Being a real estate agent can be the best job in the world. Isn’t that…
How would you like to make massively significant amounts of passive income? Passive income is the key to building life-changing wealth. The level of wealth we’re discussing is absolutely attainable for everyone willing to invest prudently in Commercial Real Estate. This is the kind of wealth that changes the course of families for generations.
How does the IRS define “passive income”?
The IRS defines “passive income” in a technical way: it is either “net rental income” or “income from a business in which the taxpayer does not materially participate.” (There are a few other cases that can include self-charged interest, etc.)
Most advertisements use the term “passive income” very loosely, as they attempt to sell a version of the “be your own boss” and “work 4 hours a week” lifestyle. This pitch is the age-old get rich quick with little effort scheme.
The kind of passive income you can achieve in Commercial Real Estate is authentic and significant because it comes from your net rental income.
How to design your Master Lease
The critical step in generating this kind of passive income is to use the correct kind of lease agreement. In most commercial leases, the principal investor is not the property manager. This distinction is a key factor in the IRS’s determination of whether your rental income is active or passive. If you directly manage the property, you are “materially participating” in the business.
To avoid this, many investors use a triple net lease (or similar arrangement) stating that the tenant incurs all the repair costs of the property. The master lessee, not the master lessor, is responsible for calling the repairman when something breaks. The lessee receives tax benefits from this arrangement because they can deduct the repair costs from their income, and you benefit from the passive rental income.
This is how commercial investors receive actual passive cash flow without having to show up to work every day. This operating principle is how commercial real estate investment works.
The Cap Rate
The CAP Rate is one of the HUGE forces multiplying the value of your asset. It is a formula used to show the potential rate of return on a commercial property and it helps investors create a valuation of the underlying asset.
The best part is that it all comes back to your rental income or cash flow on the property. To determine the CAP rate, you generally divide the net operating income (NOI) of a property by its current market value.
Figuring out the NOI is very simple: you simply take the actual income of the property (all the rental and non- rental income combined) and subtract the operating expenses, and you get the annual cash flow, or Net Operating Income.
Many investors would be very happy with a 10% return on their money. For example, let’s say a property generates $100,000 in NOI. Investors in most parts of the country would gladly pay $1 Million to buy a property with a $100,000 annual income stream (a 10% return). This desired return on investment is the CAP rate.
As a rule of thumb, you can take the net cash flow of a property and divide it by 10% to determine the value of the property. If you were able to find a way to increase the NOI on that same property from $100,000 to $150,000, the property would rise in value from $1 Million to $1.5 Million based on the 10% cap rate.
According to this valuation model, when you increase the cash flow, the bank will increase the property value by the market cap multiple! So in the above example, not only are you increasing your PASSIVE INCOME from $100,000 to $150,000, but now you have an extra $500,000 in equity in the property!
What can you do with the extra equity? Whatever you want. Normally, I advise using it to acquire another property. Rinse and repeat. Soon you’ll be cashflowing your very own healthy, wealthy commercial portfolio. HUGE PROFITS and PASSIVE INCOME are generated by this valuation model.
The good news is that you can do this. You can learn creative ways to finance your first deal and begin cashflowing properties to achieve passive income. Shortly thereafter, when you increase the net operating income, you’ll have access to the massive equity you’ve created.
It’s not a get rich quick scheme. It’s the way Commercial Real Estate works.