All Forum Posts by: Frank Gallinelli

@Stephanie Dupuis and @Jessica Swingle Thanks for the kind words about my books. Keep it up and I may start believing my own press releases ;)

Just a quick side note about cap rates in general and in regard to multi-family properties in particular. First, the market cap rate that you want to apply to your projected NOI is a function of both the property type and the particular market in which the property is located. Don't expect to use same to rate for retail properties as you would for residential. Good ol' apples and oranges. Also, the rate that prevails for a particular type of property in one market may be very different from the rate in another market. Don't expect to use the same rate in East Tumbleweed that you would use in midtown Manhattan.

The size of the property can be an issue with multifamily. In general, cap rate analysis is appropriate for a property with more than four residential units, but I believe you will find that many appraisers put less emphasis on income capitalization with smaller buildings. They may be more likely to estimate value by comparable sales or even gross rent multiplier.

Finally, while income capitalization is usually an essential part of your how-much-to-pay decision process, it should not be the only part. I would always recommend a complete cash flow analysis and pro forma projection into the future. No matter what the appraisal may say, your real objective is to achieve a positive cash flow and an acceptable overall rate of return for the entire holding period, so your price and terms should be structured to achieve those goals.

We've had the opportunity to interact with thousands of investors and developers (been providing analysis software to those folks for 30+ years), and from that perspective I can agree completely with @Brian Burke. The typical income-property investor we talk to is looking for an IRR in the mid-teens, and certainly won't object to pushing near 20%.

Also, and as Brian suggests, that expectation is typically risk-adjusted. For example, when looking at a triple-net lease property with a credit tenant, most investors we encounter will accept a lower IRR; if the property presents some significant long-term risk, then they will generally expect higher -- and will generally be less tolerant of dicey cash flow projections.

Let me just chime in to agree with Ned. Definitely analyze the deal using market rents for the space that will be owner-occupied; and charge yourself rent. You want to be able to show a valid and credible rent history in the future when you go to sell the property.

Just wait until our friends in D.C. eliminate the capital gains rate entirely, so all profit will be taxed as ordinary income. Coming to a Congressional subcommitte near you.

Originally posted by J Scott:

Thanks for the book plug! Always appreciate hearing that someone found it useful.

Yes, to get a meaningful IRR you need to keep track of all the cash inflows and outflows. So if you have a development or construction loan with draws or if you infuse your own cash from time to time, then keeping track of amounts and timing should give you what you need. This is one of the situations where I think it's important to track cash movement on a monthly basis (annualizing is ok for long-term investment hold, but not so much for dev work). Just remember that your IRR calculation then is a monthly amount, and multiplying by 12 isn't quite right. I believe we wrote a user-defined function for our "On Schedule" dev analysis, but I think there is an XIRR function in Excel that will work.

@J Scott and @Joshua Dorkin -- Congrats on a great idea, providing this insider look at a real developer case. Case studies are an excellent way to learn and a very effective tool for bridging the gap between theory and practice. (Not just saying that to be polite -- and don't say what you're thinking, Josh. I rely on "invented" cases as a primary teaching tool for my grad students.) And J - as a numbers guy, I appreciate the detail and clarity or your exhibits.

Let me add just a sidebar thought about the calculation of profitability: Most investment decisions involve a choice. Unless you're blessed with unlimited cash, time and energy, you typically have to say, "I can do this deal today or I can do that one, but not both." Making that choice raises the issue of opportunity cost, sometimes referred to in development projects as "imputed interest."

In the development option, you typically commit cash on Day 1, but don't begin to earn any return until some future date. Your alternative might have been to invest your cash elsewhere where you begin to earn a return immediately. For the sake of argument and easy math, say Plan B is a rental property that earns a 10% / year return on your 30k. Bottom line is that your choice to go with the development project requires that you accept a 0% while you're developing, when you could have had a 10% return instead. Hence, the development project "costs" you an extra $3,000 per year to pursue because your cash is essentially dormant.

In this example, the opportunity cost is fairly small, but in many projects the up-front cost and length of time can represent a significant amount of lost return.

@Kelly P. Maintenance is an operating expense, whether you estimate ut as a dollar amount or a percentage of revenue.

Postscript to the general discussion: While capital expenditures and reserves do not affect NOI, they do (as I noted earlier) affect cash flow -- and therefore they also affect your IRR calculation.

With regard to reserves, if you put them into place on Day 0, when you acquire they property, they increase the amount of cash invested. Later, if you fund your reserve account from your cash flow, they obviously decrease your cash flow. Finally, when you sell the property, if there is a balance in your reserve account, that balance effectively adds to the proceeds you receive upon sale (your final "cash flow"). All of these events affect the timing and the amounts of cash that you must use to calculate your investment's IRR.

Bottom line: While capital expenditures and reserves do not affect NOI, they can have an important impact on the investment's overall rate of return.

@Glenn Espinosa and @Brian Burke -- Thanks so much for the kind words!

Hey @Brandon Turner Short answer: No

Capital expenditures, capital reserves (aka reserves for replacement) always go below the NOI line. Revenue minus vacancy/credit loss allowance minus operating expenses = NOI. If you subtract capital costs or reserves, then you distort the NOI and skew the valuation based on capitalized net income.

Like debt service, these capital items are subtracted below the NOI line in order to yield the cash flow.

@Aaron Mazzrillo I must respectfully, but vigorously, disagree with what you say about never meeting an investor who put together a deal using software.

My company has provided investment analysis software for 31 years and in that time we have known literally thousands of investors for whom a detailed and comprehensive financial analysis was key to their decision-making process and to their success -- and often to their avoidance of bad deals. We've seen it help beginners as well as experienced, sophisticated investors working with everything from a rental condo to a regional shopping center. We've seen it help investors secure financing, attract equity investors, and choose between alternative investments.

You are correct that in my industry, as in many, there are snake-oil salesman as well as those who simply provide products of poor quality or questionable value. A builder could buy a cheap power tool that breaks in a week, but that doesn't mean he wouldn't benefit from a good one. Hopefully, the fact that a company like mine can prevail for over three decades suggests there are software tools that offer genuine benefit to investors -- tools that indeed help them put deals together.