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CONSUELO MACK: The real estate market in 2005 had a split personality. While residential markets cooled, commercial real estate heated up. Whether this sector can continue its winning ways in 2006 is anyone’s guess.
  If you’re interested in investing in income-producing real estate, Frank Gallinelli is your man. He’s the founder and president of real data, the real estate industry’s leading investment software firm which helps individuals invest in real estate. His book, “what every real estate investor needs to know about cash flow” has been a top seller for the past two years.
  I asked Gallinelli to explain why he believes there is a huge difference between buying a home and buying an investment property.

FRANK GALLINELLI: If you want to invest in income producing real estate, you have to forget everything you know about your home, your personal residence, and how that works as a real estate investment. Because income property is an entirely different creature. Your home has a value that's based on comparable sales, other houses in the neighborhood are going up, a rising tide lifts all boats, yours will probably go up as well. But an income property, and an income property is one that would not be bought or sold as a personal residence, by that I mean perhaps a larger multi-family, more than four units, perhaps a small strip shopping center, an office building, whatever, that you would not buy to live in yourself, or no one else would. An income property's value is based entirely on its income stream. When you buy an income property, you're not buying a pile of boards and bricks and BX cables. You're just buying the cash flow.

CONSUELO MACK: Let me stop you there. What about the proposition of buying a condominium in Miami, for instance, and you make some improvements, and then in the anticipation in a hot market, that you're going to be able to sell it in a month or a couple of months or whatever, you know, what about buying a single family home, fixing it up as an investment? You know, how does that compare to the income properties that you're talking about?

FRANK GALLINELLI: Well, it's a different creature, commonly called flipping, and it's different because you're buying it based on what someone would pay for it as a personal residence, and so you don't have quite as much control over the ultimate outcome of your investment as you do with income property. And the reason for that is with an income property you will sell it for the capitalized value of its net income. You can change its net income. You can manage the property in such a way that you improve its income, and when you do that, you are quite literally making money.

CONSUELO MACK: What kind of returns can you expect from income properties? What are we talking about over, you know, ten years?

FRANK GALLINELLI: It varies quite a bit, but what I see ... what we do in ... with our ... my company's software, for example, is to do an internal rate of return analysis, which takes into account the time value of money, both the timing and the amounts of their various cash flows that you experience when you own an income property. And typically, you look at something in the ... upwards of above ten percent, and very often pushing 20 percent, in terms of the actual internal rate of return that you would get on an income property. And again, part of this is because you have some control. This is one of the few investments, you can't go, if you buy a stock and put yourself on the Board and have some impact on how that stock is going to perform. But you can make management improvements. For example, you can buy an income property where the ... let's take a small office building. You can improve security in the building. You can improve the appeal, the aesthetics of the common areas. There are any number of things that you can do that make the property more rentable, and when you improve that cash flow, again, you create value.

CONSUELO MACK: And more rentable, and you could raise the rent and ... basically just, you know, get more ... I mean on what, every year, or every two years or whatever the terms of the lease are ... (Overlap)

FRANK GALLINELLI: Exactly.

CONSUELO MACK: ... that there are things that you can actually do that have proven time that you can enhance the value of your return?

FRANK GALLINELLI: And as a matter of fact, the terms of the lease are one of the issues. It's not at all uncommon, especially with small income properties that are owned by investors who do it as a sideline, who are not professional property owners, it's easy to get comfortable with the tenants that you've got, and say well, you know, things are going well and I'm just not going to keep up with the market in regard to what I charge these tenants. You find a property like that, and it's not unlikely that the owner, if he or she wants to sell it, will want to sell it for what you could get for the rent, but that's not an argument you want to listen to. You want to pay a price that's based on what kind of income the property really is achieving. But if it's fallen behind the market, one of your first things that you can do is to take over that property, walk in and bring it up to current market rents. You'll probably lose all the tenants you've got, so you'll build in the vacancy loss as part of one of the costs of doing business, but it is not unthinkable that you can make a substantial improvement in the net income, and therefore make a substantial improvement in the value of the property, in a very short time, a year or two. I've done it.

CONSUELO MACK: How much time should you expect to put into income property? Most people, again, who are listening, aren't doing it now. They would consider it to be a sideline investment ...

FRANK GALLINELLI: Right.

CONSUELO MACK: ... in addition to whatever their professional pursuits are. So how time consuming is it?

FRANK GALLINELLI: It can be, but there are two components to the time commitment that you need to make. A very important one is before you purchase. You really do need to do your due diligence. Real estate is a local phenomenon, so you need to know about the job market, you need to know whether the main employer in town is about to, you know, put plywood over the windows. You need to know if they're going to build new schools and make substantial changes to the tax burden on property owners. You need to know what the rental market is. How much can you get for the types of rental units that you're looking at?
  You also need to do the numbers. I can't over-emphasize this, and again, this has been a business of mine for 20 some odd years, but one of the reasons is because I believe it, if you don't do your financial projections and look at best case-worst case, mostly likely scenarios for how the property is going to function as a cash flow item, as an income stream over a number of years, you ... then you might as well just throw darts at the Classifieds and buy a property that way. But if you do those kind of projections, you have a reasonable idea of what you're getting into. So that's your first time commitment. Your second time commitment obviously is managing. And that, you know, I will admit, when you buy mutual funds, they don't call you in the middle of the night to tell you the toilet's stopped up. (Laughter) But that can happen. You have to be prepared either to deal with these management issues yourselves ... yourself, or to reduce your cash flow a bit and use a management company, professional management company, to help you out with that.

CONSUELO MACK: Starting out, better to do it close to where you are, just so you can oversee things yourself?

FRANK GALLINELLI: As the anvil sales man used to say in "The Music Man", you got to know the territory. Okay? You really do have to know the terri ... you need to know where the cracks in the sidewalk are, because when you really understand your market place, then you know what it is that you're purchasing, you know what your opportunities are, you know what you can get for a particular rental unit, after it's fixed up, or after these management improvements are made. You improve the parking, you improve the outside lighting, you improve the landscaping. You add broadband connections to all the units, and include that as a freebie, as a perk. (Overlap)

CONSUELO MACK: And so these are real things that you can do that will add to the value of your income stream?

FRANK GALLINELLI: Right. And when you know what your market place is, then you can definitely make the best use of your time, and make the optimum ... gain the optimum return on your investment.

CONSUELO MACK: One last question about income producing properties. A lot of people start out by buying let's say a two family home, and then renting part of it and living in the other part. Is that a good way to start?

FRANK GALLINELLI: It's an excellent way to start. It's not really income property investing, because the person who buys that from you is still probably going to buy it based on its value as a personal residence. Nonetheless, it's a great way for someone to start with their personal investing, because it's a way ... if things are a little pricey where you are, it's a great way to begin to use the leverage of owning real estate to own some piece of real estate. You can then take that piece of real estate, leverage it up to get the financing that you need to buy the income produce ... the real income producing properties.

CONSUELO MACK: Oh, good idea. Let me switch gears for a little bit, and talk about the other real estate market, which is the single family home, the residential real estate market. You don't believe that we are in a housing bubble. Why not?

FRANK GALLINELLI: I think the economics simply don't say that to us. We have a good employment situation in most places. We have data that's coming at us that says that even though there's slowdown, as well there should be. If you raise interest rates, as the Fed has been doing, you constrict the pool of potential qualified buyers in the market place, and so as we've seen, the amount of time that it takes to sell a house has now increased from four months to 4.7 recently. That's not so terrible, and that's not so surprising, and it is not an impending cataclysm that we're looking at. I think we're going to see real estate prices slow down, and that's probably a good thing, because if they run too fast too long, I think you do run into the possibility of a bubble at that point. But if they come down with a soft landing, and there's every indication that's the situation that we're in, then we're I think in pretty good shape. With all the press that there's been about a real estate bubble over the last seven months, I think it's a credit actually to the American public that they're not buying a whole lot of that, because you've seen no stampede, you've seen no panic selling. I think most home owners recognize that we've been through worse stuff than this. You get a little bit of interest rate pressure, you get a little slowdown in the market, that's not the end of the world.

CONSUELO MACK: At what point do you, or would you get nervous about the direction of the housing market? And you know, I mean is there a mortgage rate, is there an unemployment? I mean, when ...

FRANK GALLINELLI: I think ... (Overlap)

CONSUELO MACK: ... when is it that you really would get concerned about ... (Overlap)

FRANK GALLINELLI: You almost have to have a constellation of these things all happening at once. I think if you ... if you're to look at employment becoming dicey, interest rates suddenly starting to run at an accelerating rate, vacancies among commercial properties starting to balloon, all these other indicators, if they're all starting to come together at the same time then you might get a little antsy. We're not seeing anything of that sort at this point, so I'm not antsy.

CONSUELO MACK: Okay. One last question, and I guess it would be in the biggest mistake category. The biggest mistake that an investor in a real estate producing property can make, what are the kind ... what's the kind of mistake that you see people making over and over again that turn what could potentially be a good investment into a bad one?

FRANK GALLINELLI: I think one of the biggest mistakes is when you don't have the regard for the property that you really need to. You can not expect your tenants to take better care of your property than you do. If you allow deferred maintenance to accumulate, if you buy a property that has deferred maintenance and don't fix it, you're asking for trouble, you're asking for a disaster. Because no one is ever going to treat the property better than you do yourself. So the first thing you always must do is set very high standards for yourself as a property owner. If something is broken, fix it. If something is unsafe, make it safe. If something is dirty, clean it up.

CONSUELO MACK: Frank Gallinelli, really great tips. Thank you so much ...

FRANK GALLINELLI: Thank you.

CONSUELO MACK: ... for joining us.