The Real Estate Espresso Podcast

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.

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.

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.

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.

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.

Mike from NJ asks: With the rapid increase in prices, I’m finding the environment so much more competitive and it is getting harder to find deals. Do you have any advice for someone who is looking to find deals in today’s environment? Mike, this is a great question.  First of all, while the market has become more competitive, I’m finding that deals are still out there. But before we can find a deal we need to define what is a deal. It’s a little bit like asking if the image on a magazine cover is beautiful. Whether the image is beautiful is in the eye of the beholder. Recognizing a deal means really knowing your numbers. You need to be on top of market values in your local area. When I say market values, I’m talking about the hyper local values that apply in almost every market. It turns out that in situations of very tight supply such as we have right now, the radius you can consider is usually expanded. But above all, if you are looking to establish new values in an area, the key is to gain control over enough of the area that you can convince the market of the prices you are setting in the market. There has to be sufficient scale to create a meaningful and convincing data set. I’ll give you a simple example. Last year, I bought a property that is on the border of a fast flowing River about 30 minutes outside the city. The purchase was a bank sale, and yes we got a good deal. The second property was an off market deal for the property next door. The negotiations started when the neighbor died. The family clearly wanted to sell the property and the proceeds from the sale would be divided among 7 next of kin. At about the same time, I started a dialog with the owner of a property across the street. This house is in physical distress. The owner does not want to do any further maintenance on the property. He is in his 70’s and actually has a farm house that he wants to restore. He wants to use the proceeds from the sale to restore the farm house. So how does this small example help you? I could give you another half dozen examples that are similar. In each case there is a special story surrounding the property. In each case the finished product will not resemble the current property in its current condition. The vast majority of buyers in the market are still looking for properties that are move in ready. It’s a small percentage of buyers who are willing to redevelop a property. Let’s go back to the definition of a deal. I have a clear idea of what the finished product will be and what it would sell for in today’s market. Our team is hands on involved in quoting construction projects on a daily basis. We can back up from the final sale price to determine the residual land value that we can afford to pay and still have a project that meets our margin criteria. I’m describing three different properties that next to each other in the same neighborhood. If I was just doing a single property, I would be less confident in the prospect for the area. But I know that the value is often set by the neighbouring properties. By controlling the neighborhood, I’m controlling the value. Once you go through the effort to understand the local approval process, the incremental effort to do three is small compared with doing one. If you have been listening to this show for a while, you have no doubt heard me talk about the buy on the line, move the line strategy. The core of the strategy is to transform enough of the neighborhood that you raise the value not just for a single property, but for the entire area. We pioneered this strategy in Philadelphia during the depths of the Great Recession. Here too, we found many deals off-market. Some were auctions. But the process was exactly the same.

Alicia Jarrett is a repeat guest, all the way from Melbourne Australia. On today's show we're talking about two very different approaches to marketing. You can learn more about some direct marketing strategies from Alicia at superchargedoffers.com. 

Ryan Severino heads the economics research team at commercial brokerage house JLL. Based in NYC, Ryan is tasked with providing guidance that informs the business planning for the company. Ryan publishes a weekly economics piece on LinkedIn. You can connect with Ryan through LinkedIn or through his research team at JLL.com

Today is another AMA Episode (Ask Me Anything) Carlos from Los Angeles asks, We have a single investor who capitalizes most of our deals. He has recently been very focus on investment multiples in our investments and not as much on cash-on-cash returns, IRR, etc. He comes from the private equity world. We have recently tried to highlight our overall returns once you factor in the tax benefits from depreciation. Since we are all in different tax brackets, this is a little tricky to do (in my opinion). Is this something you try to quantify for your investors? Below is an excerpt from our investment memo highlighting the "tax-adjusted" cash yield and IRR. We worked with our CPA to quantify this. This is a deal that our investor is not too excited about. We are using 1031x funds and are trading for a lower-risk property. Carlos, this is a great question. As a general rule we don’t stray into the realm of offering tax advice for the simple reason that everyone’s personal tax circumstance is different. I’ll give you a simple example. Let’s imagine for a moment that an investor is using funds from their retirement account. Any income received within the retirement account would be tax sheltered. In that scenario any tax benefit that would accrue to the investor from depreciation would be zero since they’re already in a zero tax situation for that specific investment. On the flip side of the argument, we do point investors to educational material that may help them in the arena of making a decision on how best to structure their investment. They might decide to use cash funds instead of retirement account funds for that specific investment in order to take advantage of Investment multiples are a very simple way of evaluating the quality of an investment. But of course they neglect time. If a project is delayed, it has the effect of lowering the annualized rate of return. Of greater importance to the more sophisticated investors I speak with is the return of capital, rather than the return on investment. This involves a deeper assessment of risk. I have to agree with your investor that the returns being offered by the proposed project are rather thin. Thin deals by their very nature represent higher risk. It often takes only a small change in circumstances for a thin deal to go sideways. If you have two things go wrong, now you’re underwater. I like the inherent safety of high profit margin deals. High margin deals provide ample financial cushion for problems to occur. Risk assessment is extremely difficult to objectively quantify. After years of stable market conditions you might but a buffer for increased lumber costs. You might argue that a 20% or a 30% increase in lumber or a 3-5% increase in the overall cost of construction would be reasonable. No rational risk manager have predicted a 300% increase in the price of lumber. If your project had not pre-purchased and warehoused the materials, or if you didn’t have the financial cushion to withstand the material price increase, your project would be in trouble. The impact of the tax sheltering creates the illusion of a better investment that is not necessarily real. I personally would rather find another vanilla investment that offers a stronger IRR without relying on the tax structure to make it viable. We take the attitude that an investment should stand on its own. If the tax structure offers an even better return, then that’s icing on the cake. I find that most investors I speak with prefer to separate the tax consequence from the investment decision. Even for a single investor, their tax circumstance can change from one year to the next. What might be advantageous one year, might be of marginal value the next. Thank you Carlos for a great question.

On today’s show I’m going out on a limb to predict a fall in steel prices over the coming months. This will benefit the cost of many types of construction including industrial, and concrete structures such as apartment buildings and condo towers. While the industry insiders are not yet making this claim, I’m going to construct a thesis for this prediction and connect the dots for you. At the end of this, I believe you’re going to be convinced that my prediction has some validity. I can’t tell you exactly how much steel prices will fall, or even for how long. All I can tell you at this juncture is that steel prices will fall. The headwaters of this story start at a microchip manufacturing plant in Japan. You’re probably thinking, what does a chip manufacturing plant in Japan have to do with the price of concrete construction. About 6 weeks ago there was a fire at a Renesas semiconductor plant in Naka Japan, just NE of Tokyo. This 300mm facility manufactures chips largely for the automotive industry. In fact, Renesas commands about 1/3 of the share of the market for microcontroller chips used in automotive applications. The fire impacted about 6,500 SF of clean room, and destroyed 23 machines that are used in the manufacture of chips. Two weeks ago, Renesas executives announced that they had completed the cleanup and were preparing to restart partial manufacturing capacity by the end of April and hoped to restore full capacity by July. But even before the fire in the Renesas facility, there were signs of chip shortages in other semiconductor manufacturing facilities. The impact of the chip shortage on the automotive industry has been estimated at as much as $60B this year. Some auto manufacturers have issued warnings about production cuts as a result of the chip shortage. Volkswagen is estimating production cuts of 1.3M units in the first quarter of 2021, and the cuts are expected to be even wider in the second quarter. The new merger of Fiat, Chrysler and Peugeot called Stellantis is estimating an 11% drop in production. Supply of chips is not expected to stabilize until Q4. Honda and Nissan have reported significant shutdowns in their factories due to the chip shortage. The chip shortage means that consumption of steel from the automotive industry is also reduced by a large margin. One of the commodity metrics used to measure pricing in this sector is the Domestic Hot Rolled Coil Steel Futures price. This price is measured in USD per metric tonne. Generally speaking, the price for Steel from China is approximately 50% less expensive than the price for steel in the US of Europe. Transportation costs reduce the price gap somewhat at the point of consumption. While Steel prices are currently at an all-time high with a solid upward trajectory since the middle of 2020, I see the drop in demand from the auto industry creating a softening of prices in the coming months and a stabilization of prices. The rapid increase in the price of softwood lumber for construction has caused some builders to substitute steel for wood in some applications. That substitution has increased the demand for steel framing in applications that traditionally would not have been considered candidates for steel consumption. There are signs that lumber mill production is starting to catch up to the demand and we should see prices for lumber fall by the fourth quarter for lumber. As soon as that happens, the demand for steel framing in applications that would have used wood should evaporate. The construction industry will quickly switch back to the less expensive wood framing instead of steel as soon wood prices start to moderate.