BiggerPockets Podcast 004 with Frank Gallinelli Transcript
Link to show: BP Podcast 004: Commercial Real Estate Investing with Frank Gallinelli
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Josh: Hey Everybody. This is Josh Dorkin with Biggerpockets.com here with yet another great show for you. I’ve got my co-host Brandon Turner with me. Hey Brandon.
Brandon: Hey Josh. How’s it going?
Josh: Not too bad, not too bad. Of course today we’re very excited to bring to you one of the greats in the business, a guy named Frank Gallinelli. I don’t know if you guys have heard of him but Frank is definitely one of the smarter kids on the block, so to speak. Frank’s founder and CEO of Real Data, created back in 1981 before most of us were born. The company provides analysis and presentation software for investors and developers.
Frank is also the author of three books – Mastering Real Estate Investment, What Every Real Estate Investor Needs to Know About Cashflow… and Thirty Six Other Key Financial Measures and Insider Secrets to Financing Your Real Estate Investments: What Every Real Estate Investor Needs to Know About Finding and Financing Your Next Deal. Frank is also the author of an Ebook, which happens to be a free eBook. You can pick it up right now on Amazon.com – Ten Commandments For Real Estate Investors. All these books you guys can find on our show notes at www.biggerpockets.com/show4.
Frank is a really good guy. He actually taught back at the BiggerPockets Summit last year and got great reviews. He’s a graduate of Yale University, he serves as Adjunct Professor in Columbia University Master of Science and Real Estate Development program for developers. We are very excited to have him here. Frank Gallinelli, what’s going on? Welcome aboard.
Frank: Hey Josh and Brandon, great to be with you today.
Josh: great to have you. That was quite a mouthful - you’ve got three books with really long titles.
Frank: I didn’t write the titles to some of those, it was my publisher who did a few of those titles. I wanted to write something called Sex, Lies And Real Estate but they wouldn’t let me. We got what we got.
Josh: You’re best seller with what you got and had you gone with Sex, Lies And Real Estate you might have sold a couple more.
Frank: Actually they’ve sold more than 80,000 copies of one of those books so maybe I shouldn’t complain. Maybe they knew what they were doing. I’ll give them credit for that.
Josh: 80,000 copies. That’s pretty substantial. Does that give you a big head? Do you feel- you’re a big shot?
Frank: Not really. I do go into bookshops occasionally and volunteer to sign a copy of my book if they have it on the shelf and they always let me do that. Then I always say, ‘By the way I also wrote Hamlet.’ So I sign that as well. They never check. Apparently I’m anonymous to the entire world. They don’t know who I am. I could be Shakespeare for all they knew, it wouldn’t make a difference.
Josh: I can see you standing in the aisles of the book store, waiting for somebody to pick up a copy of your book.
Frank: I’ll put that on you when I get a chance.
Josh: So we are here today to talk about Income Properties and you’ve been teaching and writing and working in that space for a long time. I guess we’ll kick this thing off with residential versus commercial. Which do I want to think about as a new real estate investor? What do you think?
Frank: I get that question quite a lot, Josh. There’s really not a right answer to that question but there’s probably a best answer for a particular individual. One of the things I’ve always seen is that most new investors, because they’ve lived in a house or lived in an apartment, that situation is a little bit more comfortable, a little bit more familiar, so they tend to gravitate towards the residential type of income property.
The one thing I might be a little bit cautious about if you’re getting into that, is watching out for something that is too small. If you’re looking at property that’s for you, you’re probably looking at property that’s intended for somebody to live in rather than really an investment. So I advise people that if they’re going to go with residential property look at something a little bit larger. Look at the five plus or bigger.
When you get down to that basic decision between residential and commercial there’s a lot of things to think about. Some of them are global, some of them are local.
Josh: Let’s talk about that because the vast majority of folk on BiggerPockets for example, and a lot of newbies that I’ve come across over the years, they hear commercial, they hear five plus and they start breaking out in cold sweats.
What is it about the multi families that people need to know and not worry about? What are the big fears that people have and how can they overcome those fears in thinking about these properties?
Frank: Well if it’s a residential property it’s really, in terms of its character, it’s not a whole lot different from the two/four/family except where you’re trying to assess what the property might be worth. You have more concrete information to work with because you’re going to be valuing that property the same way a bank is valuing that property, and that’s based on its income stream.
When you get into smaller properties – the ones, the twos, the multiplexes – the value is determined by forces that are outside your control. You’re looking at general economic forces that cause house values to rise and fall, which means you don’t really have one of the big advantages in owning real estate as a long term investment – you don’t have the ability to create value yourself.
People don’t buy a single family house or even a duplex for its ability to produce income. They buy it as a place to live and maybe they get some income besides. But people buy the larger properties, the five and greater, for their ability to produce income. In forty years of dealing with real estate investors and ten years of dealing with grad students who are learning this sort of thing I think I find the one issue they have the hardest time wrapping their head around is the notion that a property, if it’s a true income producing property, its value is based on its income stream, not on comparable sales.
Josh: Got you. Let’s get into that because I think that’s at the crux of what’s going on here. Comps as we know are valuations based on prices of properties in and around the area of similar type and style. Income property as per your definition is a property that we’re going to evaluate based solely upon that income stream. Correct?
Frank: Absolutely. Once you can really internalize that concept you’re halfway to mastering the fine art of income property investing. Everybody thinks for example, location’s important. When you’re buying a single family house location is critically important because the value of that house is going to rise and fall the way the value of your neighbor’s houses rises and falls.
When you’re buying an income property you have to look at it through the prism of its income stream. Yes location is important but why is it important? Because good locations can probably generate a greater and more reliable income stream than dicey locations.
Everything really comes down to the income stream. You’re going to buy that property not as a place to live in. You’re going to buy it for its ability to produce income. You don’t buy a stock because you like the stock certificate, because it’s pretty. You don’t buy an income property because it’s a pretty building. The fact that it’s a pretty building may contribute to its ability to produce income. People like to rent nice looking buildings as opposed to ugly buildings. But what it really comes down to is the income stream.
Brandon: That makes a lot of sense. I know when I bought my apartment complex a lot of people thought, they gave me a hard time for buying one that was in not a rough location but it wasn’t amazing, and everyone always says location, location, location. But I can just point to the income that the property was producing and say well this is why this matters more to me than location.
I’m not saying I would buy something that’s in the ghetto where I’m going to worry about getting shot but just the fact that the income was there, that tipped me in the way of buying it and not just passing on it like everyone else seemed to have been doing at the time.
Frank: Absolutely. An example; my students each year when I teach this at Colombia is two properties that are right next door to each other but one has normal leases that are going to escalate over time and where there are options and so on and next door is a virtually identical building that’s locked into below market leases and locked in over time.
Physical location, everything about them physically is virtually identical. It’s the leases and hence the future income streams that’s different. So one is more valuable and a better investment than the other, even though they’re physically the same.
Josh: Let’s talk about that. The valuation of a property is determined based on that income stream. How would somebody determine the value of a property? You’ve got these two properties next to each other. One of the properties is deriving $X in income and the other property, which is virtually identical is bringing in say 60% of $X in terms of that income stream. We can then say the property that is bringing in $X is worth a lot more today than that other property. Correct?
Frank: Yes. Actually you’ve just hit on a very key point when you said today because there’s actually two issues going on when you evaluate potential income property investment. And that is how is it going to be valued today and what do I think of it as an investment? Things don’t always mesh perfectly, which is why you really have to be careful how you look at these things.
With the value today it’s a pretty standard approach, the same as your appraiser would do. You’re going to take your gross income, subtract vacancy laws, subtract operating expenses, come up with a net operating income, apply a capitalization rate that you’ve found out is appropriate by going out and talking to some commercial appraisers, and you’re going to come up with a value. You can run off the rails in doing that.
Where I’ve seen people getting this wrong is they don’t really understand the definitions of those various terms that I’ve just used. They don’t really know what is an operating expense and what isn’t. It’s important because if you don’t follow the same set of definitions as everybody else doing this sort of thing then you don’t come up with a value that squares with what a lender’s going to come up with or what other investors are coming up with. So that’s one big issue when you’re looking at the current value of the property.
Josh: Got you. And that’s probably, would you say that determining the value that a potential lender is going to be square with, I would assume that is going to be one of your most important jobs as the owner of these properties or potential owner of one of these properties, is to say this thing is worth $X. We know it’s worth $X. Anybody else, there’s not going to be any questions. Appraisers, the bank, potential buyers, everybody’s going to be in complete agreement that the value of this property today is absolute. Is that true?
Frank: Well there are no absolutes in anything, least of all real estate, but you at least have a reasonable estimate what the value is when you take this approach. It’s important for a number of reasons.
One is the fact that you’re probably going to be looking for finance on this deal. If you’re looking for financing you’re going to have to be able to have a good understanding of what that property’s worth and an understanding that squares with what the bank’s appraiser is saying.
You may need an equity partner in order to do the deal. Once again, you need to be able to show the equity partner that you’ve got your ducks in a row, that you understand what the property is worth.
So you do want to come up with a reasonable estimate of value. Is there some give in those kinds of estimates? Of course. They’re based on what’s going on in a marketplace today in terms of capitalization rates that other investors are using. When you look at those sorts of things, when you get that kind of information from an appraiser the appraiser will say, ‘Probably eight. Maybe eight and a half.’ So you develop a range of what is a value that you can live with for that property. Then you look at does it really work for you as an investment property.
Josh: You ran off a couple of terms and I just want to remind everybody listening that we’re going to actually have these terms and definitions posted in the show notes and that will be at biggerpockets.com/show4.
You just mentioned equity partners, Frank. Let’s talk about that a little bit. You’re now talking specifically about the financing of a potential purchase, correct?
Frank: It can be very important to have an equity partner in certain circumstances. The conventional wisdom about real estate investing has been that it’s great to use other people’s money. Invest as little cash of your own as you possibly can. Finance as much as you can when you buy an income property. That can be a good approach in certain circumstances but it can also be a dangerous approach in other circumstances.
For example, in the kind of economy that we’ve looked at over the last four or five years where financing has been very difficult to get it would have been impossible for you to get the financing that you need if you didn’t have equity partners. And if you did get it it would be on terms that were so onerous that it would eat up your cash flow.
In more normal economic times still leveraging up your purchase to the hilts means that you have a lot of debt service. When you don’t have any skin in the game the chances are your financing is going to be more expensive than if you were looking at a lower percentage of the purchase price that you needed to be financed.
What I generally tell people that are dealing with this issue, if they say for example, ‘I want to have the whole deal to myself. I don’t want to share it with equity partners.’ I say, ‘Listen. Would you rather have 100% of a negative cash flow or would you rather have 50% of a positive cash flow?’ Because if you’re financing it up too much and you’re getting poor terms because you’re doing that and you’re having enormous debt service because you’re doing that you’re minimizing your chances of having a positive cash flow. So maybe it’s better for you to share that purchase with some equity investors. Maybe, just as a side benefit, you might learn something from one of those equity partners because you’ll be bringing in another person who may in fact have more experience than you do.
Brandon: I couldn’t agree more, Frank. People ask me why I use partners a lot. I use a lot of partners when I buy and sell real estate, commercial or residential. I always tell people I’d rather have 50% of a good deal than 100% of no deal.
A lot of people say, ‘I wouldn’t have done that with a partner, I’d have done that by myself.’ But when I started out, doing things by myself, sometimes it worked great and sometimes it didn’t work out so great. I love going the partnership route just because of that. But like you said, sometimes it can be dangerous, you’ve just got to be careful when you’re doing it. I’d love to go back to something you mentioned earlier, Frank. We’re talking about increasing the value of property. That’s one of things I absolutely love about commercial property – that on a residential if you want to increase the value there’s not a whole lot you can do other than make it look pretty. The thing I love about commercial is you can find ways to add income and that’s going to add value and it adds it at an exponential rate. It will give you an increase in rent of $500 a month overall, that’s going to increase then total value by possibly tens of thousands of dollars, instantly.
When you can find a property with rent that’s undervalued, if typical rent in the area is $500 per unit and you find one that’s at $400 and you can easily raise it up to $500 you can jump the value leaps and bounds overnight.
Frank: You’re absolutely correct. Since the property value is based on its income stream, when you raise that income stream you by definition raise its value. Let me give you an example that’s intuitive. We’ll go back to residential as well as commercial.
With residential one of the advantages is short leases, so you have a lot of turnover. So you do have an opportunity with residential or mixed use to work on building those rents up. One of the things that’s counter intuitive is that you’ll take a look at a piece of property and you’ll see that it has low vacancy rate – not too many vacancies currently, not too many vacancies in the history. And you say that’s a good thing because I don’t want vacancies, I want to collect all my rent. One of the things that tells you however is the vacancy is low because the rents are below market.
So if you’re not tuned in to exactly what the rents are in those markets a low vacancy history on a particular property could be a tip off that you have below market rents. Your play in at that point is, ‘I want to value that property based on current income stream.’ You’re not going to accept the argument from somebody selling you the property that you should pay for what it could be. You want to pay for what it is.
You want to buy that property based on current income stream but you know in the back of your mind that that zero vacancy rate, when everybody else in the market place may be experiencing a 4% vacancy rate, the 0% vacancy rate on this property is your clue that here there is an unusual opportunity. You can go right in there and with short turnovers, especially on residential leases, you can raise that value.
Brandon: The other side of that coin is not just raising income. Would you agree that decreasing expenses is also a huge way to improve the value as well?
Frank: Absolutely. The euphemism I use is management improvements. Very often people simply don’t pay attention to what something is costing. They don’t shop – you can’t shop for property taxes, that’s for sure. But you can keep an eye on every time you get a reassessment.
I have successfully gone in and talked to the assessor after a reassessment and I said, ‘How did you come up with this?’ And had them say right back, ‘Look at that. They used the wrong cap when they made your assessment. You’re right. We’re going to lower your assessment.’ I looked at the NOI of my property, I looked at what I knew was the prevailing cap rate – this was a commercial property. I went to the assessor and I said, ‘A divided by B doesn’t equal what I’ve got on my assessment.’ He says, ‘Yes you’re right.’
Brandon: I need to try that.
Josh: That sounds great.
Frank: Same thing with property management. Do you do it yourself or do you do you farm it out? There’s an opportunity there sometimes to save some expenses.
Brandon: Actually Frank I have a question about some of that property management stuff. It’s something I’m curious about from my own investments and I know I’ve seen it on BiggerPockets quite a bit. The value of a property is based on the NOI, the Net Operating Income. Obviously a way to decrease your expenses is to not have property management. What I’m thinking is if a person doesn’t have property management that makes the value of their property much higher. Or do you include what it would normally cost for property management? How does that work exactly?
Frank: It’s not really an enormous difference in the value of the property. A typical property management expense would probably be a couple of per cent of the gross operating income. So there would be some difference but I don’t think it would be an enormous difference.
Many appraisers might indeed plug in a default number for the value of property management so there’s a possibility that they too would decrease the NOI slightly by the value of the property management expense that’s not really been taken into account.
In terms of whether you should use a property manager or do it yourself, that’s another one of those jump ball type of questions. If this is residential property and you feel fairly comfortable doing it that’s OK. However when you get into a lot of properties or perhaps when you get into commercial property where there’s a lot of dealings with leasing for example and other issues then it may be prudent to use a professional property manager.
What this does bring up is another interesting question about understanding your own particular investing objectives and preferences. This is a question that comes up a lot when we talk in Columbia in my classes. As a mater of fact I’ve now built - one of my case studies goes right to the heart of this subject and I give them a choice between a mixed use property and a stand alone retail, such as a stand alone pharmacy. It’s kind of an interesting conversation that we have because the mixed use property is one that gives the hands on investor a lot of opportunity to enhance that cash flow and therefore to enhance the value.
The triple net lease property doesn’t do that. So the question I ask my students, and I tell them right off the bat there is not a right answer to this, is which one of these properties would you prefer to purchase and why?
Brandon: You mentioned triple net lease. What exactly is that for those that don’t know?
Frank: Triple net lease is where the investor has very little personally to do with operating the property and very little to have to pay. A triple net lease occurs with commercial tenants and it’s where the commercial tenant will pay either all of or all of the increase over a base of certain operating expenses.
Let me be more specific. You rent to the free standing pharmacy I was talking about. As part of their rent, we call it additional rent, they will reimburse you the landlord for the property taxes, the property insurance, any utilities involved such as water that might be getting billed to you the landlord. They would do all their own maintenance and repairs. They would do everything. The only thing you would do would be to open the envelope that the rent check comes in. And the rent check would include these extra amounts to cover those expenses. You wouldn’t ever let them pay those rent checks directly because you wouldn’t want to be relying on a third party to pay your property taxes or your property insurance on time so they reimburse you. These things are really called expense reimbursement. But a triple net lease situation like that there is no property management expense very often because there’s very little for the property manager to do.
Also typical of that situation is that you’re anticipated return on your investment is lower. You’re getting into that mixed use property I was describing where you’re hands on and you’re dealing with tenants that are turning over frequently and so on you expect a higher return because there’s more risk, more uncertainty.
That triple net lease we were talking about is five years, everything is predefined. You’re not at risk from an increase in property taxes because they’re paying and reimbursing you. You’re not at risk from maintenance expense because they’re doing it. So it’s two different situations. The interesting conversation that comes up with our students is, which would you prefer and why?
Josh: I was going to ask on the triple net, other than the lower income, what’s the downside? I think people are going to sit here and listen and say, ‘Wow. A triple net lease sounds awesome. I could go and buy a property, not have to worry about any of these details. Maybe it would pay me a little less income. What are we talking about here in terms of that? What is a little bit less in terms of percentages and what are the other negatives that come with a triple net lease other than perhaps being stuck with somebody for five or ten years that maybe you don’t love personally?
Frank: That is certainly one of the possibilities. But even if you love them dearly you’re still stuck with them five or ten or even twenty years. What that means is if you negotiated a lease where the rent goes up on average one per cent a year – you might not actually raise it every year, it might be every three or five years – but you may have locked yourself into a ten or five or twenty year deal where suddenly you find yourself in a tremendously hot market where if you had been renting the space more frequently you could have done significantly better than that.
Another issue of course is if and when you do come upon a vacancy it could take you a good deal longer to rent out a property like that than it would if you were, for example, renting apartments in a forty unit apartment building.
Everybody has to live somewhere so demand for apartments is almost a universal constant. You can always hope to find a tenant for an apartment. If you’ve got a ten thousand square feet free standing former pharmacy your issues in terms of finding a replacement tenant overnight are obviously considerably greater. So you have that some risks in terms of the rollover that would be greater.
One of the issues that I talk to my students about is, ‘I’m a lot older than you so maybe I haven’t got quite as much energy and desire to set the world on fire as you do. So maybe you want to buy that mixed use property, spend all your nights and weekends.’
Commercial tenants are commercial tenants but residential tenants don’t keep business hours. If the toilet clogs up at three o’clock in the morning you’re going to get a call. You’ve got to be willing for that home run kind of return, be willing to roll up your sleeves and be 24/7 as a real estate investor. When you get to be someone who’s a little bit longer in the tooth, such as myself, maybe what I’d prefer is the lower return but more predictable return and the more predictable lifestyle that comes from not having to deal with the property on a daily basis.
Brandon: I think that goes back to what you said earlier that there isn’t necessarily a right or wrong answer but there is a best answer for each person. The triple net lease, lower return rate doesn’t necessarily entice me right now when I think about it because I like getting my hands a little dirty and I like going out there and working and finding ways to leverage my skills and ability to try to get more return, where I can definitely in ten years I hope I’m not doing that.
Frank: It gets back to a subject again where I kill half a lecture when I’m teaching. It’s the subject of clarity. I say you’re not being clear in terms of what you’re trying to convey to other people in a transaction. You have to be clear in your own mind. What are you doing this for? Are you doing it because you’re trying to hit a homerun? You’re trying to ultimately live off your success as a real estate investor? Are you doing it for long term security? Are you doing it to put your kids through college? You have to be clear in terms of your own objectives before you can decide what road you’re going to take on these investments.
Josh: I want to jump to these deals and opportunities. Where can somebody find these income streams? Where can somebody go and find these deals? I’m talking outside of say for example LoopNet or one of the traditional commercial broker sites online. Are you going to go and find a good deal from just calling a commercial real estate broker? Do you need to know somebody? How does somebody find a good deal?
Frank: A commercial real estate broker can be a very valuable asset. I wouldn’t dismiss that idea by any means. One of the things that I’ve always felt strongly about, and I think I talk about this in my Ten Commandments book is operating locally.
I know a lot of real estate investors try to chase the latest hot market. I recall once I was giving a talk out in Los Angeles and San Diego and nobody wanted to talk about what I came to talk about. They all wanted to know if I knew where the best places were in Las Vegas to buy property. I wouldn’t know Las Vegas if you dropped me in the middle of it out of a helicopter.
If you can become expert in your local area then you’ll really know where the cracks in the sidewalk are. Brokers can help you but when it comes to commercial property in particular, essentially every building is for sale, whether it’s for sale or not. So if you see something that you think has promise there’s no reason – it’s not like walking up to somebody’s house and saying, ‘Hey. I really like your house. Do you mind moving out?’ If you make that same proposition to somebody who owns a strip shopping center or that free standing pharmacy I talked about or the forty unit apartment building, they’ll say, ‘Well let’s have lunch and we can talk about it. With proper non-disclosure I’ll show you my rent and expenses and so on and we can talk.’
Becoming expert in a local area, where you really know everything that’s going down and as a side benefit to that you not only know the properties but you also know the local politics, you also know the local budgetary process. You know for example if you’ve now suddenly got a mayor who wants to spend you to oblivion and your property taxes are likely to be going up. You have a sense of how things are going along.
Josh: I think you nailed it there with knowing your market. That’s one of those things that I hear all these new investors coming in – particularly on the residential side – who say, ‘What market should I invest in? Where should I go?’ It always goes back to you need to know where you’re at, you need to know your market. Pick one, focus on it, get to know it. If you’re doing houses walk every block in your market, know every house that’s for sale, go to every open house. Check out these listings until you know it cold. Because when a new house pops up on the market you know that value, you don’t even have to run the numbers. You can go and look at it and you can figure it out pretty quickly.
I would assume on the commercial side we’re talking about the same thing. It might take a little longer but by being familiar with your market you become an expert whereas by flip flopping around and jumping all over the country and different parts of your area you may not necessarily know the different goings on. Is that a word, goings on?
Frank: You not only become an expert but you become a known entity. When you go for financing, they’ve seen you here before because you’ve done deals locally. Other property owners who might be thinking of selling their buildings know that you’ve ben buying this kind or that kind. So when they think of someone to call – maybe before they call their broker – they may call you.
Brandon: So Frank, do you see commercial real estate as a little more stable nationwide? What I mean by that is, I probably wouldn’t want to invest in an income property like a residential income property in Los Angeles or Seattle or New York City because the prices are so high it’s really difficult to make a return. Do you find commercial is like that as well where there’s hotspots where it doesn’t make sense to invest? Or is it pretty stable nationwide?
Frank: The commercial property as I say is typically a function of the prevailing cap rate. Whatever the prevailing rate of return that other investors are willing to accept. Yes there are markets where you have to ask yourself what are these people thinking? When they’re weighing something at a cap rate of 4%, which means as cap rates go down values go up.
You’ll find areas where the investors are buying at such high prices you have to wonder how they can make a return. Like everything else I think there are inflated markets, commercial or residential. You have to be conscious of that.
If you’re trying to do this and you’re sticking locally you have a much better chance of having a real sense of what is appropriate for the market you’re dealing in. You’ll be seeing properties being bought and sold all around you if you stick to a relatively modest radius. You’ll know when somebody has paid a price that doesn’t seem to make sense. It shouldn’t be your queue – he paid 4% cap rate where everyone else is paying 8%, which one do I want to use? That may be an aberration. You can spot an aberration more easily when you’re dealing in a restricted area.
Josh: When somebody is starting out what do they need to do? We’re talking about all these different things here and I think a lot of folks listening are saying, ‘I’m new to real estate. How on earth do I get involved in commercial?’ If I want to buy a house and flip it I can buy a house and flip it. If I want to be a landlord in a house; great.
What do I need to do to get my ducks on the road? Do I need to put together presentation material? Do I need some kind of package to go out there and go out and convince a lender perhaps to lend me money? Where do I find the properties? What do I need to do to set myself up to be this budding commercial real estate investor?
Frank: That’s a great question, Josh. And an attempt to answer that question is what I’ve been teaching for the last decade because people go into this and they don’t know where to start. They don’t know what they don’t know.
My advice invariably is you have to start with a bit of education. Before you try to do something you have to understand what it is you’re doing. I urge people in the strongest possible terms to know the vocabulary of this business, to know what this terminology means. Not only is it necessary in order for you to make a sensible analysis of a property, it’s also necessary for you to have any reasonable credibility. If you don’t get your terms right you’re not going to make any headway at all as a real estate investor, especially in commercial real estate. Brandon: Not to sound like a suck up here, Frank but your book, The 36 Other Key Financial Measures, that was the book that taught me almost every real estate term. I actually checked that out from the library when I was first beginning and that was really helpful. This is cool. I never thought I’d get to say thank you to the author, but thank you.
Frank: Well thank God. I'm right now autographing my computer monitor for you.
Josh: Yes you are a suck up, Brandon.
Frank: That’s why I wrote that book. The typical real estate investor goes into this, starts off not knowing what is an operating expense and what is not an operating expense. What does net operating income really mean? What are these different terms?
So when they go to try to do a deal they might as well be wearing a sandwich board, saying ‘I’m a newbie. Take advantage.’ When they go into the bank if they don’t know what a debt cover duration is and they haven’t done their analysis the lender there is going to look at them and say, ‘Why are you wasting my time? If I ever see you walk through that door again I’m going to tell my secretary I’m busy.’
Someone who doesn’t do the analysis and tries to go into a lender when the analysis would have shown that their debt coverage ratio is 1.0, which means they can just barely pay the mortgage if nothing goes wrong. If they had done their analysis they would know they’re not getting a loan on those terms so by walking in there they haven’t accomplished anything. They’re still not getting the loan but they have proven to this lender that they don’t know what they’re doing.
Starting off with the basic education, getting to know the terminology. Every profession has its secret handshakes and real estate investing is no different. You need to know what these terms mean and how they’re used. If you’ve accomplished that much you’ve really gone more than half way to getting it done.
But then, Josh, to answer your question about presentations and whatnot, that falls right in with the same thing. If you make a good presentation you’re saying to the world – the world being the guy on the other end of the transaction – the seller if you’re the buyer or the buyer if you’re the seller, you’re saying it to your potential equity partner, you’re saying it to the lender, you’re saying, ‘I know how this stuff works so we can do business because I clearly know how this stuff works.’
Let me give you a silly example but it’s one that I think goes to the point. Very often when I ask my students in Columbia, I give them a case study, I say, ‘Here are the facts. Work up a pro forma, do an analysis, but you’re not allowed to use my company’s software. You got to do it on your own.’
One of the things I invariably see is there is no linear logic to the presentation. Things are all over the place. You don’t go from income to expenses, debt service to cash flow, things are all over the place. If I were a lender or if I were an equity partner I would be asking, ‘What are you trying to tell me?’
But the one I find most amusing is that they will do one of these spreadsheets and all of the numbers have decimal points and cents. I try to say to them in my most serious voice, ‘If this deal doesn’t make sense at $15 million it certainly doesn’t make sense at $15 million and 27 cents. Stop with the distractions. No investor looks at the loose change. You’re announcing to the world, ‘I never did this before. This is my first shot. Give me the $15 million but don’t forget my 27 cents.’
Presentation matters. It gets back to what I said earlier on the subject of clarity. You’ve got to get your message across because you have an audience that you’re talking to when you make a real estate investment presentation and you have to address that audience you have to convey that information so that they can understand it and so that they can see your point of view. It might be the seller trying to talk to the buyer. It might be the buyer trying to convince the seller that his price is wrong. Whatever it is, understand that clarity really matters.
Brandon: That’s great. Really quick – I heard you plugging that software of yours and anyone listening can find out how to get there through the show notes again at biggerpockets.com/show4.
And of course they can find a link to pick up a copy of that book of yours amongst the other books as well.
We’re kind of running out of time here. Before we go let’s talk about a couple of really quick questions that I’ve got for you. One of them is what is your best piece of advice for new investors?
Frank: Do your homework. That starts with learning the terminology, as I mentioned before. But then when you get out of your book, out of your classroom – virtual or otherwise – then do your homework about your market and about the properties that you’re looking at.
There’s no substitute for due diligence. Due diligence is not just about the property, even though that’s essential. It’s also about the market that the property lives.
You need to know if employers are moving in or moving out. You need to know if cap rates are going up or going down and what they are currently. You need to know what is the typical vacancy rate for properties such as the one you are looking at.
Due diligence is absolutely essential. If you start off by learning the terminology and then learning your market and then finally learning your property then you are following the food chain perfectly.
Josh: That’s great. Very, very good advice. What is your favorite real estate book? And no, you can not plug your own book, Frank.
Frank: I’m being perfectly serious because I wouldn’t want an idea imprinted on my brain that I then put in one of my books and then I ended up being one of the plagiarist guys. I try to avoid reading other people’s stuff because they may have an undone influence subconsciously. But there are other good real estate books out there, I have no doubt about that, I just try not to indulge.
Josh: That’s a fair question. What about business books? What’s your favorite book? And don’t give me that same BS answer!
Frank: I guess the one I enjoyed the most was The Big Short, just trying to figure out how we got into the mess we’re in. I think it’s Michael Lewis if I’m not mistaken. The Big Short was a very interesting expose on how we got into the subprime mortgage mess and how that all played out.
Brandon: OK. I’ve got a question, Frank. You’ve been around the industry for a long time – I’m not making fun of your age here, it’s just true – I’m wondering what have you seen? What sets apart the top performers in our industry, the guys who are crushing it and doing well and making a future for themselves – what sets them apart from the people that come and go and the students – maybe you’ve seen in your class – that maybe jump in for a few minutes and then leave, try their hand one time and it’s not for them. What sets those people apart? The top performers?
Frank: I hate to sound like a broken record here but it gets back to my answer to Josh’s original question. I think it goes back to education, taking the time and the trouble to learn how this stuff really works. Not to assume there are some magic answers, a magic wand and some dust you can sprinkle on a deal and you’ll immediately find everything is worth seven times gross income.
People who take the time and trouble to actually learn this business, the way you would learn any other profession, those are the ones I think who have the leg up. Similarly those who take the trouble to understand that even if they understand it, they understand the property they have, they do have to deal with other people: buyers, sellers, equity investors, lenders, partners, all that sort of thing. In order to do that they have to really work at the other part of my previous answer to Josh’s question – the issue of clarity. Being able to make their point of view understood. Understand who their audience is and what it is they’re trying to say.
The people who take the time to do this, to learn how it really works, then to analyze the property and make an effective presentation to a third party where that presentation is geared to the interests of the third party.
A lender is concerned about certain things, an equity partner might be concerned about some other things. Understanding where it is you’re going, understanding your objectives in making the deal and trying to put the deal together, that’s what sets the winners apart from the losers I think.
Josh: That’s great. What do you do for fun? I’m sure you’ve got a hobby that’s not writing books. Or do you just sit and write books all day?
Frank: That’s mostly what I do but for a really good time I sit down and I wait for you to call. And I’m so glad you did. You just made my whole week guys.
Josh: No seriously.
Frank: I like to sit down and write and have my cell phone turned off and have nobody call me – not even you Josh. If there’s anything else, I love to play with my grandkids.
Josh: That’s great. Listen, this was fantastic. I think we’ve covered a ton of really good information here, really just starting to explore a lot of these topics. Of course listeners can follow you online. I’m assuming you have Twitter and Facebook accounts; do you want to share any of that?
Frank: All that good stuff. You can find me on LinkedIn. You can find me on Twitter, we’ve got a Facebook thing. I don’t pay as much attention to that as I should. I probably encounter more people on LinkedIn. Just look me up and you’ll find me on there.
Josh: Frank is also on BiggerPockets where he answers questions on our forums at biggerpockets.com/forums. Again, you can find out anything about today’s show – we’re going to have links to Frank’s various social profiles, to his website, to his books, and to some of his concepts and terms we’ve talked about today, at www.biggerpockets.com/show4.
Frank, thank you so much for coming on the show. We really appreciate it. I know I’m very much looking forward to having you on once again in the future.
Frank: Thanks guys. It’s been a pleasure. I really enjoyed it.
Brandon: Thank you, Frank.
Josh: Hey everyone. That was our show with best selling author Frank Gallinelli. We really hope you guys learned a lot about commercial real estate today. Hopefully you’ll end up using it to build wealth for your future.
Come check out the show notes at www.biggerpockets.com/show4 and leave us or Frank a comment. Also if you haven’t already signed up for free Biggerpockets.com membership you can do that at www.biggerpockets.com. Finally please do not forget to leave us a review in iTunes. This is really important guys. It helps us get more visibility for the show. Definitely be sure to check it out and leave us a review over at iTunes. Of course if you found the show helpful make sure to also subscribe to the show on ITunes as well.
Finally, come check us out at Facebook at Facebook.com/BiggerPockets. This is Josh Dorkin, signing off.
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