In business school, a strategy professor of mine, Rob Wiltbank, shared the secret to successful acquisitions.
He drew a line on the board and said, “This is a company’s current value over time. When you buy it, this is what you’re paying for.” Then he drew another line above it (much like the picture above). “This is what you want the company’s value to be after you buy it. See this gap? (As he runs his finger between the two lines) That’s the wedge. This is where you add value to the company above and beyond what it originally created on its own. Your goal when acquiring a company is to find the wedge. If there’s no wedge, don’t acquire the company.”
Find The Wedge
Let’s keep going down this business track a little longer with an example.
In 2012 Facebook agreed to pay $1 billion dollars for Instagram. That was $33 per user for a service that earned, at the time, ZERO dollars per user. Why did Facebook pay so much? It comes down to one buzz word: synergy, which simply means to 1) increase performance and/or 2) reduce costs by combining companies.
1) Increase Performance: This is the big reason why Facebook bought Instagram. Facebook knew that eventually they could run relevant ads on Instagram. Facebook already owned the infrastructure and knew what worked. Furthermore, even though Instagram was already growing 40% per year, Facebook believed they could help it grow faster. Finally, Facebook employees and Instagram employees would be able to freely swap ideas to improve both services.
2) Reduce Costs: Though, not as big of a deal, Facebook could also save money. Facebook could put all the code and pictures on their own servers, which cost less to run. They could also bring Instagram’s 13 employees into their offices and save a little on rent.
Facebook found the wedge. Two and half years later Instagram was estimated to be worth 49 times more than what Facebook paid.
3 Ways To Find The Wedge When Buying Property
Rental real estate is a subset of business. Think about it: you have revenue, expenses, assets, liabilities, customers, partners/vendors, and potentially employees. It’s technically taxed at at different rate, but it’s still a business. And every property you buy is like an acquisition of an existing business. So, when looking for Gyroscopic Cash Flow, the goal should be to find the wedge.
There are three general wedges you can find:
1) Economies of Scale: As you buy more property, your total cost per property goes down because your fixed costs (tools, office supplies, etc) are spread out over more units. This is a natural wedge that you’ll get 99% of the time.
2) Forced Appreciation: This is the most fun of all three because you increase the value of the property by raising the rents or reducing costs. Often times this requires a bit of creativity and work. For example, we once split half of a huge living room into a dinning room. This gave us space to add more cabinets in the kitchen because a table didn’t need to fit there anymore. The unit went from having a cramped kitchen to one with a ton of storage… That was worth an extra $100/month.
3) Diversification: This is an indirect wedge. By diversifying, it allows you to buy riskier investments because your eggs are no longer in the same basket. This often comes in the form of different types of property (size & quality) and location.
Be Clear On Why You’re Buying The Next Property
When evaluating each property and looking for the wedge, it helps to ask these questions:
- How can I make this property better?
- How can I make this property more functional? How much extra in rent can I earn?
- How can I make it more inviting? Is that worth any extra rent?
- Are there any ways to cut expenses? By how much?
- Can I use my existing tools to manage this property? Which new tools will I need? How much will that cost?
- Will I be attracting the same type of tenants? Is my location/size/type of property different enough to protect me from demographic-based vacancy fluctuations.
Only Buy If You Can Find The Wedge
As Rob Wiltbank said, “If there’s no wedge, don’t acquire the company.” The same is true when buying rental property. As a DIY landlord, you want to create returns better than what you can get in the stock market or with someone else managing your property. The way to do that is to find the wedge. Otherwise, there’s no reason to do it yourself.