Understanding IRR Calculations in Frank Gallinelli's book

[Justin Greenwood]

Hello Everyone,

I've learned a lot from Frank Gallinelli's "What Every Real Estate Investor Needs to Know About Cash Flow," however, the Internal Rate of Return concept is still a little confusing to me.

In this book there is a case study in chapter 6 that considers an "Apartment Building Investment" (pgs. 108-120). I have worked through all the categories (i.e. "NET OPERATING INCOME," "CASH FLOW BEFORE TAXES," "PROJECTED SELLING PRICE," and "BEFORE-TAX SALE PROCEEDS") and have the EXACT same numbers that Mr. Gallinelli has in the book. When I try to figure out the "Internal Rate of Return, Before Tax", however, my answers are WAY off.

Would someone who has read this book PLEASE help me understand how Mr. Gallinelli came to the IRR projections that he did?

Thank you in advance!

[Llewelyn A.]

@Justin Greenwood

Hi Justin. Don't worry too much, it really takes a long time to really understand how these complex calculations work.

But once you do, you will finally understand how to invest in ANY market, whether or not it's in NYC or Buffalo!

What's even more is that using the IRR, you can also then make comparisons to a whole lot of other types of Investments.

To answer your question, however, please refer to this snapshot:

Rather than calculate the IRR for each and every year, I just decided to calculate the 5 year IRR for the numbers you type out in your last post.

You really should split it out as I have done in this spreadsheet.

First, make a column only for the Buy/Sell, or as I put it, Appreciation.

When you buy the Investment, you paid $323,472.

Noticed you PAID for the investment.

Most people don't really understand Cash Flow so they don't understand that Cash Flow is really just a direction of how cash is flowing.

You need to first pick a reference point and then you can figure out how to properly put a sign on the Cash Flow.

In this case, we have a Cash Flow of $323,472.

HOWEVER, we need a reference point. That reference point is your pockets.

$323,472 leaves your pockets to buy the Investment. THEREFORE, the $323,472 is a NEGATIVE Cash Flow relative to your pockets.

The way I like to put it, how do you feel when money leaves your pocket? NEGATIVE!

So year Zero, your very first Cash flow is a NEGATIVE $323,472.

If people understood that every investment that they BUY starts out NEGATIVE, then they wouldn't be so hung up about Negative Cash Flows. I am hoping that the readers of this post will just try to understand that Negative Cash Flows are just numbers you put into a Calculation and that you should put more emphasis on the Assumptions and the Results. BUT HEY... that's just me explaining it.

NEXT, we know that in year 5, we sold the investment for $541,310. Money goes into your pockets then, so it's a positive cash flow.

That's the explanation of Column B.

Next, we need to know all the cash flows for all the years you held the investment, which is the next 5 years.

During that time, you received the cash flows as according to Column C.

We then total up all the Cash Flows in Column D.

NOW, we are ready to do the IRR Formula!

Here is the snapshot of the same spreadsheet, but with the IRR formula revealed:

So you can see, Excel Calculates the IRR for that 5th Year as 19.24%... very slightly off from Gallinelli's 19.25% for year 5. We should ask Frank to correct that! haha! Just kidding.

Either case, doing the calculations is just one part of it.

What Gallinelli does is explain the long and hard work that goes into doing the calculations so that you can get a very clear vision on the future of your investment.

Once you get this vision, you will clearly know if this is a good investment or not. And even more, that you can do the same IRR to other properties or even a stock investment. It's really all about cash flows.

What you also need to get a really good understanding is what does that 19.25% IRR really mean?!

It's actually a fantastic number! It sort of means that if you put your money into a savings account for 5 years, the interest in your savings account will be 19.25% per year for 5 straight years!

Even this doesn't really tell you how powerful 19.25% Compounded IRR really is! Because it's a compounded calculation, it can turn a small investment into a very large one over many years! Well.. in my case, 21 years! haha!

It's not an exact comparison, but it's close enough. There are some discrepancies in regards to the time value of money and I'm hoping you will go over the book to get a really good feel for it.

Once you understand all of these concepts, you will really understand investing.

There is a lot that goes into the projections, however.

Keep in mind that once you start thinking of the future sale price and the future cash flows, you start to think, HEY......... I BETTER GET A GOOD UNDERSTANDING of the FUTURE.

Well... how do I do that?! Time to study Economics and pay very close attention to it.

To emphasis this point, think of a scenario where if you didn't follow the economics, things would have turned out VERY bad.

Take Investing in Detroit before it went bankrupt.

10 to 20 years before Detroit went Bankrupt, there were very clear economic signs that domestic autos were in trouble. Detroit was 90% dependent on Domestic Autos.

If you followed the Charts on Ford, GM and Chrysler, you would have seen that they were declining for an awfully long time. There were plenty of signs that said RUN! Get away from here!

So even if your numbers for all the calculations were GREAT for year ONE, by the time Year 10 came, you would have lost a lot of money.

This is the BIG problem I have with these single year calculations like Cash on Cash Return. You make one calculation based on todays number and BAM... you pull the trigger. No thoughts on the future. No Economics, no Nothing. Everything based on knowing the Rents, Expenses and your investment money. WOW.... really? That's all you need to know?! I'm always shocked that's how people do it.

To me, that's just throwing darts on a board and hoping it will stick on something that will make money.

Learn the IRR. Understand the Assumptions that go into it and then you'll understand the importance of getting out your economics crystal ball.

My Partners and I invest in NYC for the last 21 years. Our Crystal Ball energized by Economics and armed with the IRR calculations told us to buy here in NYC despite all of the bad advice given to us that it's too expensive.

We've heard that same comment for the last 21 years and we will hear it again for the next 21 years.

I don't pay attention to Gurus, Posters or anyone else.

I only pay attention to the Economics and the IRR.

You can only imagine how much we made owning NYC properties over a 21 year holding period, accumulating 8 multi-family buildings.

It has been phenomenal!

You are on the right track.

The book you have should have been on the best seller's list but it won't because most people don't want to work too hard to understand more sophisticated calculations. I wish those people good luck with that.

Hopefully I helped explain the numbers for you!