All Forum Posts by: Frank Gallinelli

Mark - @Denise Evans (hello Denise! -- so glad to reconnect) is spot-on in her explanation of the income-property pro forma -- especially her emphasis on the need for "best case," "worst case," and "most likely case" scenarios, which implies that you are reconstructing the seller's representations (as suggested by @Andrew Syrios), not swallowing them whole.

In regard to development pro formas, I might add that our approach has been to produce month-by-month projection of the project's cash inflows and cash outflows (including loan draws and repayments), along with monthly estimates of project absorption.

Mark,

You have a asked a very important question -- actually two questions: What, really, are operating expenses, and how to you find them out?

Let's start with the first part. As the name implies, operating expenses are the costs that are necessary to operate the property on an ongoing basis.  These will include items like insurance, property taxes, repairs, maintenance, and management. They will not include the costs of mortgage financing or capital improvements, neither of which is necessary for the operation of the property.  

When you have the sum of those operating expenses, you will subtract them and an allowance for vacancy and credit loss to get what is called the Net Operating Income (NOI). NOI is a critical metric for real estate investors, because it is used by appraisers to estimate the current value of the property, and by lenders as part of their mortgage underwriting. That's why it's important to know what you should and what you should not include as an operating expense. Debt service and improvements will affect your cash flow, but they do not affect your NOI.

Now for the second part. Where do you get the data? You'll start with the expense data provided by the seller or the broker, but you will not assume that this information is necessarily accurate or complete.  After you collect that data you will do what is called "reconstructing the owner's statement," which is a polite way of saying that you will start with what you've been given, then try to get closer to the truth by verifying everything you can and rebuilding that statement if necessary.

First you need to fill in what the seller or broker has simply failed to include. I've seen many listings which were obviously incomplete in terms of the costs that an owner would encounter in real life. One of my favorite examples: Let's say you're looking at a building in Boston, and the broker doesn't mention snow removal as an expense. Perhaps he or she was hoping you wouldn't notice that six-foot mound of slush.

You can confirm some costs independently, such as property taxes, insurance, and, in some locations, utility costs. Many investment properties are held in LLCs; try asking for a copy of the tax return (tax ID redacted). Certainly ask to see current leases to verify the revenue. 

Obviously, this is an abbreviated answer to your question, but perhaps the most important point is this: Due diligence is critical to successful real estate investing. Don't give it a quick pass, and don't be reluctant to push for documentation and answers.

Frank

Kyle -- This looks like a Quickbooks P&L, which is fine, but it is not what a real estate investor uses, which is called an APOD (Annual Property Operating Data).  The bottom line of the APOD is Net Operating Income, and it's the word "operating" that matters most. 

Strictly speaking, an APOD is not an accounting report. Costs that are not part of the operation of the property, therefore, are not relevant. So, you should not be taking any costs of financing into account and should not be looking at depreciation, either.  Neither of these is part of the operation of the property (i.e., you don't need a mortgage or a depreciation deduction to "operate" the property).  On the other hand, you should be subtracting an allowance for vacancy and credit loss from the gross income. Bottom line with this approach is the Net Operating Income.

The reason that it is important to follow these protocols is that the market cap rate you'll find in regard to other properties sold followed the same inclusions/exclusions. For your estimate of value, by capitalization of the NOI, to be relevant, it's essential that you follow the same.

Apples to apples, and all that.

This is a great discussion and a really important topic. 

Sooner or later the roof, the HVAC system, the water line, or some unimagined but vital component will give out. So many investors, trying to operate on a shoestring, set themselves up for an inescapable big hurt, faced with an emergency but with no funds set aside to deal with it.

Sidebar note: I wrote an article about a month ago on this topic, "Reserves for Replacement and Income-Property Investing." If interested, you'll find it on my blog http://goo.gl/lcmUHh and also on LinkedIn (with a different title, but same article) http://goo.gl/P8mGv0

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Thanks

--- Frank Gallinelli

Hi Tal --

You are correct that the IRR is the discount rate that causes the NPV of all cash flows to equal zero.

Regarding the difference between cap rate and IRR: You are also correct that the cap rate looks at a property's performance at a given point in time. This is why a commercial appraiser might prefer to capitalize the current year's NOI in order to estimate value, because he or she is trying to give an estimate of value as of a specific date.

IRR, on the other hand looks at the income stream over time. It might relate to the purchase, NOI, and gross selling price (so-called unlevered IRR); or it might use the cash invested, the after-debt-service cash flow, and cash proceeds from sale (so-called levered IRR).

It is worth knowing the capitalized value of the NOI since that presumably is what the property is "worth" today, and it is the value on which a lender will probably base financing. However, from the investor's perspective, it is even more important, I believe, to keep in mind that you are not investing for a point in time but rather for a longer term. For that reason, you want to develop some sense of how the investment will perform over the entire period you wxpect to hold it.

You may be able to anticipate the ebb and flow of your future NOI or cash flow within some reasonable range and thus perform an IRR calculation over your expected holding period. (For example, you property may have commercial leases with pre-defined step increases; or you may expect loss of revenue at the end of a lease term while you re-fit a space and seek a new long-term tenant). I always recommend using best-case, worst-case and in-between set of assumptions to decide in you can accept an investment that performs somewhere within that range.

Shorter answer: Income capitalization and IRR are different, but both are important. One seeks to establish a market value at a point in time, the other to give a sense of the investment's performance over the entire holding period. Ultimately, as an investor, I think the IRR has to trump the capitalized NOI -- in other words, if the property seems unlikely to meet my rate-of-return goal at the presumed current market value, then I want to find the value at which it WILL meet my goal.

Frank

thank you!

Thank you, Jonathan!

From comments received and conversations held with fellow BP’ers I know that many of you have read my books. I have tried to thank as many of you individually as possible for your kind remarks, but please allow this to to serve as my blanket expression of gratitude.

Despite what they may have told you in your high-school health class, the composition of the average author is actually 10% water and 90% ego. So, every time someone tells me something like, “Now I finally understand what investment metrics mean,” or “You helped me make/avoid a really big deal/mistake,” I spend the rest of the day in float mode, with the closest thing to a beatific smile that could possibly cross my less-than-matinee-idol mug. Writing is a pretty solitary endeavor, and knowing that what one wrote actually made a difference to someone is — to use my grandson’s expression — awesome.

Now, about that favor…

If you are indeed one of those folks who has read one of my books, may I if you would be willing to segway over to amazon.com and post a review -- good, bad, or indifferent. Reviews are the lifeblood for any author. If you actually found the books helpful then you’ll certainly be doing a good deed for me, and perhaps even for other new investors coming up through the ranks.

You can locate the books’ pages on Amazon by searching for my name. Fortunately it’s uncommon; fyi, I’m not the guy who wrote the ebooks on Swiss politics. Really.

I realize, of course, that we’re all too busy, so no worries if you can’t do this. If anyone, I should recognize the challenge of cranking out a paragraph on demand.

Thanks — and wish you successful investing every time,

Frank Gallinelli

@Amy Arata You're very welcome ;)