What You Need to Know About Cash-Flow – Frank Gallinelli | PREI 049
The only way to win the real estate investing game is by mastering the numbers.
If you’re truly interested in real estate investing then you must first realize that investing in income properties is all about the numbers. It’s about discounted cash flow and rates of return and net operating income and cap rates. If you understand how these and other key concepts work, then you’re on your way to success – and that’s exciting.
Our guest, Frank Gallinelli is the author of the best-selling book, “What Every Real Estate Investor Needs to Know About Cash Flow… ” now in its third edition, as well as other books and numerous articles on real estate investing and finance. A graduate of Yale University, he serves as Adjunct Assistant Professor of Real Estate Development at Columbia University. Frank has been involved in real estate for more than 40 years and is the founder & president of RealData, a real estate software firm that has provided analysis and presentation tools for investors and developers since 1982.
What Every Real Estate Investor Needs to Know About Cash Flow… And 36 Other Key Financial Measures can be purchased on Amazon.com.
If you missed last week’s episode, be sure to listen to Increasing Cash-Flow, Deferring Taxes and Reducing Risk using a 1031 Exchange.
Enjoy the show!
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What You Need to Know About Cash-Flow – Frank Gallinelli
Welcome to Passive Real Estate Investing. I’m your host, Marco Santarelli. Today’s episode is about what you need to know about cash flow. I have the most appropriate guest for that subject. His name is Frank Gallinelli. He’s the author of about two or three books, which can be found at Barnes & Noble, Amazon.com and few other places. Real estate investing is a number’s game. The only way to win at this game is to understand the numbers. It’s important to know how to evaluate property, how to understand the cash flow, the rates of return, etc. but you don’t need to be a rocket scientist.
On today’s episode, we do get into some deep conversation, things that are maybe initially hard to understand or conceptualize. This podcast is on demand. You could listen to it two or three times. You can also educate yourself through books and various other resources that are available out there. This is something that you need to understand, at least, at a high level, if not be an expert at it. At least understand it at a conceptual level so you know what cash flow, cash-on-cash return is, your net operating income. These are all acronyms and part of the vocabulary. The only way to elevate yourself from being a novice or a newbie investor to a more sophisticated investor is to really grasp the vocabulary so you know what these terms mean and how you can use them and calculate them. Let’s jump in here in one moment and talk to Frank Gallinelli.
It’s my pleasure to welcome Frank Gallinelli to this show. Frank is the author of the best-selling book, What Every Real Estate Investor Needs to Know About Cash Flow, now on its third edition. He’s written other books and numerous articles on real estate investing and finance. He’s a graduate of Yale University and he serves as Adjunct Assistant Professor of Real Estate Development at Columbia University. Frank has been involved in real estate for more than 40 years. He’s the founder and president of RealData, a real estate software firm that has provided analysis and presentation tools for investors and developers since 1982. Frank, welcome to the show.
Marco, it’s a delight being with you today.
It’s great having you on the show. I’m actually pretty excited to have you because I have to tell you that there is about three or four books that I’ve read, virtually cover to cover and almost in one pass. I remember reading Robert Kiyosaki’s Rich Dad Poor Dad on a train ride from Rome, Italy to Florence, Italy. I couldn’t put the damn thing down. There was Jim Rickard’s Currency Wars that I read on an airplane ride from Orange County, California to Detroit, Michigan. Then, there’s your book, What Every Real Estate Investor Needs to Know About Cash Flow. When I started reading that, I thought this is one of the most amazing books to educate me about real estate investing and why it makes sense. I wanted to say thank you for the great book and I want to recommend that everybody pick up a copy.
Thank you, Marco. I’ve always said there’s no accounting for taste. When I wrote this book, I had really no intentions of writing a book. McGraw-Hill called me up one day and said, “Would you do that?” I gave him a hard time. Four months later, I gave him a manuscript.
We were talking about that just briefly before the show that the ignorance on the phone call paid off for you.
Really did because I had no idea of how grateful I should be when somebody calls from the 85th floor office on the 6th Avenue in New York and says, “Would you like to write a book?” Then I said something along the lines of, “Sure. Whatever you say.” They said, “We’re going to send you a copy of something that we published before. I think we would want something like that.” They sent me this book, which I took a look at and I called the editor back and continuing my attitude of being uncooperative and disdainful. I said to the guy, “I’ve been dealing with real estate investors for decades now. Thousands, if not tens of thousands, of them. I think I can name three people who would understand the book you just sent me. By the way, I’m not one of them. I think I’m going to write a book for just a regular educated individual who simply doesn’t happen to know anything about this subject area. I’ll explain it to them in plain English if I can.” I essentially dashed it off. As my mother used to say, “Some people have more luck than brains.” Apparently, I was living proof.
It’s a great book. I highly recommend it. It’s one of my top 10 recommended books that I’ve got on my blog. If you go to our website, you’ll see that there’s my favorite top 10 books for real estate investing and that’s certainly one of them. That book was really successful. Then you followed it up with another book, Insider Secrets to Financing Your Real Estate Investments.
My editor then called up and said, “You’re only as good as your last book so you better write another one.” That one was not quite as successful, it was more geared toward, I think, some of the interest of the times in terms of just closing deals. The title may have been somewhat off. Insider Secrets now, I think, is probably not the best way to try to introduce a topic. It sounds a little bit too much like snake oil. Nonetheless, it has also managed to survive the test of time and it’s still out there after a decade.
They’re both great books. I have them sitting on my desk right now. I’m looking at them. Like I said before, I keep plugging these books, but it’s because I think they are so great.
Let’s begin with you. How did you get into real estate? Tell us about how you got involved with real estate investing.
It’s an unusual story. I think, probably, living proof of the theory of unintended consequences. More than 40 years ago, maybe 45, 48 years ago, my wife and I were both teachers. In fact, she was department head in a high school. Back then, teachers didn’t make an awful lot of money, but we’ve managed to get along. When we were having our first child, we discovered something that we hadn’t planned on and that is that teachers don’t get anything called, maternity leave back in that day. When my wife had to leave to have our first child, suddenly we’re a one-income family because going on leave, if you will, to have a baby was tantamount to resigning. We need to figure out, “What am I going to do now to replace that lost income?” I’ve always been interested in real estate and I was able to convince a startup real estate company to take me on as a salesman, even though I was inexperienced as a part-time salesman so that I could keep both jobs. That’s how I got into the real estate business initially.
Just a few years later, I guess I had made a good impression on someone in another company, in a transaction we were doing because the owner of that company called to invite me to become sales manager. First in the residential and then in commercial. One thing led to the next. Fortunately, the owner of that company was also one of the leading lights in terms of investment analysis and one of the originators, I believe, of the CCIM program for realtors, the commercial investment program. That’s where I learned about investing and learned about investment analysis and the rest, as they say, may be history. I went on from doing that to investing a property for myself.
Then, yet another unintended consequence in analyzing a property that we’re looking to acquire for a family business that I had also gotten involved in. I was playing around with his new-fangled device, this was around 1980 or thereabouts. It’s something that no one had ever seen before. It’s what we called a Personal Computer. It’s one of these where it weighed a little bit more than my car did. It had this floppy disks that looked like something that you might order from Domino’s. I used an early version of a spreadsheet program to try to duplicate that financial analysis, the cash flow plan, the resale plan and so on that we had used to do in the real estate company that I worked for. I tried to duplicate that with the spreadsheet and thus, was born a software company, RealData. We’ve been doing that now for somewhat 30 or somewhat years. I think this month makes our 34th anniversary of selling investment analysis software from personal computers.
You seem to be at the right place at the right time, which is good for you. Let’s dive into analysis. That’s one of the first things you actually talked about in your book. For me, my listeners know that I like to take a top-down approach when I analyze a property. The property itself is the last think I look at, if you will. I always start with the macro picture and look at the market and then I start to look at neighborhood options. Then I will start looking at the property along with the team of people involved. All that is what I refer to as the top-down approach.
A lot of people, I think, make the mistake of seeing the property, getting mesmerized by the numbers on the property and they don’t realize that you can’t move that property to attach to the market. Let’s take your spin on this. How do you begin your analysis of rental properties?
Marco, you just nailed it. I want to tell you that one of the things that I say both in my books and in my lectures for my grad students is that the place you start is with your due diligence and that the mistake that most novice investors make, at least in my experience, is to think about their due diligence only in regard to the property that they’re looking at. Again, as I tell my students, properties don’t live in a vacuum. They are attached to a particular market. Where you really begin your due diligence is by investigating that market. What are the global considerations? What is the general economy in that market? Are new employers moving in? Are old employers moving out? Is there a great deal of vacancy or is there a lack of vacancy, a great deal of demand that can’t be filled? Understand what’s going on in the marketplace where you are considering buying a piece of property.
The way I used to put it when teaching is that you really want to know where the cracks in the sidewalk are. When you understand your market at that granular level then you’re ready to go ahead and actually look at and consider pieces of property. Until you do that, until you know what the rental rates are or if you’re dealing with commercial property, what the cap rates are in that area, what the vacancy rates are and so on. Until you have an understanding of really what’s going on in the marketplace, what’s going on with property taxes, are they building new schools and going to be raising taxes soon? Until you understand that macro view of the community in which your property is going to live, not until you’ve done that are you really in a position now to make any sense out of individual properties.
A lot of what you’re talking about are the drivers that are driving the market, the jobs, the migration, the companies that are coming in or moving out. There’s a saying in real estate, “All real estate is local,” which is very, very true. You can take that saying one step further and say that all real estate is hyper local because it gets down to quite literally the neighborhood level.
Even more than that, in the place where I used to live and buy and sell property, out of one side of the street, the rents were probably 20% higher than on the other side of the street. Literally, on a left and right basis like that. You needed to know your market that precisely in order not to get burned.
You need to become a detective. It’s essentially, what you’re doing here. Do you have any advice or tips on how to gather that necessary information and data so you can make an educated decision?
You need to get yourself involved in that community, obviously. This is one of the reasons why, especially with novice investors, I tell them to avoid this idea of chasing a hot market, wherever it may be. I can recall giving a lecture once out in California. I think it might have been two real estate bubbles ago. That’s how you measure time, of course, with the real estate business. Nobody really wanted to ask me any questions about the material that I was talking about. They only wanted to ask me if I knew, I was in California at the time, did I know what the hottest neighborhoods in Las Vegas were. I said, “I don’t know Las Vegas. I wouldn’t know Las Vegas if you drop me in there on a tether from a helicopter.” If you don’t know the area intimately, it’s not really the wisest thing to do, to being a beginning investor and try to buy in that area.
When you’re building up that market familiarity, I think you start off with a place with which you’re familiar, a place that you know so that when something changes, your antenna pick that up. Obviously, there are other ways that you can acquire information. Just keeping on top of local news events, what’s happening in the school system? What’s happening in the community events? Talking to realtors who know what’s going on because they deal with people coming and going all the time, your business community, your local business association. All of these are part of the homework that you have to do, I think, to be a successful investor.
I talk about team all the time, one of the people on your team is your property manager. Having a good relationship with your property manager is very important because they can feed you a lot of the market information that is going on in the neighborhoods you are investing in, such as vacancy rates, time to lease and whatnot.
Plus, the internet today has made access to information incredibly easy. You can pull information up from so many different websites, CityData.com, NeighborhoodScout.com. There’s just a slew of information. Zillow’s got more and more information that they’re plugging into their website. It’s not that difficult to start gathering information and become that property detective that you need to be.
You’re absolutely right. It might only take away in regards to some of the online information. It’s almost like the stock market. By the time it hits general public information, it’s already old news. If you can keep your ear to the ground and, as you say, talk to your property manager and get acquainted with community leaders, you’ll very often be able to get the jump on some of this information.
One nice thing about real estate as an asset or asset class, if you want to call it that, is that unlike paper assets and the stock market, things in real estate tend to move very slowly, relatively speaking. If there are negative population trends or positive population trends or new developments coming in, these things take time to unfold. It can take months and sometimes years for new developments to be approved and built and whatever else. You can maybe get a predictor or a forecast of what’s to come, whether it’s positive or negative. That’s one thing I really like about real estate. It’s a very slow asset.
You’re quite right about that. You raised a good point too. If you keep your antennas tuned to, for example, zoning appeals or requests for permits to build something, that’ll give you a lot of good information as to what might be going on in the community and what direction that community is headed. If you find more and more developers are looking to do things in a particular section of the community, that gives you some heads up, I believe, that they see promise there. They’re willing to commit their funds there so keep an eye out on what’s going on.
It’s not a hard thing to do and it doesn’t take a lot of time either. Just as a quick side note, I thought it was pretty funny. I don’t remember the exact website address, I have to look that up. There’s actually a website that was started back in early 2000s. They kept track of all the companies moving out of the state of California and moving to other states, particularly to Texas. You can find virtually every company under the sun listed on this website. It was just funny to see companies like Toyota, you name it, just moving out of the state.
When you see those trends, where you have companies that employ thousands or tens of thousands of people and they’re moving to Dallas, Texas or wherever they may be going. That’s an indicator. Maybe you should start looking at these markets and doing more investigation, more detective work and find out, “What other divers are going on here?” That’s how you start to identify these markets that make sense and then you work your way down. There’s just tons of information out there. There should be no excuse for an investor not to be able to do the work that they need to do to find the markets that makes sense and start investing there.
That’s right, absolutely.
This is about numbers, it’s about cash flow. Let’s start talking about that. You refer to something called, the four basic returns. I think for a lot of our listeners, they understand this. Why don’t you just take a minute and just bullet point that stuff?
The reason I discussed that in my book and I even covered in my Columbia grad school lectures has to do with the whole concept of the income stream. This is what I find is one of the most difficult aspects of real estate investing for people to apprehend, to really wrap their brains around, the notion that it’s not so much the physical asset that you’re concerned about, not so much the physical asset that you’re buying as it is the income stream from that asset that you’re buying. Then try to make this a little bit more digestible, if you will. I broke that income stream down into four components. First of those is cash flow. How much money comes in minus how much money goes out, what’s left over is your cash flow. If your property doesn’t have a positive cash flow, you’re not going to be happy with it for a whole long time.
The second element in that income stream is growth and value. I used to call that phenomenon appreciation. I stopped using that term because it is too closely associated with the type of change in value that occurs in the single family personal residence market where a rising tide lifts all boats so that external economic forces are what drive the change in value of a particular piece of property. The change in value that I’m thinking of and that I’m talking about is really the change in value that is a function of the income stream, of how much cash the property can generate.
Another component of income stream is the amortization of the loan, the reduction of debt. Most real estate is acquired through financing. You’ve got a debt on the property and it needs to be paid. To the extent of that is being paid off with funds that are given to you as a part of your revenue stream, funds from your tenants. Essentially, your tenants are reducing your debt. That’s a part of your income stream. Your reduction of debt is part of the entire income stream.
The last one, which, unfortunately, becomes less and less of an issue as the tax code gets to be less and less business and investor friendly. The last piece is tax shelter. To the extent that it’s possible, some of the income, some of the net revenue from your property can be sheltered, at least for a time, through depreciation so that you will end up, hopefully, paying taxes on a little bit less of the money, a little bit less than all of the money that you brought in. Those are the ways I’ve tried to slice and dice the income stream. The main purpose of that slicing and dicing being to try to make that notion of income stream being a little bit more approachable. That is really the income stream that you’re looking to buy.
When you mentioned income stream, the first thing that crossed my mind was cash flow, naturally, because it just sounds like what you’re talking about is cash flow. But you’re really talking about all the major benefits of owning income producing real estate, which is more than just cash flow. It’s what you’re referring to as value, what a lot of people think of is appreciation. That value can be built in more than one way. Over time, properties typically go up in value. Then there’s also the ability to build in more equity by fixing up a property that was distressed. Now, you’re forcing appreciation. You’re just building more value.
I know you’re really big on multi-unit properties and apartments and commercial properties. That’s a big thing on what you teach and what you talk about. For our listeners’ sake, with commercial property, the way they increase value, and maybe I’m getting ahead of myself here but, you increase the net operating income. If you increase the net operating income then you increase the value of that property because it’s valued based on that income not based on comparable sales in the neighborhood.
Absolutely. As a matter of fact, what’s quite some long time ago, a friend of mine and I bought a small income property. I think it was four units. The previous owner had been renting it out for many, many, many years and then lost touch with the marketplace. As we bought that property, we had a nice chat with each of the tenants and say, we are very happy for them that they’ve been able to live here at rents that were about two decades out of date. Unfortunately, now as the new owners, we couldn’t afford that luxury anymore. As of the next lease renewal, the rents were going to go to market rents. As you might expect that meant that we were also having to looking for four brand new tenants when those leases came up.
But that wasn’t the biggest issue. The biggest issue was the fact that we were then able, quite literally, to double the rents because that’s how far below market they were. Within just a couple of years, we sold the property for double what we paid for. It was simply a function of the income stream. We doubled the income stream and that’s what doubled the value. It wasn’t a matter that houses or homes in that neighborhood that double in value in those three or four years that we owned the property, it was the fact that we had doubled the income stream so that a new investor coming in would buy it based on the revenue that it was producing.
Did you say that was a fourplex?
I want to make sure our listeners are not confused here. It is always been my understanding. I think if you talk to any real estate professional or investor, they’re going to tell you that if you’re financing a one to four unit property that the appraisal and the lender will base everything based on comparable sales. If you are into the commercial space, which is larger than four units then the appraisal method is a little different. It’s based on the income approach instead of the comparable sales approach. What you’re telling me is that you revalued this property based on income not based on comparable sales.
I was still in the real estate sales business back then, this goes back quite a few years. I was an excellent salesperson, Marco. I was able to convince the new buyer that this was the right way to look at it. You’re quite correct that the typical appraiser, the typical lender will look at a four-unit property and base its value on comparable sales. I really wasn’t trying so much to justify the increase in value to this new buyer as I was simply its value. It made sense that the price we were selling it, it made sense at that price given the income stream. This person was buying it as investment and it made sense to them. Fortunately, it appraised out as well.
I was thinking about the appraisal. That’s really the contingency there. As long as it appraises, the buyer’s happy with it then you’ve got a deal. Interesting. When we talk about cash flow, and people will see this in your book, the subtitle is, The 36 Other Key Financial Measures, you talk about all kinds of things in here like NOI, net operating income, your gross rent multiplier, GRM. The list goes on and on. We live and swim in this world of acronyms. What we’re talking about is vocabulary. Why do you feel the vocabulary of real estate investing is so important?
I really do. You’re exactly right that I feel strongly about the importance of using the vocabulary correctly. It’s not just a pedantic interest in using the right terminology, it’s the fact that every business, every profession, everyone has its secret handshake, its very specific terminology. If you don’t use that terminology correctly, there are a number of possible, again, unintended consequences that may derive from that. One of those is that, as you deal with others who are professional in this industry, if you misuse the standard terminology, you paint yourself as an amateur. When you do that, you put yourself at a disadvantage. If you use the terminology incorrectly or, as I’ve also seen very often, if you simply invent a terminology that does not currently exist in nature, what you’re saying to somebody else is that, “I don’t really know what I’m talking about. Maybe I’m a good person to take advantage of since I don’t know what I’m talking about.”
Another reason to use the terminology correctly is because, if you don’t understand what the terms mean and you don’t apply them the way they are applied generally in the industry, then you may end up coming to an inaccurate or inappropriate conclusion. The most common example of this has to do with net operating income. Once again, this is primarily an issue that can turn itself with properties that are bought and sold for their ability to produce income, things that are more than four-units. If you don’t have the correct definition of net operating income burned into your cerebral cortex so that you never think of it in any other way, you may come up with a wrong number to use to try to come up with the current valuation as an appraiser would.
That net operating income relies very heavily on what you may define properly as being an operating expense or not an operating expense. For example, mortgage interest is not an operating expense. Depreciation is not an operating expense. If you were to take the business equivalent of this so-called annual property operating data form that I talked about a lot in my book, which is like a profit and loss statement. If you would take the business version of the profit and loss statement, you might find some items on there such as interest cost that would be normally inappropriately there.
On a real estate P&L on this APOD, you don’t have it there because you only include expenses that are necessary for the operation of the property. The reason that’s important is because that gets you to the industry standard definition of net operating income, the industry standard calculation of that number, which in turn is what an appraiser will use when they apply a cap rate and come up with a current market value for that property. If you get the definitions scrambled up or if you get them to be imprecise, you, at the very least if you’re lucky, simply make yourself look bad. But if you’re not having a really good day, you can also come up with a totally erroneous set of numbers on which you might be basing the value of the property. Whichever one of these things happens, it’s not good news.
I think, as a real estate investor, what’s really important about that is to be able to compare apples to apples. If you’re looking at one particular property and comparing it to another option, another property that you’re looking to purchase, you can see which one is the better deal in terms of the cash flow and then you calculate the metrics off of that so you can see which one produces the better cash-on-cash return or whatever it may be. It’s the lowest common denominator. It allows you to compare apples to apples.
That’s right. Again, when I talk, for example, on some of those discussion groups with novice investors, very often, one person is talking about one set of figures, one collection of information in terms of trying to come up with financial analysis of a property. Another person is using different items in their operating expenses, things that don’t belong there, the entire mortgage payment. They’re confusing cash flow with net operating income. You’re right. They’re losing that commonality. That commonality is essential really for being able to talk intelligently to other parties in a transaction, to brokers who are helping you try to conclude a transaction, to lenders who are presumably going to finance the transaction. If you don’t stick on speaking the same language, which is what vocabulary is, then there’s no communication. It’s the lack of communication.
Here’s something that I actually used up almost half a lecture in my graduate school class about is the notion of clarity. I’ve seen more deals go south because of individual’s inability simply to convey what it is that they’re thinking and what it is they’re figuring out to the other parties in a transaction. They don’t have an understanding of the importance, the essential nature of clarity. Communication with other people. Being of a certain vintage, the image that always comes to mind is Cool Hand Luke with Paul Newman looking at the prison warden there who wears the mirrored sunglasses. You can never see his eyes in the movie and he says, “What we have here, I think, is a failure to communicate.” That’s what happens that kills so many deals. The parties are unable to communicate effectively partly because you have individuals who are using invented vocabulary or simply not conveying the information in a way that is common to the industry so that other people can understand it.
I completely agree. I want to talk about metrics in a minute. I think a good bridge here between vocabulary and getting into those metrics is a concept that I find very interesting and fascinating. I know a lot of people initially have a hard time wrapping their mind around. That is the time value of money. I know when I say that, I can tell that there’s probably some people that are listening to this and their eyes are glazing over, “What do you mean time value of money?” I think you do a brilliant job in explaining this. It’s easier to conceptualize and imagine in your mind than it is to put it into words. I’m not even going to try. Do us the favor, explain the time value of money. More importantly, tell us why it’s really important to us as real estate investors.
With a build up like that, you really put me on the spot.
Time value of money is essential to all investing, not just real estate investing. In fact, it’s essential to the understanding of the uses of money in any context. Really, the concept is not terribly difficult. Most people have an understanding of one phase of time value of money and that’s interest compounding. I think most people, even if they have no familiarity with investing or how many works in great detail will understand the fact that if you put money in accounts where interest is compounded, that you earn interest on interest, that it grows, essentially, in a geometric way. The time value of money that we care about as investors, though, it’s like looking through the other end of the telescope instead of looking through the end where things get bigger as you look at them, as with compounding. You look through the wrong end of the telescope and see that they offer the distance that they really are smaller. What I mean by that is that we have to understand that money that we have to wait for, money that we can’t have today but that we have to expect at some point in the future is less valuable than money we can have right now.
I tell my students that this is the Janis Joplin School of Economics. Get it while you can. The idea being that if you have money in your hand today, you have it available to you to use and therefore, you can make more money with it. If you have to wait five years, ten years, whatever number of years to receive those same number of dollars that you might otherwise have had in your hand today, you’ve lost the opportunity to earn with it. Let’s say, $100 that I have in my hand today is worth $100 to me. If I have to wait five years to get that $100, then really I ask myself, “How many in dollars in hand today might I reasonably expect to grow to be $100 five years from today?” It might only be $60. That means that an investment that I have to wait for five years, the investment that will pay me $100 really isn’t worth $100 to me. It’s only worth $60.
We, as real estate investors, have to pay a special attention to this. It’s in regard to the fact that we experience multiple cash flows as we own a property. We buy a property today and we have a cash flow, hopefully, we have a cash flow in the first year and we have another cash flow in the second year. Then we have a third cash flow in the third year and so on and so forth until we get to the point where, as with all good investments, we liquidate it. We have not just the cash flow from operating it but also a cash flow from that liquidation. Now, what we’re concerned about is, how do the dollar amounts of all these different cash flows and the timing of all these different cash flows interact, interplay? When we look at that then we begin to appreciate the difference among different investment opportunities. We may get, in total, the same number of dollars from property A and from property B and from property C. But it’s the timing of receiving those dollars, the time value of the money that differentiates the quality of the investment from property A, property B, and property C.
That’s a lot to wrap your mind around. I think people will need to listen to what you just described two or three times to completely get it. Of course, they could also do their own research or buy your book and read your chapter on that. When I hear time value of money and listening to what you just said, I think there’s two ways to look at it, at least from where I sit. This is my perspective on things. You’re talking about two things in a very general sense. One is, opportunity cost or lost opportunity costs. Number two is, the effect of inflation on money because that $100 you’re talking about today is not going to be worth $100 a year from now or five years from now or ten years from now. Correct me if I’m wrong, but I think these are the two lenses that at least I look at what you’re saying through.
You’re quite right. I think almost the inflation is built right into the opportunity cost issue. You’re right that whether you’re looking through one lens or two, I think the issues is that you have to recognize that waiting to obtain a return means that return gets less valuable the farther and farther it goes at the time, because of the lost opportunity to make money with that return and, as you say it, because of the potentially changing value of the dollar.
Here’s my off the cuff example. You’re looking at two different properties, same purchase price, same cash flow today. Based on your research or your information, that first property ten years from now might be worth more than that second property for whatever factors or variables that are in play here. It may make sense to actually go with the first property worth more in ten years from now than the second property based on what you know. Here’s my twist on the example. You may actually have more cash flow today on that second property that you estimate to be worth less ten years from now than the first property where you’re going to make less today but more in ten years when you sell it. Did that make sense?
I think it did. As we get into this whole topic, the opportunities for convolution are almost unlimited. I’ll add even one more for you. Sometimes the change in cash flow is not something a straight line going up in every property. You might have a property, for example, where you know that couple years down the road, you’re going to have to put a new roof on as opposed to a second property where you don’t have to do that. If you look at your real anticipated cash flow from these two properties over a period of time, you may see that one goes up in a straight line, one goes up then dips down, then goes up again. The timing of when these things occur can affect the overall return when you look at this time value of money. The longer you can put off, for example, that major capital expenditure to fix the roof and whatnot effectively, the less expensive it makes that capital cost to you. It can affect your overall return. This is why I tell people that are getting away from the minutia of the deal. It’s why I tell people that, “You really have to do what I call a pro forma analysis, a projection, not just of how the properties operating today, but how you think you’re going to be spending or receiving money over the next several years right up to a reasonable potential resale date.” It’s only when you look at the property over a period of time like that and you try to make some best case, worst case and in the middle projections that you’re really going to sense for how well or not so well this property might perform compared to other investments. I think if you don’t try to take that forward looking approach, then I think you’re missing an opportunity to really understand how the property will play out.
I’ve had some folks say to me, “I only want to look at how the property is performing today, because trying do any anticipation on how I might either receive or spend money on this property in the future, that’s just like a crystal ball. It’s like trying to predict the future.” I can understand that point of view but at the same time, if you don’t do those projections into the future then in reality, my feeling is you’re still saying, “I can predict the future and I think it’s going to look much like the present. I’m not going to base it on anything other than how the property is operating just today in the current year.” When an appraiser does an appraisal on the property, they pretty much look at just the present because they’re looking to come up with a current market value. Our role as investors, though, if we’re going to hold a property for an extended period of time, then we’re interested in more than just how does it look in the present, we’re interested in how do we think it’s going to perform for us if we hold it for an extended period of time.
Your example was far better than mine. Like I said, it’s one of those things where it might be easy to conceptualize in your mind but to actually put it into words, and sometimes even to conceptualize it is a difficult thing. It’s something you learn with some experience and just educating yourself. Here’s what I want to do, Frank. I want to wind things down here by talking about metrics, not all metrics because there’s just many of them. I want to ask you what metrics you find most useful when you’re evaluating a property.
Before you answer the question, I want to tell you one of the reasons why I want to ask you this question. A lot of investors seem to be focused in on cap rate. I don’t like the cap rate all that much. To me, it’s overly simplistic. You may disagree, but that’s my opinion. I prefer looking at cash-on-cash return and the total return on investment. I’d like your comments and what you think about metrics and what you find most useful.
As you mentioned, from the title of my title of my book, there’s no limits to the number of metrics we could be talking about. I think the first one that I always suggest that people take a look at is very simplistic and that’s just plain cash flow. Can you anticipate not just on the current year, but in years going forward having a positive cash flow? There’s nothing that’s less appealing about a property than you’re having to support the property rather than the property supporting you. Unless you have a reasonable anticipation of a positive cash flow, I don’t think you want to spend a whole lot more time taking it any deeper.
When you’re looking at cash flow, as in my example just a moment ago, you want to be thinking also about whether or not you might have to be doing some major improvement or renovations on the property, whether it’s a new roof, an HVAC system, whatever it might be, at some point in the future because that’s going to have a significant impact on your cash flow. It may, in fact, push you well into a negative cash flow. If you can see that happening at some point in the future, the way you need to look at it is to say, “I really need to put reserves away ahead of time. That may mean I need to have more money upfront that I just salt away so that three, four years from now, I can replace that HVAC system or replace that roof.” I think a reasonable projection of your current and ongoing cash flows is definitely a place you need to start. My second choice in terms of a metric goes from the very simple to the much more complicated, that’s internal rate of return.
That’s another one of those metrics that I think a lot of people have a very hard time wrapping their mind around because you’re bringing in the time value of money.
That’s right. It’s actually less complicated than most people think it is. I hope, in my book and in my courses, that I’ve tried to make it a little bit more obvious as to what it really means. To boil it down to why it matters, is that internal rate of return is the one metric that takes into account both the timing and the magnitude of cash flows and boils them down into a single number, to the single metric. As I said earlier when we were talking about time value of money, it’s not just the number of dollars that you get out of a property, but when those dollars arrive in your pocket. Sooner is better, more is better. More sooner is best.
In comparing two or three different properties you might be considering, if you can judge how you think those cash flows will occur and when they will occur, the internal rate of return metric will give you a better handle on the overall rate of return for that property. A secondary benefit to a metric like this is if you do what we do in our investment analysis software, which is to test a potential sale of the property every year during our projected holding period and say, “What would the IRR be if I held it for one year? What would it be if I held it for two years? For five years? For seven years and so on?” It’s not uncommon to see that you’ll reach a peak in terms of rate of return after a given holding period. After that peak, then the rate of return may drop down. There’s a bit of information that you might be able to derive from something like this.
I used an example in my grad class that I think the students have a hard time understanding when they see just the numbers until we start talking about it. It’s an example where a particular property does spectacularly well in increasing its revenue stream, its income stream in the first year as opposed to a second property that doesn’t make that bonanza first year success but after that, has ongoing a greater rate of increase each year than the bonanza success property did. The thing that’s odd is that the, at least to the students when they look at this, is the property that has this tremendous success the first year has a tremendous internal rate of return after one year. The internal rate of return keeps on dropping the longer you hold he property, which illustrates the point that I’m trying to bring out here that since we are so successful so early, what IRR is telling us when we look at it over a period of time, is that maybe we need to sell those property because every year’s subsequent performance just dilutes the overall performance.
Are you suggesting that an internal rate of return that starts to plateau may suggest that it’s time to sell that property or do a tax rate, 1031 Exchange into other properties where you can get back to that early part of that IRR curve?
Exactly. As the IRR starts to decline over time, it’s showing that those future years are now diluting your overall return on investment. If that’s the case, maybe it’s time to take the money out of the investment and start over with something else. Absolutely.
It’s just opportunity cost, where’s the best use of your cash, where’s the best use of your equity.
It’s very easy to become complacent with a property saying, “I have a positive cash flow. Everything’s good. I’m paying my bills. I’ll continue to do more of the same.” But when you look at it in this way, I can’t tell you that you could perhaps do better.
Very good point. What you just described here in the last two minutes ties very well with an episode I just recorded yesterday on 1031 Exchanges. It dovetails right into the 1031 Exchange and why you would use it. Those things go hand-in-hand. It’s just one more thing that real estate investors need to continually educate themselves. They need to learn about cash flow. They need to learn 1031 Exchanges. They need to learn about property management. They need to learn about a lot of things, but you don’t need to learn everything about everything because that’ll never happen. If you know enough, you can get started, you can build your portfolio, you can increase your wealth and your cash flow. Then you can take the information that they can get from people like yourself and your books and now start to multiply your returns.
Really, that’s what it’s about, it’s to increase those returns so you can get the lifestyle that you want out of real estate. It’s not about the real estate, it’s about the freedom and the lifestyle that you want. Let’s wrap up with one question here. What are the biggest mistakes investors make with income property?
One of the biggest I see is that they don’t really do their due diligence, that they believe the information that they’ve been presented. To be more specific about that, I think what I’ve seen when I, again, interact with individuals on discussion groups and whatnot, they’ll have information they’ve been given by broker or an owner about a property. They’ll look at it and they’ll confirm that all of the facts that they’ve been given are in fact, accurate. But they don’t look beyond what they’ve been told. Trivial example, this property is here where I live in New England. I don’t see any expense here for snow removal. Not this year, but the previous year we had about four feet of snow here. Somebody had to pay to have that taken away. They don’t look for the things that have been missing.
Related to that, an item that I like to use with my grad students also, is that they look at what the information says without really thinking about what does the information mean. What I’m trying to convey by that is that they don’t look at the story behind the story. I’m a numbers guy, obviously. They don’t look behind the numbers to see what information might be lurking there. The way that I do this in my grad school class is I give them a mix-use building where one of the commercial tenants on the first floor is on a fairly long-term lease and it’s a local bookstore. We can run all these numbers, but you know what? Given what’s happening with mom and pop owned bookstore, do you really think you can rely on a ten-year projection based on the revenue from that business? Do you have to think beyond that and say, “Maybe I need to make a secondary analysis of this property on the assumption that that business, lease or no lease, is not going to survive.” Or they may not look at the fact that for a multi-family property that a major employer is moving out of town, are you going to project the fact there may be a lot of vacancy as people leave town looking for jobs? Look not just what the facts are and what the numbers are, even if the numbers that are handed to you, current numbers are accurate, but what is the story behind the story? What is the meaning behind the information you’ve been given? Is there obvious information that is missing?
Property management is another one of these that I see a lot of times with beginning investors. They will look at a property and make no accommodation for the cost of property management because the previous owner hasn’t volunteered anything about property management. They’ll say to me, “I’m going to manage the property myself.” I reply as politely as I possibly can, “Your time has no value? What you need to do when you estimate how good this property is going to perform, you need to plug in the number for the cost of property management even if you do decide that initially you’re going to try do that yourself because the time you spend on that has a value.” That value should impact the value of the property. If you went out and bought stock at IBM, they’re not going to expect you as an investor to come and clean the restrooms once a month for no compensation. You shouldn’t be expecting to have the property management in there at no compensation even if you are the person who’s doing it. You need to look at what’s missing from the information you’re getting and what is behind the information you are getting.
The two takeaways I’m getting from what you’re saying is number one, you need to be a detective on all the line items related to the property both today and potentially what may be there future. Number two, is you need to step back and look at the bigger picture. Using your example of the bookstore, Amazon has already eliminated Borders’ books. They don’t exist anymore. Who knows what’s going to happen ten years from now with Barnes & Noble? The point is, look at what’s happening or potentially going to happen five, ten years down the road to see if things are improving or getting better for you or worse.
You said that so much more succinctly and clearly than I did. Thank you, Marco.
Thank you, Frank. On that note, you’ve been very, very generous with your time. We’ve gone over an hour here. I really do appreciate it. Do me a favor, tell our listeners where they can find your books, how they can get more information about your company. Also, I just found out last night that you have this new online course that, to me, sounds like your university education, just on demand.
Pretty much so. If you go to Learn.RealData.com, you’ll get to our new eLearning platform. Just a couple of months ago, we launched a fairly comprehensive course that’s got 34 videos and other resources and sample practice problems to work on, materials like that, even a couple of sample spreadsheets where you can do simple calculations, that sort of thing. Essentially, what I do is convey lot of the information that I convey in my Columbia course. I do a couple of case studies as an example. That course, by the way, is going to grow with time. Anyone who is an enrollee, as you may want to call them, will have access to the new lectures that I add to this course. I do have new lectures planned, for example, in partnership analysis and development projects and so on. In that course, you’ll learn starting right off from these four components of the income stream going through discussion of these various metrics and how to use them, discussion of the APOD form, how to do the pro forma analysis, financing calculations on different kinds of metrics and so on. I hope we’ve made it as understandable as possible.
The course was Learn.RealData.com. Our software site is simply RealData.com. You can find out a lot about the products that we’ve been selling for the last 30 somewhat years and the analysis tools. Hopefully, those will be of value to some of your listeners. Our books are on Amazon. It’s probably the easiest place to find them. McGraw-Hill does pop them up on bookstores from time to time but certainly, Amazon is a convenient place to look for them. Just search for them by my name, Gallinelli and there it will be.
Perfect. I’ll put that on the show notes. Like I said, I couldn’t put the book down when I was reading it. I highly, highly recommend you get a copy of this book on Amazon or wherever. It’s well worth the read. It’ll make you a much more efficient and intelligent investor. Frank, I appreciate your time. Thank you so much. We will certainly put this out here soon. I look forward to having you again on the show.
Marco, thank you so much for having me. It was really been a pleasure and I hope I conveyed at least a nugget or two of useful information.
It’s been a lot. Thank you so much.