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On today's show, we're joined by Frank Gallinelli, author of the bestselling book What Every Real Estate Investor Needs To Know About Cash Flow and 36 Other Key Financial Measures and the founder and president of realdata.com, a leading real estate investment software firm. Frank also teaches real estate investment analysis at Columbia University.
In this episode, we will discuss investment analysis and key financial metrics real estate investors need to be aware of including NOI, cap rate, cash flow, IRR, and more.
Frank has been in the real estate investment industry for over 40 years, entering the field as a real estate agent to generate supplemental income. After spending some time in the field, Frank learned about income property and income property analysis and subsequently came to teach other salespeople this information. As Frank continued to grow his real estate investment business, the advent of personal computers and spreadsheet software allowed him to generate measurements and analyze his investments with greater ease and accuracy. With colleagues expressing interest in his work, Frank moved to developing software for this analysis. After writing articles online about real estate investing analysis, Frank realized that there was a need for education for those without much direct real estate experience or technical training - so he decided to write books in plain English that any aspiring investor could understand and develop online video courses. Learn more about this education and find Frank's promo code for our listeners at the bottom of this page!
This should proceed any crunching of numbers. You must first have a sense of what the numbers are and what they should be. Due diligence is very important - instead of taking the information at face value, investors should not be shy in asking for additional information, such as viewing leases to view rent rates and important renewal or kick-out clauses. The same thing is true on the expense side - will property taxes increase or decrease? Is the insurance coverage cost going to remain the same when you take over? Another part of due diligence is the market due diligence. No property lives in a vacuum and the realities about the location of this property will influence future value, such as taxes and employers in the area.
NOI - Net Operating Income is computed by adding revenue lines and subtracting operating expense lines. You also subtract out an allowance for vacancy and credit loss. It's suggested to always subtract these amounts because other parties will use this when looking at your property, such as a bank appraiser.
What exactly is an operating expense? These expenses are all expenses related to operating the property. For example, mortgage interest isn't necessary because a mortgage isn't necessary to own real estate. Depreciation also isn't included, as it doesn't involve actually operating the property. Property management is one of the most commonly missed items - these expenses or an allowance for these expenses should be included, even if you are self-managing the property. It's better to calculate this correctly on the front-end to avoid any issues down the line because other parties, such as lenders and investors, will be looking for this figure to be added. Properly calculating the NOI is essential as the figure is used in other measurements.
Cap Rate - To calculate a capitalization rate, you must take the NOI and divide it by the value of the property. Capitalizing the income can help understand the relative current market value of the property.
The capitalization rate and the value of the property are independent of the financing situations of any other investors. Thus, the relative market value of the property shouldn't change based on the different credit and financing positions of investors. The net cash flow may change from investor to investor, but the NOI and cap rate calculations are independent.
Capitalization rates are entirely specific to the location and property type. Cap rates for markets as a whole could be looked at against cap rates for individual properties, but you must do an apples to apples comparison with similar types of properties. A higher cap rate means you're paying less for the same NOI as a similar property with a lower cap rate. The lower the cap rate, the more expensive the property is relative to the projected amount of return.
When you look at the cap rate as a method of valuing property, you must appreciate the fact that you're doing exactly what an appraiser is doing: looking at the market value of a property at a point in time. This is useful and helpful information, but it isn't the end-all of the analysis process.
DSCR - The NOI is also used in calculating the Debt Service Coverage Ratio. Take the NOI and divide it by the annual debt service (total of annual mortgage payments, principal plus interest). If these two numbers were identical, the DSCR is 1. When your lender looks at the property and looks at you as a borrower, they are making sure there is some wiggle room, or a margin for error. This is because, if any factor is likely to change, it's most likely that the expenses will increase. A DSCR above one implies that this wiggle room does exist.
This ratio is important because it can help ensure that the property will support you and that you, the investor, won't be in a situation where you need to support the property out of your own pocket.
Cash Flow - Money in less money out = cash flow. It doesn't matter why the money came in or why it came out. The difference of everything received and paid is your cash flow. This is different from NOI, it's more inclusive. Not all cash flow transactions are involved in computing NOI. For example, mortgage interest isn't included in NOI but it is included in cash flow. Capital expenditures also don't effect NOI but are included in cash flow.
It's important to understand that cash flow is what's hitting your pocket at the end of the day, but we want to report losses on taxes if possible. So, cash flow is independent of your tax position. The higher the cash flow, the better. If you see negative numbers, you must seriously look at your portfolio.
Discounted Cash Flow - As a real estate investor, you need to recognize that you're not just buying bricks and a roof, you're buying an income stream. Under the assumption you're a typical long term real estate investor (not a wholesaler or rehabber), you're looking at a series of cash flows over time, comprised of the total rents to be paid and the funds received at sale. By definition, these cash flows don't occur at the same time. Thus, the time value of money discussion must be had - money received in the future is less valuable than money received today. These cash flows must be discounted based on the amount of time that will pass until the cash is received. All of these amounts are added, and this is the total present value of all future cash flow. This is the amount that an investor could pay right now for the cash flow of this property.
IRR - The Internal Rate of Return could be considered the one metric that takes into account the timing and the size of all future cash flows (including the eventual sale of the property) and boils it down into one metric. Most agree that the higher the IRR, the better. However, many don't understand where it comes from. It's using the same present value logic from the discounted cash flows and changing the variable, the section below explains this.
With a PV (Present Value) calculation, we can reasonably estimate the future cash flows and we can discount them by a certain rate to decide their current value. IRR starts off at the same place, by estimating future cash flows, but instead of choosing a discount rate, we must use another variable. This other variable is the amount to be paid - or the amount the investor has decided to put into the deal. Now, what single rate actually describes getting all of those cash flows with all of that timing? Essentially you're finding the discount rate that says that the future value of the cash flows are worth the amount of money that I am committing to the property.
Based on the components of IRR, there are ways to manipulate the output. For example, you may increase the future cash flows. Inflating these projections is likely not prudent. The other way to change this figure would be to change the amount of money you are willing to invest in the property.
The software at realdata.com does these analyses, including the discounting and other more complicated calculations. Again, it's important to make sure your source numbers are accurate or your analysis won't paint the correct picture.
Frank also elaborates on these metrics and teaches on other areas of real estate analysis through his online video courses. He has offered a promo code for his video series! Visit learn.realdata.com and use promo code realcpa20.