the opportunities of a lifetime were right around the corner. I thought we’d be seeing rock-bottom prices and bank foreclosures like 2008 again.
I was wrong.
We’ve probably never seen a real estate market as hot as this one. I’ve heard endless stories about record prices and manic behavior in almost every real estate investment realm.
Residential homes and land have gone crazy. Multiple bids above asking price are the norm these days. Most commercial real estate is in the same boat. Multifamily, mobile home parks, and self-storage, the areas I invest in, are experiencing record low cap rates (high prices!).
New real estate investors, and even experienced ones, are looking elsewhere for value. Those who bought Bitcoin at $3,000 are feeling pretty smart right now. (And many of us are honestly feeling pretty jealous.) It’s tough–and quite frustrating–to make sense of things right now.
Are you feeling that way, too?
Then you might be wondering why I’m taunting you with dreams about 1970s asset prices and buying money at a discount. (What the heck does that mean anyway?)
I’m writing because, for some people, this is no fantasy. Getting money on sale and discounts on assets is their daily reality. Even in this market—and in every market.
(And no, I’m not talking about buying a foreclosed hotel at fifty cents on the dollar.)
How to buy money on sale
Some call it arbitrage, but it’s not that. Others call it value-add, and that’s getting closer.
I call it “intrinsic value extraction.” And I’m hoping the term will catch on.
- Who can pull this off? This is a process for a specialist. And I’m writing to tell you that you could become that specialist.
- How does it work? The first step in the process is spotting the right asset. This is an asset that has hypothetical value that the current owner doesn’t realize or isn’t utilizing. Latent potential.
It used to be the cheapest house on the street or the smallest house in the neighborhood. Or the dumpiest, or most run-down. No more.
This overheated market has skyrocketed prices on every house (and other assets) in almost any condition and location. And HGTV shows have convinced millions they are house flippers.
I’m talking about something deeper than that. Something less obvious. A strategy with a higher knowledge barrier to entry. This is actually good news for the few that pursue it, because it means less competition.
Intrinsic value extractors find properties whose operators are significantly underutilizing their assets. They typically don’t have the knowledge, creativity, resources, or desire to increase the property’s income and maximize its value. If you can envision the potential, you may be in a position to acquire this diamond in the rough.
Let’s look at a few examples. (Note that I’ve changed some of the names and details.)
Intrinsic value extraction #1: Residential rental upgrade
Aaron acquired a three-bedroom home near Ohio State University. It had an unfinished basement and a large den. He had to pay full price. This seemed crazy to his friends because, at $500,000, it was $80,000 higher than the 2016 price. Even his Realtor was surprised at what he paid (since it only rented for $1,900 per month).
Aaron knew something the prior owner (and his critics) hadn’t considered. He realized it could be partially furnished and rented by the bedroom. He was willing to move into the now-semi-finished basement and live for free. And he charged each of seven tenants (two per bedroom plus one in the den) $750 per month. Bingo!
Intrinsic value extraction #2: Under-utilized self-storage facility
Cindy acquired a mom-and-pop-owned self-storage facility in Utah. The main partner had passed away and the passive partner was running it—quite poorly. Costs were out of control, vacancy and delinquency were high, and rates were 25% below market. It didn’t even have a website.
Cindy bought it for a fair price ($2 million) using investor cash. She hired an experienced manager who went to work evicting bad tenants, catching up on deferred maintenance, and adding a showroom to sell retail items (locks, boxes, tape, and scissors). The manager contracted with U-Haul and started community marketing outreach. He turned two of the five acres into parking for boats and RVs and negotiated a cell tower lease.
Cindy went to work building a website and implementing digital marketing. She set up a management portal and hired a tax strategist. She did a cost segregation study, which provided her investors with massive paper losses in year one.
Within a year, Cindy got a new appraisal for $3 million, 50% more than she paid. She acquired financing at 70% LTV ($2.1 million) and paid off the investors. Cindy and her investors are now enjoying powerful cash flow and appreciation with the risk off the table.
Where was the intrinsic value in this storage deal? It was the under-utilization of the asset by the previous owner/manager. There were a dozen things the prior manager could have done to boost profits and value. He didn’t know, didn’t care, couldn’t afford it, or chose not to.
For example, Cindy noticed there were no U-Haul dealers for miles around. By contracting with U-Haul, she increased profits by $2,000 per month. This $24,000 annual increase translated to value escalation of $400,000 at a 6% cap rate (value increase = net operating income increase ÷ cap rate).
This opportunity was intrinsically available to the prior owner, but they chose not to act on it. Just like the marketing, the rates, the ancillary sales, and other management improvements.
Intrinsic value extraction #3: Happy accident
My wife and I were out and about when we passed the location of an old restaurant that was recently condemned and torn down. I had been feeling sorry for the new owner who inherited such a crummy building. He had reportedly applied for a building permit to expand it and had to tear it down instead.
The owner made the best of the situation for the lowest possible investment.
After flattening the building, he graveled the lot and rented it to food trucks. My friend who owns a truck said the owner is getting $800 per month from each truck, times about a dozen trucks. He has turned lemons into lemonade. And he has gone from the grueling business of running a restaurant to the nearly passive business of running a gravel parking lot.
Intrinsic value extraction #4: Mobile home park mania
I recently joined my friend Matt in investing in a 300+ lot mobile home park in Kentucky. The owner was aging and had not been to the park in at least five years. The salaried manager of the park was motivated to maintain the status quo but not to move the ball forward in filling vacant lots or keeping costs down.
The park owner was eating the high costs for water, sewer, trash, and more—costs that are virtually always passed back to tenants, especially in a park this size. Many other costs were inflated under the long-time owner’s model. She was ready to sell, and Matt’s team happened to reach out to her at just the right time.
The seller benefitted greatly from cap rate compression. This compression from roughly 10% to 6% or so created millions of dollars of gain for the owner without working harder. Matt paid her a fair price for what the asset was when he acquired it.
Matt metered the utilities and immediately passed them back to tenants. (Note that this is environmentally responsible, since tenant-funded utilities often result in about 30% lower usage than company-paid.) He slashed operating costs and began a program to fill vacant lots.
Matt got an offer he couldn’t refuse within the first year of owning the park. He sold it for more than double what he had paid. With 50% leverage, the equity experienced a gross profit of over 240%. Grand slam!
I’ve started my third decade investing in residential and commercial real estate. I’ve seen good times and bad times. But I can confidently say that this intrinsic value extraction model is the best method I’ve seen to locate acquisition opportunities in any market, guard against downside risk, and reap massive rewards for investors.