The Real Estate Espresso Podcast

On today’s show I’m going to share the final segment in this forecast based on highlights from Dr. Duncan’s presentation that I believe are relevant for all real estate investors. On today’s show we’re focusing on new construction. Here we go. People who are currently homeowners are more fearful of the Corona virus and are not listing their homes for sale. Sellers don’t want strangers come into their house and possibly infect the family. On the other hand, those who are tenants in multi-family apartments are more fearful of the virus in the high density environment than they are of moving. They are taking advantage of the low interest rate environment as an opportunity to buy and lock in an interest rate for a long time. This surge in demand, with a drop in supply is putting a lot of upward pressure on prices. Both Fannie Mae and Freddie Mac are reporting record years for loan originations. Across the nation there are 2.7 months of inventory on the market. That’s the lowest level since data has been collected. New home builders have seen a surge in contracts for new homes. The builders will eventually need to catch up and build those homes. It’s hard to say how they will respond to demand for new sales if they get too far ahead of construction. Availability of skilled labor is the constraint in the construction industry right now. We can anticipate that once the pandemic is under control, whether that is through a an effective therapeutic, or widespread adoption of a vaccine, supply of houses on the market will increase. Depending on the locations for that supply, interest rates for new loans, and the demand at that point in time, we could expect to see a softening in prices. For now, new home builder backlog is at record levels. If we go back to 2005 through 2006, the industry had a capacity to deliver 1.4 million new homes a year and sales peaked in 2006 at that level. In the aftermath of the 2008 downturn the industry delivered about 300,000 new homes a year at the bottom of the market. And has been averaging between 500,000 and 600,000 new homes a year for the past 5 years. It’s fair to say that the industry is sized to deliver that volume of new homes. In October, sales peaked at an annualized rate of 1M homes a year which is well above the capacity of the market at current staffing levels. The question is whether the industry can and will grow to to meet the challenge of the higher sales volumes without becoming overheated and perpetuating a boom and bust cycle yet again. Based on the Fannie Mae data, the outlook for new home construction shows demand for 830k new single family home sales in 2020, a 21% increase over 2019. This is expected to grow a further 6.2% to 881k units in 2021 and remain flat at 881k units in 2022. 2020 has been a banner year for refinance activities, representing a 127% growth over 2019. Next year, refinance activity is expected to contract by 56.5%. Normally a 56.5% contraction would be a huge deal. But it will basically match 2019 refinance volumes and 2019 was a banner year for refinance activity. Based on everything I’m hearing, I going to go out on a limb and predict that single family new construction for rental is going to be a product that is in high demand. In particular, I believe that new construction townhouses which live like a single family home are going to be in high demand because they are more affordable than a detached home. The drive for affordability is going to influence demand for the coming next several years.

Last week I attended a small private presentation hosted by my good friend Tom Wilson at the BACOMM monthly meeting held in Silicon Valley. The guest speaker was Dr. Doug Duncan, Chief Economist for Fannie Mae. Doug has been a guest on the show before. Doug leads a large team of nearly 200 economic analysts and have consistently won awards for having the most accurate economic predictions anywhere in the US. We covered part 1 of Doug’s predictions on Friday’s show. On today’s show I’m going to share a few more highlights from Dr. Duncan’s presentation that I believe are relevant for all real estate investors. This year the Federal Reserve changed their stance on inflation. The Fed doesn’t see moving the overnight funds rate above 0.25% until the end of 2022. This is the part that is significant. They have also changed their stance on inflation. Rather than setting a 2% ceiling on the rate of inflation, the Fed is now saying that they’re going to be fine with an average 2% for inflation. That’s a dramatically different stance. That means that the Fed might not raise interest rates when core CPI creeps up above 2%. They will wait until the average is above 2%. For 2020, they’re estimating inflation below 1.8%. This means that inflation would need to exceed 2.2% next year before they take action to cool inflationary pressures. So as real estate investors we can count on low interest rate policy for some time to come. Dr. Duncan shared data on the office market for a number of cities across the US. He noted that many office markets can expect it to take more than 6 years for local office vacancies to return to pre-Covid levels. Part of the reason has to do with the amount of new office construction in the pipeline. Most cities are experiencing growth in supply that is far in excess of demand over the next three years. That new supply was already committed prior to the pandemic. San Francisco is expecting a 7% growth in office supply over the next 3 years, with a 0% increase in demand. Many of the major markets are experiencing flat demand over the next several years and increasing supply. Doug believes that many businesses will want to return to the higher productivity environment of an office. Nevertheless, office space is one of those areas that is under extreme pressure over the next 5-7 years. The only city that is expected to show a fast rebound in office is Washington DC. That’s largely driven by government. Cap rates in multifamily don’t appear to have changed at all during 2020. Fannie Mae is looking hard at migration. They’re looking at where applications for new loans are being from, and the location of the loans for the subject properties. From this data, they can clearly see that migration is underway from more dense zip codes to less dense zip codes. They have the actual data from real transactions. This isn’t a survey or a statistical poll. It’s based on boots on the ground activity. Whether that is sustainable remains to be seen. Job prospects for millennials over the past 5 years have been in the urban core. Not surprisingly, they have moved close to their jobs. Do they want single family homes? Yes, but those don’t exist in the downtown core. Now that they aren’t tied to being in the core, millennial are migrating to the suburbs. When it comes to rental properties, Fannie Mae is seeing much more tenant rotation in the A class properties than in the B and C properties. Those who are upwardly mobile and can afford a house are buying a house and moving out of a high density property to low density.

On today's show I'm talking with Mike Wolf about strategies for the coming quarter. Mike has been in the business for 31 years and is wintering in Puerto Vallarta Mexico. To connect with Mike, visit MikeWolfMastery.com

Joel Block hails from Los Angeles California where he has been a fund manager for many years, specializing in hedge funds, real estate syndications, and all kinds of businesses. On today's show we're talking about the latest impacts of the pandemic on real estate assets.  You can reach Joel at bullseyecap.com.

Last week I attended a small private presentation hosted by my good friend Tom Wilson at the BACOMM monthly meeting held in Silicon Valley. The guest speaker was Dr. Doug Duncan, Chief Economist for Fannie Mae. Doug has been a guest on the show before. Doug leads a large team of nearly 200 economic analysts and have consistently won awards for having the most accurate economic predictions anywhere in the US. When I speak with Doug, he’s not just reciting data. He has layers upon layers of evidence to support the conclusions drawn. This one hour talk was packed with market insights that I have not seen anywhere else and I want to share these with you. If Dr. Duncan’s observations are correct, they will serve as a guide for what’s to come in 2021 and beyond. On today’s show I’m going to share a few highlights from Dr. Duncan’s presentation that I believe are relevant for all real estate investors. What we’re dealing with in 2020 is a pandemic and not an economic variable. We simply don’t have economic models that have a pandemic built in as an economic variable. The Fannie Mae forecast is based on data over the past 4 quarters and is making reasonable assumptions about the trajectory of the disease in the first half of 2021. There are a number of conclusions that can be drawn from the data that Dr. Doug Duncan presented. What they found is that the highest percentage of renters are in the food and beverage, retail and hospitality sectors of the economy. These are the very sectors that have been most impacted by the pandemic. Therefore, they conclude that the impact to home owners has been proportionately much less. The folks at Fannie Mae looked at the loans that are in forbearance. Again, the lenders are in direct communication with their customers. Fully 25% of those who took the option of a forbearance agreement did so out of an abundance of caution. They did not experience job loss, nor a reduction in income. They took the forbearance just in case. Another 25% of those who took the forbearance option did experience a partial loss of income, but still had sufficient cash flow to make their mortgage payments. Strictly speaking, they didn’t need to take the forbearance agreement. When those forbearance agreements expired, those home owners were in fact able to resume mortgage payments and have not gone into default. Based on this, we can conclude that the state of financial distress for home owners is about half of what the total numbers would suggest. That’s a good sign. So let’s see what’s going to happen to the remaining 50% of the homes that are in distress. Dr. Duncan believes that loan modification agreements will be signed with the borrowers that the banks believe are good credit risks. If a borrower is 6 months behind on their payments, they may extend the loan by a year, add the outstanding payments to the loan, spread over the remainder of the loan and bring the loan into good standing. Those properties will not go into foreclosure. That leaves a much smaller number that will actually go into foreclosure. Dr. Duncan also shared that several large institutional players who are sitting on large sums of cash are prepared to step in and purchase portfolios of distressed properties in bulk. Therefore the impact to the lenders can be reduced with a few large transactions, rather than the waves of auctions on the court house steps that were daily occurrences in 2009 and beyond. On this basis, I’m going back on what I’ve reported previously. Will there be distress in the coming months? Yes there will. But I believe that distress is going to be confined to specific sectors of commercial real estate. Specifically, I’m referring to retail, office and hospitality. I’m concluding that we will not see a repeat of 2008 with millions of homes appearing on the market at deep discounts.

There is a growing movement aiming to address the perception of racial bias when it comes to housing. The US has a history of racial division dating back to the days of segregation. Those practices were outlawed in 1917 when the US Supreme Court deemed those practices as contravening the law. The law was further strengthened in 1964 with the Civil Rights bill was signed into law by Lyndon Johnson. The practice of designating certain neighborhoods as white only, or black only clearly violates every moral and ethical and legal principle in a free and modern society. To be clear, our society has made huge strides since those days. At the same time, it’s also clear that racial inequality still exists on multiple levels. The question remains whether certain newer regulations have the unintended consequence of discriminating against racial groups. The City of Minneapolis has tackled this question with respect to the zoning code. The argument is that a high proportion of dark skinned people are tenants in Minneapolis, and a high proportion of light skinned people are home owners. Therefore, it could be argued that the zoning code that limits certain zones to single family homes that are predominantly owner occupied has the same effect as racial segregation, even if that was not the intent of the regulation. In response, the city has decided to eliminate the single family home designation in the zoning code. In fact, a number of states and the department of housing and urban development (HUD) have started to tackle the question as to whether zoning is exclusionary. They added provisions for higher density in transit oriented areas. This approach seems both balanced and positive. As a developer, the creation of more opportunity for higher density development within the core of the city is a positive step. This could be one of those rare moments when there is consensus on what might be a politically charged, or perhaps racially charged topic. Developers welcome a more relaxed regulatory environment. Home owners and tenants grappling with affordability would welcome the move as well. Curiously, some cities like Philadelphia have gone in the opposite direction. The city has moved to reduce the areas in the city which are zoned for multi-family development. I’ve personally owned property in the city that has had the zoning arbitrarily changed from residential multifamily to residential single family. Those properties that are zoned multi-family are arguably more valuable because you can build higher density. If you look at cities like Houston, which has no zoning code whatsoever, the city functions without a problem. Market forces and practical considerations like traffic and utilities provide the only broad constraints. Unless a property has a deed restriction specific to the property, you can build a warehouse next to a single family  home, next to a school, next to an office building. The city has assumed that common sense will prevail and the free market will determine whether a project will succeed in a specific location or not. When you look at the work of almost any municipal government, if you take the time to read the minutes of the city council meeting, or watch the video replay of the meetings, you’ll find that more than 90% of the work of local government is tied up in land use. The amount of resource that is frankly wasted in bureaucratic red tape is astounding. Some residents will argue that maintaining the historic nature of some areas can only be done with the protection of strict regulation. No doubt, cities all over will be looking at what Minneapolis has done to help guide their own future land use policy. A change in zoning regulations has the potential to change the supply demand balance dynamics within a city. This one factor can do more to determine the long term viability of a new multi-family project than most people recognize.

Charlie Munger, is Warren Buffet’s partner in Berkshire Hathaway. He’s famous for saying, “Show me the incentive and I’ll show you the outcome.” Society and government alike have been conditioned to think of regulation as the path to controlling market behaviour, to eliminate so-called “bad behaviour”. The internet is the great equalizer that has broken many business assumptions. We live in a physical world. People live in houses. They eat real food (mostly). The doctor cures the physical ailments. Governments pave the streets so you can travel with ease from your house to your destination. Local, state and provincial governments tax their residents in order to pay for these items. The local governments try to control what happens in the local communities through regulation. The recent runup in share price for Tesla has increased Elon Musk’s paper net worth to the point where he is now the second wealthiest person on the planet. This week he announced that he moved from Silicon Valley in California to Austin Texas. In May of this year he announced that he was selling all of his properties in California. He clearly cut all ties to California to make it abundantly clear that he is no longer a California resident. Apart from needing to raise a bunch of cash to exercise his stock options this year, his nearly $1B in stock option compensation, which become exercisable this year would bring a whopping tax bill. Texas of course has no state income tax, compared with California’s new proposed 16.8% top marginal tax rate. So if Elon Musk cashes in on $1B in stock option profits, he could conceivably save $168M in tax just by moving to Austin. Would I accept $168M in cash in order to move to Austin? I suspect that virtually anyone would. On the first of December, Hewlett Packard Enterprise announced it was moving its corporate headquarters from San Jose to the Houston suburb of Spring. Spring is located in the NW of Houston, very close to where HP had it’s enterprise server and storage division. HP has said that it is listening to its employees who want greater choice on where to locate. They want a place where there is a lower tax rate, a lower cost of living, and more ability to spread out without the congestion of traffic in Silicon Valley. Hewlett Packard split into two companies in 2015, with the more profitable server and IT services business forming HPE, and the consumer computer and printer business remained as HP Inc and is still based in Cupertino near the original HP headquarters. Here again, we have a company that is a fixture in Silicon Valley, one of the Silicon Valley originals, making the move to a lower cost, lower tax, lower regulation environment. I hired engineers in both Silicon Valley and in Texas in my hi-tech career. I can tell you from first hand experience, that equally talented people cost 25% more in Silicon Valley, simply because the cost of living in that area is so much higher. I used to hire organizations from India and relocate portions of the team to North America to facilitate the communication. The bulk of the team remained in Bangalore. Today, that model is gone. I regularly hire top talent in India even today. Not only do I save money, the main reason I do it is for speed and quality. North Americans culturally tend to work in isolation. My team in India will throw 4-6 people at solving a design problem and deliver a high-quality result in a quarter of the time and at a fraction of the cost of a comparable North American team.  In my case, the incentives are cost, quality and time. Those are strong incentives.  If there are local regulations that make work here locally more expensive, or more cumbersome, we’re not obligated to conduct business or invest in a particular geography. We will invest where the numbers make sense. As Charlie Munger says, Show me the incentive and I’ll show you the outcome.

On today’s show we’re talking about the dangers of stock market manipulation and why every investor who has exposure to the stock market needs to pay attention . The performance of the stock market is a phrase that makes no sense. What we’re describing is the aggregate performance of the underlying companies that make up the stock index.  There are a few things that determine company value. First there are the fundamentals. Is the company generating a profit? Is it growing both revenue and profit? Is it gaining market share? Then there are technical factors that are influenced by market sentiment? These are the headwinds and tailwinds that have more to do with the buyers and sellers of shares than the underlying companies. We’ll come back to that in a minute. Finally, there is the financial engineering that manipulates the price per share of a company without changing the fundamental value of the business. In fact, sometimes the management can goose the price of a stock artificially for short term gain while harming the long term health of the business. This is the part that is the most troublesome and we’ve seen happen on a large scale in recent years. A buyback occurs when a company uses some of its cash to repurchase its own shares. Other choices include investing for growth, acquisitions, paying down debt or paying dividends. Legalized in 1982 by the Reagan administration, buybacks took off after a 1992 tax bill created incentive for more stock compensation. Now stocks and options making up about two-thirds of executive pay. In the current low-interest-rate environment, many companies have taken on more debt, whose interest cost can be tax-deductible, to buy back shares whose dividends may be more costly. Imagine if you have a preferred share that has an interest coupon at 7%, and you can borrow funds at say 5%. You can buy back equity which reduces the number of outstanding shares, and reduce your interest expense. That would be an obvious move for any company to undertake. Where it gets dangerous is when a company retires common shares that do not pay a dividend and increase the company’s interest expense in order to reduce the number of shares outstanding. Reducing a company’s float of outstanding shares through a buy-back program increases the earnings per share, creating the illusion that the company is performing better than it really is. The increase in earnings per share can drive bonuses for company executives. Imagine for a moment that executive compensation is tied to earnings per share. In some cases the compensation might be a cash payment, or as increasingly the case, stock options. On the surface that seems like a fair and reasonable method. Let’s create a fictional example. We’re going to use the company from the Road Runner and Wiley Coyote cartoon. Our company is Acme. The company has an enterprise value of $1B with virtually no debt and the stock is trading at $10. The company is earning $1 per share in earnings. The company executives are given a stock option grant at $10. The company had a hiccup in the past year and isn’t growing. It’s revenue is flat, and earnings are flat. So the executives decide to go borrow $100 million dollars to buy back 10% of the shares of the company. The interest cost has gone up a bit, so they decide to lay off a few employees to reduce expenses. The impact of the layoffs is on projects that would deliver revenue in 3-4 years, so the immediate impact to revenue is zero. It’s merely a cost saving. With fewer shares in circulation, the earnings per share has increased by 10%. All other things being equal, the shares are now worth $11. The company executives are now sitting on $1 worth of profit on their stock options.

Natalia says, “I have a property that is my personal residence that I’m looking to rent out as an entire property on a short-term basis. I also have several condos that I own that would do better as a short-term rental than as a long-term rental. How do I decide on pricing a nightly rate?” Natalia this is a great question. It’s also a huge question and I’m going to try and condense about an entire day worth of content into about 5 minutes. Your question is more about marketing and digital marketing in particular. The whole process starts with understanding who your target client is. Let’s imagine you’re buying chocolate. You could go to the grocery and purchase a giant bag of Hershey’s kisses. You can buy the 4-pound bag for about $23. You could also go out and buy a specialty hand-made box of three unique truffles for about $20. These are vastly different products. They’re targeted at different customers. The difference in price on a per pound basis is more than 20:1. The same is true for a short-term rental. If your property is a commodity, then you’re going to be positioned in the market as a commodity. You’re going to be one of those Hershey’s kisses in the bottom of the bag, indistinguishable from the next hoping that you’re the one who is going to get picked today. But if your property has distinguishing features, then you’re set apart from the rest. If your property is a ski-in ski-out property, 300 feet from the base of the gondola that takes you to the top of the mountain, that’s a unique product. There might be 500 short term rentals available at the ski resort. In that case you’re chance of being picked is 1 in 500. But if your product is that unique ski-in ski-out chalet, then your chances of being picked improve to 1 in 3 or 1 in 5. I like those odds a lot better. If you’re serious about being in the short term rental business, then you want to think about dynamic pricing. This is similar to what the airlines do. It’s no secret that it’s less expensive to fly on Wednesday than on Monday or Friday. Likewise, you may price weekends higher than weekdays. There are tools that help that process of determining the best pricing. One that I recommend is a company called Airdna. The have over 25 performance metrics for over 80,000 cities worldwide. They examine thinks like market occupancy, number of active listings, average daily rate, revenue per available room, booking lead times and so on. You can also get customized competitive data sets which allows you to get a much more accurate perspective on your specific segment of the market. Some properties are seasonal with a peak season, a low season and two shoulder seasons. Your pricing strategy is going to vary depending on which season you’re in. I own a portfolio of short term rentals in a seasonal market. We know that the highest nightly rate is in the 16-20 weeks during the summer. Demand is good during ski season, but a fraction of what it is during the summer, hence the lower nightly rate. This is where the importance of product positioning comes back into play. I want my properties to have the best positioning in the market. I want the vacancy to go to the junk in the market. I want more than my fair share of the market during those periods of softer demand. Key to that is the reviews. So we will spend extra on a few items of furnishing. We will buy the most comfortable king sized mattress that money can buy. I don’t mind spending extra on that. I want you to get those guest reviews that say “Wow, this was the most comfortable bed ever.” If you have those reviews for your property, then you will get more than your share of the market. Finally, I want you to make sure that you show up as a superhost in AirBnB. All these little things separate you from the rest of the properties that are just commodities in the market.

Sharon Restrepo is based in West Palm Beach, Florida. On today's show we're talking about market cycles and how to recognize the four phases of the market cycle. You can Sharon at takingthelandinvestors.com.