Growth rates in operating leverage can hide a bad deal, like magic!
I was recently on a trip to Oklahoma City and stayed with my aunt and uncle, the latter of whom is a self-trained magician. He performs magic for birthday parties, senior centers and the like and has fun watching children and seniors marvel at the seemingly impossible illusions he creates. Prior to dinner one evening, he did a ten-minute show illustrating some of his most recent bits. Some I figured out, but others seemed to defy reality. Too good to be true. How did he do that? Magicians employ sleight of hand to create illusions that astound and bewilder their audiences by using subtle, precise, and swift movements. They manipulate objects to deceive the eye and defy logic. These skilled performers rely on dexterity, timing, and misdirection to draw attention away from their actions, allowing them to perform seemingly impossible feats. Audience members, often captivated by the magician's charisma and the spectacle of the performance, remain blissfully unaware of the carefully orchestrated maneuvers that create the enchanting illusion of magic.
In many ways, this is how I think about commercial real estate investing. There are many "magicians" out there performing their feats of mastery: brokers, sellers, general partners (GPs), sellers of courses! Come one, come all to see how we create value out of thin air! Investors flock to the spectacle, ready to see the magic and believe it.
Let's break down the two illusions we need to really break down initially. First is the exit cap rate vs. the entry cap rate. We have talked at length about how this can be manipulated to increase IRR returns and make a mediocre investment looking like a winner. The second thing is more sleight of hand and involves future operations of the property: rent inflation and expense inflation.
"Hey Rocky, watch me pull a rabbit out of my hat!"
Let's look at a simple cashflow sheet and our expense ratio:
If you breakdown these numbers you see that our expense ratios decline over time by dividing our operating expenses over our effective gross income.
Opex Ratio = Operating Expenses
Effective Gross Income
And here is a chart over time:
What you will notice is this is declining over our 5-year holding period and has a direct impact on both our NOI and final valuation at sale. Now, most investors are focused on the return metrics (trick) and not the sleight of hand. Why is our ratio declining and does this make sense in the context of the market?
If you were to divide year 2 gross income by year 1 gross income and so forth, you would see that income is growing at a CAGR of 7%. If you were to perform the same calculation for the expenses, you would see a CAGR of only 2%. This is known as operating leverage and a good trick to increase projected returns on an acquisition. A question for an analyst would be, why is our market rent growth outperforming our expense growth and should this remain constant through the holding period? The answer could be that this makes sense, but it could also be oversimplifying the investment and setting up some poor results.
A stress test on the investment would be to make the rent and expense growth the same and see if the investment still looks solid. If not, perhaps this isn't the right investment, or perhaps further investigation is warranted. Either way, look under the table and watch the trick carefully, because the returns on your next investment could be the real illusion.