The Real Estate Espresso Podcast

On today’s show we’re talking about the real estate required for renewal energy. There are significant narratives about the need to transition from carbon based energy sources to renewable energy source. Renewable energy sources fall into three principal categories 1) Hydro-electric 2) Solar 3) Wind But we’re also talking about how the increase in the use of solar and wind power will also require an equivalent production capacity of natural gas or other carbon based generation. This may sound counter-intuitive. But when you understand how renewable energy sources work, you will quickly understand how the renewable resources will require a complete duplication of the power generating capacity. I’m a huge fan of solar energy. I love the idea that you can get energy for free just by sitting there in the sunshine. I have solar power on my boat and I love that I rarely have to plug into shore power. But the problem is that the math doesn’t add up when you try to extend the renewable argument on a national or global scale. The problem with solar and wind energy is that they only operate on average between 10-30% of the time. They reduce your average fossil fuel consumption, but you have to design the entire electrical system to handle the peak consumption, not just the average. When it’s dark and it’s hot and there’s no wind, your electrical system still has to produce enough power. If it doesn’t, then you have large scale outages which can take days or weeks to recover from. You have to assume that at least part of the time the solar and wind infrastructure are contributing nothing to the network. It’s as if they don’t exist. So you must have a completely parallel system to produce power that is not relying on renewable forms of energy. Even assuming that you could cover an area the size of the state of Texas with solar panels, you would need to replace that area with new panels every 25 years. In addition, you would still need to maintain a fossil fuel infrastructure for those times when the sun is out of view and the wind stops blowing. If you replaced an area the size of the state of Texas with solar panels, you can imagine the impact on wildlife and ecosystems by essentially paving over that much wilderness. You can’t relocate that much wildlife successfully. I believe there is a real estate play in the realm of renewable energy. This is an area that will increase in importance in the coming years. But the projections of replacing a large percentage of fossil fuel consumption with renewables in the next 20 years are wildly optimistic and are simply not supported by the scale of investments that are being contemplated. Too much of the near term narrative is really about arguing over who gets to pay and who gets to keep the carbon credits. Carbon credits don’t help the environment directly. They don’t result in any reduction in carbon consumption. The natural environment is not a party to our financial system. When an environmental argument gets reduced to a fight over money I start to lose sight of how we are going to replace our carbon consumption.

On today’s show we’re talking about the discipline of performing your due diligence in underwriting and budgeting. I had the experience earlier this week when I received a construction estimate from a major, very experienced general contractor. This particular GC does several billion dollars a year in new construction. They have a top notch team and they have top notch systems internally. The number was much higher than our budget allowed for. If the estimate was true, we didn’t have a viable project. Naturally our team leapt into action to try and understand why the numbers were so high. We scrutinized all of the assumptions. This involved examining specific line items against the benchmarks we have for similar projects. For example we had a budget estimate of $19,000 per condo apartment for plumbing. It’s not as if a condo has more sinks or toilets or pipes than a rental apartment. There is still only one sink in the kitchen, one dishwasher. Why was this line item so high? Was there a technical requirement to use copper for water and cast iron for sewer? After further review, no the plumbing pipes could be plastic and the sewer pipes could be PVC or ABS. It turns out the GC had assumed higher end finishes for the fixtures in the bathrooms, but in reality there was no justification for the cost of plumbing to be so much higher than expected. There were several line items like this out of several hundred detailed line items. The General contractor provided their internal material take-off tool to help us understand how the estimate was put together. A phone call ensued in which we outlined our assumptions for the level of finishes, types of windows, amenities and so on. On that basis, the GC took the feedback and a few days later they came back with a new estimate. This new estimate was slightly below out budget. The initial reaction by most of the team members was one of relief. It’s amazing how it’s tempting to feel good when someone tells you what you want to hear. When you hear the right answer the curiosity to dig deeper often dissipates. But a good number is every bit as dangerous as a surprising number. It deserves every bit as much scrutiny as before. It’s not because the cost of drywall went up by 10% that the project will be over budget. In my experience, there will be a fundamental assumption error in the project. That’s where the big errors creep into a budgetary estimate. It’s because a line item was zero when it should have had another number. Even when the number is what you’re expecting, it can have mistakes. You can have a situation where two errors cancel each other out and hide the mistake. We took the time to scrub the numbers. Here too, we found problems in the estimate. This time, the numbers were too low. That situation is just as damaging, perhaps even more damaging than the reverse situation. But I have to say it took a lot more energy to muster the motivation to scrutinize these numbers that looked so much more attractive. But as soon as we found the first problem, the motivation was there to keep digging and make sure we understood the budget estimate fully. It takes a lot of energy to check everything for safety. It take diligence. As humans it’s exhausting to be on high alert all the time. So instead of performing due diligence on everything, most people have adopted a check for comfort as a proxy for due diligence. If they feel comfortable then they don’t bother looking any further. You don’t walk around the house checking if all the windows are closed at night. You do a simpler check. Are you comfortable? Is the house drafty? If you don’t feel a draft you don’t check the windows. A check for comfort is used instead of a check for safety.

Anthony asks Real Estate is a game of big numbers. Amassing enough capital can be challenging and time consuming. If you only had $100,000 to invest, how would you do it? Anthony, This is a great question. Rather than answer the question directly, I’m going to give you some things to think about. I’m going to raise more questions that I’m going to answer. Before we even talk about what to buy, you need to answer the first question which is whether you want to be investing actively, or investing passively. In the case of an active investment, you’re doing the asset management, which means you’re overseeing the construction management by hiring a general contractor, you’re overseeing the property management by hiring a property manager, you’re performing all the analysis on the property and securing any debt on the property. The other option is for you to invest passively in someone else’s project. In that case, you’re likely going to be part of a syndication, or perhaps you can invest in someone else’s project either through a joint venture or a tenants in common structure. From a legal standpoint, you probably want to ensure that if you’re going to be investing in someone else’s project, that they are following the securities regulations that prevail for where the project is located, and for where you are located. When there are multiple jurisdictions involved, the syndicator may need to be in compliance with multiple sets of rules. If you’re going to be investing passively, then I would recommend that you spread your cash between two projects that meet your criteria, and that you don’t deplete your cash position down to zero. Always ensure that you keep some cash in reserve. These projects could be strong cashflow projects such as a self storage project, or perhaps an apartment syndication. But more important than the deal, you need to perform significant due diligence on the sponsor. If you’re going to be a more active investor, then you want to pay attention to the kind of asset you intend to buy. That means the location, the profit potential for the deal, and the risk of the deal going sideways on you. In today’s market, there’s very little of quality that you can buy for $100,000 that will create a significant income stream. The key to accomplishing more in real estate is leverage. Leverage comes in several different forms. The traditional form of leverage is to go to a bank, borrow funds, secure the funds against the real estate and bring your equity to the table. If you do that, you might be able to use your $100,000 along with, say, $400,000 of the bank’s money for a total of $500,000. Then the asset you’re buying has a cost of $500,000. The problem is that you’re out of cash and if the property has a problem, you need to find more money somehow to solve the problem. A small project of only $500,000 has the drawback of being a small project. It’s not large enough to attract the kind of top talent that you want to be managing your real estate investment. So my recommendation is that you find a partner who has sufficient cash to bring the majority of the equity to the table. Let’s say that you bring $100,000 and the other partners bring $900,000 in equity to the table. You’re leveraging your equity. Then let’s plan that the equity will also get leveraged with some debt, where you bring $4,000,000 in debt to your $1M in equity. Now you’ve purchased a $5M asset with your $100,000. You might only own 10% of the $5M asset instead of owning 100% of a $500,000 asset. Why would you choose to do one versus the other?

On today’s show we’re talking about how rising real estate prices can kill a rental market, but create an opportunity for new products in the market that might defy conventional wisdom. There’s no question that many different folks are struggling with the changes that have taken place in the market in the past year. Some have lost their employment. The incredibly low inventory of single family homes has seen prices shoot up across many markets. This is particularly true at the entry level of the market where first time home buyers are bidding up the price of entry level homes in order to overcome the fear of missing out on home ownership altogether as prices increase out of reach of some buyers. Many growing markets are also experiencing a shortage of rental housing. But some of these homes are too expensive to put into the rental market. So there is financial incentive for owners to remove rental stock from the market and move it into the owner occupied segment of the market. They can get a financial win simply by listing the property on the market. As soon as that happens, there is one less property for rent in the market which reduces vacancy. The smaller rental supply pushes up prices for rental homes, until a new equilibrium in found. But in some ways, no new equilibrium truly exists. This is because the numbers don’t support creation of new rental stock at relatively low rents. Given the choice of building a rental building or a condo building, the economics don’t support a rental building. The net result is the most successful developers look for the combination of demand in the market combined with the ability to buy in that market segment. Even the home owners who would like to sell are saying that they can’t sell because they have no place to go. So if you have a client with a 4 bedroom house in the core of the city and they still want to live in the same area, how do they cash out of their existing home and move into something smaller, but not something so small that they can’t live their lifestyle. Someone downsizing from a 3,000 SF home will not likely move into a 700 SF apartment, where the bedrooms are 10 feet or less in size. You can’t even fit a dresser in the room with a queen sized bed. So for this specific client, the condo’s need to be at least 900 SF, and in many cases ideally 1,300-1,700 SF. They can afford the larger units because they’re downsizing from a much larger house.

On today's show we’re talking about when an approval is not really an approval. You think that once you’ve got your zoning approval, or a development agreement with the city for a particular property, you’re good to go. The vast majority of the time, that’s the case. But in the rarest of instances, you can experience a reversal of that approval. I’m increasingly of the opinion, that these occurrences are in fact not that rare. Why would I say that? Well, because it has happened to me on one occasion so far in my career and I know of it happening one two other occasions to friends of mine. Then there are the highly publicized cases that make the headline news like the property at 200 Amsterdam Avenue in NYC. That case was a 52 story residential tower in Manhattan. The developer received it’s building permit after a lengthy process with the board of standards and appeals. Local residents objected to politicians after the building was already under construction. A court case followed and NY State Supreme Court justice W. Franc Perry ruled that the developer had improperly deceived the zoning department when it applied for the 52 story tower. The court ruled that the building was illegally high and ordered the illegal floors already constructed to be removed. That would mean demolishing about 20 floors of construction. The ruling was appealed and the appeals court countered that the state Supreme Court should have deferred to the BSA’s “rational interpretation” of zoning regulations. You’re a real estate investor, a developer, or merely a purchaser of a new unit in a project that is to be built. You expect that when the city says yes, they mean yes. In the latest incarnation of a municipal flip-flop, we have a new development subdivision held by one of our team members. There is a signed development agreement. But in the past three months the city has changed their zoning code and eliminated the R4 zoning from their code. The approved site plan would not be approved if we applied today, but the application was started before the change in the zoning. We had been told that the application would be grandfathered. So the application continued and the engineering of the entire plan was completed assuming the building permit would be approved with the final zoning plat approval. The last step in the process to seal the deal is a vote by city council to ratify the signed development agreement. But somewhere along the way, the lawyers for the city reviewed any new development agreement that didn’t comply with the new zoning to see if there was a mechanism to terminate the agreement. Indeed the city fully intends to terminate the agreement. This will require a redesign of the subdivision in order to comply with the new zoning density. The approval process is not straightforward. As we reported a few weeks ago, the city of Caldwell in Idaho is implementing a moratorium on new development applications for 120 days. The risks are not only achieving your desired plan, but time. Time delays are routine in the zoning process and as we have seen, even after all the approvals are granted and the project is under construction, it’s still possible for obstacles to appear. It is for that reason that in our development applications we aim whenever possible to submit an application that complies fully with the zoning and has zero variances. If we’re going to ask for a variance, it’s got to be for a really good reason. It won’t be to get an extra 5%. It’s not worth risking the entire project for such a small gain. If there is a variance to be granted, you have to ask a simple question. What does the community get as a benefit as a result of granting the variance? If the only benefit is that the developer gets to make a bit more money, then that may not be good enough a reason. There has to be a win for the community.

Billy Brown is based in Nashville. On today's show we're talking about taking chips off the table to ensure you have a strong cash position going into the next economic cycle. To connect with Billy, visit https://theinvestorscapitalgroup.com. 

Kevin Brenner is based in Washington DC where he is still on active Air Force duty. He's launching his first real estate investment fund and on today's show we talk about the merits of the fund model versus the individual investment. To learn more, reach out to Kevin at risewithnimbus.com.

Tom asks, First of all, thank you for your dedication to provide as much value as you do on such a remarkably consistent basis. I own a portfolio of multi family properties with about 2/3 debt and 1/3 equity. Almost all of my net worth is in my real estate holdings. The way I see it, I am long economic growth and inflation. I’d like to buy a hedge so that if we get hit with a contraction or deflation or spike in cap rates that decrease values, the hedge pays off. How would you - or do you - hedge? Which financial products would you consider? Tom, This is a great question. I’m hearing a couple of assumptions and questions wrapped up in your question. The first is that we could see a market down-cycle at some point in the future. The challenge with pure hedge investments is that they tend to be short term. I’m thinking of options to sell shares in the stock market. That’s a traditional hedge. But you need to time the market pull-back correctly for that to work. Unless you have a strong analysis team and have developed an expertise in hedging, it’s very difficult as a short term strategy. Longer term hedges are more moderated in approach. I think the basic premise of using inflation to give you leverage is sound. We have gone through nearly a century with no sustained reversal of inflation. If you’ve been listening to this show for a while you know that inflation can be your enemy or your friend, depending on which side of the trade you are participating in. Inflation devalues the purchasing power for those on fixed income, it devalues cash savings and it devalues debt. Inflation results in higher asset prices for real assets which provides an effective hedge against inflation. Your strategy is the right one in my opinion. In this instance, leverage is your friend. It means that even in an environment of slower economic growth, or perhaps economic stagnation, if inflation continues, the benefit goes to the equity side of the equation. You don’t want to be so highly leveraged that you build a house of cards. The most important thing is to protect your assets. The first step in doing that is to convert your debt from recourse debt to non-recourse debt with the longest possible term. This may sound like a small point, but it’s not. Recourse debt has a personal guarantee associated with it. While you’re probably investing through a corporate entity, you probably have personally guaranteed the debt. But if the debt is non-recourse debt then you get to keep the asset on your personal balance sheet, and you don’t need to report the debt on your personal balance sheet. You also want to maximize your cash position by maximizing your leverage. Once you’ve done that, you can purchase additional inflation hedges. I’m thinking specifically of gold. When I say gold, I’m talking about the physical metal. Gold is a very liquid asset and it’s also a pretty good store of value. It’s an effective hedge. The critics of gold would say that gold doesn’t cash flow and therefore they don’t consider it to be a very good investment. They would say that gold goes up and down and that investors pile into gold during times of economic worry. Investors largely ignore gold in the good times. You would like to use cash but your cash is tied up in gold and in properties. So you go to your cash rich uncle, or cash rich lawyer and negotiate a low interest loan where the lender holds the physical gold as collateral. The lender is completely secure in their loan. They’re holding highly liquid collateral. There is no need to qualify the borrower since this is an asset based loan. The market has created a lot of value for equity investors lately. Some are using it as an opportunity to take some chips off the table and hold them in reserve for future opportunities when they arise. I personally think that gold is a good hedging strategy when kept as a liquid borrowing tool.

On today’s show we’re talking about a disease that is rampant throughout the world of real estate investing. This disease is everywhere and it is the source of millions of dollars in lost revenue and increased expenses. There is no vaccine against it. There is no outright cure. But with good process it is possible to be immune from this disease. The disease I’m referring to is called versionitis. Versionitis happens when you reference the wrong version of a document, an outdated version of regulation, or the wrong version of a drawing. It’s the source of misunderstandings, it causes wasted materials, cost over-runs, and contractual disputes between contractors, architects, subcontractors and owners. It happened to me very recently. The planner for the city sent me a document. She told me it was the latest and greatest. It was not yet published by the city on their website, but we should use the one she sent us as a guide for our development plans. So I did as she suggested and saved the file, referred to it frequently, and built our plan based on her guidance. Imagine our surprise when the newly updated published document on the website didn’t match the version the planner sent us. All of this happened in the span of two weeks. You might be a subject matter expert in a particular area. You know the regulations. But the regulations change without warning. I had a real estate agent give me an environmental report for a site that had contamination. She told me that the concentration levels of gasoline in the ground were below the required level of 150 ppm. But then the regulation changed to 50ppm and she had no idea. She was operating on stale data. We had a subcontractor bid a job based on an old drawing. The GC made a mistake and didn’t include the latest drawings in the contract, even though the old drawings referenced in the contract were nearly 6 months old. The result was several mis-steps where the wrong components were ordered. The building inspector for the city pointed out the deficiencies and the new parts needed to be ordered for the HVAC system. The cost of this single error was more than $60,000. Every time a copy of a file is made, there is a chance of versionitis. So how do you prevent versionitis? It requires a discipline. It means that every time you reference a government regulation, you go to the website and download a fresh copy of the document. Every time you share a file, you send a link to the file and not the file itself. You see, the second you make a duplicate copy a file, one of those versions is potentially out of date. Even within our own team, we have to exercise great care and put version numbers and date codes in the name of a file. The cost of implemented a bullet proof document management system is not that much. It’s a few thousand dollars a year. But saving a single costly mistake makes the investment look like a bargain. We’re in the process of evaluating several software systems. In the coming months, once we have selected and implemented a system we’ll share more about what we chose to use and why.

On today’s show we’re taking a look at how job creation is going to drive migration and ultimately affect local real estate markets. The US recorded the lowest number of jobless claims in the pandemic in the second last week of May. This is a further sign that economic recovery is taking hold. The number of people vaccinated rose quickly in the first quarter and is slowing. Still, the number of infections and hospitalizations in the US are falling steadily and many local economies are re-opening as a result. We have some states that have been slow to open up from the pandemic and others that have been faster on the path to economic recovery. In a recent report published in the Wall Street Journal which relies on data from Zip Recruiter, there are some states where the number of job seekers exceeds the number of job openings. Those who have lost their jobs are having a hard time looking for work. I’m thinking of states like California and Arizona. This is not a red versus blue argument. These states were very hard hit by the pandemic and they have been slow to re-open their economies. California’s unemployment rate is at 8.3% and has held pretty steady since earlier this year. But in other states like Utah, Idaho, and Kansas the number of job openings far exceed the number of unemployed by more than 3:1. Finding qualified labor in today’s market has proven difficult in those states. The current unemployment rate in Utah is on 2.8%. A number that low would be the envy of any economy. Idaho had an unemployment rate of 3.1% at the end of April. Fully half the states in the US have decided to end the special pandemic unemployment benefits ahead of the previously published September deadline. Many states are ending the benefits in the next 2-3 weeks. It remains to be seen whether the labor shortage is the result of people preferring to stay home and collect unemployment benefits, as many have asserted, or whether there is truly a labor shortage in many markets. By the end of June we will start to know the answer. As these benefits end, we will want to keep a close eye on the job metrics and how these new jobs get filled. Will the labor come from the local population, or will it be the result of migration from other parts of the country. It’s very difficult to generalize. But some states like Utah which have strong midwestern values, I have a hard time believing that people are sitting at home collecting a government check and watching Netflix all day long. So the real question is whether the new job creation will also create new demand for housing that is not apparent in the current real estate market metrics. We are seeing strong migration into those midwestern mountain states. Some people are clearly moving to those states. I’ve spoken with several people over the past year who are relocating. Some are moving for work, but in fact some are moving for the lifestyle and more relaxed pace of life associated with these states. When I look at unemployment numbers, they can be a leading indicator of housing demand.