How to Start Commercial Real Estate Investing in 2020
This is a question I hear often from new investors looking to start the journey into commercial real estate investing.
Where do you start?
Today, we’re going to start with the foundation. Because without understanding the basics of money and how it impacts the value of commercial properties- it’s very difficult to know when to invest. What properties will prosper, in the right locations.
Question: How would you define money?
Before I answer this question- I want to share a quick story. As it will hammer home the importance of understanding this basic investing question.
This weekend while taking my daughter to soccer, I asked Brooke: “how come you weren’t nervous performing in front of 300 strangers on Saturday“.
Both my girls, Brooke (8) and Blake (6) are in theater- and this weekend they had 2 Christmas shows (The Polar Express).
Neither are trained singers or dancers.
But, in the past 2 years, they’ve taken to the theater.
When I asked Brooke, she answered: because we practiced Dad, that’s why I was so confident.
Good answer for an 8 year old.
Later that day I asked Blake the same question.
Her answer: “dad, it because for the past 6 months, I’ve been singing in front of 60 other kids.”
She had done the reps in front of people.
It wasn’t really that much different when she got in front of the audience.
So, last week, when a client asked: How to get into commercial real estate investing in 2020, in such uncertain times?
My answer- because I study daily (yes, weekends too), the macro market fundamentals, and have done so for the past 15 years (not including my econ degree from UofC)- the practice gives me confidence.
Am I worried about inflation? Deflation? Government debt? Job loss and the market potentially at an all time high?
Yes. Which is why I’m investing in properties and locations that I believe in for the long term.
With sound fundamentals.
With opportunities to add value and provide stable cash flow for the long term.
Today, I’d like to share some of the most recent concepts I’ve been studying which will help you understand how to start investing in commercial real estate like the pro’s.
I’m going back to the foundations.
What is Money and how is it created?
And, how does this impact my investments?
- What is Money.
- We’ll explore Inflation and Deflation.
- How to take this knowledge and apply it to investing in commercial real estate
That’s the agenda for this post.
With the goal of helping you get the reps to feel confident investing (or maybe you decide not to invest- it’s up to you).
When several of my clients ask me: Shane what happens if (plug in any unexpected event- none of which I can predict or forecast)… I know it’s a symptom of not having the foundational understanding of money and the economy.
Frankly, much of the economic information I come across is confusing.
Not easy to understand or relate to my situation.
I’m going to do my best to give you enough insight and resources to back it up. If you want to go deep or doubt, this, you’re welcome to research it and get back to me.
Where do I get this information?
While I was out for my 8k run on Sunday, I was listening to David Steins podcast- Money For The Rest Of Us.
(David used to manage a $30B fund- he’s one of the few guys that is able to explain the complexity of the markets in simple terms).
In an episode I was listening to- David explains the origin of Money.
What is Money?
The definition of Money according to Oxford: serves as a medium of exchange, a unit of accounting and a store of value.
I define Money as Trust.
What do I mean trust?
Trust that we can convert the money (think paper) into something of value. That value may be food. A house. A commercial property.
If we trust our money has value- and we understand that value, then we can exchange it for goods and services.
Excerpt from a recent email I sent to my audience:
My dad asked- give me an example Shane? How does inflation and money work in the real world?
I thought about it and said- ok, here’s how this could work in the real world. And, then, I’ll tie it back to investing in commercial properties.
Here’s $100 bill.
Money is trust. Trust that I can exchange this $100 bill for a tank of gas. Or, food for my family for a week.
Dad- ok, I see that.
Let’s say, that the government starts printing money (the Central Bank/Federal Government) do this through lowering interest rates (email 1), government spending (Quantitative easing- or QE).
Now, the Canadian economy has more of these $100 bills floating around. Let’s take it to the extreme (as it will be easier to follow).
If the government prints ‘too much money’ and now the economy has 1000x the amount of money in the market, all chasing the same amount of goods.
Supply of paper money is extremely high.
The number of goods remains the same (food in a grocery store is the same).
This is called Inflation- in extreme cases- hyperinflation.
My $100 no longer buys me a food for my family for a day.
Now, I may need $1,000 to buy that same amount of food for a day.
Trust for the currency has gone down. (Paper money is not backed by anything).
Markets where currency is not trusted – people convert their paper money into tangible, hard assets.
Real estate would be a good example of this.
The belief is: we need a place to live. We need places to store goods for sale (retail locations), to produce goods (warehouses/industrial) and to go to work (offices).
People exchange paper money- for tangible, hard assets.
As inflation sets in- the value of these hard assets rise.
Here’s a link to a very good, albeit complex 14 page article The Bank of England put out discussing how Money is Created in the modern economy.
I’ll do my best in giving you my interpretation of the article- as it was deep and complex.
(NOTE: I’m not going to proclaim to be an expert on the topics.
I’m sharing my key takeaways.
None of what I’m about to say is investing-advice – just my personal interpretation of the banking system based on my personal research)
Principle 1: Governments collect taxes from its citizens.
These taxes are accepted in the Currency of that country.
The Currency, is issued by the Central Bank of the Country.
This means the country issuing the currency has a monopoly.
If I’m a Canadian citizen and need to pay my taxes to the Federal Government, and must pay in the currency accepted by the Federal Government- I must use the countries money.
Principle 2: The central government has control over how much money is ‘created’.
While my old understanding of how money was created- an actual printing press that printed hundred dollar bills– that’s not actually how money is created and infused into the economy (on scale).
Today, most of the money in the economy are ‘digital’ or ‘digits’ that show up in bank accounts.
Not, actual paper money or currency as we know it.
(Several examples below and why this is important as you chose to invest)
How is Money Created or Destroyed today?
- Money Creation: Governments can create money out of thin air.
Governments do this through expanding money supply: spending money.
Take your social security check.
Let’s say the Federal Government owes you $1,000/month for your social security.
Some people are worried that the federal government could run out of ‘cash’ and not be able to make these payments.
But, because our currencies are Fiat and not backed by Gold- the Federal Government is able to change digits in your bank account, to reflect the $1,000 owed to you.
Money created out of thin air.
Don’t believe me:
Here is a conversation between Alan Greenspan (Federal Reserve Chair) and Congressman Paul Ryan on this exact topic in 2014.
Congressman Ryan: Do you believe personal retirement accounts can help us achieve solvency for the system and make those future retirements more secure.
(Ryan is asking/concerned with the security of retirement accounts of the elderly in the US. He wants to open up a separate bank account where the money is not touched).
Alan Greenspan: I wouldn’t say the pay as you go benefits are insecure, in the sense that there is nothing to prevent the Federal Government from creating as much money as it wants to pay somebody.
The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase?
So it is not a question of security.
It is a question of the structure of a financial system which assures that the real resources are created for retirement as distinct from the cash. The cash itself is nice to have, but it has got to be in the context of the real resources being created at the time those benefits are paid and so that you can purchase real resources with the benefits, which of course are cash.”
He’s talking about inflation and how much the money will be worth- if the federal gov’t just prints new money.
The Federal government can just create money.
And, what is the Value of the money- at the time it is issued (Inflation)?
Most leaders and investors don’t understand this explanation.
You could probably read what Greenspan said several times and it would still be difficult to truly grasp what he means by this.
Initially, until it was explained to me, I really didn’t grasp what he meant.
The Federal government can’t really run out of money– because they have the ability to change digits in accounts and create money.
The second way the Federal Government increases money supply- is through the Central Bank.
In Canada- Bank of Canada, in the UK, Bank of England, in US- The Federal Reserve System or The Fed.
When Central Banks lower interest rates – the price cost to borrow money for Commercial Banks goes down.
Important to understand the difference between Central Bank (controlled/influenced by Federal Government) and Commercial Banks (where most business and individuals go to borrow or have savings)
Commercial Banks: Royal Bank of Canada or Bank of America.
These commercial banks make loans to end users – individuals and business.
When it’s cheaper to lend money (lower interest rates) – it encourages businesses and individuals to borrow money.
Loans Create Money.
There are 2 main misconceptions about banks that I should clear up before going further:
- That Commercial banks are Intermediaries (NO).
When I deposit $1,000 at Royal Bank (commercial banks) , they pay me a small interest rate and then they go out and lend it to someone else at a higher interest rate. This is NOT how banks make their money
2. Central Banks set the Quantity of Loans a Commercial Bank.
This concept of “Money Multiplier” where a Central Bank sets the amount a Commercial Bank can lend out is not really accurate. The Central Bank controls the quantity of loans (and therefore) amount of money in the market by the Interest Rates.
Just to make sure we’re on the same page: so far, here are the 2 main concepts:
Money is Trust – Trust that I can take my $100 and purchase goods/services in the economy.
Governments have ability to Create Money:
- Government Spending- Social Security- changing #’ers in your bank account.
- Through Central Bank- Lowering Interest rates to encourage Commercial Banks to lend money
Commercial Banks Create new money through Loans.
Commercial Banks focus on: How much do we want to lend?
They do not ask- how much can we lend?
This is a very important distinction.
Commercial Banks (think Royal Bank or Bank of America) determine how many loans to create by their profitability.
Profitability from Commercial Banks depends on several factors:
- Interest Rates set by the Central Bank.
- The quality of loans (ie- risk). – who is borrowing and for what purpose?
- The demand for loans– how many ‘good’ loans. More demand, Banks can pick and chose the best loans, and, potentially charge higher rates (spread between Central Bank rate and rates they charge to consumers) while remaining competitive in the market
When a bank makes a loan, it doesn’t need to go into it’s vault to take out cash to put into your account.
The Commercial Bank credits your account with the Loan amount. This loan now becomes an Asset on the Commercial Banks balance sheet.
The more money the bank lends, on quality loans, the more money (in the form of interest) the bank earns and the more money flows into the economy.
Here’s an example of How a Commercial Bank Could Finance Your Multifamily Building
Let’s say you want to purchase an apartment building. You need a $1M mortgage from the commercial bank, Royal Bank of Canada (RBC).
RBC doesn’t go into the vault and pull out $1M in cash (reserve) to lend you the $1M.
RBC credits your account with $1M deposit. (Money created out of thin air, or, in this case with the Bank Manger agreeing to credit $1M in your account).
The bank increases its assets by $1M as this new mortgage is on the banks balance sheet as an asset.
Let’s say, 1 year later, you pay off your $1M loan to RBC.
RBC no longer has a $1M asset (mortgage backed by an apartment building) and the Money that was once created- is now destroyed.
In reality, when you purchase the apartment building there’s a seller who may have a mortgage. Let’s say the seller has a mortgage at Scotia Bank.
You buyer) get the $1M loan from RBC.
The new loan is an asset- but, the $1M goes from your bank (RBC) to Scotia (where the sellers has an account). How commercial banks handle inter-banking transfers is outside the scope of this article.
- Money is created by Loans
- Money is destroyed when loans are paid back
Money is Created by Government Spending
- Federal Government Commitments- Social Security
- Quantitative Easing – discussed later
- Lowering Interest Rates: Central Banks lower interest rates – encourages borrowing (loans) and thus increases money supply.
Money is destroyed:
- Raising Interest Rates (more expensive to borrow)
When you consider the primary goal of the Central Bank- to keep consumer price index (inflation) to about 2%/year you can see how the Central bank will use the interest rate as the main lever to pull to increase money supply in the market or take out.
The Fed has 3 primary goals: maximum sustainable employment, stable prices and moderate long-term interest rates.
James Tobin, Nobel Prize winner, explains how money is supplied in an open economy- Also called Monetary Policy.
Money supply is influenced by interest rates (set by the Central Bank)
1. Why Commercial Banks can’t just create an infinite amount of loans?
Banks face limits on how much they can lend. Loans = New $ supply in the market. But banks must remain profitable.
When a commercial bank lends money- they are regulated to make ‘good loans’. They also have liabilities in the form of interest on Savings accounts (on deposits) and money borrowed from the Central Bank.
So, they must make ‘good loans’ and there are policies on risk and not making bad loans. As the risk of loan not being paid back increases- so then does the interest rates increase to compensate the bank for additional risk.
Therefore, banks like cash flowing CRE- the bank has a hard asset as collateral.
It also explains why banks like to have longer term deposits on hand. Think of it this way- if a bank only had Short term deposits held in instant access savings accounts- when people want their money out of the bank- they could drain the reserves of the bank. The bank wouldn’t be able to cover these immediate cash obligations.
It is for this reason; banks like to have some savings on longer term hold- to match off against the longer term loans they have.
2. What is the Demand (Behavior) of the Marketplace?
When I say marketplace- I am referring to non-financial institutions: business owners and individuals.
If there is positive sentiment in the economy- business and individuals tend to spend money and thus borrow more (ie- creating more money in the economy- Inflation).
The opposite is also true.
When people are fearful- losing jobs, drop in assets values (ie homes go down in value)- people and business go into survival mode.
They stop borrowing and spending. This typically leads to less money in the market (less loans, spending leads to prices falling- Deflation).
Recall Money is created with new loans and destroyed when loans are paid back.
Example: A first time home buyer purchases a home from an elderly couple. A new loan is created (1st time home buyer).
But, what happens on the other side of the equation?
If the elderly couple pay off their loan and decide to rent- there is no net new money created (assume buyer and seller loans are equal).
If the elderly couple just pay off their existing mortgage- money is destroyed (known as Reflux Theory- money taken out of the economy).
Let’s say the elderly couple, take the sale proceeds, they didn’t have a mortgage and they decide to invest in the stock market. Maybe buy a new car. Take a vacation.
Money is circulated in the economy (Hot Potato effect).
Increased spending- more money in the economy, chasing same amount of goods- leads to prices increasing (Inflation).
Why did the first-time home buyer decide to purchase a home in the first place?
Buyer had confidence in the economy. Interest rates were so low.
3. Monetary Policy: The Central Bank sets the interest rates in the economy.
Recall: the central bank’s 3 main objectives: maintain prices (in some nations to keep the Consumer Price Index at 2%/year- also called Inflation), maximum jobs and moderate long term interest rates.
If Central Banks notices inflation rising too much (the price of a basket of goods) and too quickly- they can raise interest rates.
Effectively making it more expensive to borrow money and thus taking money out of the economy. Less $ in the economy, chasing same # of goods- puts downward pressure on price of goods.
If they see inflation dip too low- they can lower interest rates to encourage borrowing.
Central banks do not set the quantity of money (reserves) in the economy – as I used to think (the multiplier effect).
Central banks focus on the price of money (Interest Rates) they lend to Commercial Banks to influence the demand for money in the marketplace.
Ultimately it is the demand from the marketplace (businesses and individuals) who borrow these new loans.
The central bank will stimulate an economy by lowering rates to encourage borrowing when inflation is lower than 2%.
When inflation is rising too quickly, the bank can increase rates to slow down consumer/business spending.
Now, what happens when Central Banks can no longer stimulate an economy because the interest rate is so low they can’t influence the market by lowering interest rates any further?
You saw the Fed in US raise rates in the past 2 years (from 2016- 2018) from 0.5% to 2.5%. In my opinion, they did this for a few reasons- 1, the economy was doing well, jobs were being created and, it gave the Feds a lever to stimulate the economy again, if need be.
Starting July 31, 2019 the Fed has dropped Interest rates 3x – from 2.5% down to 1.75%
With an understanding of why Central Banks lower interest rates- it’s reasonable to believe the Fed’s are looking to maintain/stimulate borrowing and spending by consumers in the US.
The 2nd big lever Central Banks pull to stimulate the economy: QE or Quantitative Easing.
Essentially government spending, through the central bank.
The Mechanism: Central banks spend money not how you might think. The Central bank doesn’t ‘print billions’ in new paper money.
A Central Bank will deposit money into Financial Institutions (Commercial Banks)- through what are effectively IOU’s.
Here’s an example of how this could play out (as I understand it). I’ll use Canada and 2 large companies people would know for this example:
3 Players required for this to occur:
- Central Bank – Bank of Canada (BofC)
- Commercial Bank – RBC
- Non-Financial Institution: Life Companies/Pension Funds: Sun Life
BofC is going to stimulate the economy through QE.
So, the BofC will buy back Government held bonds from non-financial players- Sun Life.
In this scenario, lets say the BofC buys $1B in Government Bonds from Sun Life Financial.
Sun Life sells the bonds back to the Government/Central Bank.
Now, Sun Life doesn’t take the $1B. No, lets say Sun Life uses RBC as their bank. RBC will credit Sun Life with $1B in their savings account.
Now, RBC has a problem- they have a liability on their balance sheet- $1B owed to Sun Life.
The Central Bank (BofC) says- don’t worry RBC. We’ve got that covered, here’s effectively an IOU from the BofC to cover the $1B owed to Sun Life.
$1B in new money is created through the purchase of Government bonds.
RBC acts as the intermediary for the transaction.
Result: RBC has a new Liability to Sun Life of $1B (which it will need to pay some interest rate on).
Sun Life new asset of $1B from the sale of the bonds to BofC- which is earning a very low interest rate (sitting in a savings account at RBC).
Both RBC and Sun Life are incentivized to put that $1B to work.
The hope/idea is that as new money which was deposited by the BofC (buying the Bond and then giving RBC an IOU) – will cause Sun Life to invest the money and RBC to make more loans.
Practically speaking, Sun Life has obligations to their shareholders and those who have insurance polices. When, Sun Life was earning, say 3% on their government bond, but now the money sitting in the RBC account may be earning less than 3%.
Sun Life might withdraw some of that money and invest it in commercial real estate.
A core commercial property earning 5%- 6% cash flow, plus the opportunity to pay down debt is better than sitting in a bank.
Side Note: most large institutions buy CRE all cash, but the outcome is the same- more money in the economy.
RBC has a $1B IOU from the central bank and will own Sun Life interest on.
RBC can’t just sit on the IOU. It needs to make new loans- putting more money into the market.
There are stipulations on how the bank can utilize these IOU’s. And it’s beyond the scope of this article.
Just the understanding of how QE is effectively pumped into the market and how it will influence spending- you can see how it will impact asset prices.
This entire article was written to give you an understanding of how money is created and destroyed in an economy.
Because the amount of money in the economy influences asset prices and how people make commercial real estate investing decisions.
When you have this basic understanding of interest rates, how and why banks lend money- you can start to see where the market is going. When asset values are poised to rise or potentially come down.
You can also see why it’s important to invest for cash flow – not appreciation.
With interest rates at historically low rates- there’s less room for assets to rise in value with the lowering of interest rates.
On the same note- it would be dangerous (from my perspective) for the central banks to increase interest rates too much (unless the economy was doing extremely well).
The banks loans are backed by collateral in many cases. And, if interest rates increase and effectively lower the value of the assets- they are shooting themselves in the foot.
There are many things to consider when investing- but understanding how money flows, is created and destroyed in an economy is critical.
Given this information- you can take this information and start applying to the market/country you live in.
- When banks lend money- money is created (and typically pushes asset prices up).
- When central banks lower interest rates- they encourage more borrowing, thus increasing the supply of money in the market (pushing up asset prices).
When you understand this- you can start to see how commercial real estate fits in.
Commercial real estate is valued on NOI (net operating income) calculated by taking the Revenue – Expenses.
The NOI, the free cash flow is then divided by a Cap Rate.
Think of the Cap Rate as the return you would expect if you bought the property all cash.
When you apply leverage to your property- you essentially boost the returns, so long as there is a delta between the Cap Rate (6%) and the Interest Rate (4%).
You have what is known as Positive Leverage.
The more positive “Leverage” (difference between Cap Rate and the Interest Rate) the more active investors typically get.
More investors- more demand- higher prices go.
If you understand how Central Banks manipulate interest rates, with the intention of putting money in a market or taking money out- you can start to forecast where interest rates might go into the future.
Video of the Conversation between Alan Greenspan and Congressman Ryan: https://www.youtube.com/watch?v=DNCZHAQnfGU
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