The Real Estate Espresso Podcast

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AMA - Will Opportunity Zones Pull Money Out of The Stock Market? May 31, 2019

Show notes

David from Placencia in Belize asks:

"I was wondering your thoughts on opportunity zones. Specifically do you feel this can trigger a mass exit in the market that will drop stock prices for ones wanting to get into Opportunity Zones and trigger a crash or at least a a major correction?"

David, that’s a great question.

First let’s define the opportunity zone and what it’s used for, and then we’ll talk about the source of funds for opportunity zone investment.

Opportunity Zones are low income census tracts nominated by governors and certified by the U.S. Department of the Treasury into which investors can now put capital to work financing new projects and enterprises in exchange for certain federal capital gains tax advantages. The country now has over 8,700 Opportunity Zones in every state and territory.

They make up about 25% of the low income areas in the country.

Opportunity Funds are new private sector investment vehicles where the fund must invest at least 90 percent of their capital in qualifying assets in Opportunity Zones. Opportunity Zone investments offer a number of benefits for the investor.

A temporary tax deferral for capital gains reinvested in an Opportunity Fund. The deferred gain must be recognized on the earlier of the date on which the opportunity zone investment is sold or December 31, 2026.
A step-up in basis for capital gains reinvested in an Opportunity Fund. The basis of the original investment is increased by 10% if the investment in the qualified opportunity zone fund is held by the taxpayer for at least 5 years, and by an additional 5% if held for at least 7 years, excluding up to 15% of the original gain from taxation.
A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in a qualified opportunity zone fund, if the investment is held for at least 10 years. (Note: this exclusion applies to the gains accrued from an investment in an Opportunity Fund, not the original gains).

So virtually any capital gain would qualify to be reinvested in an OZ fund. You might have made a ton of money in, say, Bitcoin, or a piece of rare art work.

There is a ton of money in the stock market. But remember, less than 10% of the transactions on the stock market are made up of actual bona-fide value investing. About 90% of the volume on the stock market are program trades by the brokerage houses for their own account or for institutional investors. Those vast sums of money are largely seeking arbitrage profits. These short term trades fall under the category of trading, and not investing. The hold period is often too short to be considered eligible for treatment as a capital gain.

There are likely a spectrum of opinions on the topic and there are likely people who disagree with me.

I really don’t see the advent of opportunity zone tax sheltering as driving a selloff in the equity markets. There is a mismatch between liquidities in those two types of investments. I really don’t see stock market investors who have the ability to execute a trade on a moments notice then agreeing to tie up their money for the next 10 years. I think those investors are fundamentally different investors. Most of the long term money in the stock market is in the form of mutual funds, and a lot of that money is tied up in retirement accounts.

I expect that the majority of money going into opportunity zone investments is going to come from the sale of businesses where there is a substantial capital gain from a single event, the sale of other real estate assets where the purchase of a suitable replacement asset is proving to be difficult under a section 1031 exchange.

Tornado Insurance May 30, 2019

Show notes

The recent tornadoes to hit the midwest have cut a swath of damage and devastation. The storms hit populated areas including Dayton Ohio, and Kansas City. Over 100 tornados have hit the midwest in 12 straight days. Federal government weather forecasters logged preliminary reports of more than 500 tornadoes in a 30-day period.

These storms touch down quickly and offer little time to escape, especially in heavily populated areas where you don’t have a clear line of sight of the sky. Some people become complacent and ignore the severe weather alerts that are broadcast onto cell phones using the emergency preparedness system.

Even areas that are not known for tornado activity like New Jersey and Staten Island in the heart of New York City had tornado warnings this week. They can truly strike anywhere. Last summer, four tornadoes narrowly missed our home in Ottawa Canada.

A particularly destructive storm splintered homes, ripped up trees and downed power lines southwest of Kansas City.

One of our regular listeners to the show had a tornado damage their car, uproot trees, and destroy multiples homes in the neighborhood. Their own home fortunately was spared a direct hit and the impact was a lengthy loss of electricity.

Every year, homeowners dutifully pay their insurance premium, expecting that they will be covered against major risks like tornadoes.

Insurance companies are not in the habit of losing money. So it’s important to read your policy carefully.

Policies come in two major forms. There are named peril policies and broad form policies. In a named peril policy, you are insured against the specific risks that are named in the policy. These usually include policy limits both in terms of the scope of coverage provided and dollar limits for each named peril.

If your risk isn’t specifically insured you’re probably not covered.

The second type of policy is broad form. This basically covers everything and the exclusions are named specifically. Broad form policies generally cover more. But either way you still want to read the policy and ensure that you are properly covered.

Tornadoes represent several major risks. These include wind, hail, flooding, fire.

You might discover that the insurance company will attempt to assess which damage was caused by wind and which was caused by water. Water damage is the number one category for insurance claims and is therefore subject to the greatest limitations.

You may be able to purchase a separate flood insurance policy through the National Flood Insurance Program. Only 12% of homes in the US actually have flood insurance coverage. The remaining 88% are making the bet that they will not experience that risk, or they mistakenly think that they are covered.

However, if rain water gets into your home because your roof was damaged by wind, you may find that your insurance offers some protection — but only if your policy includes coverage for wind. Some policies that offer coverage for wind, list named storms as being excluded. For example if a storm is given a name like, say, Hurricane Andrew, that would be excluded from the policy coverage. Tornadoes are so short lived that they are not named storms. By the time they could be given a name, the storm is over.

It’s really important to read the policy, not just the one page term sheet that your insurance broker give you.

Exercising Leverage In Your Business May 29, 2019

Show notes

On today’s show we are talking about leverage. But folks I’m here to tell you that most people think of the word leverage in a very narrow way.

Most of the time when we say the word leverage it’s assumed that we are talking about borrowing money, financial leverage.

Let’s go back to the root of the word. A lever is used to describe what happens when you take a large stick or a pole and use it to multiply the forces. For example, I have a shovel with a really long handle. If I’m trying to remove a rock in my garden, I will use that long shovel as a lever. The force applied at the end of the handle is not very large and I’m able to multiply the force considerably at the end of the spade and pull that rock out of the ground easily. A lever can multiply forces, or it can multiply distance traveled.

There are many places in real estate investing that we can seek to get a multiplier. Financial leverage is what most people think of first.

But we can get a multiplier many different ways. For example it doesn’t take very much energy to release a huge amount of energy when you apply a needle to a balloon. Popping a balloon is a form of leverage where you get a huge multiplier.

The second form of leverage is when you can multiply your time. The easiest way to do that is to hire someone to do the work for you. That multiplier comes simply from saving you time. But if you hire the right people, they will also have skills that you lack in some areas. They will perform that same task many times faster than you could.

Another form of leverage is education. When you know of a better way, you can take a huge shortcut and reduce something complex into something that is extremely easy.

But there is one other form of leverage that is extremely powerful for real estate investors. That is scale.

You might work for days on a renovation of small single family home in an older neighborhood. When it’s complete, you might make $20,000 or $30,000 profit on that deal.

But even if you apply the other forms of leverage, you can leverage money by using other people’s money. You can hire people to leverage your time. You can use systems, processes and automation to make the use of time even more efficient. But at the end of the day, your profit potential is still that $20,000 or $30,000 profit.

But if you are working on a project with 100 apartments or 1,000 apartments you are leveraging scale. Instead of improving one single family home, you’re improving 100 or 1,000.

There are so many places in the system when you can get a multiplier in your business. Each one of these is an opportunity to exercise leverage. For example, an insurance policy is a form of leverage. You pay a relatively small insurance premium and in exchange, the insurance company promises to cover the risks named in the policy.

So many of you are stuck because you’re thinking linearly. You are thinking using simple the math of addition and subtraction. If you want an extra dollar, then you need to add a dollar to your bank account. There’s no question that addition and subtraction are essential to what we do. But given the choice between using addition or multiplication to bring cash into your bank account, a multiplier seems very attractive.

UHaul Isn't Just For Moving May 28, 2019

Show notes

U-Haul is known for the do-it yourself mover. Frankly they have a great product.

I especially have a soft spot in my heart for their smaller moving trucks. Are used to rent them on a regular basis when I was in my teens and early 20s.

One of the great things about Uhaul is that you can do a one-way rental without having a drop charge. But this also represents a problem for Uhaul. Eventually over time as people migrate around the country trucks and a bunch up in cities the people are moving to, leaving a shortage in cities where people are moving from.

Today as a real estate investor, Uhaul is a powerful source of data. They know where those excess trucks and trailers are bunching up. And I can mean only one thing. People are moving there.

The government also provides very useful information about net migration when they conduct their census every few years. But this information only gets updated every few years. Uhaul has the ability to measure statistically when and where people are moving on a real-time basis.

One of my criteria for investing in a particular location is influx of population. I will not invest in a shrinking city. I don’t care how good the deals are.

The state of Texas ranked number one in Uhaul‘s growth state for the third consecutive year in Florida ranked second and the Carolina’s ranked third.

The three states at the bottom of the list having the largest number of people leaving work Illinois California and Michigan.

Uhaul has a pretty good statistical data set. They compile their data from more than 2 million one-way truck and trailer rentals each year. And while migration trends do not correlate directly to population wreaking on the growth, the Uhaul data is an effective gauge of how well states and cities are attracting and maintaining residents.

In 2018, the North Dallas suburbs of Frisco and McKinney are some of the fastest growing areas. In fact the entire Dallas-Fort Worth metroplex is it tracking more population than any metro area in the country.

In Florida, Orlando topped the list as the number one growth market. Orlando offers a number of great opportunities. The city became known for its theme parks and resorts. But it's one of the top transportation hubs in the country. Within a few hours drive, you have access to 20 million population. The warm weather, low taxes, affordable cost of living, makes Orlando a top destination for retirement, and a vibrant place to work. It's one of the best connected cities in the country in terms of air travel with a large number of low cost direct flights to most cities.

It’s only one hour drive to the coast. So a day at the beach is easily accomplished.

AMA - Why Do Banks Write 30 Year Loans? May 27, 2019

Show notes

Today is another AMA episode, Ask Me Anything. Ryan from Fresno, California asks.

"I really enjoy your Real Estate Espresso podcast. Thanks for the great work.

The silly question has in my mind for a while. Why do banks, including lenders backed by Fannie Mae, make 30 year fixed loan to home buyers? When I bought first home in China, all home loans are adjustable rate. Let's say the interest rate goes back to normal level like 6-8% 2 years later, the bank (or whoever bought the security from bank) can still only get 4% for the remaining 28 years, do they lose money? On other hand, if interest rates go even lower, the home owner can always refinance. The bank does not have such freedom, will it put them at a disadvantage?

Regarding refinance, what is good criteria to apply for refinance? Interest rate dropped 10%? 20%? "

Ryan, that is a great question. In fact two great questions.

Let’s talk for a moment about how the banking system works. And let’s talk about how the banks make money. In the US, Canada, Europe, and much of the world banking system is based on a fractional reserve system.

That means that when depositors put say, $1 million in deposit at the bank, the bank makes money in several different ways. The bank is taking 1 million in deposits, but has the authority to write $10 million worth of loans against that 1M in deposits. The bank makes money on the difference between the interest rate it pays to depositors and the interest it collects from borrowers. Let’s do some simple math. Let’s say that the bank pays 1% interest to its depositor on the $1m deposit. Let’s say that it’s lending the money at 4%. The difference between the deposit and the loan is 3%. So the bank is making 3% on the money it loaned out for the first loan that it makes. But the bank gets to loan the money out another 9 times. In that case it’s making a full 4% interest times 9, which is 36%, plus the 3% from the original loan. So the bank is making 39% interest on the original deposit. That’s a pretty good rate of return. Now let’s say that interest rates go up during the term of the loan. Let’s say that the bank now needs to pay 4% to the depositors instead of 1%. In that situation the banks rate of return drops from 39% to 36%. They’re still very far from losing money.

Understand, when the bank makes a loan that is insured by a federally backed insurer, whether it is Fannie Mae, Freddie Mac, or the US government directly through the department of housing and urban development (HUD ), that is about the lowest risk loan you can write.

The business of banking is made lucrative by the bank leverage, that 10:1 leverage we just talked about. The other side of that is what happens when a loan goes bad.

If the loan is a conventional loan, then the bank has to write down the loss from the loan and it needs to find another $1m in cash quickly, otherwise it can’t pay the depositors their money when they go to the bank to make a withdrawal.

The other way that the bank makes money is through fees. They typically charge an origination fee at the start of a new loan. That fee is usually 1% of the loan amount. In the first year of the loan, the bank makes another 1% on each loan, which brings their total rate of return to 49% instead of the measly 39% they will make in subsequent years.

The second part of your question was about refinancing. Your question was about interest rates. It is true that getting a lower interest rate is part of the motivation for a refinance. But usually the main reason to refinance is to change how your equity is being used. Let’s say you own a building that has 50% equity. You might refinance to increase the loan amount and free up a bunch of equity. You can then take that money and go buy another building.

George Ross on Huawei Negotiation May 26, 2019

Show notes

On today's show I'm talking with George Ross on the current state of the negotiations between the administration and China surrounding Huawei, who happens to have a leading next generation cellular infrastructure offering with their 5G base stations.

Multi-Family Apartment Case Study with Sonia Lee May 25, 2019

Show notes

Sonia Lee is a syndicator based in San Francisco. She invests in multiple asset classes. On today's show we take a look at a 252 unit apartment complex in Evansville Indiana. Sonia's company can be found at leewardrei.com

Power Co-Generation For Fun And Profit May 24, 2019

Show notes

Earlier we talked about the economics of solar power compared with purchasing electricity from the power grid. On today’s show we’re talking about another form of power co-generation.

Many larger commercial facilities are turning to co-generation as a way of reducing high electricity costs. This only makes sense in areas where the cost of natural gas is considerably cheaper than the comparable cost of electricity.

Where these systems really shine is in the harnessing of the waste heat to heat water. The use of energy for producing hot water means that the savings can be substantial. If you’re familiar with the internal combustion engine, or the diesel engine, you are already aware that most of the energy is wasted in the form of excess heat. The diesel cycle generates much more mechanical work and relatively much less wasted heat than other systems. It’s about 44% efficient, which means 56% of the energy is wasted as heat. But if you can harness that heat and put it to good use, the savings can be substantial. The are particularly true in areas where the cost of electricity is high.

The latest example is a new hotel that just opened at JFK airport in NYC on the site of the old TWA flight center. The original structure was built in 1962 and was updated to create a 512 room hotel. The hotel incorporates some of the most innovative power generation technology. It stands apart because their system is so good that the hotel has fully disconnected from the utility’s power grid.

The system has four main features. The roof mounted generators are powered by low cost natural gas. Second, the hotel has a sizeable battery bank which allows the power plant to store excess energy during periods of lower demand. This means that a smaller power plant is needed to handle peak demand and the plant can operate with less fuel on average.

Third, they use the cooling system for the power plant to produce the hotel’s hot water rather than allow the excess heat to go to waste. Finally, the hotel also uses absorption chillers to create cold water from the hot water.

The hotel calculated their power consumption based on other hotel metrics and determined that their annual electricity bill with the utility would be about $5M. The payback on their entire installation is estimated at 3 years. Now that number definitely makes sense. But it makes sense partly because NY power rates are $0.21 per Kwh, the highest in the country. If the same hotel were located in Texas where electricity costs $0.11 per kWh, the payback period would double to 6 years, which frankly is still pretty good.

To date, about 600 buildings in NY state have installed systems like this. But most of them still connect to the power grid. The TWA hotel is one of the rare buildings that has gone fully off-grid.

There are an increasing number of systems like the one at the TWA hotel where the connection to the power grid is used to sell excess power back to the utility. Many health care facilities are required to have backup power generation systems under the building code. Rather than have these systems which have a high capital cost sit idle, many facilities choose to operate the systems to produce their critical power needs on a regular basis. They may draw peak power demand from the utility and sell the excess power back to the utility.

The final piece of the puzzle is the financing of these systems. An entirely new group of company s have surface which are willing to install the systems for a low monthly lease cost where the lease cost is offset by the power sales to the utility. The operation of power plant is maintained by the supplier, and the lower electricity bill can often result in operational savings in addition to the up front capital savings.

The Senator Lost His Tape Measure. May 23, 2019

Show notes

Have you ever had a situation where you had purchased something and then couldn’t find it? So you went out and bought another one? It happened to me. I couldn’t find my tape measure. It was in my toolbox. Eventually, I really needed it so I went out and bought another one. A few weeks later I found my tape measure. Now I have two.

The latest bit of insanity to come out of Albany New York is a proposed new bureaucracy.

Earlier this week, NY State Senate Deputy Leader Michael Gianaris joined members of the Neighbors Beyond Amazon coalition today to launch a new platform of policy proposals aimed at improving New York’s economic development climate. Senator Gianaris is leading the way with legislation that would require a social impact study for any major economic development project.

"For too long we have funded economic development without considering the impact it has on our neighborhoods,” said Senate Deputy Leader Michael Gianaris. “It’s time to change that and insist on development that helps our communities rather than hurts them. We must prioritize the benefit of everyday people and not just wealthy interests."

Senator Gianaris’ new legislation would require a Social Impact Study, similar to the currently required Environmental Impact Study, to be completed before major economic development projects are undertaken. This would give communities a chance to understand the need for addressing housing and transportation before funding is permitted.

It’s inconceivable that any major project gets undertaken in the state of NY without involving a zoning application. The zoning process is a 5 step process. This is required for anything that does not fit the criteria of being built “by right”.

The final review process once all the applications have been submitted is also a 6 step process called the Uniform Land Use Review Procedure.

Certification
Community Board Review
Borough President Review
City Planning Commission Review
City Council Review
Mayoral Review

Within sixty (60) days of receiving the certified application, the Community Board is required to hold a public hearing and adopt and submit a written recommendation to CPC, the applicant, the Borough President and when appropriate, the Borough Board. The entire process takes 265 days according to the City of NY disclosures. The ULURP rules include provisions relating to the notice and conduct of a Community Board public hearing.

The senator is concerned with the financial impact on infrastructure for any planned project. It seems to me that the City Planning Commission, City Council, and the Mayor are already tasked and mandated with managing those aspects of the impact of a project. That’s why those organizations exist.

If an environmental impact study is required, then you can add a minimum of 110 days to the process, and that’s a minimum. That’s the fastest the process could ever be. If you read the environmental impact study rules, chapter 5 already deals with social and economic impact. It lays out the rules for conducting a social impact study in addition to the environmental impact study. A socioeconomic assessment should be conducted if a project may be reasonably expected to create socioeconomic changes within the area affected by the project that would not be expected to occur without the project. There are chapters that deal specifically with Water and Sewer Infrastructure, Transportation, Energy, Air Quality, Noise, Neighborhood Character, Sanitation, and Public Health.

The whole thing reminds me of the time when I lost my tape measure. Our legal system is so stuffed with regulations that our own lawmakers have no idea what’s in there.

AMA - How to Design A Podcast Show? May 22, 2019

Show notes

Billy from Barcelona Spain asks:

I’ve been listening to you RE Espresso podcast recently and I really enjoy your perspective and the content…

I’ve been thinking of starting a podcast and have gotten stuck on the design of the show, and some of the technical aspects of creating a podcast. What has been your experience in producing a daily show?

Billy, that's a great question.

I had three main ideas in designing the show.

1) I felt that if I was going to get good at podcasting, it would need to be a regular show. Putting out a show once a week, or less didn’t seem to make sense to me.

2) The current population of podcast listeners is about 75 million people in the US. It’s growing about 15% -20% per year. Those listeners on average subscribe to 6 and listen to 5 because that’s all they have time for.

Increasingly, podcasting is attracting the same kind of attention and production values that radio and TV have been known for. The major networks are starting to enter the fray with well produced shows. If I’m going to be one of 5-6 shows, I need to be that good.

3) I’m a huge fan of Seth Godin. He’s written 18 books in his career so far.

He has a daily blog that aims to communicate one idea each day. Not two, not three, just one. That idea seemed very appealing to me.

So I designed a show that incorporated those three ideas at the core of the show.

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