The Real Estate Espresso Podcast

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Don't Drink The Wall Street Koolaid May 27, 2021

Show notes

On today’s show we’re taking a look at a front page article in the Wall Street Journal. I’m not one to rant very often about articles in the mainstream media. You could build a career out that endeavor. But this prominent article in such a widely read newspaper was particularly offensive. The article was entitled:

"Investors Buying Real Estate to Beat Inflation May Find Tactic Backfires"

I was a more offended by the slant of the article than by any of the detailed points in the article itself. The article seemed to imply that real estate is a bad investment in the current inflationary market environment.

I quote directly from the article.

There is no question that there are risks in any asset. But the article seems to criticize investors for piling into real estate and completely neglects the pricing of certain tech stocks and the stock market indices.

Of course any investor needs to properly analyze any investment opportunity and recognize where there are risks. Rent controlled properties can face situations where expenses rise faster than rents in an inflationary environment. This can be death to an investor. Real Estate isn’t the problem. Buying property in a rent controlled environment can be a bad idea.

For example, I’ve been a landlord in NY state in the past. I learned my lesson and I won’t do it again.

There is no question that some assets in some locations may experience a rise in vacancy. Yes, it’s more difficult to raise prices to match inflation in an oversupplied market condition.

The author of the article seemed to dance around one central issue without coming out and stating it.

Real Estate values follow the laws of supply and demand. News flash, you have to pay attention to the law of supply and demand. Since when did ignoring the law of supply and demand result in a good investment, of any description. Show me any investment asset that operates completely independently of the law of supply and demand.

All the author needed to say is that any investor needs to pay attention to the law of supply and demand when making investment decisions. Instead, he tried to paint the possibility of oversupply as a problem which in some markets makes real estate a bad investment. He also tried to paint longer term leases as a reason not to invest in real estate in an inflationary environment.

There are so many things wrong with this article that I almost don’t know where to begin.

The fact is, we have experienced rapid devaluation of the currency steadily for the past 50 years, dating back to the early 1970’s. Yes, we are in a period of heightened inflation. Who knows for how long. But a broad retrospective look at real estate over the past 50 years shows that almost all asset classes have experienced dramatic resilience against inflation.

Three things get wiped out in inflation.

purchasing power for those on fixed income
Savings gets wiped out
Debt gets wiped out

Since real estate investors tend to use a high proportion of debt in their investments, they almost always end up being the beneficiary of inflation because those long term loans get devalued disproportionately compared with all the other elements associated with real estate. Rents go up in price. Operating expenses go up in price. New Construction goes up in price. It’s the last item that causes existing real estate to rise in price. Since the loan on a property doesn’t go up due to inflation, the increase in price is always to the benefit of the equity holder. Therein lies the inflation hedge.

The Seller Knows Less May 26, 2021

Show notes

On today’s show we’re talking about the seller who knows very little about their own property.

It makes sense, the seller of a property had no reason to know about the development potential of their property. They’re an owner. All they do is live in a house on a property.

This week I was involved in a dialog with a seller who was offering their property at a good price. The purchase made sense. That is, it made sense until I was able to check the government regulations that would come into play.

In this particular location, the minimum lot size was larger than the current property. That meant that any changes to the existing structure on the property would require a zoning variance. The existing structure is in derelict condition and is not worth salvaging, hence the good purchase price.

But further examination found that the property is located across the street from an environmentally protected zone. That was the trigger to go and investigate whether the conservation authority over the environmentally protected zone also had jurisdiction over what could be built on this property which is outside the environmentally protected zone.

Two minutes of search with the address showed very clearly that the property was on the edge of a flood zone where 1/4 of the property was fully within the flood zone. The remaining 80% of the property was within the regulation limit of the conservation authority. The regulation limit of the conservation authority extends another 90 feet beyond the edge of the flood zone and the environmentally protected zone.

So what does this mean?

It means that permission would need to be granted simultaneously by two different bureaucracies for anything to be built on the property. That means simultaneously satisfying two different sets of rules, one of them clearly written, and the second one not written.

Naturally, I declined to purchase the property. The best I could offer was that if the redevelopment permit could be obtained while the property was still in the hands of the seller, then I would buy the property with the entitlement as a condition of purchase.

It’s possible that someone who doesn’t perform due diligence might buy the property. In an environment of people offering over the asking price, someone with more money than sense might come along. But the seller is now facing a choice. Nobody who knows what they’re doing will buy this property in its current state.

It’s the seller who has the problem, not the buyer.

In another case, the seller looked on his tax bill and assumed that just because his tax bill said that his property was residential, he assumed that it was zoned residential. Imagine his surprise when I let him know that the property was not in fact zoned residential. That meant that redevelopment of the property would require a zoning change since the existing zoning would not permit any form of development on the property.

You see these are not isolated cases. Sellers rarely know what they own. Sometimes the zoning is changed without their knowledge. Sometimes they knew that the zoning was going to be changed and were unaware of the consequences. Property owners often assume that since the property exists, it’s allowed to exist.

I’ve seen additions to properties that do not conform. The owners of the property never even bothered to check whether a building permit had been issued when they bought the property. Imagine their surprise when I told the seller that the back half of their property was not legally permitted and if there was ever a fire, the insurance company would not pay out on the claim.

That’s right, insurance companies will only insure property that was legally built. If it was built without a permit, their attitude is that it’s not a legal property and therefore they’re under no obligation to insure an illegal property.

The Value of Face To Face May 25, 2021

Show notes

On today’s show we’re looking at a potential backlash to the work form anywhere wave that we’ve experienced as a result of the pandemic.

There are several factors that have been largely ignored in the narrative over the past year. There are numerous businesses predicting a massive reduction in business travel, and traditional office co-location.

I’ve been reflecting on the majority of my career, in the world of real estate investing, and in my prior career in the high tech industry. In the tech industry we had video conferencing readily available from the early 1990’s. We used it frequently. There are lots of people for whom 2020 was the year of zoom meetings. Before zoom we had Webex, and GotoMeeting and a host of other platforms. You could screen share a powerpoint presentation. The audio quality was good and the video quality was also good. But even then, I would travel on average about twice a month for business. I had status on several airlines, and my number one business expense was travel. The question is, why did I travel so much? How did I justify all that travel when seemingly, so much was accomplished in 2020 and in the first half of 2021 with virtually no business travel?

What was it about physical proximity that made business so much more effective? Will we experience a zoom backlash and a return to physical meetings? I believe that the answer is yes. We will rediscover all the reasons why physical meetings are valuable.

Employee training
Mind share
The acceleration that results from physical proximity
Regulatory and tax consequences

Let’s look at all four of these elements.

1) Employee training. When people are physically separated, the time period between touch points can increase. Junior people who have not established the relationships and confidence to interrupt a senior leader have trouble knowing when to ask for help. The result is a tremendous loss of time before a problem is noticed and a course correction is initiated. Active management of people requires frequent check-ins of short duration. It takes a mature organization to learn how to do this well.

2) I find that when I travel and meet someone face to face, I get more attention from the person I’m visiting than if I were attempting to speak by scheduling a phone call. Many people don’t like to spend that long on the phone. They don’t have the mental stamina to spend two hours on the phone. But you can easily imagine having a white board discussion to plan out a project in a face to face setting. Even a two hour zoom meeting can be exhausting for many. You simply get a lot more done by meeting face to face. By meeting in person you get mind share, free of interruptions.

3) Despite the time involved with physical travel, I find that mistakes get uncovered faster, and misunderstandings get resolved when people meet face to face. While it is possible to have zoom meetings and those meetings can be productive, there is much more accomplished in a face to face meeting.

4) Many companies are taking the step to accommodate workers’ desires for more flexibility, but if employers aren’t careful, companies could open themselves up to costly tax headaches. Companies also have to shoulder the compliance burden involved with navigating a complex patchwork of local, state and, potentially, international tax laws.

Someone who resides in one state, but has their place of employment in another state faces multiple tax jurisdictions. But if they’re now working from home, where is their place of employment? If you’re the sole employee in that state, or in that city, did the company just open a new branch office?

No More Water May 24, 2021

Show notes

On today’s show we’re talking about something we take for granted. Water is ubiquitous. There is so much abundant water that it only becomes conspicuous by its absence.

Right now, drought is afflicting 88% of the American West, up from 40% a year ago, according to the U.S. Drought Monitor. In California, the mountain snowpack is at 58% of normal, largely as the result of one of the lowest statewide precipitation totals on record and an unusual spring warm-up. Most of the big reservoirs in California have sunk below half of their capacities.

This is profoundly affecting agriculture, and now real estate. We will feel the impact later this year as yields for many major crops including tomatoes, rice, lettuce, wine, almonds, and garlic all rely on water from this region.

Reservoir levels across the Southwest have been falling. The biggest of those reservoirs, Lake Mead, is 41% full after years of declining flow from the Colorado River. Federal officials are warning it is on track to slip below a threshold of 1,075 feet over the next two years, which would trigger government-mandated water cuts to millions of users. The Colorado River also supplies water to Mexico. Sadly, the river has been so taxed for agriculture and human consumption along its path, that the river no longer even reaches the Pacific Ocean.

Complicating matters is the Southwest’s explosive population growth. There seems to be a willingness to build cities where one of the essentials for living is missing. Why would you build a city like Las Vegas with a population of 2.7M in the middle of a desert. Why would you build a city of 4.6 million people in the middle of a desert. Of course I’m speaking of Phoenix Arizona.

Even coastal cities like Los Angeles are experiencing water shortages. But at least if you’re next to an ocean, you can get fresh water through desalinization. It’s expensive and consumes energy to produce fresh water from the sea, but at least it’s possible.

The Colorado river supplies much of the irrigation to California, the water supply to Phoenix Arizona and the surrounding area through the Central Arizona project which is a diversion of the river through central Phoenix.

There is another aspect to the drought in an area that has traditionally produced food in the US than any other region. 80% of the world’s production of almonds comes from the central valley in California. This crop is a huge consumer of water accounting for three times the water consumption of the city of Los Angeles. About 2/3 of those nuts are exported outside the state.

When we talk about real estate, we rarely worry about access to water. It’s almost taken for granted.

Tony Javier May 23, 2021

Show notes

Tony Javier is a specialist in using TV to market his real estate investment business. On today's show we're talking about the nuances of using this non-traditional marketing channel to generate interest with clients. You can connect with Tony at TonyJavier.com or at RealEstateMastersTV.com.

Boris Mordkovich May 22, 2021

Show notes

On today's show we're talking with a true expert in managing a portfolio of short term rentals. There are a lot of systems and some nuance to managing a portfolio of short term rentals. This is not a game for amateurs. You can reach out to Boris and learn more at buildyourbnb.com.

The Gambler And The Investor May 21, 2021

Show notes

On today’s show we’re taking a step back and taking a fresh look at what it means to be an investor.

But before we do, we need to clarify what we mean by investor. The English language fortunately has a rich vocabulary which makes it easier to make distinctions. These different words have different meanings. But sometimes in casual conversation it has become increasingly common to stretch the meaning of these words and use them inappropriately.

I think we would agree that a gambler and an investor are not the same thing. A gambler is engaged in a game of chance, knowing that the odds could result in a win or a loss. When you roll a pair of dice you have a 1/36 chance of rolling double sixes. That’s a 2.77% chance. Depending on the construct of the game, you could win, or you could lose.

When you go to the roulette table at the casino, you have a 1 in 37 chance of choosing the winning number. The casino will payout 35 times the bet, so on average, the casino will win all your money if you play long enough. But if you stop after a winning round, you could come away with some pocket money at the end of the evening. Nobody would ever confuse a gambler with an investor.

Gambling might be a way to raise money, but it’s not something you would ever do to raise money. You would never say, I’m going to the casino to raise an A round of financing for my startup company. There is a very clear distinction.

Investing first and foremost is about value creation and riding the coat-tails of value creation. When you sit back and ask a simple question like, “Why is that single family home worth $400,000?” The answer might be elusive to some. Some might say, well it’s because comparable properties in the area have sold close to that price.

If you ask the same question about a crypto-currency. Why is Bitcoin worth $40,000 or $60,000, or $2,000? The best you can come up with is “just because”. Well Just because doesn’t cut it. We get more sophisticated versions of just because. Some will say that there are a finite number of bitcoin in existence. It’s the artificial scarcity of a maximum 21 million that makes bitcoin valuable.

At last count, there were close to 10,000 other crypto-currencies in existence that are all variants of the theme on crypto. When you add the potential for those other currencies to provide substitution, the supposed scarcity of bitcoin is questionable. We have seen crypto enthusiasts talk about Etherium, RIPL, Doge, and numerous others.

But the notion that its value can fluctuate by 40% in a single month as we have witnessed in the past 30 days, means that crypto is not a useful store of value.

When you exchange dollars or Euros or Pesos for a crypto currency, you’re not investing. You’re not investing because there is no intrinsic creation of value. Which brings me to a new word we have not discussed yet today. That’s the word speculation. The word speculation is not that different from the word gambling when you closely examine the underlying meaning.

In the world of investing, I can buy shares in a project or a property or a company that is creating value in the marketplace. The residual cash created by that venture creates additional value that can be distributed to the investors as a return on their investment.

There is almost nothing in common between the world of gambling and the world of investing, even though there are those who seek to oversimplify the two and consider them equivalent. In the world of investing, you are taking calculated risks on the future performance of a venture. There is agency between the risk and the outcome which ultimately affects the outcome. In the world of gambling throwing the dice harder or with greater wrist action or a larger swing doesn’t affect the outcome. There is no agency.

Unintended Consequences May 20, 2021

Show notes

On today’s show we’re talking about what can happen when politicians monkey around with taxation structures. Tax structures are designed to raise revenue to provide services for the citizens. Unlike the Federal government which has the latitude to print money, states and cities eventually have to balance their books.

Cities and towns are not officially recognized entities in the constitution of the country. They are given their powers by state or provincial legislation, depending on which country you live in. So state or provincial legislation always trumps the local legislation. At the state level, they can enact new regulations that can turn things upside down for a city.

On today’s show we’re going to look at a well intentioned piece of state legislation that is having some unintended side effects at the local level. It’s a cautionary tale of what can happen even when things look stable and predictable. It’s the reason why you need to have an unreasonable amount of cash reserve available to handle the possible delays that can result.

The State of Idaho has implemented new legislation designed to protect home owners from surprises in property taxes. These rules put limits on cities and towns in terms of how they can increase property taxes on their citizens. Now the new rules are complex.

A really fast growing city might experience annual growth of 2% a year. So if the state imposes a cap of 8% growth in their budget for property taxes to grow from one year to the next, that seems reasonable. It seems reasonable until you look at specific boundary conditions. Let’s say that you have a number of small satellite communities outside the boundary of a major metro area. The overall metro area might be experiencing 1% annual growth. But if the growth of the city happens outwardly as it often does, then you can have a situation where a satellite community may experience hyper growth for a period of a few years. It’s not uncommon for a few major developers to come in and build 1,000 houses in a town of 5,000. That town of 5,000 might be on the edge of a town of 500,000. In that case, 1,000 houses as measured on 500,000 seems insignificant, but on 5,000 is 20% growth. That small town cannot support the growth because they would be required to expand services faster than they’re permitted to expand their tax rolls.

Now I won’t go into all the nuances of this particular legislation. It took a few hours to explain in the city council meeting I reviewed. For those of you who take the time to fully understand the new legislation will quickly realize that there are many provisions of these new rules which I’ve not included in this short discussion.

The city in question is Caldwell Idaho. Caldwell is a suburb of Boise which has experienced a tremendous amount of growth in recent years. Boise is one of the fastest growing areas in the country right now. We have several land development projects underway in the area.

So the city of Caldwell immediately implemented a 120 day moratorium on approval of any new development in order to give them time to figure out how they were going to respond to the new rules.

There is already very low inventory of properties for sale, and the continued migration of population into the area doesn’t know anything about why development applications are being slowed down. The result of that is that prices for existing homes will likely increase further and faster than they already have over the past year as the pent up demand is not satisfied. As the market values increase due to the higher demand, the assessed value for those properties will also increase. That means that those same communities will experience an increase in property taxes because of the rising values which was caused by the shortage of supply which was caused by the legislation aimed at reducing property taxes.

Adding A Few Zero's To A Mistake May 19, 2021

Show notes

On today’s show we are taking a look at a failure that has attempted to ignore what the underlying market data has been showing for years. The world of business follows the laws of supply and demand. But sometimes you see large companies making large investments hoping that large investments will somehow overwhelm the market and change the course of history.

Imagine for a moment if you went out and bought a poor quality shopping mall with high vacancy. You got a discount to the value from a few years ago and figured you would turn things around by offering some deals to entice new tenants. When that doesn’t work, you then go out and buying the gas station across the street to give you more control over the area. Yeah, that will help fix things.

The world of media has been constantly evolving over the past 20 years, and even longer. But since the 1990’s more and more people have spent more time interacting with the internet and less time with television. That is a clear trend with no doubt. Falling viewership has changed the economics of TV. The number of TV households in the US, Canada and Europe have consistently fallen year over year for the past decade. Our family cut the cord to cable TV back in 2007.

Therefore it’s no surprise that AT&T’s foray into the world of media has failed. Three years ago ATT was in court trying to defend their $80B purchase of Time Warner. We saw a foreshadowing of this outcome earlier in the year with the divestment of its stake in satellite distributor DirecTV.

The spin-off includes HBO, CNN, TNT, TBS and the Warner Bros. studio, into a new venture with Discovery Inc. Discovery’s CEO will be the CEO of the new venture and AT&T shareholders will own 71% of the new venture with Discovery shareholders owning the remaining 29%.

They’re wiping out tens of billions in shareholder equity in the process.

The folks at AT&T made a simple fundamental mistake. They forgot to understand what would add value in the eyes of customers.

This is the second time that the sale of Time Warner failed. The first time, was the $106 billion merger in 2001 with AOL Inc. which was one of the biggest flops in business history. Time Warner eventually spun off AOL.

What is striking about the entire Time Warner acquisition by AT&T is that much of the focus of the merger was internal. There were numerous reorganizations over the past four years. Each time, another wave of experienced people left the company. In the last round, they let go about 2,000 people including some of the industry’s best and brightest creative people.

This left rookie people running the show. They forgot that Time Warner was an entertainment company.

At this point you’re probably wondering what this has to do with real estate.

AT&T, or any business needs to remain relevant to its customers and fulfill its mission. When the business focus shifts to financial engineering of a profit, you can improve the numbers for a quarter. Some investments take longer to realize. So you can make a company profitable for the short term while taking the eye off the future profitability of the company. This kind of corporate shortchanging of shareholder value is rampant in corporate America.

In real estate, you can buy an obsolete asset for a discount and squeeze out a profit. You can buy a property in a shrinking market with falling values. If you buy it cheap enough, you can make a short term profit.

Buying DirecTV was like buying the Titanic after it had hit the iceberg. You could spend a lot of energy re-arranging the deck chairs and selling more drinks at the bar. But the ship is still going down. Buying Time Warner was a way of doubling down on the DirecTV purchase. If AT&T owned both content and distribution, then somehow it would wield more power in the marketplace and multiply its profits. At least that was the theory.

Unbundling The One Stop Shop May 18, 2021

Show notes

On today’s show we are talking about the trade-off of unbundling.

When you undertake a project, it’s tempting to have a one stop shop take the full responsibility for managing a project from start to finish. After all, the detailed steps along the way are not that complicated. How much more will you end up paying by bundling a few tasks together.

You would expect the small steps along the way to be fairly priced.

But detailed analysis almost always uncovers inefficiency.

Let me give you a few examples.

The first one is for a demolition project. The demolition contractor is someone I’ve used before. They’re being contracted to demolish the structure on a newly acquired site and to scrape the site clean.

I got a decent quote from the demolition contractor. But then I asked him a simple question. How much was he paying for disposal of the demolition and he said that he was paying $1,800 for a 40 yard bin. These are the really huge bins that you often see on construction sites that roll off the back of a truck with a hydraulic winch. That price included the bin and the disposal fee at the city landfill. It turns out that I have a relationship with a disposal company where I pay $225 for the bin and $95 per ton. So on an apples to apples comparison, I’m paying about $700 per bin as compared with $1,800 per bin.

A waste disposal bin is strictly a commodity. There is nothing about one bin that is going to result in a better finished product than another. When you multiply the number of waste bins needed, the savings are about $10,000. We’re talking about $10,000 in exchange for making one phone call and then sending 8 text messages when it’s time to deliver a new bin. The return for unbundling that segment of the project is very clear.

At the other end of the spectrum, we have an assisted living project that is scheduled to open in the next month. The budget for furniture is about $500,000. There are tables and chairs and sofas and coffee tables and artwork and outdoor furniture and umbrellas and on and on.

They need to tie together aesthetically and be functionally appropriate for an assisted living care home. This means that the furniture has to be durable and strong. This is not the kind of furniture that you might find at Costco or Ikea.

Initially we contacted a supplier who specialized in that kind of furniture. Very quickly it became clear that we would not meet the budget requirements if we sourced the entire project from a single supplier. So instead we decided to hire an interior designer. At first you might think that adding a designer would be an additional expense to the project. If we were budget challenged before, then adding an additional expense for a designer might seem strange.

There are a lot of moving parts and a multitude of details to be managed in sourcing the furniture, choice of fabrics, coordination of lead times and delivery to match the construction schedule.

By hiring the right designer, we were able to choose from a wider array of suppliers. Outdoor patio furniture which sees lower utilization than the indoor furniture could be from a less expensive product line. In the end, by using a designer we were able to stay within budget, despite the additional cost of hiring a designer.

Ultimately it comes down to managing the tradeoff of time versus money. Hiring someone to take charge of shopping around for the best deal only makes sense if you have leverage. Leverage means a small number of items where the savings can be substantial for minimal effort, or a large number of high value items where it makes sense to dedicate a staff member to getting the best deal.

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