Frank Gallinelli has been involved with income-property investments for more than 40 years. In the early 1980s he founded the software company RealData to produce programs to help real estate investors and developers evaluate prospective deals.
In the updated edition of What Every Real Estate Investor Needs to Know About Cash Flow . . . And 36 Other Key Financial Measures, Frank has added detailed investment case studies while still keeping the critical essentials that make the book an important read for serious rental property investors.
Key Takeaways / Lessons Learned
Learning to invest in real estate is similar to learning to play golf, choosing the best car to buy, or the right spouse to marry. Instead of trying to guess how the game is played, you need to understand the basics.
In investment real estate, measurements such as rates of return, cash flows, and value estimates are just a few of the things investors need to know to avoid making big, expensive mistakes. Sometimes rental property appears to be a cash flow cow, but once you examine it you’ll discover it’s about to run dry.
In What Every Real Estate Investor Needs to Know About Cash Flow . . . And 36 Other Key Financial Measures, Updated Edition you’ll learn about important investment fundamentals such as:
- Estimating the current and future value of investment real estate
- Reading between the lines to discover why the seller is really selling his property
- Forecasting revenue streams, expenses, net operating income, and cash flows – before you invest
- Using the “time value of money” concept to help make the best investment decisions possible
- Comparing investment opportunities “apples to apples”
- Calculating financing, rates of return, potential tax liability
- And much more . . . .
Here’s a quick overview of some of the most important lessons learned.
What are successful investors really buying?
Many people would say that real estate investors buy real estate, such as a single-family house, small multi-tenant property, an office building, or a neighborhood shopping center. Unfortunately, most people would be wrong.
The fact is that the real, physical property is a secondary issue. What successful investors are really buying when they invest in real estate is anticipated economic benefits of the property. In other words, they’re buying the income stream the property generates.
Of course, there are physical attributes that make one property generate more income than another one. The floorplan of the property – such as 2-bedrooms vs. 3-bedrooms – or the location in a market where jobs are growing and the demand for rental property is stronger are just two examples of how the property itself can affect the income stream.
However, the prudent investor buys based on the anticipated return on investment. Decisions on whether to buy, hold, or sell are based on the:
- Income stream
- Return on investment (ROI) that the income stream represents
By thoroughly analyzing the current financial data and making reasonable projections of how the property will perform in the future you can easily determine what makes one property a better investment than another.
Making money in real estate: four basic investment returns
Everything discussed in the book revolves around the four basic elements of return that are part of any income property:
- Cash flow
- Loan Amortization
- Tax shelter
The book notes that because every piece of property is unique, the blend of these four basic elements will always be different, and some investments may lack one or more.
Earlier in this review we used the term “cash cow.” A rental property that throws off a lot of cash may not appreciate very much, but what it lacks in market value increase it makes up for in cash flow.
On the other hand, income property that has a lower level of cash flow may be an excellent tax shelter after depreciation expense is used to reduce or even completely eliminate net taxable income.
Here’s a deeper look at how these four basic investment return elements work:
Doing the math on cash flow is pretty simple:
- Cash Flow = Cash In minus Cash Out
Calculating cash flow is just like balancing your checkbook. Even though the calculation is simple, the impact of cash flow is of major importance for real estate investors.
Unless you’re a “too big to fail” mega corporation, negative cash flow is much more than just an accounting entry. If the property isn’t generating enough money to pay the bills, you’ll have to contribute funds out of your own pocket to make up the difference.
It’s not unusual to have negative cash flow from a rental property every now and then. If you’ve thoroughly crunched the numbers and determined the property is a good investment, you can take negative cash flow in stride. However, investors who become overly optimistic by letting their emotions guide the decision-making process can easily end up getting blindsided.
While cash flow is the #1 way investors profit from rental property, appreciation is #2. Every buyer hopes the market value of their property will rise over time.
The formula for calculating appreciation is just as easy as calculating cash flow:
- Appreciation = Future Resale Price minus Original Purchase Price
While cash flow is comparable to having a checking account, appreciation is more similar to having a savings account.
There are two important questions to ask about real estate appreciation:
- How much does the market value or appreciation grow?
- How much time does it take for the property appreciation to increase?
But what drives property appreciation in the first place? The answer is revenue. In general, the greater the net revenue is (after operating expenses) the more valuable the property will be. That’s because the main reason for buying investment real estate is for the income the property produces.
Using a mortgage loan to purchase an income property is like letting someone else pay your bills. With conservative leverage, you have more personal funds to invest in additional property while using rental revenue to pay the property’s operating expense and debt service.
Loan amortization is the liquidation of debt by the application of installment payments over time. In Latin, the word “ad” means “toward”, and the word “mort” means “death.” So, by using loan amortization you’re killing off the loan over time.
The formula for loan amortization is as simple as the formulas for cash flow and appreciation:
- Amortization = Debt Service (or mortgage payment) minus Interest Paid
Although a mortgage is normally paid monthly, investors usually look at income property data on an annualized basis. That’s why when you look at a proforma income statement, you’ll normally see the term “ADS”, which is an acronym for “annualized debt service.”
We’ve all heard of real estate investors who are very wealthy, but who pay very little money in taxes. They’re able to minimize their taxable income by using rental property as a tax shelter.
After paying for the normal operating expenses of a property from the revenue it generates, there are two more deductions to make:
- Mortgage interest deduction
- Depreciation deduction
Even though your tenants are really paying for your mortgage as part of their rent, the IRS allows you to deduct the interest expense part of your mortgage.
Depreciation is a non-cash deduction you can take because the IRS assumes that your building (excluding the value of the land) wears out over a certain period of time, even though the market value of the property may be increasing due to appreciation.
Once again, the math for calculating the potential tax shelter benefits that a property provides are straightforward and is done in two steps:
- Net Operating Income = Income minus Operating Expenses
- Taxable Income = Net Operating Income minus Mortgage Interest minus Depreciation
How to be a financial detective
One of the very real risks that real estate investors face is buying the seller’s problem or mistake. A property may appear to be generating solid cash flow, but the question a buyer needs to ask is how strong the cash flow will be, and for how long, after he purchases the property.
What Every Real Estate Investor Needs to Know About Cash Flow lists several ways an investor can be a “financial detective” to discover why the seller is really selling:
- Property related data such as information about income and expenses
- Read the actual lease
- Review the property tax bill, noting when the property is scheduled to be reassessed
- Spot-check utility bills
- Look at the appropriate sections of the seller’s tax return that are related to property you are buying
- Recite the representations about the lease and schedule of rental income in your written offer to purchase
- Investigate market-related data such as comparable sales, lease rates and operating expense data, and going capitalization rates for similar property in the same market
As the preface to What Every Real Estate Investor Needs to Know About Cash Flow . . . And 36 Other Key Financial Measures, Updated Edition notes, there are three potential outcomes when you invest in income-producing property:
- You can make a lot of money
- You can make a little money, but could have made a lot by being better prepared
- You can lose money in real estate when you could have made a great deal
Some beginning investors make the mistake of thinking that real estate is a “no brainer” and that nothing can go wrong. The fact is that there’s plenty of things that can go wrong when you’re buying real estate if you don’t do it the right way.
Real estate investing is a numbers game, and this book will show you exactly how to do the numbers and what they really mean.
Part I: How to Analyze a Potential Real Estate Deal
- Do Your Homework: How to Gather the Data Needed to Make an Investment Decision
- Financial Detective Work Before You Buy: Finding the Truth Behind What the Seller Is Telling You
- How the “Time Value of Money” Should Influence Your Real Estate Investing Decisions
- How to Estimate What an Income Property is Really Worth
- Measuring the Return on a Real Estate Investment
- Case Studies: Apartment, Mixed-Use, and Triple-Net Lease
Part II: Thirty-Seven Calculations Every Real Estate Investor Needs to Know
- Simple Interest
- Compound Interest
- Rule of 72s
- Present Value of a Future Cash Flow
- Gross Rent Multiplier
- Gross Scheduled Income
- Vacancy and Credit Loss
- Gross Operating Income
- Net Operating Income
- Capitalization Rate
- Net Income Multiplier
- Taxable Income
- Cash Flow
- Cash-on-Cash Return
- Sales Proceeds
- Discounted Cash Flow
- Net Present Value
- Profitability Index
- Internal Rate of Return
- Price, Income, and Expenses per Unit
- Price, Income, and Expenses per Square Foot
- Operating Expense Ratio
- Debt Coverage Ratio
- Break-Even Ratio
- Return on Equity
- Loan-to-Value Ratio
- Mortgage Payment/Mortgage Constant
- Principal Balance/Balloon Payment
- Principal and Interest per Period
- Maximum Loan Amount
- Assessed Value, Property Taxes, and Value Indicated by Assessment
- Adjusted Basis
- Gain on Sale
- Land Measurements
- Building Measurements
Best chapter for using the time value of money to your advantage
Chapter 3 of What Every Real Estate Investor Needs to Know About Cash Flow discusses two key investment concepts – time value of money and discounted cash flow - that at first glance may seem complicated. But they are actually very easy to understand, calculate, and use to your best advantage.
Most people are familiar with the concept of “compounding.” For example, if you have a $10,000 investment that grows at an annual rate of 12%, your money grows by 1% each month:
- Month 1: $10,000 x 1% = $10,100
- Month 2: $10,100 x 1% = $10,201
- Month 3: $10,201 x 1% = $10,303.01
- Month after month after month . . . .
Compounding in real estate works the same way. The $10,000 is PV or present value, the periodic interest rate is 12%, the number of compounding periods is 12 (months per year), and the ending balance is FV or future value.
For example, let’s say you’re thinking about buying a single-family rental house with a current market value of $100,000 and want to keep the property until it doubles in price. So, the question is, how many years will it take for the house value to appreciate from $100,000 to $200,000 if the average appreciation rate in the market is 3%?
- PV (present value) = $100,000
- Periodic rate = 3%
- FV (future value) = $200,000
- Periods = ?
When you know three of the four variables, you can solve for the fourth. There are several approaches you can take to get the answer, including using a spreadsheet program template, a financial calculator, or using the formula:
- Periodic interest = (FV / PV) (1/N) – 1
No matter which method you choose, the answer is 23.45 years. So, a house purchased for $100,000 in a market where the average annual appreciation is 3% would be worth $200,000 about 23 ½ years from today.
You can also use the same formula to calculate the present value of a property’s cash flow, or the time value of the money. Money received at some point in the future is worth less than money received today for two reasons:
- A dollar received five years from now loses some buying power
- You can’t put money to work that you don’t have cash in hand today
Discounting the cash flow is a way of measuring the loss of value caused by the deferral of the return. Investment real estate normally generates two different returns, each of which require their own discounting: 1) Annual cash flow after the operating expenses and debt have been paid, and 2) Sales proceeds from when the property is sold.
Let’s assume you’re buying a rental property with the following cash flows that you expect to sell for a net profit of $100,000 five years from now:
- Year 1: $9,000
- Year 2: $11,000
- Year 3: $11,500
- Year 4: $12,500
- Year 5: $115,000 (year 5 cash flow + net profit from sale)
You know that you can earn 10% from similar properties with similar risk. The next step is to discount the cash flows received over the next five years to see what they would be worth if you received them today:
- Year 1: $8,181.82
- Year 2: $9,090.91
- Year 3: $8,640.42
- Year 4: $8,537.67
- Year 5: $71,405.95
The value total of these discounted cash flows is $105,856.77. If you can buy the property for $90,000 today, you would have a net present value (NPV) of $15,856.77 and your rate of return is higher than the 10% discount rate you used.
Best chapter for knowing if what you’re buying is really worth the price
Although they may sometimes appear to be at odds with one another, buyers, sellers, and lenders have at least one thing in common. They want to know what a property is really worth.
Chapter 4 of What Every Real Estate Investor Needs to Know About Cash Flow explains how the value of a property is determined by the numbers.
The first number to consider is NOI or net operating income, which is calculated by subtracting operating expenses from gross operating income. NOI is essential to understanding the market value of an investment property. That’s because market value is a function of a property’s income stream, and NOI is at the core of the income stream.
Cash flow before taxes and taxable income (or loss) are two natural extensions of NOI, although the bottom line numbers will be different. One branch leads to taxable income, while the other goes to cash flow.
Cash flow before taxes is calculated by subtracting the cash expenses of debt service and capital expenditures from NOI. On the other hand, taxable income or less is determined by subtracting interest paid and the non-cash expenses of depreciation and amortization from NOI.
Finally, by subtracting the amount of income tax paid based on the individual tax bracket, we arrive at cash flow after taxes. Taxable income can be positive or negative. Negative CFAT (cash flow after taxes) creates a negative tax liability which can then be used to shelter other earnings from other sources.
Best chapter for measuring returns
In Chapter 5 of What Every Real Estate Investor Needs to Know About Cash Flow . . . And 36 Other Key Financial Measures, Updated Edition, Frank Gallinelli looks at several methods to measure the success of a real estate investment:
- Cash-on-Cash Return is a popular method of measuring return, but doesn’t tell you if the cash flow is strong or weak
- GRM (gross rent multiplier) is a basic way to evaluate income property by dividing the property market value by the gross scheduled income then comparing the GRM ratio to similar properties in the same area
- DCR (debt coverage ratio) divides the net operating income (NOI) by the annual debt service to show how much net income is left over after the mortgage debt has been paid
- Derived Capitalization Rate breaks the traditional cap rate calculation (Cap rate = NOI / Market value) into two components: financing and equity to obtain a weighted average or derived cap rate
- IRR (internal rate of return) is the discount rate based on the present value of future cash flows and is superior to other measures of investment quality because it takes into account the magnitude and timing of every cash flow
Frank Gallinelli recommends investors run the IRR numbers for a variety of holding periods. Then, look to see if there is one year where the IRR peaks. If there is, that’s the year to sell in order to maximize your return. If not, then there’s no optimal holding time, meaning you can sell whenever you choose to.
Highlights from Part II: 37 real estate calculations
When you know how to crunch the numbers in real estate your chances of investing success significantly improve and to a large degree you’ll be able to control the results of your investment.
Part II of What Every Real Estate Investor Needs to Know About Cash Flow . . . And 36 Other Key Financial Measures, Updated Edition lists and explains in an easy to understand way the 37 real estate calculations that every income property investor needs to know, including:
Rules of 72s
Used to calculate the approximate number of years for an investment to double in value based on a specific compound rate of interest:
- Number of years to double in value = 72 / Rate of growth
So, if a property is purchased for $100,000 and the rate of growth in the market is 8%, the market value of the property will double to $200,000 in approximately 9 years.
Present value of a future cash flow
Choosing the right discount rate can be the most difficult part of calculating the present value of future cash flows.
One way to think about the discount rate is by asking yourself how much you should be compensated – in other words, how large the discount rate should be – for undertaking the risk of making the investment.
Everything else being equal, your discount rate should be the rate of return you reasonably expect by investing the same amount of money in a similar investment posing a comparable level of risk.
BER (break-even ratio) – sometimes called the “default ratio” – is a benchmark used by lenders when they underwrite mortgages on investment property. The purpose of the BER is to estimate how vulnerable a property is to default if the rental income declines:
- BER = (Debt service + Operating expenses) / Gross operating income
As a rule of thumb, most lenders look for a BER of 85% or less. In markets where occupancy rates are heading lower, the revenue stream is going down as well. Since part of the revenue stream is used to service debt, lenders may look for a break-even ratio of less than 80% due to the additional potential risk of default.
Is the Book Worth Reading?
Recent reviewers of What Every Real Estate Investor Needs to Know About Cash Flow . . . And 36 Other Key Financial Measures use the words “brilliant” and “priceless,” and for good reason. Here are some of the positives and negatives about the book, although criticisms are very difficult to find.
Positives about the book
- Zero fluff or get rich quick schemes
- Explains difficult concepts in an easy to understand way
- Great book for “late blooming” real estate investors who can’t afford time to learn from their mistakes
- Amazing tool for anyone who is serious about understanding real estate finance and cash flow
Negatives about the book
- Some readers feel the book discourages the use of a real estate agent
- Book may not format properly for some e-book readers
What Every Real Estate Investor Needs to Know About Cash Flow . . . And 36 Other Key Financial Measures, Updated Edition discusses critical aspects of income-producing real estate investments such as:
- Discounted cash flow
- Capitalization rate
- Net operating income
- Profitability index
- Net present value
- Cash-on-cash return
- Internal rate of return
- Return on equity
The book is highly recommended for both beginning real estate investors who want to hit the ground running and for seasoned investors looking for a refresher course before doing their next deal.