I was talking to a friend earlier today (ironically after I sent this newsletter). He’s a real estate guy - REPE for a living and his family develops houses for their job. He mentioned into looking into property management businesses or operating. It was mentioned as a viable path to weath.

It’s become a meme in the Twitter/X community for real estate guys to buy a services business.

The real estate market is not in a favorable place right now. The market has been battered by high interest rates, sellers not budging, and aging expenses.

Nowadays, folks who need to place capital (private equity or individuals) are seeking other ways to get outsized returns. If traditional channels like real estate are overvalued, they are looking to other places to seek alpha.

Let’s talk about:

Businesses are akin to valuing commercial real estate.

In residential real estate, you value a property off comparable sales. In commercial real estate, it’s based off the income approach.

It all starts with understanding the basics - income statement.

You have top line revenue or gross revenue. This is the amount of total money the business brings in every year. You want this number to be high and you have to try to find ways to make more money.

Next up, you have your expenses. This is the total amount of cost the business has annually. You want this number to be low and have to find ways to consolidate costs.

Revenue - expenses = earnings before interest, taxes, depreciation, and amortization (EBITDA). This is “NOI” in real estate speak. This is basically cash flow before paying for capital improvements and debt service. This is very important to optimize.

Capex = money you spend to acquire, upgrade, maintain physical long term assets. For some companies, this could mean delivery trucks, stoves, or computers. Ideally this stays low and you’re able to maximize the value out of the assets. Sometimes people may buy things to increase depreciation to increase their EBITDA.

Free Cash Flow (FCF) or Seller Discretionary Earnings (SDE): This is basically free cash flow from the business after paying for capex. SDE is essentially “take home pay” for the owner after deciding what they want to reinvest into the business - usually reserved for smaller operations.

Now that we have the basics of an income statement down, let’s talk about the multiples.

FCF/SDE multiples are one way that smaller businesses are valued where the owner is involved. Similar to cap rates in real estate, companies are valued on a multiple that’s dependent on industry benchmarks.

For example, SaaS might sell for 4-6x (as of recently) but it depends on how niche the business is, the customer concentration risk, etc. Service based businesses might trade for 1-3x depending on the niche and systems involved.

Some of the things to consider in the valuation are.

For example, if I wanted to buy a newsletter, here’s what I would consider:

Certain businesses make sense with revenue multiples if profit isn’t achievable (ex, software businesses), but it’s got a recurring revenue portion.

This is most commonly done with SaaS and calculated with churn in mind. A software doing $200k ARR (annual recurring revenue) and no churn (100% retention) might be valued at 5x ARR or $1mm.

This is also why software businesses were valued so highly during the 2010s and early 2020s before AI.

A discounted cash flow (DCF) is when you take the FCF of a business and forecast them for the next 3-5 years and discount it back at your expected return and then add a terminal value.

This was an exercise I did a lot in my finance class, but ultimately I see most people use revenue multiples or FDE multiples.

Now that we have understood the basics, let’s talk about the differences between property and business.

If money is no constraint, you should do both. The path to wealth is variable, but a common theme I’ve seen is high income earner W2 and buy real estate on the side. It could also be small business owner and invest in real estate on the side.

Businesses tend to have higher returns based on purchase prices and free cash flow. Real estate tends to be an extremely capital intensive business that doesn’t have the highest returns but the returns are very consistent.

Take this into consideration when you compare it with something like a retail store or a service based business.

A service based business might cost you $1mm, but might earn you $300-400k in SDE. This is a 30-40% return. Consider this when you buy a rental property and earn an 8% yield on investment.

The benefit of real estate is the fact that you can use leverage. Most people tend to think you can’t use leverage with buying businesses.

There is a lending institution called Small Business Association - the business version of the Federal Housing Administration. They will lend you money to buy a business (restrictions apply) and you can still use a bank’s money.

Ex, if you want to buy a $2mm manufacturing business, you are able to borrow 80% of the purchase price (aka $1.6mm) and get the same benefits of leverage.

Real estate is an extremely cash intensive business. Scalability is great in business and it’s easier to increase value through technology & offshoring. This in turn increases value, very similar to reducing expenses in CRE.

That being said, it depends on the type of business you have. One thing to look for is finding an older business that has systems and staff, but incorporating technologies and standard operating procedures (SOPs) into it.

People are not aware of the world of business brokers. A business broker is a company or a person akin to a real estate broker whose job it is to list your property and try to find a buyer.

A lot of the same factors are involved with escrow etc, but buyer beware.

Even internet businesses have business brokers. Check out quietlightbrokerage.com and acquire.com and empireflippers.com if you’re interested.

Ultimately, businesses are great to buy if you have the right skillset and are able to have systems in place. It also depends on where your strengths and passions are.

You can start an internet business and sell it for some extreme value and then use the proceeds to invest in real estate.

Me personally? I want to expand my digital businesses and grow that income for cash flow and use the proceeds to buy real estate.

Different strokes for different folks. Share this newsletter if you learned something new 🙂

Appreciate you for reading!