All Forum Posts by: Frank Gallinelli

@Jason Abbott -- @Ned Carey has hit the nail right on the head. You need understand the market dynamics and to recognize that there are multiple metrics that can contribute to your final decision about a particular property -- and that some may carry more weight than others. For example, a low DCR (generally anything below 1.20) will probably be a serious red flag even if some other metrics look good.

Beware of locking in permanenetly to a target cap rate. Market cap rates are specific to a particular market at a particular time, and to a specific property type. Hence, what might be appropriate for apartment buildings might not be suitable for evaluating retail property, and might likelwise not be suitable for apartments in a different market.

Finally, re: the comment by @Lee Smith about switching from cash-on-cash. I recently wrote a 2-part series, "The Cash-on-Cash Conundrum."

http://www.realdata.com/blog/the-cash-on-cash-conundrum-part-1/ and

http://www.realdata.com/blog/the-cash-on-cash-conundrum-part-2/

I know a lot of people here swear by CoC, so excuse me while I go hide under my desk ;)

Frank

Exactly. That says it best of all.

Brad - Some very good points here, but please permit me to tweak your first statement, "The IRR is really just the cumulative cash on cash (CoC) return for the entire hold period... ."

IRR is sensitive to the interplay of the timing and the magnitude of cash flows. An example I use in my grad-school class is to show two properties, each with a 10-year hold, each requiring the same initial cash investment, and each having exactly the same cumulative cash flow (including proceeds of sale). With one of the properties I vary the size and timing of the cash flows -- keeping the total always the same -- and demonstrate that the IRR can differ dramatically from that of the first property even though the initial investment and the total cash returned is the same.

... and just a quick postscript in case I wasn't clear: You should be doing your own IRR/MIRR based on your own reconstruction of the data. I would not recommend putting any credence into the metrics provided by an interested third-party, such as the seller or broker.

@Jeffrey Kovnick Jeff-- Sorry if my book didn't provide a path to solve your problem, but allow me to add a couple of thoughts to the discourse here:

A couple of articles I've written recently might shed a bit of light on your question, in particular a 2-part series, "The Cash-on-Cash Conundrum."

http://www.realdata.com/blog/the-cash-on-cash-conundrum-part-1/ and

http://www.realdata.com/blog/the-cash-on-cash-conundrum-part-2/

As you'll pick up from those articles, I strongly favor comparing investment opportunities by doing a DCF analysis (i.e., IRR or MIRR) rather than a simple CoC. Taking the DCF one step further, I urge doing "best-case, worst-case, in-between" projections to give you a sense of a realistic range of possibilities.

Sorry also that you had to search for an IRR calculator. As you probably know, my company's commercial software can do very robust DCF/IRR/MIRR pro formas, but I also provided a free set of Excel-based calculators and worksheets for readers of my "...Cash Flow..." book. I'll let the proverbial cat out of the bag here for all of my good friends on BP. You can download it at

http://www.realdata.com/book/download.html

It's the top item on that page. It will give you very simple IRR, MIRR, APOD, annuity functions, etc.

Regards,

Frank

In regard to the ensuing holy war, I can only say...

Amen ;)

just a postscript, to clarify:

IRR is the discount rate that causes your NPV to equal zero.

With DCF Analysis, you apply what you believe is the appropriate discount rate and calculate the Present Value of the future cash flows. With IRR, you take it a step further and essentially calculate the rate rather than the PV. Whatever rate causes the discounted value of your future cash flows (including resale cash) to equal what you paid for those cash flows (your initial cash investment) -- in other words, whatever rate causes your NET Present Value to equal zero -- is your Internal Rate of Return.

It makes sense. You're weighing the value of what you get (accounting for both the timing and the amount of each cash flow) against what you paid to buy that income stream and finding what rate of return describes the whole scenario.

I have long been a proponent of doing thorough pro forma analyses of income-producing investments. I think DCF / IRR projections of best-case / worst-case / in-between scenarios are essential to making informed decisions. And I agree with Bryan that a lot of folks simply don't understand these metrics or are apprehensive about the math.

I've got a couple of recent articles where I discuss in detail why I think this type of financial analysis is important, and the issues I see with some of the short-cut alternatives. If you care to read them, here are the links:

The 50% Rule vs. Discounted Cash Flow Analysis

The Cash-on-Cash Conundrum, Part 1 and Part 2

I think you're probably right about human nature. Everyone would love to find the silver bullet, magic wand, or secret sauce.

Anyway, this discussion has prompted me to write an article on my company blog about DCF vs 50%.

And thanks for the kind words about my books. I'm thinking it may be time for another.

@Thierry Van Roy The "pupil" gets an A+ for hitting the nail on the head ;)

I may not be old enough to have discovered fire, but having done this kind of analysis for more than 40 years might qualify me as the ur numbers guy. And so I'm especially glad to see you encourage others to do the kind of financial work-up that I think is essential to making informed investment decisions.

Sadly, I find too many investors dismiss the importance of doing a Discounted Cash Flow Analysis and opt instead for very simplified (and dare I say sometimes too simple?) approaches. Those techniques may suffice for smaller properties, but when one gets involved with larger residential or just about any size commercial investment, I don't see how you can commit a serious amount of cash without performing such an analysis as part of your decision-making process.

I know I'm repeating myself from former posts, but I believe the process should go something like this:

a) Careful due diligence to determine current and likely future revenue stream, operating expenses, capital costs, and financing for the particular property; as well as investigation of market data regarding prevailing rents, vacancy levels, cap rates, and general economic trends.

b) Next, using that data to project current performance along with best-case, worst-case, and in-between future performance. This is where you start to take the investment's vital signs: Is the cash flow adequate, is the debt coverage ratio strong enough to secure financing, etc?

c) Using the projections not only to make a decision about an appropriate price to pay or to sell for, but also using the DCF to demonstrate (i.e. "sell") your reasoning to other parties involved in the transaction -- to the seller if you're the buyer, the buyer if you're the seller; the lender; or your potential equity partners.

Let me take this a step further, and bring up a point that is a big part of the grad-school course I teach. It is essential to run the numbers and to do so as reasonably and realistically as possible, but then you have to look for the story that may lurk behind those numbers. Why are the operating expenses or the current vacancy level higher or lower than you might have expected? The revenue figures may be accurate, but how strong are the tenants? -- in other words, is the revenue stream sustainable? Or perhaps, could you re-lease the property to stronger tenants in the future, creating a greater income stream and a higher value?

Running the numbers in a DCF is essential, but it's not just about what the numbers are; it's about what they can tell you.

In short, I don't believe in shortcuts, such as taking the rent roll and knocking off 50%. Buying and operating an investment property involves commitment, and that should start with a thorough financial analysis.