Working Capital The Real Estate Podcast
What Every Real Estate Investor Needs to Know About Cashflow with Frank Gallinelli|EP16
Aug 18, 2020
In This Episode
Frank Gallinelli founded RealData, Inc. (realdata.com) in 1981 to provide analysis software for real estate investors and developers. He is the author of “What Every Real Estate Investor Needs to Know About Cash Flow…” (McGraw-Hill, 2004; 2nd Edition, 2008, 3rd Edition, 2015), “Mastering Real Estate Investment – Examples, Metrics and Case Studies,” (RealData, 2008), “10 Commandment for Real Estate Investors,” (RealData, 2012) and “Insider Secrets To Financing Your Real Estate Investments” (Mc-Graw-Hill, 2004).
In this episode, we talked about how he started in real estate, how real estate analysis and interpreting metrics can help real estate investors, the idea behind the software Realdata, Inc., cap rate, income stream, internal rate of return and cash flow and MANY MORE!
- “Income-producing property is its value to an investor is a function of its ability to cash flow. So if you can increase the cash flow of a property, you can increase the value of the property.”
- “But if you’re an investor, maybe you want to be thinking not about a point in time, but about the long-term building of wealth and have to look at not only the performance of the property currently but what is the potential performance of the property over time.”
Resources and Links:
Welcome to the Working Capital The Real Estate Podcast. My name is Jesse Fragale. And on this show, we discuss all things real estate with investors and experts in a variety of industries that impact real estate. Whether you’re looking at your first investment or raising your first fund joined me and let’s build that portfolio one square foot at a time. Ladies and gentlemen, I have the pleasure of having mr. Frank Gallinelli on the show today. Frank is the founder and president of Real data. Inc you can find email@example.com real estate software firm offering an analysis and presentation tools for investors and developers. Since you heard it correctly, 1981 Frank is a graduate of Yale university and his, the author of several books on real estate investing and financing, including my favorite, what every real estate investor needs to know about Cashflow and Mastering Real Estate Investment Frank used to serve, and I think is still associated today with a Columbia Columbia university’s master of science in real estate development program, where he served as an adjunct assistant professor.
Jesse (1m 3s):
Frank, how are you doing today? Good. Jesse thanks for having me on your show. Yeah. And absolutely did that. Did I get that correctly there in terms of the day?
Frank (1m 12s):
That was perfect by life in a nutshell. Okay.
Jesse (1m 14s):
Okay. Fantastic. Well, listen, I’m, I’m very excited because I’ve, I’ve heard you speak on a couple of different other podcasts, but this particular book I’ve, I don’t know how many times I’ve recommended it to, you know, brokers. I work with Investors this book here to try to get that in focus. And that’s this one, I was this your first book? The,
Frank (1m 35s):
The Cashflow book. Yeah, we had actually, it’s just one of those things I had even no intention of writing it. There was one of these things that just kind of was a serendipitous event. No, no plan behind this at all. Okay.
Jesse (1m 48s):
So I guess if we go back to a little bit at the beginning, what was your first, you know, how did you come in contact with real estate and real estate finance?
Frank (1m 57s):
A, this is a three hour Podcast right. Just checking. I’ll try to, I’ll try to fast forward. Let’s take a look at the back of auctioneer. Hear if I can a graduated as you, as you mentioned from you now that wasn’t the, in the, in the late sixties, which was a fairly turbulent time. But even though I was at, you know, he had a degree in psychology that didn’t seem to be going anywhere at that point. So I ended up being a, a teacher in the new Haven school system, a teacher of math and a leader, a teacher of English. So anybody who’s, you know, into, into a foreshadowing can see math, plus the English later, a book with lots of numbers in it. You know, those kinds of things kinda kinda of add up a was a teacher by my wife, was a teacher, the suburban school, you know, we worked, we were muddling along.
Frank (2m 46s):
And then when she became pregnant with our first child and we were down to one Income, it became really apparent that a, my teaching salary, which was nominal back in The in the sixties, wasn’t gonna support us anymore. So its hard looking for a, you know, a side job then that was kind of interested in, in, in real estate, generally just a, you know, and, and passing of. So I got aside job a as a, as a real estate agent and found fairly quickly that I was making more money as an agent than it was as a teacher. So, you know, this didn’t take too long for me to figure out what to do, what to do next. But actually that is serendipity seems to, seems to have been the, a, the prime mover, most of my quantum leaps in my career.
Frank (3m 34s):
So the first, the first one was when I got recruited to be sales manager for a local real estate company, based on the previous interactions I had had with them and more serendipity is that it turns out that the owner of that company turned out to be my mentor back then also a fellow Yale graduate was one of the first presidents of the realtor’s CCIM program. The the program, the educational arm of four commercial real estate. So a being a captive student, I learned quite a lot about commercial real estate, commercial real estate analysis of from that, from that job.
Frank (4m 15s):
And he had me training the, a, the sales staff in how to analyze Investment properties. So that that’s where I got my, my first exposure to it. Then I got recruited yet once again, buy it by a, a close family member who had to a retail business. And there, her, her business partner was a, was terminally ill. And she needed me to come help manage that business branch, the financial side of that business business. So there I am leaping out of the real estate business into the, into an industry. I knew absolutely nothing about. So since I knew nothing about it, I figured I wasn’t encumbered with any knowledge and I could, I can do what I wanted to do that that happens to be serendipitously enough, once again, a executive the same moment when some of those, these little funny boxes were becoming we’re coming onto the market, they were called personal computers.
Frank (5m 7s):
So I was, you know, figuring out, used to buy a ham radio operator. And that was a kid I figured, you know, I’m good with techie stuff. Let me see if I can figure this out. And I, so he got one. And at that very same time, we were looking to acquire a commercial property. That was a deal. The deal was a little, a little convoluted. So he said, well, let me see if I can use this personal computer thing eager that I’ve gotten along with this spreadsheet, Programme that came with it to see if I can figure out this, this deal. And so I basically translated what I’d been doing in my commercial real estate career into, into that, into that little black box was a big black box back then. And a, some D did in fact, make the deal by the way.
Frank (5m 51s):
And some colleagues look at what I was doing and said, how did you do that? And can we do that too? And a, a, a computer software company. He was born then that was, so this is around in 1980. One is actually produced to this software program in 1980. To again, began settling in the, as you mentioned, we, we still do sell it through realdata.com. Fastforward just a little bit now. And so we’re, you know, we are dealing with a lot of real estate investors, developers, people that do are doing deals. And after a number of years, one of the things that we noticed was that the people who were asking, you know, calling us for support, it, wasn’t so much support.
Frank (6m 35s):
About, you know, which button do I push to make my computer work as a kid, you look at this, a, at this finally, and to get a look at this analysis, if something doesn’t seem right, or does this look like we’re doing to correctly analyzing the property correctly? And it became apparent that there were an awful lot of people who were doing deals who had show you a less than, than a perfect understanding of the numbers that they were generating and how to interpret those numbers. That led me to, to start writing what today would be called blog posts. We were also early adopters of the internet. We were all, we had a website in 1996, and I started writing these what we then call it articles with this.
Frank (7m 17s):
Again, we now call about blog posts, which were essentially educational in, in their, in their content and explaining to people in the, how do you, you know, how do you interpret these metrics are, how do we calculate these metrics that led to a phone call from McGraw Hill one day? I remember I told you this book was totally, you know, unplanned. Well, I had no intention of, of writing a book until you get this phone call one day. And I don’t, I barely even take it seriously because I knew nothing about book publishing then, you know, gave the, gave the editor a, a hard time. But eventually I agree to it, you know, To to write this, write this book at the risk that they should say is a history that was a hit the streets around December, 2003, January of 2004.
Frank (8m 2s):
And its been, you know, it’s go figure, it’s been go with like gangbusters ever since a vastly exceeded our expectations are mine. And if I can do, if I can try to in for a, a reason is because I didn’t try to write one of these, you know, you too can be a, I can be a millionaire overnight. Do you know, just working in your spare time or YouTube can, you know, with no money, no credit and no common sense can be, can be a wealthy real estate investor. I tried to just teach the same thing that a, you know, I had learned at the real estate company for my CCO have a mentor and that to them to try to teach my salespeople, just, you know, just the facts Commandment is that the check with might have, might have said, and I seemed to have caught on some, all that was good.
Frank (8m 53s):
And then serendipity have raised, you know, it’s curious head once again, then that leads to, uhh, would you like to teach this stuff in the grad school? What’s a Colombian, maybe this is all true. So I did that for 15 years or they’re about, so one thing, you know, the knee bone is connected to the shin bone and all the rest of it by, and very little, a bit by intent. It’s just been a, you know, a, a good, a, a good sequence of a, of lucky events and a hopefully that, that, that may continue a bit longer.
Jesse (9m 25s):
Yeah. That’s a great story. And there was actually a little piece, I remember you talking about, maybe you could expand on it where McGraw Hill was basically asking you the, your opinion on this are to write a at a certain way. And, and you were, you were interested in writing it the other way.
Frank (9m 40s):
Yeah. Again, I had, I had no sense, no respect. So I figured, you know, I had nothing on this, on, in this deal to start with. So I had nothing to lose. So a as I said, they, that they, they, they called me up and this was at a height of what, of the real estate, you know, and they said that we’d like you to write a book if we, you know, kind of like your, your, your, your, your writing stuff, but let’s help you write something sorta like a, a book that we had published a once before. Let me send you a copy of, to take a look and see if you think so that they send me this tha this book, and of course it shall remain nameless, but I take a, I take a look at it and then I called them back.
Frank (10m 22s):
And I said, you know, and of course this, this goes back 15, 20 years, whatever it is. And I said, you know, I’ve been, I’ve been dealing with real estate investors for, at that point. He might of been, might of been about 20 to 25 years. I’ve dealt with thousands or real estate investors. And I’ve talked to, well, a lot of them as customers for our software. And I can think of three people who’ve been understand the book you just sent me, by the way, I am not one of them. So I don’t think I’ll write something like that. If that’s all the same with you I’ll, you know, visit well, OK. I guess they said, dad, why don’t you not got a couple of chapters and, and sends it off? And so I did, and they did agree to let me write to the rest of the book after seeing those couple of chapters and to make once again, and the rest is history, but I guess there was an advantage for their ignorance proof to be my greatest ally in this entire, in the entire event.
Frank (11m 18s):
Because if I had really known what I was, what I was supposed to be getting into, I probably would have, you know, done what I was asked, but I didn’t know. So yeah, I just felt like,
Jesse (11m 30s):
Is that what I liked so much about the book was, you know, there’s the main title and then the 36 Other Key Financial Measures. And What one of my favorite parts about the book is that you go kind of methodically through the different types of evaluations or evaluation Metrics. And maybe you can give for somebody that is in real estate or real estate investing that is trying to understand the concept of, you know, valuing a property or asset today by the Cashflow
Frank (11m 54s):
It spits off into the future. And just that concept of bringing everything back to the present and how you do that and what metrics you would typically use on a commercial piece of property that is generating income. Yeah. That’s a, that’s a, an excellent point to add, to bring up Jesse now. And I think it goes kinda to the heart of the matter, because one of the, one of the Key misunderstandings I’ve always encountered, especially among the novice Investor, you know, one of the things I would do with my, with my Columbia class and doesn’t have a hundred. So, you know, students sitting up there in an auditorium and I’d say, Nope, how many people here in their own home and, you know, give you a number of people.
Frank (12m 37s):
These, these were not just newly minted graduate students. A lot of these I’d worked in the financial industry and we’re, and we’re in essentially learning a, you know, a more in depth about this, this industry, and invariably trying to get somewhere, people will raise their hand and that would take it to the well, that’s what, I’m a very happy for you, but you’re going to be operating at a significant disadvantage because you’re going to have to need to forget everything you thought you knew about real estate in order to understand what I’m going to teach you about. Because a residential property homes follow an entirely different, a mind set, an entirely different, a, a type of understanding from income producing property, with homes, which are buying our amenities, your buying a location.
Frank (13m 29s):
And that is true, that the value of a home is largely driven by what’s going on in the marketplace with other properties, have a similar type. This is not necessarily true of income producing property income producing property is a it’s value to an Investor is a function of it’s ability to throw off cash flow. So if you can increase the cashflow of a property, you can increase the value of the property because that’s where the value drives. So the, the, the whole idea that a property’s value is a function of his income stream was a revelation certain of those students, and turns out to be a revelation, to an awful lot of novice investors, because the approach, it, the coach is kind of investing with the supposition that what they know about their home Investment that the knowledge, that information is transferrable to income properties, but its not really a, an example that I would give against them to tell the students will be to take two virtually identical properties that set side by side in a central business districts.
Frank (14m 46s):
In fact, they be in the middle of the block. So one of them didn’t even have the advantage of being a quarter property and they have, the properties were identical that were designed by at the same architect builds by the same contractor. Everything about them was the same except for their leases. One property was tied into longterm lease is that might’ve been market rates of where they were for sign, but we’re now the committing the owner to be below market of a revenue stream for a number of years going into the future. Where’s the other property had the Lisa’s that were at current market rates and had either option’s to, you know, To to renew at a realistic, a future market rates or, or, or whatever were in a confined that other way.
Frank (15m 35s):
They said Know, if you were in Investor which of those two properties would you find to be the most valuable or the more valuable a physically they’re identical? So a presumably if you were to use The the home valuation a paradigm, they should be identical in value, but they’re not the one that gives you the latitude to increase the income stream is the more valuable to an Investor. So income stream is what it all comes down to in terms of, in terms of income producing property. When you’re looking to value, if you look at various ways of understanding what the current and the projected future income stream might be.
Jesse (16m 16s):
Now what’s interesting also to me is that, you know, with these income streams, you have, we have to at some point derive at a net operating income and its, you, you hear terms thrown around in our industry constantly and a real misunderstanding of what those terms are. You know, you hear a net operating income, does it include, does it include replacement reserves? Does it include mortgage payments and really just, just kind of a convoluted understanding of that term. So maybe you can take us through the, if you go with the scheduled income or the potential gross income and kind of moving down to how we do get at NOI.
Frank (16m 54s):
Yeah. That’s, that’s an essential part. Start with the financial analysis of back in the day we called it an APAD form, annual property operating data, although for the purposes of my analysis software and even for my, for my book and for my online course, I take the annual part of it and kind of, and kind of expand it because I take the annual and expanded out into a projection of a future years. But nonetheless, the a, the structure is the same, whether you’re looking at it, it in a single year will look at it over multiple years. And it is, as you say, kind of a stepwise accounting for various aspects of the, of the, of the, a revenue and expense streams.
Frank (17m 38s):
So you can get to the net operating income that starts at the top with a gross scheduled income or potential gross income, but both the terms are interchangeable essentially. And that’s the amount of income that you would get if all units were rented right below that line should come, that allows for vacancy and credit loss. And here is the very first tripping point for most novice Investors of, Oh, we hear them say, well, yeah, yeah, fine, fine, fine. Except I know I’m not going to have any vacancies. He said, yeah, well I know that may in fact be true, but true doesn’t count in this reality, it’s, you know, the dispense with a reality here for a moment and, and, and, and deal with a different reality.
Frank (18m 25s):
And that reality would be that whether you really are expecting to have, they can see you in credit loss are not factoring means that any third party who was evaluating this property, including a third party and might be evaluating on your behalf, such as a commercial appraiser, a lender, an equity partner, they are going to impose a vacancy and credit loss. OK. So if you don’t do it, they’re going to do it for you. And that’s probably not going to be something you’re going to want to have happen because you’re better off deciding for yourself what is a realistic vacancy and credit loss. So put in, even if you realistically don’t, you don’t expect to have that occur no later when your, you know, kind of, kind of lucky in your office privately, and the lights are down low and you want to take a look at how this property might perform for you.
Frank (19m 21s):
I always, I always suggest to people, ah, with the entire a pod form, you, you might as well. So start thinking about it. You can, with this particular line is that you can do a best case, worst case than in the middle kind of analysis. Talk a little bit more about that interest a second, but y’know, if you want to be very private about how things might really look at, then maybe you can ratchet that you can see in credit and loss down So down to her or up to nothing, but in terms of your interaction with the rest of the world, you better have that line in there. And once you do, you come down to a line that comes below it, which is gross operating income, I think a commercial printers is also I’ll use the term effective, gross income again, synonymous.
Frank (20m 2s):
Okay. So you’ve gotten two through three of the lines. Once you get past that, what you’re supposed to be subtracting out from your gross operating income, our, the operating expenses. And here it was once again, as you alluded to it is where people a run off the rails, quite a bit for a number of different reasons. Number one is in identifying what things really are operating expenses. Why does that matter? Well, once again, just as what the vacancy and credit loss, you need to be speaking with the same language as everybody else who might be looking to get this property. So if you’re not speaking the same language as other Investors, for example, a person from home, you are buying a property where the person to whom you’re trying to sell the property or the lender or the commercial appraiser or the equity partner or whoever.
Frank (20m 58s):
And if you’re not speaking the same language, then you know, you’re, you’re not going to come to the same conclusion about anything. So you’ve got to be speaking the same language, which means you need to be uniform in your definitions of what our operating expenses operating expenses or the costs that you need to, to, to a incur, to operate the property that might give you some clues as to somethings that don’t pertain. And, you know, when we first started selling software, we, we get phone calls from people saying, you know, how come you don’t have, this are how come you don’t add that? And this and the, that tended to be things like mortgage payments or just the mortgage interest to which we would, you know, politely explain to, you may need a mortgage in order to be able to buy this property, but you don’t need it to operate the property, right?
Frank (21m 52s):
The mortgage, what they said, well, put the interest is tax deductible, which is fine. That’s a different issue. Okay? Yes, you can deduct the interest or the mortgage are at least it’s, you know, it, as we speak today, who knows what they’ll do, but so with the, with the tax code, but it doesn’t re you know, paying interest is not part of operating the property. And what about the depreciation? Same thing. That’s not even a Cash item OK. That you don’t need, you don’t need that to operate the property. Another area in that area list of a health expenses that would, to that, that I would find, okay.
Frank (22m 34s):
Would be problematic in terms of people making the analysis is that they would take at face value, the information they had received from a, if they were the butter that they would from the cellar or the seller’s broker as to what expenses the property was actually incurring. And I said, you know, just So just because someone gave you this information and just be called you verify it, that, you know, those are the property taxes, that’s the right number a yeah. I called my insurance broker and that looks like a reasonable number for the property insurance. And even the, even, you know, the, the treasury people. But that seems like a common area, utilities, all of these seem like reasonable numbers.
Frank (23m 14s):
So I think we’re good here. Well, I don’t think we’re good here very often. It’s because typically the cellar, if the seller or the seller’s broker is trying to, is trying to convey, you know, a happy face here are this property, their may be things that they have that they’ve chosen to overlook. And the most common one of these is a property manager. Yeah. And I’m sure Jesse then you can already anticipate the conversation that goes on. When did I tell people that they should be plugging in a number for property management?
Jesse (23m 50s):
You see the guy manage it myself.
Frank (23m 52s):
Exactly. He must have been dry. And he was dropping all of those 800 conversations that I’ve had with other investors that say, Oh yeah, I’m going to die. I’m going to imagine myself. And there’s a, there’s a whole litany of reasons why that explanation, isn’t going to wash number one. Doesn’t your time have any value. Okay. I mean, if you were to go out and buy a treasury bond, okay. They wouldn’t be expecting you of course, to come in. You know, you were coming back into the hallways at The at the treasury department. Okay. You wouldn’t have to put that kind of work in to get the guaranteed return.
Frank (24m 32s):
So if you own this property, a if it’s not, you that’s doing it, the value of your that’s the value of the time. If you had to get somebody else that has to be taken into account. And once again, we get back to The to the business of those third parties who will look at your you’re a pro forma, you’re a, your workup on this property. You don’t put the property management and they’re going to put their property management in, and that’s going to reduce ultimately the net operating income on this property. So all of these things affect where we come down to four a week for a net operating income. You have mentioned a, I think reserves, that’s a trickier one.
Frank (25m 16s):
I’ve got an article on my, on my blog about this. And reasonable people do disagree on this one. Now
Jesse (25m 24s):
I think a, and I think I’ve read this article and I’ll put a link up to it, but it’s, it’s very interesting because you do talk a little bit about, you know, the, the cap ex reserve argument of, well, you’re paying yourself to a certain extent, but its for a future expense. So maybe you could expand on that
Frank (25m 38s):
A little bit. Yeah. You know, basically a way that, that probably would you use of the list of our time here to do the weeds. But essentially when you’re, when you’re putting money into, into a cap set cap ex account, you’re not actually spending it, you are taking it out of one pocket and your putting it into another, it’s a treated as an operating expense. It currently, I think is his, this is not the, the wisest approach to, you know, if you’re looking at artificially, reduce the July, maybe, maybe you want it to have that. But I think it’s not yet. And operating expense, not necessarily that needs to be ignored in Your in terms of your Cashflow planning, clearly you, I think you want to be thinking about what’s happening, but I would put it as a below the NOI line item in the, in doing a cash flow proforma.
Frank (26m 33s):
Yeah. That would be my preference. It’s a reasonable people do disagree on this, but I, I think I’m happy to say that I’m not alone in my position either. It’s a matter of fact I think get up and if I’m, I couldn’t be incorrect about this, but I think I researched once how they teach and the CCR of courses. I think they agree with the, with the, with my approach on the at least last time, but a lot.
Jesse (26m 54s):
Yeah. And I think it goes back to your point about, you know, who is, who is making the proforma? Is it the broker or is it the investor or is it the seller so that, you know, all those variables I think will have an effect. I’m what is your take on? We get a lot of Investors that talk about repair and maintenance. And I know it’s going to depend on kind of the market that you’re in, you know, our underwriters, oftentimes $500, a unit seven 50 unit thousand, a unit. How do you have any metric for that? Or is it, is it kind of where the market is in that area?
Frank (27m 24s):
Like politics is local it’s really, it’s, it’s, it’s really, it’s really a function of ah, of the, of the property and the location that it’s in. And you know, I, I think in the, in my book I give a, a, a, a discourse that the tries to get to The to the issue of a, how, no matter what, when you’re looking at, then in terms of the repairs and maintenance, the numbers you’re looking at could, could tell different stories that, that a, a high that the seller reporting a high cost of repairs and maintenance could mean that he or she has just recently done a major, a major fix you up and giving you honest numbers, but that might not necessarily be what’s going to happen going forward.
Frank (28m 13s):
Likewise, the seller given you a low, a repair and maintenance numbers couldn’t mean either there’s a lot of deferred maintenance or that in fact, this is the year after that big fix up when there is less need for repairs and maintenance, because everything is in tiptop shape. So you can’t really cut to a conclusion based on the magnitude or the numbers. Its gotta be the, the sort of thing were you have to have boots on the ground and actually look at the property and do your due date,
Jesse (28m 42s):
Which is now there’s a couple of Metrics that, you know, you could really get in the weeds with, but I want it to hopefully touch in a few here, cap rate cash on cash return, an internal rate of return. I don’t want to go too far down the cap rate, you know, a whole, because I think most people will kind of understand generally what it is. I recently did a video on a bigger pockets podcast and I know that, you know, I tried to explain to people there’s, you know, there’s two ways you can look at it. There’s a very arithmetic way. And if you go and take, you know, real estate finance, you can get into really into the weeds of dividend discount model and how it emulates that. And exactly. And with keeping that aside just for one second, The you talked a lot about the cash on cash return and I like how you talk or how you explain how a lot of investors seem to think it’s a metric that they can use multi-year when it seems to be more appropriate as a metric for the next year or for a, a one year.
Jesse (29m 41s):
Could, could you kind of expand on what you meant by that? If that’s correct. Yeah.
Frank (29m 45s):
Yup. I that’s how I feel about it. I, I, you have a limited respect for cash on cash return, but not nearly as much as a lot of novice investors do. And you know, we can cycle back to cap rate to we in a moment because we are gonna hit our NOI of their bottom line on thee on the iPod. But in terms of the cash on cash return, what that overlooks is Tod value of money. If you look at the cash on cash return for the first year, well at the time that has passed is, is, is, is nominal. So the amounts of a, of, of, of opportunity costs or a lost value or whatever have the Cash of receiving relative to the cash flow invested is is, is not a, it’s not critical.
Frank (30m 32s):
And it has the advantage of being really, really easy to calculate. So its really easy to figure out that what your cash on cash return is and to compare it to something else that has short term consequences like us, you don’t like a one year CD. This is my cash on cash return. Gotta be better than to simply sticking to money in the bank. So that’s good. But then if you start looking at the cash on cash return in subsequent years, you are looking at cash that you would receive, let’s say five years from now, that’s their cash flow. Okay. Compared to Cash that you are investing today. Hmm. Well that’s apples and oranges.
Frank (31m 12s):
We, we’re not, we’re not comparing the, the value of that Cashflow five years from now is not its face value. So if it’s not a space value you should be using or something entirely different as the metric Hmm. To account for the fact that it has less value to you in your current life in today’s, you know, and its prisons value, which is where this counting is going to come in. So
Jesse (31m 37s):
Sorry. I just I’m because we have actually had somebody else on the Podcast and your name came up, have a section in your book where you did, there was a comparison, have cash on cash. To the basically return on equity. And I just want to make sure, cause sometimes people misunderstand the two of these things, w w one is a little bit more nuanced than the other.
Frank (31m 58s):
You know, I talked about a, a return on equity calculation. This fact, I think I, I think we’ve used them in our software where its, where the, where the rather than, rather than looking at the, in the initial cash. Investment a one thing you can look down, but maybe at least illustrative of in terms of, in terms of its in terms of its magnitude and maybe not as, as useful in terms of comparing it to, to other metrics. Because if you look at a, at the flow in a given year, let’s just take your five. So here’s your Your five Cashflow and compare not to the equity that you invest in the property Your Cash Investment but your presumed equity and the property in year five, by which I mean, let’s now take into account a, what do you think is the actual realistic market value take into account?
Frank (32m 55s):
How much you’ve paid now to the mortgage and look at what kind of equity do you have in that property and how is the return of the cashflow relative to, because most of those things now are looking at the same time period where that can wear that can give you some useful information is not so much in to how much that return is, but in what directions that returned is going, because what can happen is if you look at your return on equity in that fashion, then you look at it. How to a year after a year after year basis, you can see a situation sometimes where you’re cash flow might be going up.
Frank (33m 42s):
The value of the property is going up. Our internal rate of return is going up at oops, by return on equity is going down. What’s wrong with this picture, but there’s nothing wrong with a picture except for the fact that what’s really happening is that in most cases what’s happening is that your equity is, is growing faster than Your. Then you’re a cash flow is growing and that can be happening because your mortgage is becoming seasoned. Okay. Your maybe it’s not your fight. Maybe its your tent a and you’re, you’re paying down the mortgage so that you’re building up equity and the property faster than you are developing a growth in cash flow.
Frank (34m 24s):
So the message to me, when I look at that is that maybe I got too much equity in this property to make it continued good. Investment the waves I can deal with that. Of course I could sell the property, buy something bigger. I will take all that so that they take all that full of green money and go, ah, and go into another property or maybe I’ll simply refinance the property and take some of that equity out, use that money to buy another property. But that’s where I think an insightful look at the end. He has to show you how new ones to look at. Some of these metrics can be beneficial. If we can help you learn how to, how to help to manage your Investments in something other than, than the present moment, which is unfortunately what metrics like cash on cash return, encourage people to do a two look at the, at the property in the current moment.
Frank (35m 13s):
And then getting back to your earlier a, a remark about cap rate and how would you know of maybe some people are, are, are a little disenchanted with cap rate cap rate also has the potential for leading you down that path of looking at the property in the current moment, looking at the property, the current moment is at an appropriate thing for an appraiser to be doing because they’re for the current market value a property they’re not looking for its long term investment potential so much as to tell you what is this property worth in today’s market. And so if you had a cap rate that you can apply to that net operating income, which is of course the bottom line, but we would have gotten to subtracting at home is operating expenses.
Frank (35m 57s):
If you have a cap rate, you can apply that you might not have the appropriate market value of the property at a point and time, but are you are an appraiser? Are you already, are you Investor? What is your point of view? Okay. If you’re an appraiser fine, that’s the end of the story. But if you’re an investor, maybe you want to be thinking not about a point in time, but About long term building of wealth and the longterm building of wealth that implies. But I had to look at not only the performance of the property currently, but what is the potential performance of the property over time and will that meet my Investment needs? When we start doing that, we started getting into projections.
Frank (36m 39s):
This is kind of a Cashflow us and
Jesse (36m 42s):
Or yeah. And that’s a, that’s what I wanted to take this to. Cause I think there’s something, something that you see in the book that I think especially novice investors really get a lot of benefit out of. Ah, there’s a situation in the book where, you know, you have an, Investors say to you, well, if I make all these assumptions and projections into the future, I don’t know the future and, and your, your retort or your rebuttal to that was well, if you make no assumptions, that’s an assumption as well. So there’s this kind of thinking that just cause you just cause you don’t make assumptions. Now you’re assuming that the future unfolds in a particular way. So that segue brings us perfectly to what I think you believe is the gold standard when we’re evaluating. And its certainly the metrics we use for a longer term investments and its the internal rate of return.
Jesse (37m 26s):
And maybe you can talk a little bit about how reversion or a exit cap rate kind of factors in and kind of puts a bow on the, on the total, you know, calculation of the IRR.
Frank (37m 38s):
Great. Yes. And then that allows me to get back to what I was saying earlier about My my suggestion is that people do not try to make a single proforma projection of future performance because that, that does assume that you’ve got a crystal ball and that you do know with some down to the fourth decimal point, what are your electric, which is probably not true, what you do have depending on the property type, you have greater or lesser confidence about the revenue stream, The the operating expenses and so on so that you can make a differential estimates of what might happen with these items in the future.
Frank (38m 20s):
For example, if you have a triple net lease property, wait, that’s where you’ve got, you know, solid, Lisa’s going out 10 years, you’ve got a pretty good lock on what your top line is going to be in what your NOI is going to be on that. If you have something to say that let’s take it a multifamily apartment building, you may not necessarily know exactly what all of these things are going to be going forward, but you probably do have some good historic data, historical data that will tell you that. Well, you know, rents typically have gone in this, in this direction, at this rate that most operating expenses with a possible exception, a property tax is and property insurance tends to follow, you know, you know, reasonable expectations about that inflation rate a So I need to look at maybe those other two expenses or is there anything unusual going on that I can discover my due diligence, you know, are all of the schools going to, has to be, you know, have a, as best to sort of move that were going have to have a bonding issue or things just kind of running according to her, it’s a, it’s a normal, so you can probably make some best case and worst case presumptions and like most things in life.
Frank (39m 30s):
The truth usually lies. So we’re in between, if you can, if you can make the best case in the worst case assumptions, then maybe you can look at whether or not you could survive on the worst case And and be relatively content with the, with the summer and in between the same kind of logic applies then for your exit category because the, the extra cap rate will in fact go a long way to determining what that, what that final cash flow that you are going to achieve and will be the final Cashflow in court. So of course being the sale proceeds and there again, I think you need to make more than one possible estimate.
Frank (40m 12s):
The most realistic for most people is to say that, okay, I’m going to use a assuming that I’m not going 20 years out in future. In which case we really notice what’s happening 20 years that know if you’d ask the people in a month ago about a, about a health and welfare. Yeah. But, but if you’re going into reasonable length of time and starting off as a Your, your Your midline you’re you’re the most probable would be the se to the extra cap rate is gonna look pretty much like the, a, the car with a cap rate. And then you say, well, OK, but things could get, could get worse.
Frank (40m 52s):
Okay. So we’ll use a different cap rate for that. The Investors law to the band’s a higher return or the things that, you know, maybe we are going to have some kind of maybe I see reasons in this particular market to think that there is a growth on the horizon. I see, I see evidence of new businesses for me. I see evidence of new employers moving in. I see reasons to think that property of that Investment, but that vacancy rates are gonna go down. He goes more and more people are going to want what’s here. In that case, you could try the lower for your best case scenario, try to lower your, try the The the worst.
Frank (41m 33s):
Then you look at middle and, and to
Jesse (41m 34s):
Clarify for listeners, when you, you know, sometimes we think about this and it doesn’t make intuitive sense when you say greater cap rate that being worse, your thinking, well, my yields is great or that should be better for me. But the inverse relationship between value and cap rate. So that exit cap rate being higher, the value of that property will be lower. Now, when, when you do apply this reversion, this exit cap rate, that would be my understanding. That would be The, you know, the last or the second last year of cash flow to generate. So if you’re a net operating income is a million and your exit cap rate, a estimate is 5%. You’re dividing that million by 5% to produce what you believe would be the, the value of that.
Jesse (42m 16s):
Is that correct?
Frank (42m 17s):
Yeah. Except that a in, in practice, what I see happening is that depending upon the, what do you have the cellar or the buyer you may use the last years in Ojai or the estimated Your after the last year in Hawaii, depending upon what your, whether your logic is that in a way I’m selling you is the one that just happened or the NOI that I’m selling you is the one that you can anticipate will happen next year. So
Jesse (42m 42s):
A great little one for sellers, right?
Frank (42m 44s):
Yeah. Right. So, you know, sellers like too, like to get the NOI as high as possible. So they will, they’ll, they’ll tend to look for assuming that it’s going up. They’ll tend to look for the NOI that you were buying proactively prospectively, I should say, as opposed to the one that just happened. So that it’s one of these things, just like, The just like the Congress, you know, where you stand depends upon where you send it.
Jesse (43m 9s):
Yeah. So when you’re, when you’re teaching students, so if we go back to, we kind of jumped ahead a little bit there, but well, if we go back to the IRR itself, you know, when, you know, you always hear in intro class, you know, what’s the one that makes The the net present value zero, but that doesn’t really help anybody to think about it. Analytically, if you were to explain it simply to a student, that’s asking, you know, what is an internal rate of return? What is it, what is that metric telling me?
Frank (43m 35s):
Okay, let me see if I can, let me see if I can resurrect my My professorial explanation. You can see that I haven’t had my second cup of coffee. So if I get this wrong, you can tell you, I’m hoping you’ll edit this part out. Okay. So we started off looking at the fact that future cash flows, their value needs to be discounted back to the present to see what they’re really worth today. So how do we do that part before we get to the IRR, let’s talk about the discounted cashflow of logic. So I know how much I invested today, and I’ve estimated how much I’m going to get each year in the future, including that last cash flow, which includes the proceeds of sale.
Frank (44m 18s):
I say, well, okay, except they have to wait for each of those cash flows. So I’m going to discount those back to the present by a certain discount rate. My opportunity costs if you will. So I’m going to discount the first year, Cashflow back one year at that rate and put it in the pot. We want to take my second year cash flow discounted back to years at that rate, putting in my pocket third year and so on until you get to the sale year, discount that back however many years and put in the pot, then see how much I’ve got in the pump and have them all within the pot. And that is the present value of the future cash flows. Okay. So that’s what my income stream should be worth.
Frank (45m 3s):
Okay, fine. The logic of doing that assumes that we know what the future cash flows are, and we know what the discount rate that we’re gonna use is, and we use those two bits of information to come up with what the present value of that income stream is. That’s usually pretty understandable to most people. Would you agree or have already gone too far? Now we know that one always, you know, make sure that the positive number and, and we’re we’re cracking. Okay, good. So, okay. So we got that now. So we had three variables in this and this calculation here, we had the future, Cashflow the discount rate and the present value as with most things that you might remember from your experience in algebra one, you can always change what the unknown is.
Frank (46m 2s):
If you have three variables and you know, two of them, you can find the third. So in IRR, are we going to do is change the unknown. We’re going to say, okay. I still know, but I think the future cash flows are going to be, but now I think I know what they’re worth. So they’ll just find me that discount rate. That makes that true. Well, how do I know what they’re worth? So how much are you prepared to pay for it? If I’m prepared to pay at a million dollars for those cash flows, tell me what discount rate that represents. That’s what we call the IRR and that that’s all there is to.
Frank (46m 42s):
And that’s where that net present value. All those discounted cash flows that you took back to your zero is equal to zero. Is that correct? Right. Right. Because you’ve made the net present value equal to zero. And what’s, what’s unique though, about the IRR. What what’s this, what’s the sort of thing that you, that you are not going to be able to calculate on the back of an envelope yourselves is that what’s, what’s happening in this iterative process that your computer’s doing in the background is it’s finding the one and only discount rate. If a cruelty exists, the one only discount, right. That will make all of those things true. That will make the, the, you know, the fifth year you plus the fourth year discounts is posted on third year discounts and what the animal is equal to how much you’re paying for it to find the one and only rate that will make that true.
Frank (47m 35s):
Okay. And that’s something that you can’t do calculate easily. That’s what do you use a computer?
2 (47m 40s):
What would that IRR, if your cost of capital is 6% in your IRR is 9%, is it, is it as simple as saying is if your IRR is greater than your cost of capital,
Frank (47m 50s):
That would be a project that you would you’d want to embark on. Yeah. I think it, at the risk of have of trying to make it all of life’s to a simple sites that probably would be, would be true. But at the same time, I think I would be looking at perhaps even more than, than just cost capital in terms of deciding what is an acceptable internal rate of return for a particular property. Because I would be looking at first of all, my personal investment objectives and the amount of risk that’s involved here, a, one of the, a, one of the Examples that I use with, with, with, with my students is to point out them in case they hadn’t noticed, but I am a bit older than they are.
Frank (48m 43s):
So what would be a, an acceptable Investment scenario to me, a what would be an acceptable Investment scenario, so then points out to them, but, okay, so you guys are 25 years old, 30 years old, they’re not nearly ready to graduate students. So So, is it, you know, you can look at the property where the opportunity, a four value add perhaps is a greater where your looking to nail down, you know, a high internal rate of return hire, you know, try to do that at variably involves higher risk, but you are young.
Frank (49m 25s):
And therefor, if you mess up, God willing, you have got a lot of years, this is still make this up it’s to make good on it. Alright. I, on the other hand, I’ve given up buying green bananas. I don’t know how I’m going to go So so I would be looking at, and the Investments scenario that is a much more conservative and therefore I would be looking at an IRR that’s lower, or a triple net at least situation, for example, where I might be, I might be getting a return than a significantly lower than the aggressive value add opportunity. So the cost of capital is, is a, is a relevant consideration, but I think there needs to be a, I think you need to be really looking, as I tell him, look at the picture behind the pitcher very often.
Frank (50m 14s):
And C if you can start to see what’s been painted over in liquids, what is behind they’re and see if you can understand really what it is that you’re trying to accomplish, you know, have the, have your own clearly in mind as you start going forward. Yeah. And that will help you to make the right decision. Yeah. And that’s great. And just a, just two points. They’re one on just cause that’s come up a few times, triple net leases for a fee for listeners, you know, that’s where the you’re a tenant is paying taxes, maintenance, insurance, and, you know, applicable additional rent. It’s typically lower risk and usually longer term leases in terms of the, you know, we’ve, we’re coming up to the kinda end of time here.
Frank (50m 54s):
I knew this discussion was going to take us right to an hour, but you have a really good paper and I’ll, and I’ll put a link to this as well. I think its on the real data site where it talks about sinking IRS and a lot of people don’t know that, you know, if you do calculate IRR on an annual basis, you do get to kind of a crescendo potentially with IRS and then they start going down. So say you’re seven and you’re eight. Maybe you could talk a little bit briefly on what you mean by sinking IRR. And that may be how that in fact a affects your investment philosophy. Well, and I think what’s a, What, it’s really all about his, the fact that a, what tends to happen. And a lot of Investments scenarios is that IRR may make grow over time.
Frank (51m 40s):
So if you look at the IRR, it presumes a sale. So if you look at it, if you are looking at IRR over time, your presuming, okay, a what if I still it in your one, I get an IRR. What if I still in year to get an IRR calculation? Or what if I sell in your three and so on? And there are certain phenomena that seems to be fairly commonplace. First of all, if you sell it in year one, you should not be at all surprised or even alarmed to see that the IRR is dreadful as a matter of fact and may cause you’re a computer to reboot, try to calculate this then because you’re looking at try to sell a property of when you have just incurred the expenses of acquisition.
Frank (52m 24s):
And you’re also, now I’m going to incur the expenses of this position and you’re compressing those old ones with a short time for it. And so, okay. Don’t get The don’t get put off when you see that your first year IRR is minus 40% or something. Oh look, look beyond that. OK. Then you started looking at what if I sell it you two, three, four, five, six, seven, and so on. And you see that it, it grows up a and maybe until you were seven and then this starts to decline again, that has a relatively common phenomenon. A because a very often the The the growth in, in Cashflow is more and more substantial in those early years and may not be as substantial in subsequent years.
Frank (53m 16s):
What the reason for it is that we may, we, we, we may need anthropologists to help us figure that one out, but nonetheless, it does tend to occur, but what’s more important than, than the whether or not. It really occurs is the fact that if you’re making these projections, it’s worthwhile doing the longterm projections, which is one of the reasons that, again, I a M I disagree with people. Who’s saying you shouldn’t make a projection. You know, going out more than one year, do try to make the longterm projections. Because one of the things you’ll look for is when does that peak occur? Because if you can identify with any reasonable confidence when that peak might occur, that should be in messaged.
Frank (53m 59s):
Do you just have that return on equity? And the discussion we had might be a message to you as to when might be a time, if you think about selling the property, because if you’re IRR, if you can sustain that kind of growth in Income over a long, longer period, then maybe this is the time to sell and invest in something else, another property, because if your IRR is going to decline over time, then wow, that’s what it is. It’s, you know, if your IRR used to be 15%, if you held it for, for, for seven years, but now if you hold it for 15 years, it’s going down two to 10 or nine or 8%.
Frank (54m 40s):
Well, that’s your overall return for the holding period of the Investment. So maybe that shouldn’t be the holding period of the investment. Maybe the holding period should be the, the shorter term when you maximize your return.
Jesse (54m 51s):
Yeah, that’s great. Frank if I’m, if people want to find some of your stuff, get any of the books you have, where is the best place they can, they can read you.
Frank (54m 60s):
Yeah. Okay. First of all, before the books, of course go to Amazon, that’s a, that’s a real books get sold for these days. I have have pictures of them on our website, but we don’t actually sell them there. Then for most things, if you go to realdata.com, you’ll find information about the software that does the kind of analysis that we’ve been discussing. You also find the links. I don’t think I mentioned earlier that one of the things I did, To going back to what maybe four or five years ago, what’s the launch, an online video course where I go through a lot of this material, even more, actually more topics.
Frank (55m 44s):
Now, of course, it’s grown over a couple of years, not a lot more topics now, even that night they had of mine yet my and my grad school, of course. So that’s available there and I wanted to make a, a special little goodI here for listen to this, to your podcast, which all put up there for a while. One of the things that we felt that people were you particularly liked in the course was I had a series of case study examples where I go through Case that he problems on a different property types. So, you know, a multifamily, a triple net pleats, a mixed use property and so on. And so we spun that off as a kind of a mini course. And so I, we want to make that available from time to time, but I, I asked my it guy for you.
Frank (56m 27s):
So if we will put that back on our whole page a today, so the folks could find it and anybody who’s listening to your podcasts, I’m going to give them a, a promo code, which I will now recite. If I can find a job he wrote down Working 20, 20 Working, 20 Working, 2020. Okay. So if they use that promo code for that MANY course with a case study, Examples will get a 30% discount at least, you know, for the, a couple of weeks after you’re a, your podcast comes out. Fantastic. So I hope that it will be of some benefit, another, a side benefit there that say a really can’t get enough, have a good thing.
Frank (57m 9s):
We will apply the purchase price. Is that mini course. So the, so the full course, so this is the opportunity to do a little extra as well. Okay.
3 (57m 17s):
My guest today has been Frank Gallinelli Frank thank you for coming on the Working Capital The Real Estate Podcast
Frank (57m 23s):
Its been a delight. Thank you for having me just curious
3 (57m 28s):
Favor, listening to the work in Capital Podcast my goal is to help individuals break into real estate investing as well as educate experience Investors. If you enjoyed the show, please share with a friend subscribe and give us a rating on iTunes. It really helps us. If you have any questions, want to learn more or likely to cover a specific topic on the show, please reach out to me via Instagram at Jay, for gals or head to www.jessefragale.com. My name is Jesse Fragale and I’ll see you back here for the next episode or the working capital real estate podcast.