How to extract the intrinsic value of real estate?

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 for everything have returned for half a century.

But only for you. And only if you buy.

Houses, cars and chewing gum are sold for 1971 prices. Wrigley’s chewing gum is seven cents a pack. You can buy a new luxury car for $9,000. A large house in the country is sold for $100,000. Flip houses will cost you $8,000, but can be resold as usual for $150,000.

As a real estate investor, you would have a field day to buy low, sell high and make 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 that is now trying to buy low and sell high? Is it a fantasy to try and get a lot in this overheated market?”

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I speak with many real estate investors in my role as investor relations at my company. I host a Pyjama People show where I interact weekly with dozens of real estate investors at all levels. And I can tell you with confidence that it is very difficult to find a good deal right now!

And there’s no sign of it stopping. Last year at this time (in the second month of COVID-19), I predicted that the opportunity of a lifetime was just around the corner. I thought we would see rock bottom prices and bank failures again, like in 2008.

I was wrong.

We’ve probably never seen a real estate market as hot as this one. I’ve heard endless stories of record prices and manic behavior in almost every real estate investment domain.

Homes and land have gone mad. Multiple bids above the asking price are the norm these days. Most commercial real estate is in the same boat. Multi-family homes, mobile home parks, and self-storage, the areas I invest in, face record-low cap rates (high prices!).

New real estate investors, and even experienced investors, are looking for value elsewhere. Those who bought Bitcoin for $3,000 feel pretty smart right now. (And many of us, frankly, are quite jealous.) It’s hard — and pretty frustrating — to understand things now.

Do you feel that way too?

Then you might be wondering why I’m mocking you for dreaming about 1970s asset prices and buying money at a discount. (What does that mean anyway?)

I write because this is not fantasy for some people. 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 for fifty cents a dollar.)

How to buy money on sale

Some call it arbitration, but it isn’t. Others call it added value, and that is getting closer and closer.

I call it ‘intrinsic value extraction’. And I hope the term catches on.

  • Who can make this happen? 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 finding the right asset. This is an asset with a hypothetical value that the current owner does not realize or use. Latent potential.

It used to be the cheapest house on the street or the smallest house in the neighborhood. Or the dirtiest, or the most run down. Not anymore.

This overheated market has skyrocketed prices for every home (and other assets) in almost every state and location. And HGTV shows have convinced millions that they are house fins.

I’m talking about something deeper than that. A little less obvious. A strategy with a higher knowledge threshold. This is actually good news for the few who pursue it, as it means less competition.

Intrinsic value extractors find properties whose operators are significantly underusing their assets. They usually do not have the knowledge, creativity, resources or desire to increase the income of the property and maximize its value. If you can imagine 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 names and details.)

Intrinsic Value Extraction #1: Residential Rent Upgrade

Aaron bought a three-bedroom house near Ohio State University. It had an unfinished basement and a large study. 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 real estate agent was amazed at what he paid (since it was only renting for $1,900 a month).

Aaron knew something the previous 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 half-finished basement and live for free. And he charged each of the seven tenants (two per bedroom plus one in the den) $750 a month. Bingo!

Intrinsic Value Extraction #2: Underutilized Self-Storage Facility

Cindy acquired a self-storage facility owned by Mom and Dad in Utah. The lead partner had died and the passive partner was leading – rather badly. Costs got out of hand, vacancy and arrears were high and rates were 25% below the market price. It didn’t even have a website.

Cindy bought it for a fair price ($2 million) with investor money. She hired an experienced manager who went to work evicting bad tenants, making up for overdue maintenance, and adding a showroom to sell retail items (locks, boxes, tape, and scissors). The manager signed a contract with U-Haul and started community marketing. He turned two of the five acres into parking for boats and RVs and negotiated a lease for a cell tower.

Cindy set to work building a website and implementing digital marketing. She set up a management portal and hired a tax strategist. She conducted a study on cost segregation, which resulted in huge paper losses for her investors in the first year.

Within a year, Cindy received a new appraisal of $3 million, 50% more than she paid. She secured financing at 70% LTV ($2.1 million) and paid off the investors. Cindy and her investors now enjoy strong cash flow and valuation with the risk off the table.

Where was the intrinsic value in this storage deal? It was the underutilization of the asset by the previous owner/operator. There were a dozen things the previous manager could have done to increase profits and value. He didn’t know, didn’t care, couldn’t afford it or chose not to.

For example, Cindy noticed that there were no U-Haul dealers for miles around. By entering into a contract with U-Haul, she increased profits by $2,000 per month. This $24,000 annual increase translated into a $400,000 value escalation at a 6% cap rate (value increase = increase in net operating income ÷ cap rate).

This capability was intrinsically available to the previous owner, but they chose not to take any action on it. Just like the marketing, the rates, the side sales and other management improvements.

Intrinsic Value Extraction #3: Lucky Coincidence

My wife and I were out and about when we passed the site of an old restaurant that had recently been condemned and demolished. I would have felt sorry for the new owner who had inherited such a worthless building. He had reportedly applied for planning permission to expand it and had to tear it down instead.

The owner made the best of the situation for the lowest possible investment.

After he flattened the building, he grinded the lot and rented it out to food trucks. My friend who owns a truck said the owner gets $800 a month from each truck, times about a dozen trucks. He turned lemons into lemonade. And he’s gone from the grueling business of running a restaurant to the almost passive business of running a dirt parking lot.

Intrinsic value extraction #4: Mobile home park mania

I recently invested in a mobile home park with over 300 lots in Kentucky with my friend Matt. The owner was elderly and hadn’t been to the park for at least five years. The salaried manager of the park was motivated to maintain the status quo, but not to help fill vacant lots or keep costs down.

The park owner ate the high costs for water, sewage, garbage and more – costs that are almost always passed on to tenants, especially in a park of this size. Many other costs were inflated under the old owner’s model. She was ready to sell and Matt’s team happened to contact her at the right time.

The seller benefited greatly from the cap rate compression. This compression of about 10% to 6% or so provided millions of dollars in profit for the owner without having to work harder. Matt paid her a fair price for what it was good when he bought it.

Matt measured the utilities and immediately returned them to the tenants. (Note that this is environmentally friendly, as tenant-funded utilities often result in about 30% less consumption than the company pays.) He lowered operating costs and started a program to fill vacant lots.

Matt got an offer he couldn’t refuse within the first year he owned the park. He sold it for more than double what he paid. With 50% leverage, shareholders’ equity posted a gross profit of over 240%. Grand Slam!

I have 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 for locating acquisition opportunities in any market, guarding against downside risks, and reaping huge rewards for investors.

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