In this episode Jason reviews prediction indexes fr various markets and reviews the accuracy of predictions he’s made. Jason speaks with Frank Gallinelli of Real Data about longterm holding strategies versus going for quick profits.
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Jason is a genuine self-made multimillionaire, who not only talks the talk, but walks the walk. He’s been a successful investor for 20 years and currently owns properties in 11 states and 17 cities. This program will help you follow in Jason’s footsteps on the road to financial freedom. You really can do it. And now, here’s your host, Jason Hartman, with the complete solution for real estate investors.
Jason Hartman: Good afternoon, radio listeners. This is Jason Hartman and it is great to be here broadcasting from Glendale, California, KRLA studios. It’s about 80 degrees and sunny in Southern California. It’s a beautiful day. Welcome to the show, and just so I don’t forget, happy Mother’s Day tomorrow to all you mothers out there. Thank you for doing such a great job bringing us all up.
Had lunch last week with real estate consultant, John Burns. He is a very renowned consultant and publishes a fantastic email newsletter. One of them that I recently was looking at was his Housing Cycle Barometer and in it, he rates potential bubble markets, markets that are overpriced in comparison to history and markets where there is no housing bubble. And you know it’s really gratifying to see, for better or worse, I guess I should say, that all of the predictions I made and my group made at Platinum Properties Investor Network about a year and a half ago have really come true, whether it be in the California market or all over the country.
Just to give you an example, we predicted that the Southern California – well, really most of the California market – was a potential bubble. John Burns certainly agrees. On a scale of one to ten, ten being the most likely to be a bubble market, Los Angeles rates an 8.6. Several other California markets in there, Riverside-San Bernardino, 7.6; Orange County, my home, beautiful place, rates a 7.2, San Francisco, 7.1 and the most likely to be a bubble again; San Diego, 6.9.
And then you look down the list and, again, what we’ve been doing for our clients is helping them reposition their equity to safer, better cash flow oriented markets around the United States and you look at the end of the list, where it’s basically rated as no bubble at all, and you see Austin, Texas, very low on the potential bubble ranking, basically no bubble, 4.7. Houston, Texas, 3.2; Tulsa, Oklahoma, a new market for us that we just started investing in, 3.0; Fort Worth, part of the Dallas-Fort Worth metroplex, 2.9; Dallas itself, 1.9; Boise, 1.8. Salt Lake City, fantastic place to invest, 1.3, and Charlotte, North Carolina, I purchased there last year and that’s a 1.2.
Also, interesting article in the Wall Street Journal, April 26, Wednesday: “Housing Strength Shifts to New Markets – As the real estate boom slows on the coast, Texas and other overlooked area gain heat.” And this just talks about how there are very robust markets in Houston, Dallas, Atlanta, and then slowing markets in Boston, Miami, Los Angeles. Exactly what we predicted a year ago or about a year and a half ago, actually, so it’s gratifying to see that we’re doing the right thing. If you’re out there listening and you aren’t diversifying your equity now, if you’re not diversifying your savings, your mutual funds, into good, healthy, solid real estate markets, take advantage of that immediately.
We won’t have time to talk to you on the show today because it’s my pleasure to introduce a special guest. As you all know, I was in Morocco and Portugal a few weeks ago. I read a couple of great books on the trip. One of them was entitled What Every Real Estate Investor Needs to Know about Cash Flow and 36 Other Key Financial Measures by Frank Gallinelli.
Frank is our guest today on the show. Just to give him a little introduction, he’s founder and president of Real Data, Inc. His website is www.realdata.com. He is a software creator, and I purchased his software last year and it’s a fantastic tool in your real estate investing. It’s basically real estate industry’s leading investment software for individual investors. Frank is a graduate of Yale University and has been a very successful real estate investor since 1972. Welcome to the show, Frank.
Frank Gallinelli: Well, thank you, Jason. It’s a pleasure to be on here with you today.
Jason Hartman: The pleasure is all ours. Frank, in your book and in your talks, you talk a lot about the difference between investing in real estate for the longer term as opposed to speculating or what I call “gambling” for quick profit. Can you tell us more about that?
Frank Gallinelli: Well, yeah, first, let me say that a quick profit is not something I really have a problem with. People do it in the stock market every day, but you might even draw the analogy of the difference between a long-term stock investor and a day trader when you look at the difference between someone who is going to invest in real estate with the intent of building wealth over a period of time, as opposed to someone who thinks he or she is going to buy something before breakfast and sell it before lunch.
Jason Hartman: That’s not investing, is it?
Frank Gallinelli: No, that’s really speculating. That’s gambling. Sometimes you can make some very significant money, but it’s not really my idea of a plan for long-term building of wealth.
Jason Hartman: I agree. There’s a difference between luck and sound, prudent, long-term strategies. So are you saying that the holding period is really the point at issue here?
Frank Gallinelli: Well, when you think about investing, you really need to be thinking about a long-term commitment, so the holding period with, at least by my definition, true investing is typically longer. With real estate, I would say a three to seven year horizon is probably something that is realistic with most real estate investments. But it’s by no means – that’s not the only difference between investing and speculating.
I think the notion of going in and just trying to flip properties immediately is something that has become so much in vogue that individuals go and attempt to do this without really understanding the fundamentals of what makes real estate work. So they simply think – well, it’s kind of like becoming a case study in the Greater Fool Theory that it doesn’t really matter what I buy. I can just go out there and throw darts at the classifieds, pick up something, and somebody’s going to come along and give me more money for it and that’s my idea of an investment plan. Well, it’s not my idea of an investment plan.
Jason Hartman: But it’s some people’s idea and you know history tells us, Frank, that people that have followed that plan have been burned over and over again because there is not always a greater fool that will pay more.
Frank Gallinelli: No, when the music stops, sometimes things get ugly. And there are certainly markets that have become overheated where the speculators have been buying from and selling to each other. When they suddenly stop doing that and all run for the exit at the same time, some bad things can happen.
Jason Hartman: I completely agree with you. But when you look at the real estate trends out there in the markets, the rising and falling, do they all tend to operate the same way or what are the differences?
Frank Gallinelli: Well, I think one of the most important distinctions that a real estate investor needs to make for himself is the distinction between personal residence type of real estate and what is by my definition income property. A personal residence operates essentially as your own home does, where the market is what causes the value to rise and fall. And by the market, I mean the local market, which is governed by matters such as local employment, schools, property taxes, and obviously, more global issues, such as interest rates and the state of the economy in general.
So comparable sales are essentially the driving force there and it’s sort of a rising tide lifts all boats kind of scenario, where in a particular circumscribed market, if values are trending upward and you buy a particular piece of property in that location, you can really predict that values will trend upward. If they’re trending downward, same thing follows.
Income property is property that you wouldn’t buy for yourself or someone wouldn’t buy from you as a personal residence. This could be multi-family property. This could be small apartment buildings, small strip shopping center. It can be anything up to large commercial property, obviously. Not the sort of thing that someone’s going to buy as a personal residence and where the difference is with this kind of property is that its value will rise and fall strictly based on the income that it generates.
Jason Hartman: Okay, so let me ask you a question there, Frank. One of the reasons that we like and we teach in our seminars for our people to lean toward the residential investments – now, that doesn’t always work because if one has a lot of money to place, it just gets too hard to manage a bunch of small single-family homes or condos and so after you get to about 15 – 20 of them, I’ve got an aunt and uncle in Sacramento who own – I’m not sure of the exact number now – but almost 100 single-family homes, I believe, and they’ve been doing that for years and the management just gets to be very difficult. And so one has to sort of consolidate their management if they want to build a really large real estate empire, and look at large apartment buildings, shopping centers, etc.
But the one thing I love about residential real estate, and I know you’re the numbers guy and you’ve got a great book here, is that it’s almost not based on the income. So when you look at income for commercial property, it’s usually tied to what? The Consumer Price Index, right?
Frank Gallinelli: Well, that would be for indexing commercial leases. But the value of the personal residence type of residential property is not keyed to the rent income that it generates, the income stream that it generates. But that doesn’t mean that the buyer of that kind of property shouldn’t be concerned about doing the same kind of financial analysis that the buyer of an apartment building or a strip shopping center.
Jason Hartman: It’s amazing to me that investors think they’re being analytical numbers people as they should be. That’s good. It’s just a strange, instinctual thing, I think. When people look at a property, they think, oh, well, that’s a cute house. That’s not the way to invest.
Frank Gallinelli: No, it’s like buying a stock and saying isn’t that an attractive stock certificate.
Jason Hartman: Right.
Frank Gallinelli: No, that’s really not the approach to take by any means. But as I say, even if it’s not what I define as an income property, but rather a personal residence that you will happen to be renting out, you still need to do the numbers to say okay, I’m going to buy it at a given price. These are going to be my operating expenses. I’m going to have to treat it like an income property while I own it because it’s going to generate a cash flow. Whether it’s positive or negative remains to be seen, but you’re going to have money coming in. You’re going to be dealing with vacancy and credit losses. You’re going to be dealing with operating expenses and debt service, and ultimately, you’re going to be dealing with a final cash flow, which is the proceeds of selling that property.
Jason Hartman: Absolutely.
Frank Gallinelli: Now, even though that final cash flow is not going to be based as it would with a shopping center on its income stream, it’s still going to be the type of situation where you need to make your financial projection and say okay, here’s what I’ve got into it. Here’s what my cash flows have been as I went along. Here’s what I ultimately got out of it, so what kind of return did I make on that investment and does that return justify tying up whatever money I used to acquire the property and does that return justify the time that I spent to manage that property.
And that can become, obviously, a greater issue as you begin to accumulate more and more single-family houses, as you say, because of the management, then you obviously do not have the economies of scale if you have a 16-unit apartment building. You don’t have the management issues that you do with 16 separate single-family houses in different locations.
Jason Hartman: Absolutely. So when we get back from our break, we’re going to actually run the numbers, Frank, so let’s do that. Let’s take about a 90-second break right now and we will be right back.
Frank Gallinelli: Okay.
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Jason Hartman: Everybody dreams of financial freedom, but how do you actually live that dream? The Platinum Properties Investor Network has the answer, the wealth-generating power of real estate. Our five-step process is your road map to financial freedom. The first step is Education and Consultation. Step 2 is Financial Analysis. We are the only financial planning firm for real estate investors. Next, we identify outstanding opportunities and make it easy to buy properties. Fourth is Portfolio Management. And the final step, Wealth Accumulation and Asset Preservation. We’ve helped hundreds of real estate investors achieve wealth through real estate.
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Announcer 3: Where your opinion counts, News Talk 870, KRLA. More news, more traffic, more talk.
Jason Hartman: Welcome back. This is Jason Hartman. You’re listening to Creating Wealth. Just before we invite our guest Frank back on, just wanted to highlight a property as an example for you. This one is in the Salt Lake City metro area, Utah. It’s just incredible what someone on one of the coasts can do with their equity in terms of diversifying it, a projected rate of return of 46 percent, with only $8,950.00 down.
Utah’s home appreciation has in the past years been ranked the worst nationwide. Now, why am I mentioning that? Because it is really coming back. Prices rose an average of 13.4 percent in 2005. CNN Money in January of ’06 showed Salt Lake City as fairly valued. Employment growth in Utah has exceeded even optimistic expectations. Job growth in 2005 was 4.8 percent, well above the national average. Population is growing. There are just some phenomenal opportunities out there all around the country, and as I shared at the beginning of the show, a real estate consultant, John Burns, rated Salt Lake City very, very well and soundly in terms of the price perspective.
Okay, we’re talking to Frank Gallinelli, author of What Every Real Estate Investor Needs to Know about Cash Flow and 36 Other Key Financial Measures. Frank, welcome back.
Frank Gallinelli: Thank you.
Jason Hartman: We are going to run the numbers and look at some examples of how an investor can use the techniques in your book, in your software, and make sure that they reduce their risk and play it smart.
Frank Gallinelli: Why don’t we take two different types of scenarios, if I may, one where an individual is purchasing a strictly residential property, by which I mean a single-family house or condo, and for comparison, perhaps a small income property, such as a multi-family house or a small apartment building? Would that be okay with you?
Jason Hartman: Sure.
Frank Gallinelli: Okay, with the single-family house – first, with absolutely shameless self-promotion, let me say these kinds of calculations, if you use some of Real Data’s software, you’ll find that they allow you to do these calculations without having to stay up all night. But the first thing you’d want to do with a single-family house is to look at your projection of cash flow for each year of your expected holding period.
So let’s say that you’re planning to hold a property for five years. You’re going to start off with the gross scheduled income, which is how much money can I get for this property, assuming that I rent it at its maximum rent value? You’ll decrease that by a percentage, perhaps somewhere in the 3 – 5 – 7 percent, depending on your market, for potential vacancy or credit loss.
Jason Hartman: We usually estimate 8 percent vacancy.
Frank Gallinelli: Okay, well, here I am on the superheated, overheated Gold Coast, East Coast market.
Jason Hartman: That’s right, and you’re in Connecticut. We should mention that.
Frank Gallinelli: I’ve got a property that I’ve had for 30 years. I’ve had one vacancy.
Jason Hartman: Isn’t that great?
Frank Gallinelli: Mine’s a decimal point percentage, though.
Jason Hartman: That means you need to raise the rent.
Frank Gallinelli: Exactly. As I say in my book, if you never have a vacancy, you’re not charging enough rent.
Jason Hartman: That’s right.
Frank Gallinelli: I should take my own advice. Then you subtract out your operating expenses, such as property taxes, insurance, maintenance, lawn care, snow removal. You probably don’t have snow where you are.
Jason Hartman: We don’t worry about snow removal out here.
Frank Gallinelli: There you go. And that will get you down to something called a net operating income. Now, tuck that word away for a second. We’ll use that in our second example also.
Jason Hartman: That’s NOI, net operating income, a key measure used universally in real estate investing.
Frank Gallinelli: Right. And keep in mind that that number is calculated before you take any consideration of either your debt service, in other words, your mortgage payments, or any depreciation tax advantages. But you’ve got that NOI now and you’re going to subtract out your debt service, your mortgage payments, and that will leave you with a reasonable estimation of your cash flow. And you’ll want to project that out every year during your holding period and then ultimately, you’re going to ask yourself the big question, which is five years from now, six, seven, whenever I plan to sell this, what can I realistically expect to get for this property?
Now, again, if it’s a single-family house, you’re going to need to make that projection based on your understanding of what the overall market is for single-family houses in that particular community and how you think it’s trending. But whatever it is, selling price minus the financing, minus the commission and so on will be the proceeds of the sale of that property, and that is your final cash flow.
Now, what you want to do when you’ve got all these cash flows is to run a little software program to calculate what’s called the Internal Rate of Return.
Jason Hartman: The IRR. Now, Frank, is that the most final and most accurate indicator of a real estate investment, IRR, Internal Rate of Return?
Frank Gallinelli: It’s probably the most widely used. There are refinements that you can do, modified internal rate of return. It gets a lot more arcane than we need to get into in our discussion here, so, but essentially, that is the gold standard for rates of return, and the reason it is so important is that it takes into account not only the amounts of the cash flow, but their precise timing because how your overall return really calculates out is going to be different depending upon whether the return is a little bit more frontloaded, a little bit more back loaded; do I get bigger cash flows early, small or late, do I get small or early, bigger-late?
Jason Hartman: And so then you’re taking into consideration the time value of the money, right?
Frank Gallinelli: Absolutely. Exactly right. Time value and magnitude of money are dealt with essentially simultaneously to come down to a single rate of return measure and the beauty of this is that you can use an internal rate of return to look at a piece of real estate, to look at a bond investment, to look at a T-bill, to look at a
Jason Hartman: Any investment.
Frank Gallinelli: – stock investment. You can compare any two investments using the same kind of measure.
Jason Hartman: Okay, so go ahead. You were talking about the calculations, though.
Frank Gallinelli: Okay, well, that will tell you now does that rate of return justify what I’m about to do. If that rate of return looks like 4 percent, 5 percent, well, I don’t need to do that with a piece of real estate. I can go put my money in a T-bill and the Treasury Department will not call me in the middle of the night to tell me the toilet’s clogged up. So I’m not going to do that for a 4 percent return. I’m going to be looking for 10, 12, 15, 20 percent return on a piece of real estate to justify the risk and the work involved in being an investor.
Jason Hartman: So what is that number? A 25 percent rate of return, is that what you say justifies?
Frank Gallinelli: I say anything from maybe ten up to 20, something north of ten. Let’s put it that way.
Jason Hartman: Yeah, depending on what other rates pay at the time the person’s making the investment decision.
Frank Gallinelli: Exactly. You have to look at what competition there is for your money.
Jason Hartman: Sure, absolutely, and typically, when we project our deals out, Frank, we assume 6 percent appreciation, 8 percent vacancy. We have some other costs assumed in there as well. And nothing really seems to perform any worse than 40 percent because of the advantage of leverage and we just like using leverage a lot because it’s a great way to grow the investment faster.
Frank Gallinelli: Jason, one of the benefits of running the numbers as I was speaking of is that you can test different scenarios and look at the effects of greater or lesser leverage, so that, for example, if you find that there may be a tipping point where going too leveraged, the additional financing may be more costly than the investment justifies so that you back off that leverage a little bit to find where your optimal return occurs.
Jason Hartman: Absolutely. Frank, we’ve got to run. The time flew by. Just wanted to tell our listeners www.realdata.com is where they can get more information. Give us a call, visit our website, and join us for an upcoming event. Thank you for joining us today. I’m Jason Hartman and we will see you next week.
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Anyway, we’ll talk to you next week. Thanks for listening.
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Duration: 33 minutes
