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What Every Real Estate Investor Needs To Know About Cash Flow & 36 Other Key Financial Measures By Frank Gallinelli



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Jason Hartman interviews Frank Gallinelli, founder and President of Real Data and author of the book What Every Real Estate Investor Needs to Know About Cash Flow & 36 Other Key Financial Measures. Franks discusses the most important metrics when it comes to buying single family rentals. They also talk about when you should not be investing in real estate.

Investor 0:00
You don’t have any investment real estate investments, you will not have the opportunity to learn to make mistakes and learn from it. And then you will not be able to tell which one is a better investment. I think you just have to get it started somewhere and with the help of your investment counselor, and then move forward.

Announcer 0:19
Welcome to the creating wealth show with Jason Hartman. You’re about to learn a new slant on investing some exciting techniques and fresh new approaches to the world’s most historically proven asset class that will enable you to create more wealth and freedom than you ever thought possible. Jason is a genuine self made multi millionaire who’s actually been there and done it. He’s a successful investor, lender, developer and entrepreneur who’s owned properties in 11 states had hundreds of tenants and been involved in thousands of real estate transactions. This program will help you follow in Jason’s footsteps on the road to your financial independence day. You really can do it. And now here’s your host, Jason Hartman with the complete solution for real estate investors.

Jason Hartman 1:09
Welcome and thank you for joining me. This is your host Jason Hartman with Episode 1162 1162. Today we have a returning guest on the show, and we are going to talk about metrics and numbers and calculations. with Frank gallon le. I gave his book to all of the people in my venture lions mastermind group several events ago, he’s got some great content. He also has sent us some content, given us permission to publish it on the show. So we’re going to be publishing some little lessons on future episodes and I think you’ll enjoy those two. today. We have an actual interview with him. Couple of events coming up I thought I’d let you know about our venture Alliance mastermind event in Savannah, Georgia is coming up in May with a focus on tax lien and tax deed investing, it will be my first time having a focus session on that. My friend has agreed to speak at that event, I think she will be sharing some really good stuff with our venture Alliance mastermind group, you can always come to the venture Alliance mastermind as a one time guest. You can check out more about that at venture Alliance mastermind calm or at Jason Hartman calm as well. And we have after that we have our Cuba cruise, Cuba and Grand Cayman coming up in November as well. It’s our first cruise event where we’re doing it at sea. And I think that’ll be a lot of fun. So in a nice relaxed environment. So some of you out there I know have been saying you want more access to yours truly and I am honored. So if you want that the way to get it is in the smaller mastermind group because at big events that we do, I just have to tell you, my intention is pulled in a million directions. And by the way, We had some good suggestions. We always get good suggestions because we’ve got such a great audience. So we thank you for that. But one of them from meet the Masters in in looking over your evaluations of the event was to offer a meal package and offer to include certain meals in the conference. Now, for our VIP and elite ticket holders, we did have a breakfast meeting. I want to do that every day of our events. But I also want to offer some more meal packages. We’ve done dinners and lunches before and all this kind of stuff. So we definitely are taking that into account at our profits in paradise event that will be on either side of our venture Alliance cruise coming up in November. We will definitely take that into account and do it. We might have another event coming up in the summer sometime. We probably will and just look for announcements on that later. But as far as the cruise and some of these really Need events we do. We want you to take your vacations with us, the cruise is family friendly, by the way. So you can bring the kids you can bring the family. I think these are just good opportunities. I mean, if you’re going to go on vacation, why not vacation with like minded people, people who are doing the same things you are either doing or want to do, and people that are going somewhere in life, you know, one of the one of the most costly mistakes I think I ever made in my life is not picking my friends, not like really choosing them with some direction, right? Mostly, we all choose our friendships and our associations with just who’s proximate, who’s nearby who’s around us. And that’s fine, to be friendly with all of those people. But you can actually make your friendships work for you a little more. When you’re intentionally forming bonds with like minded people who are going places who are doing the things you want to do. So that’s one of the things we really aim to offer here. Go to Jason hartman.com To find out more about all that stuff, or venture Alliance mastermind calm to find out specifically about the venture lines. Anyway, without further ado, let’s go to our guest Frank gallon le. It’s my pleasure to welcome a returning guests back to the show. And that is Frank gellin. Le, he is founder and president of real data, best selling author of what every real estate investor needs to know about cash flow, and 36. Other key financial measures. Frank, welcome back. How are you?

Frank Gallinelli 5:33
Good, Jason, thank you for having me on.

Jason Hartman 5:35
Good. And you’re coming to us from Connecticut. Is that correct?

Frank Gallinelli 5:37
That’s right. beautiful, sunny, Connecticut and almost warm enough to go outside.

Jason Hartman 5:42
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 analytic. Well, 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?

Frank Gallinelli 6:25
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. That operating income really is exactly what its name implies. It’s the net income from operating the property. The

Jason Hartman 7:00
OI, so it doesn’t include debt service or your mortgage or your financing, right?

Frank Gallinelli 7:04
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, you know, look a little bit more with it to understand that and they’ll say, well, it didn’t give me any place to put my, you know, 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 and that income, which involves the revenue that you get from tenants, and 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 going to take issue with you on the couch. Great things. See, I don’t love cap rate, because I think it’s it doesn’t take into account enough data, commercial real estate investors love cap rate because one great thing about it and analyze it does

Jason Hartman 8:11
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 yeah, I don’t know, what do you think I’d argue with? Well, actually,

Frank Gallinelli 8:37
I’m fully getting in accord with you there that cap rate, the use of cap rate by especially by beginning investors tends to be over done and I have a cap rate as us 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 that 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 a snapshot, and would the best overtime metric be IRR or internal rate of return? Absolutely. Okay, that’s where you need to go with this, you need to say, okay, fine, I’m going to do my annual property operating debt. And I’m going to come up with a cap rate 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 our forecast how this is going to work for me over a holding period of five or seven or 10 years, because it’s like 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 releasing 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 five or seven 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 in the worst case? Is it going to be as you know, so good that you’re going to brag about it? Or is it going to be at its worst case? Can you still, you know, survive that kind of a return? So the discounted cash flow, which then, you know, bring 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.

Jason Hartman 11:54
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 pop. I taught me about this when I was a young child, you know, he said, I Dad, I’ll gladly pay you Tuesday for a hamburger today, you know? And that’s how I began to understand inflation and the time value of money.

Frank Gallinelli 12:20
We’re showing our age there, Jason,

Frank Gallinelli 12:23
a comic strip?

Jason Hartman 12:24
Absolutely, absolutely. A comic strip taught me that and also to be eat my spinach. So what is discounted cash flow,

Frank Gallinelli 12:32
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 money today, 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. That’s I have to wait five years for cash flow. Obviously, that’s going to be even less valuable to me today, because I’ve lost the opportunity for investing 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 the longer you wait, the less that money is a value to you today. And this is why it’s so important to look at a metric that combines both of the amounts of each cash flow and the timing of each cash flow,

Jason Hartman 13:50
right and that is IRR, right because that does the discounted cash flow over the course of time. And so that really is is, I mean is that the ultimate metric when I was 20 years old, and I was taking real estate investment classes, and CCI AM, that was like the holy grail, the IRR. And you know, we had to figure it out with just an HP 12 c calculator, and it was quite a bit of work.

Frank Gallinelli 14:17
You know, do I’ll tell you what, I’m a little older than you are. So when I learned that there were no HP 12. Right. We had this book of something called Elwood tables. And we had, and we had to try to do it manually. And interesting aside here, when Microsoft first came out with multi plan, which was the precursor to excel, we were beta test site for Excel and had done models on multiplayer. 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?

Jason Hartman 14:50
Yeah, they’re very interesting. Very interesting. You know, I used to walk to school, and it was uphill both ways. In the southern California snow Of course. Okay, so back to the topic at hand IRR still the holy grail,

Frank Gallinelli 15:07
I think so we’ve, as I said, we’ve been dealing with real estate investors through our software business for let me do the math 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.

Jason Hartman 15:30
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 and do step destruction, my little trademark term, right? It’s bad to wait for your cash flow. you rather have it today. 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 the time value of money makes the debt decline in value. So you actually pay it back and cheaper dollars. Do you want to speak to both sides of that equation at all?

Frank Gallinelli 16:06
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 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 in both in my books, and in my 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 The return on that presumed or unrealized equity of iseult 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. And 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.

Jason Hartman 18:25
Right. 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 r o e or return on equity, meaning we exactly what you’re saying. I know there is 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’ve just been Woke up recently. But um, it’s an interesting point. And what you’re saying is that the more equity accumulates in the property, the more your return actually decline. Right? Is that what you’re saying?

Frank Gallinelli 19:15
Yes, exactly what I’m saying.

Jason Hartman 19:16
So I 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 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.

Frank Gallinelli 19:40
Right? Yeah, 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

Jason Hartman 19:51
do that beautiful thing we call a 1031 tax deferred exchange. You could do that as well. Thank you. third option. There you go. You know, you can do the refinance strategy as well. Yeah, go ahead.

Frank Gallinelli 20:04
Yeah, no, you’re exactly right. This is one of those metrics that’s kind of hidden under the bed covers 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,

Jason Hartman 20:22
no, that’s good. Okay. Is there a time Frank where it just doesn’t make any financial sense to acquire properties?

Frank Gallinelli 20:29
That could be a whole number of situations, I think we’re investing in real estate just doesn’t make sense for an individual. They 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, their personal and others are property specific, and other times its market specific. On a personal level. One thing that I always try to remind everyone when I’m taking a class, is that investment involves risk and if you don’t have a tolerance for risk, either big Your personal makeup or your financial situation, they may be able to think twice about this, but 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. Yeah,

Jason Hartman 21:13
the time that I get burned, and I from time to time I just make the mistake, even though I’m, I’m violating my own 10 commandments of successful investing. But you know, what, I believe in my position I, I have to be kind of a laboratory a little bit for listeners and clients. And so 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,

Frank Gallinelli 21:53
absolutely. That’s certainly one. The other area where I see that people go astray is not really doing their due diligence. So well, sir. 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. And 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

Jason Hartman 22:52
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 a frank lags the appreciation rate, the appreciation will almost always go faster than the income increases. They both go up over time. You know, they don’t go up in lockstep there’s a lag and so when the market is booming, the cap rates

Frank Gallinelli 23:32
sink there, they’re terrible and if they are that a sinking mode, as I say, have no place to go but up. So if you’re buying into that market, you’re buying into a bubble.

Jason Hartman 23:43
Yeah, right. Okay. So give us a range though those cap rates, you know, I love these trophy properties in places like Southern California, well, Northern California, we’re on the coast or New York City or you know, any of these high priced markets South Florida. You know, where the cap rates are terrible. And you know, you’re just playing an appreciation only game. It’s very risky it is. And I can

Frank Gallinelli 24:07
often ask, what’s a good cap rate? And there is no answer to that question, because it’s entirely specific to the market. And to the property type. I’ve seen cap rates in the 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 a typical that it should have been somewhere closer to six, because if you looked at a 10 year history, you would have seen six 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, that’s, you know, I really like the cap rate that this is showing right now. Because it may not be it may not be typical for the market.

Jason Hartman 25:05
Do you have sort of a range on cap rates, like a minimum acceptable cap rate that you think of it all

Frank Gallinelli 25:10
that really, as I say, because it would really depend on the location. I hate to keep on evading your question, Jason, but 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, you know, 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, you know, going forward unless we have a real economic disruption of some kind But if traditionally it has been 10%, then, you know, you might be looking at 10% and then accept a lower price.

Jason Hartman 26:06
Yeah, yeah. Okay. Okay, good. What else do you want people to know?

Frank Gallinelli 26:09
Oh, my goodness. Yeah.

Jason Hartman 26:11
There’s, there’s an open question for you. Here you go.

Frank Gallinelli 26:14
Yeah, 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 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, you know, was having a challenger, 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 this 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 the deal 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, you know, 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, or back then we call 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, you know, 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 investment property, is that as with any other business, you really need to know how it works. You need to get your education or Don’t just jump in and figure Well, you know, it’s all gonna work out just fine.

Jason Hartman 28:03
Yeah, sure. 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 I don’t think there’s anything denying that you know, the student, loan debacle, and so forth, or just taking advantage of people and outrageously expensive. But even the school of hard knocks that you get from real estate investing and listen, you’re going to have them things will not go as expected. If there is one rule or law that applies universally, 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 have some tough things happen from time to time and you’re learning 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 was.

Frank Gallinelli 29:06
My feeling is that you can at least hope to minimize the unintended consequences of some interactions. If you understand how the process works. So you cannot guarantee as I said earlier, investing is all about 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

Jason Hartman 29:36
very good point, Frank, give out your website,

Frank Gallinelli 29:39
real data.com that’s where you can find information both about our software and about our coursework.

Jason Hartman 29:44
And and the books I gave your book. I bought a bunch of your books and gave them to my venture Alliance mastermind group and 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 Allen. Thanks for joining us. Thank you so much for listening. Please be sure to subscribe so that you don’t miss any episodes. Be sure to check out the show’s specific website and our general website heart and Mediacom for appropriate disclaimers and Terms of Service. Remember that guest opinions are their own. And if you require specific legal or tax advice, or advice and any other specialized area, please consult an appropriate professional. And we also very much appreciate you reviewing the show. Please go to iTunes or Stitcher Radio or whatever platform you’re using and write a review for the show we would very much appreciate that. And be sure to make it official and subscribe so you do not miss any episodes. We look forward to seeing you on the next episode.