The Real Estate Espresso Podcast

AMA - Anu from San Diego asks: In the current SF real estate boom (last 6 months), the most growth has happened in the luxury end of the market. A new report from Redfin confirms this trend over the past year. Two questions: 1. I would like to know your opinion on why this has happened. 2. Do you think this is a temporary phenomenon or is it here to stay? Anu this is a great question. The pandemic has hurt the economy in numerous ways. But the pain has not been uniform. Those who have been most impacted by the business shutdowns have been those hourly paid workers. Those at the top of the economic ladder have continued to do well in 2020, even if some of the gains might be argued to be an illusion. The fall in the stock market it Q2 was overtaken by a run up in the market in Q3 and Q4. That has given people more confidence. Some recognized that the profits could evaporate and chose to redeploy the cash into property The low interest rate environment, combined with the forward interest rate guidance for the next three years has created incentive for homeowners to borrow even more money than ever before. It’s clear that the Fed intends to keep interest rates low for at least the next few years. But remember, when we’re talking about the luxury segment of the market, we’re talking about the top 5% of the properties in a market by price. The analysis that Redfin performed in the article you referenced broke down their analysis into 5 segments.. There are three equal-sized tiers based on Redfin Estimates of the market values as of Dec. 15, 2020, as well as tiers for the bottom 5% and top 5% of the market. The top 5% of the market by price is considered “luxury” for the purposes of this report, while the bottom 5% is titled “most affordable. These luxury properties still make up a small percentage of the market, and they’re still taking longer to sell than properties in the middle and lower end of the market. When people make a decision to purchase their homestead property, they’re looking with a longer time horizon. They’re looking past the pandemic. It might have been a purchase that was planned in the future, but merely accelerated. The increase in land costs and the increase in construction cost has caused some builders to focus on the upper end of the market. Those builders found a combination of robust market demand drive by low interest rates, and better profit margins. You see builders make most of their profit on upgrades and custom finishes. These buyers are willing to spend more. Some buyers took the opportunity that the pandemic afforded to invest in personal projects. The lockdown in the spring created extra time while the world figured out how to work from home. Some people took on home renovation projects, perhaps a backyard space like a deck or a pool. Others chose to design a new house. We’re seeing that reflected in the numbers. It’s tempting to look at short term trends in the market and extrapolate those trends into the future. In a stable boring market where nothing changes from one month to the next, you might be able to project into the future a little bit. It’s a little like trying to make sense out of the spike in toilet paper sales in Q2 of 2020. Store shelves were emptied of toilet paper. Did the population start using the bathroom at an accelerated rate? Did the population grow all of a sudden therefore driving demand for more toilet paper? Of course the answer is no. Over the long term, toilet paper consumption will revert to the average consumption, despite short term decisions to buy sooner than needed. I expect the same will be true in the luxury property segment. It appears like a large increase, but in reality, the numbers are small and it doesn’t take a large shift in absolute numbers to materially affect the percentages.

On today’s show we’re talking about one of the traps that the market might be luring investors with. When you make an investment in real property, this is often majority funded by permanent financing, usually amortized over a long time like 20-30 years. But if the market window for your demand is short term, then you’re at risk of making a bad investment. I’m hearing reports that cottages and other similar vacation properties are already fully booked for next summer. Some investors I’ve spoken with have indicated a desire to purchase a vacation property and rent it out when not in use. They point to the strong demand as the rationale for the investment. The fact is we don’t know what the demand will look like in a year or two, or five. We know that global travel is down 90% due to the pandemic. People who are desperate for a getaway are booking accommodations within driving distance of home that allow for them to remain socially isolated. In a pandemic environment, this all makes perfect sense. Even our own short term rental portfolio has continued to experience strong demand well into the coming year. But we expect that the pandemic will eventually come to an end. It won’t be in the next few months. It will take much of 2021 before enough of the population is immunized for these restrictions on social activities to eliminated. Israel stands alone in the world as having the most aggressive roll-out of vaccination of any nation. They have already immunized 20% of the population and expect to complete the entire population over 16 years of age before the end of March. The roll-out in the US, Canada, Europe, is looking like it will be well into the 4th quarter before the majority of the population is immunized. It could be even longer. I’m expecting 2021 to look an awful lot like 2020 in terms of travel and leisure. Cruise ships probably won’t be sailing anytime in 2021. If they do, it will be later in the year. In 2019, the cruise industry had nearly 30 million passengers, the majority of them from North America. There are all these tourists who are looking for a different vacation this year. But eventually, many will return to cruise ships, to beach resorts in the islands, to the bus tour through Asia, to the luxury cottages in the middle of a game reserve in Africa or Australia. All of these experiences are off-limits for many because of the higher risk of infection that comes with international travel. So what happens to all those cottages that are fully booked this year when people return to traveling? What will bookings look like in 2022 and 2023 and beyond? I think back to the lean years at resorts that built excess capacity. Many of those condo units sat empty for much of the year.  In retrospect turned out to be very poor investments. Yes, they look great again in 2020 and perhaps in 2021. But if it took a black swan event like a global pandemic to make your investment viable, is that really a good strategy? If you currently own a vacation property and you want to make a small incremental investment in maximize the revenue for that property, I say go for it. Maybe you want to upgrade the furniture and the interior finishes so you can command a higher price in the market. That’s a good move. But if you’re an investor looking to make a major investment with a 25 or 30 year commitment, how do you know if the demand for your product is going to be there in a year from now, or five? After all, just as quickly as conditions changed this year, they could change again next year. I would go back to the market conditions of 2017 and 2018 as a better indicator of what the market demand might look like in the post covid environment. You want to use market analysis tools like Alltherooms or AirDNA to determine both demand and pricing for your local market before you make an investment.

On today’s show we’re talking about the notion of valuation or what is sometimes called price discovery. I was 13 years old when I got my first taste of price discovery. In Istanbul Turkey there is the largest covered bazaar that comprises over 61 streets and over 4,000 vendors. The vendor was trying to sell me a metal sword and a negotiation ensued. I was a rookie at this, but my father knew the game and by the end of a 5 minute negotiation we settled on a price that was about 1/3 of the original asking price. The seller was grumbling the whole time as he wrapped up my purchase. I left his shop confident that I had just got a great deal. As I reflect back on it now, how much was that souvenir really worth? It’s worth what I paid for it. Did I pay too much? Did I get a great deal? I have truly no idea. There is the story of Honus Wagner played in major league baseball for 21 seasons, most of that for the Pittsburg Pirates. He was one the first five players to be inducted into the National Baseball Hall of Fame in 1936. On October 31 of last year, one of 50 Wagner baseball cards sold for $1.4M dollars. It’s not the most expensive version of that card to ever sell. The most expensive one sold for $3.25M. The scarcity is part of what drives the notion of value. If there were 1,000 of these cards, they would be worth much less. It’s because there are only 50 remaining in existence that drives the notion of value. Maybe the baseball card worth 2.5 cents, the cost of the paper and ink to print it? When you buy shares in a public company, you’re buying a fraction of a company, that presumably has the ability through its active ongoing business to generate a profit for its owners. As a shareholder, you’re an owner. You would think that the value of a business is somehow tied to its ability to generate a profit. A business that generates a lot of profit should be worth more than a business that generates very little profit. Tesla Stock is currently trading at 1,667 times earnings. That means that if Tesla remained at the same level of profitability, it would take 1,667 years to earn your initial investment back, and that’s assuming of course that the company paid out 100% of its earnings in dividends to investors. At that point, I’m starting to wonder which is a better deal, Tesla stock or the baseball card? The notion of value has become distorted. A single family home in an expensive neighborhood is worth $1M because we all agree that it’s worth that much. This is what is called price discovery. If a house on the street sells for $100,000 more, now all of a sudden everyone on the street thinks their house is worth $100,000 more. But the world of real estate investing is different than the world of residential home ownership. It might seem to the uninitiated that they’re similar. But they’re quite different. You see if an apartment rents for $1,500 a month, that rent check clears every month. If you have a 100 unit building, then you have 1,200 transactions that closed over the past 12 months. There is no speculation about what the apartments will rent for. There is hard data. So when it comes to valuation, if rental properties are valuing at a 6% cap rate, then you can easily determine what a property is worth. You have lots of data from hundreds and hundreds actual transactions that settled each and every month. So what is a piece of real estate worth? Is it merely the result of negotiation, or perhaps the real estate business that is wrapped around the property is worth a multiple of its net income, its ability to generate a profit.

Today is another AMA episode (ask me anything). Karla asks: Your book “Magnetic Capital” in my opinion is a quality , easy to follow book. Would you please share your own process to write, market and publish your book? Any highs and lows from lessons learned in the process that you can recommend? Have a successful year. Karla, This is a great question. There are undoubtedly numerous ways to write a book, but I’ll share with you my process. When I say this, I’m confining the discussion to non-fiction books. The process for fiction books is somewhat different. It all starts with intention. Some people write a book as a vanity project. For some it’s a large expensive business card. For some it is a real contribution to the world to advance the art and science in a particular area. You really want to get clear on why you are writing a book. It starts with asking a few simple questions, “Who are you writing the book for?” “Why does the world need this book?” “Why are you the one to write this book?” Do you seek publisher or to self publish? In the case of Magnetic Capital, I saw many people who wanted to grow as real estate investors who were lacking the skill in raising capital. Some were trying to raise money and having terrible results. So the book was written for the investor who was looking to grow beyond their own capital, but most importantly, those who were looking to grow beyond the initial stages of leveraging other people’s money. Some people start out by performing a joint venture or two and then get stuck. Most of the books written on the topic tended to be academic in nature and lacked a practical approach to understanding the psychology of raising capital. It seemed like people were out there trying to violate laws of nature, violate laws of human respect, and certainly violate securities laws. So I saw a gap in the marketplace. So let’s talk about how to outline a book. In my case, I took a stack of blank 8.5x11 sheets of paper and brainstormed the chapter titles. I put one chapter title on each page. Some chapter titles didn’t make sense and I threw those away. I then spread out all of the pages on my dining room table so that I could see the big picture for the structure of the book. I could easily move the sheets around so that the sequence of the chapters made sense. I then took each sheet and wrote down 3-5 major points that would need to be covered in each chapter. I then decided which chapters would need real life examples to support the points being made in the chapters. Some books require a lot of research. I’m thinking of authors like Malcolm Gladwell or Jim Collins. In those cases, you might be facing a couple of years of work prior to writing the book. In my case, the book was already inside me and just needed to come out on paper. The mechanics of writing the book was extremely straightforward. I would write every day. Some days I would sit at the computer and write a few pages each day. In the case of Magnetic Capital, the first draft of the entire book was written in under a month, followed by a few weeks of editing. The publishing process has two choices, working with a publisher or self publishing. If you’re going to work with a publisher, the industry has changed. In fact, the work is pretty much all going to fall to you unless you already have a huge brand name with a massive following. Before you can even engage with a literary agent you’re going to need to prepare a book proposal. What they call a book proposal is really a detailed marketing plan when you look at all the headings. There are several templates out there on the internet from various literary agents. I chose to self-publish my book using Amazon as the platform. It was easy to do and there are lots of good resources out there that can guide you on the particulars.

Bryan Miller is a musician, composer, a musician to the film industry in Hollywood, and a real estate investor. You can learn more about Bryan and his strategies at capitalstackinvestments.com.

Aaron Norris is based in Riverside California, but invests in purpose built rental communities in SW Florida. His company Property Radar provides a level of data analytics that goes above and beyond the usual freely available data on the internet. To learn more check out propertyradar.com. 

Today’s question is a beginner question coming from Gord in Hamilton Ontario. He writes: We’re guiding our kids into adulthood in the context of real estate and investment.  My kids are 20 and 22, one living at home working an HVAC apprenticeship and the other in university for teaching, living in another city and working part time.  They are both very responsible with their money and are saving for their futures.  I want to guide them as to how they should save or invest now so that one day they can own a home (it is looking less and less affordable).  My son (HVAC) wants to buy a two unit and live in one eventually to start out, but I am having difficulty knowing how to guide him correctly. Gord, this is a great question. I’ve often said that if you can’t afford to buy a house you should buy two. The structure of that deal will depend a little on the base income of your kids. But as a first time buyer, they should qualify for a high ratio insured loan. The structure we’re talking about in Canada is a CMHC insured loan. You will pay an insurance premium on the loan which means a higher rate, but you will also get a high ratio loan. Typically these loans max out at 95% loan to cost. The specifics of the program allow for the first $500,000 to have a 5% downpayment and then a 10% downpayment for anything above $500,000 up to a maximum purchase price of $1M. For those listeners in the US, you can do the same thing with an FHA 203B loan. The FHA loan will max out at 97% loan to cost. The max loan amount of the FHA program varies depending on the community. Generally speaking the name of the game here is to get the rental income from the second unit in a duplex to subsidize the cost of ownership of your principal residence. At two units, the lender is going to look at the property in the same way as they would look at a residential property. The high ratio loan program qualifies for a single owner occupied home or a duplex where one half is owner occupied. It would not apply to a triplex or a 4-plex. You would likely want a duplex like this to be self managed by the owner. As a first taste of being a landlord, this is a great way to start. The owner is always onsite and can monitor what is happening at the property. But you don’t want to do all the work yourself without the guidance of someone more experienced looking over their shoulder in an advisory capacity. The biggest mistake that rookie landlords make is in knowing how to qualify the prospective tenants and then knowing the rules under the landlord tenant regulations. The key for properties like this is to choose a property that is going to attract the right quality of tenant. If you choose a property that is at the lower end of the income spectrum, you run the risk of attracting tenants that can’t afford your property. Get yourself a property that is going to attract the kind of tenant that you ultimately want living there for a long time. A Duplex can be a great house hack. The market in Hamilton has become an extension of the Greater Toronto area. The overall Toronto area sports a population of 6.1M people and historically has added about 125,000 residents a year. Your son may not have the income to qualify for a single family home at $720,000, but may qualify for a duplex at $750,000. The addition of the rental income when added to your son’s employment income may be enough to make the project viable. Later down the road, that first investment could act as a stepping stone to bigger and better properties. It is from these modest beginnings buying their first property in their 20’s can grow to having a vibrant portfolio which can provide financial independence later in life. The message here is one of encouragement. Thank you Gord for a great question. For the listeners at home, if you can’t afford to buy a house, perhaps you should buy two.

Some personal reflections on the scenes we all witnessed at the Capitol on January 6.

On today’s show we talking about a cultural shift that is underway in one of the technology companies that defines the current era in which we live. On today’s show I’m going to connect the dots as a thought experiment. I’m going to draw a parallel between the post office and Google. The post office is a utility that provides some of the basic plumbing for our society. There are private companies that have tried to compete with the post office in providing this basic transportation of goods. It’s a commodity. You know that it’s a commodity because you simply expect it to be there. The postal service is ubiquitous. It’s not conspicuous. Nobody drives down the street and says “oh cool, there’s a mailbox.” The post office would be more conspicuous by its absence. The post office is also unionized. The collective bargaining for employees by unions has tied the hands of the leaders at the postal service In this discussion, the outcome has been pretty consistent across nations. We could be talking about the US, France, England, Canada. Attempts to innovate within the postal service have largely failed. This is the world of slow decision making and bureaucracy that has come to exemplify quasi government organizations. The technology world on the other hand is the world of innovation, of experimentation. Technology companies create new prototype products and services in a race to create value ahead of the competition. In some cases, the technology companies will develop the new capabilities internally. If they move too slowly, then acquiring and integrating a startup can be an effective shortcut. Google acquired YouTube. Facebook acquired Instagram. You get the idea. These moves were made with the speed and agility of a startup. In an earlier part of my career As Vice President of Engineering, I was leading the microprocessor development team that my company acquired from IBM. This was back in 2004. There were two parts of the team located in France. We had a team outside Paris, and a team just outside of Nice. I used to spend a week a month in France with the team face to face and naturally on the phone with them on a daily basis. I can tell you from first hand experience that the goals of the business leadership is to maximize the growth of the business in order to create the opportunity for all the stakeholders of the business to benefit. That means healthy compensation for the employees, it means employee stock plans and stock options for employees. The goals of the union are not shared with the goals of the business. The net result was that the union representing the roughly 10,000 IBM employees in France filed a lawsuit challenging the validity of the acquisition in the courts. The net result was that all 110 employees in France ended up back at IBM and I built a new microprocessor design team in Austin Texas and in Silicon Valley. Only a handful of the people in France chose to relocate to the new design centres in the US. So when I heard this week that more than 225 Google engineers and other workers have formed a union, I was surprised to say the least. The Alphabet Workers Union, which represents employees in Silicon Valley and cities like Cambridge, Massachusetts, and Seattle, gives protection and resources to workers who join. Those who opt to become members will contribute 1% of their total compensation to the union to fund its efforts. For now, this is a minority union. It will not have the power to negotiate compensation on behalf of employees. I find this particular effort to be important because we see a company that has maintained its startup culture now being bogged down by increasing public scrutiny, a justice department anti-trust lawsuit, and now a union movement. Companies that have their hands tied through government bureaucracies are destined to be about as agile and as innovative as the post office.

This question is from Anu in San Diego. I am a big fan of your show and i listen to all your episodes. I would like to know your opinion on the relative effect of upward vs downward forces on SF home prices. There is upward pressure on SF homes currently because of low interest rates and pent up demand. In the coming months, there may be downward pressure due to job losses and overall bad state of the economy. But there may be additional demand for bigger houses because of many more people working from home and thus needing more space. In my local market, I am seeing a ton of folks upgrading their houses because a 3-4 bedroom house is not enough anymore as both spouses require a separate home office now. This trend may be here to stay as more companies announce permanent work from home options. I would love to know your opinion on how this may play out in future. Will some category of homes see increased demand vs lots of delinquencies in another segment? Or do you think the delinquencies will have an effect on the entire housing market? Anu this is a great question. In fact there are several questions. You are correct in pointing out that very few existing houses were designed with work spaces in mind. Some homes had an office designed into them. My house was a rare exception to that trend. Most of the time, people are repurposing a bedroom as an office. If you live in an apartment, then the dining room table is one of the few options. San Francisco itself is a small market, but the SF Bay area consists of many markets and spans nearly 2 hours driving distance from one end to the other. The Bay area seems to be mirroring many of the same migration characteristics that we’ve seen in other hub cities like NYC, Toronto and Seattle. Those who have been renting luxury apartments in the city left the high density environment when it was clear that they had no reason to be a short distance from an office that was closed anyway. They can afford to buy a much larger property in a lower density environment, but don’t necessarily want to leave the metro area altogether. After all, they’re not quitting their job. People are shunning downtown apartments. Conversations with people I know who live in San Francisco are showing the trend clearly. The same has happened in NYC and Toronto. Toronto currently has 30,000 vacant apartments for rent in the core of the city. That’s a huge number. People are leaving their rental apartments in droves. Vacancies in some buildings are approaching 50%. Rents have fallen 35% across the city. I’m hearing that it’s like a ghost town in the core of the city. People simply don’t want to be confined to a box in the sky with no amenities during a lockdown situation where they have to work, eat, sleep and exercise. All of this seems like a prison. For half the price of a rental 1BR apartment in San Francisco, you can buy a 3BR 1,400 SF townhouse in San Rafael with a patio, plenty of amenities including a swimming pool and gym, a two car garage. The suburbs don’t have the problem of homeless people. You don’t see protest marches in a residential neighborhood. But you do in the core of the city. People feel safer in the suburbs. The reasons for exiting the core of the city just keep piling up. We are seeing millennials who had been living in the city finally getting married, starting families and now looking for a bit more space to spread out. The condo market, in particular the luxury end of the condo market is over-supplied in the short term. The luxury apartment rental market is also oversupplied for the next while and this is where we are seeing a massive correction. I believe the correction we are seeing is confined to select segments of the market. This change is going to be with us for another 3-5 years before we find a new market balance point.