274: What Every Real Estate Investor Needs to Know About Cash Flow by Frank Gallinelli, Real Data

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It's my pleasure to welcome a returning guest back to the show and that is Frank Gallinelli. He is founder and president of Real Data, it's best selling author of what Every Real Estate Investor Needs to know about Cash FL and 36 other key financial Measures. Frank, welcome back. How are you?

Good, Jason, thank you for having me on.

Good. And you're coming to us from Connecticut, is that correct?

That's right. Beautiful, sunny Connecticut and almost warm enough to go outside.

I know you're joking. I think. I don't know. Maybe not. But there are so many numbers to know and one of the real downfalls that especially the single family home investor faces is they really don't pay enough attention to the numbers. They tend to, as much as they might like to think, they're logical and analytical, they get a little emotional about things when investing. Of all the different metrics that an investor can pay attention to, when I was taking pilot training, for example, you know, there's a lot of instruments in the cockpit, obviously. Right. But there are six that are the core instruments. They call them the six pack. What are the core metrics that are really, really meaningful? If you couldn't look at 36, what would be a few that are really important on the dashboard?

Well, one of them certainly is actually. It's a pair of metrics, as very often these things are sort of inextricably linked. And that pair would be net operating income and cap rate. I find that an awful lot of investors, first of all, don't really understand what net operating income is. And then once they figure it out, they perhaps put too much of an emphasis on using it with cap rate to try to estimate the value of a property. Net operating income or really is exactly what its name implies. It's the net income from operating the property, the noi.

So it doesn't include debt service or your mortgage or your financing, right?

That's correct. And that's one of the common misunderstandings. I've had people, you know with our software call us up and say, hey, your software is broken. Didn't give me any place to put in my mortgage in this NOI calculation. And it didn't give me any place to put in my depreciation, which also doesn't belong in the noi. And then you'll find investors who are a little bit more with it, who understand that, and they'll say, well, it didn't give me any place to put my capital expenses like the cost of a new roof. And all of those things don't belong in your NOI because they're not part of operating a property. You're trying to find the net income from just operating the property. The net income which involves the revenue that you get from tenants and the, the expenses that you have to pay to keep that property running on a day to day basis. So that's a very important figure.

Okay, sure, sure. So noi, very important. Now, Frank, I'm gonna take issue with you on the cap rate thing. See, I don't love cap rate because I think it's a, it doesn't take into account enough data. Commercial real estate investors love cap rate because one great thing about it and NOI is it does allow you to compare like apples to apples. You know, you don't want to include financing, and appreciation, of course, is speculative. So cap rate is good like that. You know, it does give you a clean comparison of properties, which I do really like. But you know, you don't take into account the value of leverage. And so I don't know, what do you think to argue with?

Well, no, actually I'm fully in accord with you there. That cap rate, the use of cap rate by, especially by beginning investors tends to be overdone. And I have a cap rate is used, of course, as you know, by typical appraiser, you apply that against the noi, you divide the NOI by the cap rate, and that gives you your current market value. Presumably, and you're right, it doesn't take into account the debt service, doesn't take into account the leverage. But there's another issue that I think causes some investors to kind of run off the rails when they use that. Because cap rate, what it does is what an appraiser is looking to do, which is to estimate the current market value of a property. What do I think this property is worth today? And that's useful information to have. And that's how I think it ought to be used by the typical investor. But also, the typical investor is not planning in most cases to own the property. Just today, the Investor is planning to own it over a period of time. And in order to make an intelligent and informed investment decision, what that investment really needs to do is to look at the expected or at least the forecast performance of that investment over time. And the cap rate looks at it at a point in time.

Okay, so the cap rate is a snapshot. And would the best overtime metric be IRR or internal rate of return?

Absolutely. That's where you need to go with this. You need to say, okay, fine, I'm going to do my annual property operating data and I'm going to come up with a cap rate. And that's going to give me an idea of more or less where the market thinks this property is today. But that's not necessarily going to be good enough for me to project how this is or forecast how this is going to work for me over a holding period of 5 or 7 or 10 years. Because take a commercial property, for example, where you might have a tenant whose lease is going to be up in three or four years. The cap rate, if you look at it just today, is going to tell you what that property might be worth with that tenant in place. But you might have to predict and forecast that you're going to have to have rollover vacancy and re leasing costs and whatever somewhere in the middle of your holding period that's going to impact the overall performance and return on that property. Which is why I always urge people not to simply make a single forecast of 5 or 7 or 10 years of cash flow, not just net operating income, actual cash flow. And those alternative projections forecasts ought to be best case, worst case, and somewhere in between, so that you can kind of get a sense of how this might play out. Can you live somewhere in the middle of those boundaries between the best case and the worst case? Is it's going to be so good that you're going to brag about it, or is it going to be at its worst case? Can you still survive that kind of a return? So the discounted cash flow, which then brings itself back to internal rate of return, that's the one metric that gives you a sense of both the timing and the amount of all of your cash flows so that you get a sense of how this property might perform, how it's going to work for you.

Okay. Okay, good. So you mentioned discounted cash flow, and I want to have you go over that with investors, because that also is going to relate to the overall picture of the time value of money. Of course, Wimpy from Popeye taught me about this, when I was a young child, he said, I'll gladly pay you Tuesday for a hamburger today. And that's how I began to understand inflation and the time value of money.

And we're showing our age there. Jason.

Yeah.

Remember that comic strip?

Absolutely. Absolutely. A comic strip taught me that. And also to eat my spinach. What is discounted cash flow?

It's very simply an acknowledgement of the fact that the longer you have to wait to receive a return, the less valuable it becomes to you in present dollars. So, for example, if I'm going to put X number of dollars into acquiring a property today, and it has every year fortunately, some kind of a positive cash flow. And that's something obviously that you want to be forecasting. Also, will this property have a positive cash flow? But you look at those future cash flows and you say, well, if I have to wait one year for this cash flow, it's worth a little bit less than if I had that, because I haven't got that money in my hand to invest it somewhere.

Otherwise known as opportunity cost.

Exactly. I haven't got the opportunity to reinvest that money. And if I have to wait five years for cash flow, well, obviously that's going to be even less valuable to me today because I've lost the opportunity for investing it in something else for five years. And keep in mind that what is typically the biggest cash flow that occurs when owning a rental property is the cash that you get when you sell it, ultimately. So that the longer you wait, the less that money is of value to you today. And this is why it's so important to look at a metric that combines both the amount of each cash flow and the timing of each cash flow. Right.

And that is irr. Right. Because that does the discounted cash flow over the course of time. And so that really is. I mean, is that the ultimate metric? When I was 20 years old and I was taking real estate investment classes and ccim, that was like the Holy Grail, the irr. And, you know, we had to figure it out with just an HP12C calculator. And it was quite a bit of work, you know, to do.

Well, I'll tell you what, I'm a little older than you are, so when I learned it, there were no HP12 calculators. And we had this book of something called Elwood Tables. And we had to. And we had to try to do it manually. And interesting aside, when Microsoft first came out with Multiplan, which was the precursor to Excel, we were beta test site for Excel and had done models on multiplan. And we actually figured out a way to do an internal rate of return calculation in a spreadsheet without having an IRR function. And so they called me up one day and they said, how'd you do that?

Yeah, very interesting, very interesting. You know, I used to walk to school and it was uphill both ways in the Southern California snow. Joking, of course. Okay, so back to the topic at hand. IRR still the holy grail, I think.

So, as I said, we've been dealing with real estate investors through our software business for. Let me do the math in my head here. I think it's 37, maybe 38 years now. And so we've had an opportunity to talk to a lot of them. And it seems that the IRR among the more experienced, among the more knowledgeable investors, the IRR is what they want to look at. Yes.

Okay, good. Talk more about discounted cash flow a little bit and inflation and so forth. Because what's interesting about this is I talk, as you know, about inflation induced debt destruction. My little trademark term. Right. It's bad to wait for your cash flow. You'd rather have it, it's better to have it today than tomorrow or next year, in five years. But it's also beneficial when it comes to the debt side of the equation, because that time value of money makes the debt decline in value, so you actually pay it back in cheaper dollars. Do you want to speak to both sides of that equation at all?

Yeah, that is true. The decrease in your debt is certainly an important component of how this property is performing. And since you're paying it off with, as you say, cheaper and cheaper dollars, that's something that I think investors need to take into account. Which kind of brings to mind, by the way, there's a metric that most investors usually don't take a look at that can sometimes be illustrative. And it has to do with the pay down of the debt, and that's return on equity. A lot of investors think of return on equity as being essentially the same thing as cash on cash return. But both in my books and in my online course, I suggest that people might want to take a look at an alternative version of return on equity because it can give you some actionable information. And that alternative version says, okay, my equity really is in a given year, not just the amount that I put into the property, but the presumed equity, if you will, the unrealized equity, the equity that I would get if I actually sold this, let's say in year five compared to how much cash I put into the property. And the reason that can be interesting to take a look at, and you can look at it retrospectively as easily as prospectively, is that because your mortgage may be declining in balance faster and faster and faster as time goes on, and because the value of the property due to increased net operating income may be going up at the same time that unrealized equity may be growing at a rate that's faster than your cash flow was growing. So to put this in the simplest terms, you could look at a property and say, okay, I'm going to look at the return on equity if I sold it at the end of year one, I'll look at the return on that presumed or unrealized equity if I sold at the end of year two. Or I could even look backwards over the past several years, and I want to see if that return on equity is declining dramatically. It very often does. As you hold a property longer and longer, the equity may grow faster than the return does. And what that can tell you is I've got too much cash tied up in this property.

Right. Ah, I love it. I love it because I have argued before, and I don't really mean this literally, okay, When I do it, but I have argued that there is no such thing as ROE or return on equity, meaning exactly what you're saying. I know there is, but. There is, but there isn't. Okay. It's kind of a play on words. In other words, the return on equity will happen regardless of how much equity you have. Some return on equity will exist or not exist, but I don't know. I might be not explaining it well. I just woke up recently here, but it's an interesting point. And what you're saying is that the more equity accumulates in the property, the more your return actually declines. Right? Is that what you're saying?

Yeah, that's exactly what I'm saying.

So I'm glad you said that, but let me just make one more comment. So this is the problem and why I say to investors, don't be deceived by cash flow, because as your equity increases, your return declines, but your cash flow goes up and down. So many investors are hypnotized and they think they're winning when they're actually losing. And other times they think they're losing when they're actually winning. Right?

You're exactly right. And this is a situation that's very often overlooked. If there's too much equity in that property, well, then maybe you need to Sell it and trade up. Or maybe you need to refinance it and trade up and you can do.

That beautiful thing we call a 1031 tax deferred exchange.

You could do that as well. Thank you. Third option. There you go.

Or refi till you die. You can do the refinancing finance strategy as well. Yeah, go ahead.

Yeah, no, you're exactly right. This is one of those metrics that's kind of hidden under the bed cover somewhere that folks just don't take a look at. The way I'm describing is kind of non standard, I think. I haven't seen anybody else really suggest doing this kind of a calculation this way. Kind of violates the standard definitions, but that's okay.

Yeah, no, that's good. Okay. Is there a time, Frank, where it just doesn't make any financial sense to acquire properties?

There can be a whole number of situations, I think, where investing in real estate just doesn't make sense for an individual. It can start as. It's almost like you throw a pebble in the pond. There you see these ripples. Some of the ripples are really close to the investor. They're personal, and others are property specific. And other times it's market specific on a personal level. One thing that I always try to remind everyone when I'm teaching a class is that investment involves risk. And if you don't have a tolerance for risk, either because of your personal makeup or your financial situation, then you maybe ought to think twice about this because you're not going to be a happy camper because not every investment works out, no matter how good you are. Have you ever had a bad investment, Jason?

Oh, sure. Yeah. There you go. Yeah. The time that I get burned. And from time to time I just make the mistake, even though I'm violating my own ten commandments of sin, successful investing. But, you know, I believe in my position, I. I have to be kind of a laboratory a little bit for our listeners and clients. And so I'll. I'll do some things that are off the reservation, and, and the time I get burned is what it seems whenever I invest in some kind of pooled money asset, some kind of fund, you know, when I violate my rule of be a direct investor. Commandment number three, thou shalt maintain control. And I do violate it once in a while, and I'm sure I'll do it again. If nothing else, it's a learning experience and you minimize the amount you put up in those kinds of things.

But yeah, absolutely, that's certainly one the Other area where I see that people go astray is not really doing their due diligence.

Oh, well, sure, yeah.

They forget that the due diligence involves not just the property where you've got to look at the physical structure, but also, for example, make sure you read all the leases. But then the due diligence has to extend out to the marketplace because no property lives in a vacuum. And if you don't do your due diligence about the place where you're investing, you really don't know what you're getting into. An example now I think that we can talk in terms about the financial markets is that you should be doing, we talked about cap rates. Now you should be doing your due diligence about the history of cap rates in this particular market for this type of property. Because if cap rates right now are noticeably lower than they have been historically and typically, well, there's a red flag for you because they have no place to go but up.

One thing I do want to say about cap rates is cap rate. This is a very simple thing, but people just don't understand. Look at when the market is booming and properties are appreciating, cap rates almost always decline because the price, it's really the price to income ratio. That's what a cap rate is. Okay. And so the income almost universally, and you know, disagree with this if you have a, have anything to say about it, Frank lags the appreciation rate. The appreciation will almost always go faster than the income increases. They both go up over time, but you know, they don't go up in lockstep. There's a lag. And so when the market is booming, the cap rates sink. They're terrible.

And if they are in a sinking mode, as I say, they have no place to go but up. So if you're buying into that market, you're buying into a bubble.

Yeah, right. Okay, so give us a range though of those cap rates. You know, I love these trophy properties in places like Southern California or, well, Northern California, where on the coast or New York City or you know, any of these high priced markets, south Florida, you know, where the, the cap rates are terrible and you know, you're just playing an appreciation only game. It's, it's very risky.

It is. And I can often ask what's a good cap rate? And there is no answer to that question because it is entirely specific to the market and to the property type. I've seen cap rates in a boom time go as low as 3% or even a little lower than 3%, which I think personally is crazy. But nonetheless that was the market. But that suggested that that was atypical that it should have been somewhere closer to 6, because if you looked at a 10 year history, you would have seen 6 was typical. In a different market though, where the return on investment needs to be higher in order to attract buyers, it's certainly not uncommon to see cap rates in the range of 10 or even higher. So it really is very much, it's like politics, it's very much a local phenomenon and I think that the investor needs to be aware of that fact that can't go and look at a property and say, oh, I really like the cap rate that this is showing right now because it may not be typical for the market.

Do you have sort of a range on cap rates like a minimum acceptable cap rate that you think of at all?

Not really, as I say, because it would really depend on the location. I hate to keep on evading your question, Jason, but it really is, I think if you lose sight of the fact that it is local, it is market driven, that if you do get into these coastal communities sometimes where the demand is so high that investors will accept a lower cap rate, if that historically seems to maintain itself during normal economic times as well as boom and bust, well then that would be the appropriate cap rate. That would be what other people. Because one of the things you're looking at when you're looking at a cap rate is what do I think I can get for this property five years down the road when I go to sell it? Well, if for the last five years the cap rate around here has been 6%, there's a good chance that that was going to be the right cap rate going forward. Unless we have a real economic disruption of some kind. But if traditionally it has been 10%, then you might perhaps be looking at 10% and accept a lower price.

Okay, good. What else do you want people to know?

Oh my goodness.

Yeah, there's an open question for you.

There you go. I want them to know, I think, and this is an entirely self serving comment, but I want them to know that in education is an essential part of being a good investor. One of the things that we learned being in business for as long as we have, we started this business quite by accident more than 30 years ago. Not because we wanted to go into business. I developed these models for myself because I was trying to figure out a deal that I was having a challenge doing all those numbers on a yellow pad and had one of these new funny Devices that no one had heard of before, a personal computer. So I tried to do that and a couple of colleagues looked at what I was doing. Again, I got this, how did you do that? Kind of comment. So I decided to try to see if other people might be interested in it and in doing that and then dealing with the people who would take our analysis software and try to use it. I came to realize not too many years into that business that if you didn't understand how investing works, if you didn't understand how the metrics affected your decision to buy or not buy, to sell or not sell, what was the point of our developing software for people? Because they really wouldn't understand what they were getting out of it. And that got us onto a second track in an educational track. Started writing blog posts. Back then we called them articles because there were no blogs, then blog posts and then books, and then finally to online courses that could teach people from the beginning, how do you work through the metrics? How do you understand the process of evaluating an income property? So if there's one thing I'd want people to know about investing in investment property is that as with any other business, you really need to know how it works. You need to get your education and not just jump in and figure, well, it's all going to work out just fine.

Yeah, I would even say, I mean, you look at this broken model known as college, you know, it's just a rip off, it used to be good and you still need it for some professions. Of course, I'm not saying that education is bad, I think it's great. But it's become a bit of a scam. I mean, I don't think there's anything denying that, you know, the student loan debacle and so forth are just taking advantage of people and it's outrageously expensive. But even the school of hard knocks that you get from real estate investing and, and listen, you're gonna have them. Things will not go as expected. If there is one rule or law that applies universally, it is that one. There will be problems, things will surprise you. They will not go as expected. And even that is, you know, really part of your education. You know, look at it as like, hey, you're paying for some education here. You know, you had some tough things happen from time to time and, and you learn something out of it and you know, you make sure it doesn't happen the next time. That's just part of life too. So that's part of the education.

I don't disagree at all my feeling is that you can at least hope to minimize the unintended consequences of some of your actions if you understand how the process works. So you cannot guarantee. As I said earlier, investing is all about risk, all about a willingness to make decisions and take action in a situation where you have imperfect knowledge. But at the same time, you should be able to recognize the signs of a good investment or a bad investment so that you can minimize the number of hard knocks that you get.

Very good point, Frank.

Give out your website realdata.com that's where you can find information both about our software and about our courseware and the.

Books I gave your book. I bought a bunch of your books and gave them to my Venture Alliance Mastermind group. Everybody really enjoyed those. So keep up the good work and we should have you come and speak at one of our events in the future sometime. So we'll we'll talk about that. Frank Gillinelli, thanks for joining us.

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