The Real Estate Espresso Podcast

On today’s show we’re talking about where are we with this darned pandemic that has dominated this year 2020. There are lots of conflicting data points and individuals, business leaders, public health officials, elected officials, and investors are trying to figure out where this is all heading. This is an area I’ve been studying deeply for a long time. The Corona Virus is new in the past year, it’s not that well understood to the medical community, and it threatened our global society with a very high mortality rate. We’ve had a bit of a reprieve over the summer months. The weather is getting cooler and people are spending more time indoors. We are seeing infection rates rising dramatically in many countries including Spain, Israel, France, India and Brazil. The United States will pass a grim milestone in the next day or so with 200,000 deaths so far this year from the pandemic. There are some potential vaccines undergoing early clinical trials, and it’s reported that a few hold considerable promise. However, even if these are found to be effective, it will be many more months before they can be manufactured in sufficient quantities and administered to a large enough percentage of the population to have a meaningful impact. We’re hearing of outbreaks in the school system as children return to school. We’re hearing first hand accounts of outbreaks in university residence buildings. So where does that leave us? It’s possible that we have a second wave coming. Some point to the Spanish Flu pandemic of 1918, which infected 1/3 of the world’s population in four successive waves. It was the later waves of the Spanish Flu that were the most deadly. Is history about repeat itself with the Covid-19 virus? I’ve been following the work of Dr. John Campbell from the UK. He has been reporting on a number of recent studies showing the correlation between the severity of Covid symptoms and Vitamin D levels. There are numerous studies showing that there is a strong link to severe Covid symptoms and vitamin D deficiency. A recent small scale experiment of 76 patients conducted in Spain showed that out of 50 Covid patients chosen at random who were given the best available treatment and high doses of vitamin D, all survived, and only one out of 50 deteriorated to where they needed to be admitted to intensive care. Out of the remaining 26 cases, all were given the best available treatment, and no vitamin D supplements. From this control group 13 / 26 deteriorated to where they needed intensive care and two died. Fully 50% ended up in intensive care. You can find the videos from Dr. Campbell on Youtube at https://youtu.be/iNji13yoW9g Over the past week, Dr. Campbell has presented numerous other papers and studies from the Journal of the American Medical Association, two large scale studies from Israel, to name just a few. It’s strange that the WHO, the CDC, the Oxford Center have not initiated a large scale clinical trial of Vitamin D. But the studies to date seem pretty compelling. I’ve maintained for a long time that it would take one of two things to bring the pandemic to an end from a social and economic impact. 1) Full herd immunity. Either everyone got it, or large scale deployment of a vaccine 2) An Effective treatment If you look at the statistics coming from Europe, we see that case counts are rising dramatically. Paradoxically the death counts have not been rising correspondingly.  It’s too early to declare the pandemic over. Some of the studies have shown Vitamin D to be effective as both preventative and as a therapeutic. Vitamin D is produced within the body by exposure to sunlight. As a supplement, it is readily available, and is easily manufactured in high volume.

On today’s show we’re talking about the usefulness of your property and how the title report can help you understand what you’re buying. You’re buying a piece of property. You pay the purchase price, and now it’s yours. But the truth is, it’s not that simple. There are so many things that can encumber the use of your property. All kinds of things that affect your property can be recorded in the official records of a property. To start with, the title report can tell you a lot about your property. There is an enormous amount of complexity in what seems like a pretty straightforward transaction. Sometimes these reports can be lengthy and boring to read. But they contain a ton of information about the history of a property. I recently received a title report that was 96 pages in length. It had all kinds of details, including when transfers happened between family members, loans taken out against the property, when they were repaid, when the owners were behind on their taxes, or their water bills. So much information is contained in the property records. The first and simplest item is the deed. This is the ownership. Who owns it and under what kind of structure is it owned? Is it owned by a person, an entity like a company, or a land trust. If the property was transferred as a result of a foreclosure, the new owner would be listed on the property. But some areas have a right of redemption period after the transfer whereby the original owner can get their property back. For example, there is a rule in Philadelphia that says if a property is sold at the Sherriff’s tax sale, and the original owner was not properly notified of the impending sale, they have a right of redemption period whereby they can pay the back taxes owing and get their property back. How long is that redemption period? Get ready for this. It’s 21 years. That’s right, 21 years. There is additional complexity coming from the various forms of encumbrances that can be attached to a property. This can be a lien. But there are other forms of encumbrances. There could be a right of way or an easement. These are sometimes used to provide utility companies the right to have a pipeline, or an electric transmission line cross your property. It might be a right for a neighbor to access your property for a driveway in order to prevent their property from being isolated. Sometimes there can be a deed restriction recorded on title. It could literally say anything. It might say that the property is transferred on the condition that the any structure built on the property must be painted yellow. You can literally put that kind of restriction on a deed. That restriction might be temporary or perpetual. Unless you perform a full title search, you may not know what burdens you are signing up to. They’re contained in the history of the property. I’m dealing with an issue on a property right now where one of the owners granted an easement to the electric utility company to have wires crossing the middle of the property. That easement was granted in 1938 and the property owners were paid a grand total of $4 for the right of way from the utility company. From a practical standpoint, the electric utility is highly unlikely to ever enforce their right to access the property. But if I build a house in the easement, they could theoretically come to me one day and ask me to demolish the house. Then you have to consider what new regulations might be in place. Just because a house exists on a property, doesn’t mean you’re permitted to modify what’s there. Many elements of the building code allow existing structures to continue in their current location. These are the so-called grandfathering clauses. But sometimes, the new rules say that if you make any modifications to the property then the new rules apply. Pay very close attention to the title report and I recommend that you read every word contained in it.

Today is another AMA episode (Ask Me Anything). Brad from Ottawa asked me to look at a prospectus for an international hotel fund. He is asking for my opinion on the offering. Clearly the global environment for hospitality has changed dramatically. Nobody knows what the new normal will be for hospitality following the pandemic. We’re talking about hotels in warm weather getaway destinations. We don’t know what airline capacity will be in the coming months or years for those destinations. Without knowing the airline capacity on those routes we have no way of assessing the demand for hotel nights. There’s no basis for building a new hotel without that data. The offering memorandum document is out of date with respect to the current market conditions. There’s no way that an investor should be even thinking about putting capital into a new construction hotel. I want every listener to understand that I’m not preaching about someone elses’s project. I say this even for myself. I have a development project in the core of the city in one of the hottest neighborhoods. My original plan was to build a 4-star hotel in that location. It would have been the perfect location and an ideal product in that location. I really wanted to build that 120 room hotel. And then the pandemic hit. I know that in an environment where hotel occupancies worldwide are below profitability for the existing hotels, there is no basis for engaging anyone in a discussion about building a new hotel. The most knowledgeable investors for hotels are those who have invested in hotels in the past. Many of these investors have decades of experience having invested in the hotel sector. It makes sense to talk to those investors and ask them about their strategy for hotels going forward. Understand that we have a set of market conditions where a large percentage of existing hotels are in default on their debt. The actual percentage depends on the location. On August 28 of this year, just a few weeks ago we dedicated an entire episode to what is happening in the CMBS market for hotels. In NYC, the default rate is 38%, in Houston 66%. While these hotels have not gone into foreclosure yet, I predict that some of them will. When they do, there will be high quality assets for sale in the market at a discount. In that environment, would an investor rather acquire an existing hotel for a deep discount or would they roll the dice on a new development project that won’t generate revenue for another 2-3 years? I’ve been saying this for a while. Now is the time to be patient. I’ve had a number of conversations with investors in recent weeks where they’ve had funds available. It seems like the money is burning a hole in their pocket and they want to put the money to work. I totally get that money sitting in a bank account is earning essentially zero interest. I have the same situation and it’s tempting to put the money to work. I know we’re in what appears to be a hot market. In the residential market prices are continuing to rise, largely fueled by low interest rates. But that doesn’t translate into higher prices in the investment market. As investors we value property based on its income potential. In my home city, sale prices for condo’s are up 24% this year over last. That means that at the entry level of the market, people are willing to pay more and they’re gobbling up inventory in order to avoid being priced out of the market. But that has nothing to do with the valuation of rental apartments. Unless rents have gone up 24%, and I can tell you that they have not, the valuations for rental properties has remained steady or perhaps gone down a little. The valuations for hotels have gone down a lot.

This talk was given earlier this week at the Durham Real Estate Investors meeting in Toronto. When we think about project management, there are so many facets to consider. The goal of this talk was to give attendees something tangible and actionable to use the very next day.  Enjoy...   

Britnie Turner is CEO of the Aerial Development Group in Nashville, Tennessee. She is also the founder and CEO of the Aerial Recovery Group. On today's show we're talking with Britnie and her chief of operations Jeremy Locke about the initiative that she and her team are taking to aid in the disaster recovery from Hurricane Laura in Lake Charles Louisiana.  If you want to learn more, you can direct message @AerialRecoveryGroup on Instagram, @BritnieTurner on Instagram. You can also find out more ways to help at laura.usastronger.com. 

On today’s show we’re talking about the law of large numbers. The law of large numbers is a mathematical theorem in statistics thatdescribes the result of performing the same experiment a large number of times. According to the law, the average of the results obtained from a large number of trials should be close to the expected value and will tend to become closer to the expected value as more trials are performed. But we’re not going to be talking about statistical theorems today. We’re talking about the ability of the human mind to process large numbers when presented with these big numbers. We have so many facts and figures that are so big that they become incomprehensible. If I said to you 100,000 or 1,000,000,000, the impact is almost the same. I mean think about it. The wildfires in California have burned 2.3 million acres so far this fire season. Most people can’t process what that means. Yes, I know it’s a lot. But how big is 2.3 million acres. It’s not a unit of area that most people can process, let alone multiply by a large number. An acre is a unit of area that measures about 208 feet by 208 feet. In a dense urban setting you will often get between 6-8 houses per acre, and 12-15 townhouses per acre. An acre isn’t huge, but it’s not small either. Maybe square feet are easier to understand. A square foot is a unit of area that measures 12 inches by 12 inches. Or if you prefer metric, it’s a unit of area that measures 30 cm x 30 cm. We’re talking wildfires that have burned 100 billion 188 million square feet. Somehow, I’m not finding it any easier to comprehend how much has been burned in California in this year’s wild fires. Perhaps it’s easier to talk in square miles. This year’s fires have burned about 3,600 square miles. Even that is hard to process. If I told you that this is an area equivalent to 12 times the size of New York City, it’s starting to get easier to understand. Or if I told you that it’s about 40% of the total area of the Dallas-Fort Worth metro area, you’re now starting to be able to comprehend it. In truth, I haven’t told you anything different in any of these examples. But when I give you a frame of reference, it’s starting to become easier to process. So far this year, the Corona Virus pandemic has killed 196,000 people in the US over a six month period. Exactly how many people is that? Yes, that’s a lot of people. It’s a massive human tragedy. It’s three times more American soldiers than were killed in the Vietnam War. That doesn’t really help either. Think about taking Fenway Park in Boston where the Boston Red Socks play. You would need 5.2 stadiums the size of Fenway park to hold that number of people. That’s a jarring visual image. Numbers by themselves are abstract, even for mathematicians to comprehend the scale and proportion. If I told you that the newest Amazon fulfillment center to be built in my home town was 1 million square feet, how many people could truly comprehend what that means? But if I told you that you could put 60 NHL hockey rinks in the same area, or you could fit 17 football fields, it is starting to get easier to understand. So why am I telling you this? As you communicate with your investors, with your stakeholders, with your business partners, or with you grandmother, don’t throw numbers at them. Make sure you create a frame of reference that is understandable when you communicate a number. Have an awesome 86400 seconds.

Today is another AMA episode (Ask Me Anything) John from New York asks: With states, cities and towns possibly being under financial pressure due to decreased business during pandemic, how would you underwrite the purchase of a multifamily asset?  How much of the increased tax can be passed along in a rental increase? John, this is a great question. If you look at most cities, they get their cash from one of several sources. 1) Property Taxes 2) Service Fees 3) Other Levels of Government 4) Borrowing Despite the pandemic, I don’t expect property tax collections to go down very much. Eventually, the city will get the property taxes, whether it means a tax lien on a property, or an outright tax sale, the city will get their money.  Service fees are the area that have been hit the hardest during the pandemic. Services fees include everything from the revenue collected when a someone rents a meeting room for an event, to parking tickets, to library fines. This is where cities have experienced the most impact during the pandemic and it’s also the area where the cities have reduced staff. You don’t need to hire life guards if the swimming pools are closed this year. Transfers from other levels of government have been largely unaffected. Borrowing is restricted to capital projects in most cities. Most cities are prohibited from borrowing to fund day to day operations. The only way to cover the shortfall is to either raise property taxes or to beg another level of government for more money. How each city will deal with the problem will vary from one to another. Nashville increased their property taxes by 34% in their most recent budget. Hopefully most cities don’t experience that kind of increase. One  problem in your question is how can you pass on these costs to tenants and recover some or all of the income lost to higher taxes? Some jurisdictions have rent controls. Where you’re from in NY is famous for its complex web of rent control regulations. Where I live in Ontario Canada, the province limited rent increases to zero % for 2020, arguing that the pandemic has caused enough pain for tenants. In most communities,  taxes,  utilities, insurance, have all increased rates in the past year. A zero percent rent increase is basically legislating landlords to lose money. So back to your question which is how to underwrite a new project? When there is uncertainty, you need to build safety into the project. That means increasing the debt coverage ratio to ensure you have a higher profit margin and lower debt service. Most lenders require a debt coverage ratio of 1.2. Let’s look at a simple example. Let’s say that your project generates 120,000 in profit before debt service. In that scenario you would have $100,000 in debt service and $20,000 in free cash flow. But that’s the minimum your lender would allow and it doesn’t leave much margin for things to go wrong. For example, if your property taxes went up $10,000 and your occupancy dropped, and you had some unplanned maintenance, you could find yourself in a negative cash flow situation. I would urge you to borrow a little less money, and bring more equity to the table. You might lower your borrowing from 80% loan to value to something lower, like maybe 65% or 70%. You would want to target a higher debt coverage ratio like 1.5. In that scenario you might take that same $120,000 profit and target $80,000 of that to go towards debt service and $40,000 in free cash flow. The stronger cash flow on paper makes the project more resilient towards surprises. You could need that extra buffer. In our projects we are targeting higher debt coverage ratios above the minimums in order to bring that extra level of safety into the projects.

On today’s show we’re talking about an event that took place about a month ago. It made a few headlines at the time, but there’s been very little said about it ever since. There’s a global debate raging on the best way to handle the global pandemic. Let’s be clear, there is no good solution. There are three trade-offs to be made. 1) Protecting health for people who might be susceptible. 2) Minimizing damage to the economy through social isolation and quarantine activities 3) Protecting the health care system from being overwhelmed with hospitalizations Unfortunately, what is a scientific and economic problem has become politicized. At the end of the day, the virus doesn’t care what passport you hold, what political party affiliation you have, where you live, whether you’re old or young. Last month, there was a motorcycle rally that was held in Sturgis South Dakota over a 10 day period in which nearly 500,000 people descended upon a small town of about 7,000. This annual event brings people from all over the country. A new paper which examines this event was published last week by the IZA Institute for Economic Development, funded by The Deutsche Post. The paper is  DP No. 13670 entitled: "The Contagion Externality of a Superspreading Event: The Sturgis Motorcycle Rally and COVID-19".  The Sturgis Motorcycle Rally represents a situation where many of the “worst case scenarios” for superspreading occurred simultaneously: the event was prolonged lasting 10 days, included individuals packed closely together, involved a large out-of-town population. Attendees to the events were only required to show that they had a mask in their possession, but were not required to wear it. The only large factors working to prevent the spread of infection was the outdoor venue, and low population density in the state of South Dakota. A month after the event, it looks like the number of cases in the community multiplied by a factor of 4-5. To be clear, the case counts in Meade county prior to the motorcycle rally were low. There were approximately 2 cases per 1,000 population. After the rally, the number grew to 9 cases 1,000 population. Not only that, but the event was also responsible for the spread of the disease in the communities where attendees originated from. The study used anonymized smartphone data from SafeGraph, Inc. They used the SafeGraph data to measure the number of non-resident visitors to the census block groups (CBGs) where Sturgis Motorcycle Rally events took place, (ii) trace those attendees back to their home counties, and (iii) measure stay- at-home behavior among residents of Meade County. South Dakota is one of the least densely populated states in the country. They naturally had social distancing built into their society. For that reason, South Dakota has had no restrictions on restaurant closings, no restrictions on social gatherings, no restrictions. They put the responsibility in the hands of residents and visitors to act responsibly. There is no mask wearing mandate, and there is no work from home requirement. The makeup of attendees was 0.9% from the local county, about 8.5% from other counties in South Dakota and close 90.7% from out of state. All of this data was provided by the smartphone pings. The authors of the study concluded that the Sturgis Motorcycle Rally generated public health costs of approximately $12.2 billion. The authors financial conclusions were flawed in my opinion, but the rest of the study was solid.   This study is the first real petri dish experiment of a large gathering involving large numbers of people to a live event, and involving travel from many parts of the country into a single location. Since the study was published last week, I expect that it will play a role in shaping public health policy for governments around the world.

There’s no question that there is a monumental shift happening in the world of commerce. Much of this is driven by the continual need to cut costs. Retail space which touches the end consumer is still relatively expensive. In fact, rent for a retail business rates among one of its top expenses. Not only that, the density of merchandise per square foot is quite low. After all, you want to be able to browse the aisles and see what you are about to buy without visual clutter. Clutter creates confusion, indecision, and ultimately undermines the buying experience. We know that e-commerce is gaining market share. It’s not just the convenience of buying online. Even the bricks and mortar retailers are realizing that they need to reduce their retail footprint in order to compete. The purpose of the showroom has changed. It’s now just what’s required to showcase the merchandise, and not to hold inventory. The space is too expensive. If you want to have a large catalog, and you want to drive a lot of volume, then you need a large space. Customers want to be able to enter a store without feeling crowded.  Think of Ikea furniture stores from Sweden that have designed their stores to showcase how to use their product. But the stores themselves relegate the majority of the inventory to an attached warehouse where the product is flat-packed and stacked to minimize the warehouse footprint. Last month, Colliers International published their industrial market update for the second quarter. This year, despite the pandemic, there has been a market absorption of 104M square feet of industrial space so far in 2020. There is 170M square feet of new supply that has entered the market during the period, and there is a further 314M square feet under construction. The new supply represents the eighth quarter in a row where supply has exceeded demand. Vacancies are trending upwards, despite the robust demand growth. Vacancies were 5.5% for the quarter up by 0.5% from the same period last year. Clearly supply is getting ahead of demand in some areas. You see, in every sector you need to look at both supply and demand. Some cities have a very large industrial footprint. I’m thinking cities like Dallas and Houston which each have about 896M SF and 615MSF respectively. Now industrial demand breaks down into several sectors, including warehouse, flex, and manufacturing. The growth in the Dallas market in Q2 was 10M SF which represents an addition of 1.1% of the total market inventory in the second quarter. But if you compare with other markets like Austin Texas which only has 56M SF in the entire market, it looks like Austin is under-supplied compared with its population. Austin does have some major players with companies like AMD, Dell, Whole Foods, having sizable industrial footprints. The announcement of Tesla’s new factory in Austin is sure to bring more activity to the market. There is a shortage of industrial zoned land in the community and there is a need for additional last mile logistics space for many e-commerce businesses. As with any business, you need to understand your customer, and you need to understand the supply demand dynamics of the local market. Like retail, industrial projects are often tailored to a specific customer’s needs. Making an investment requires a deep understanding of the market dynamics for both supply and demand. Repurposing a warehouse from one customer to another is generally not that difficult. But location is important, outdoor storage is important, turning radius for trucks is important, freeway access is important, and transportation for employees to get to work is important. For example, if the employees in a warehouse need a car to get to work, then they will need to earn more than those who can take public transit.

While the August numbers for unemployment look encouraging, there are signs on the horizon of a fresh wave of corporate layoffs that will deal another blow to the global fragile economy. Some of the layoffs are merely announced and have not taken place yet, so they won’t appear in the official statistics until September, October, and in some cases after the US election. Some businesses in the resorts and hospitality industry have now started to make temporary job cuts permanent. MGM Resorts sent layoff notices to 18,000 people a little over a week ago. The airline industry is poised to cut hundreds of thousands of jobs starting on October 1. The US Federal government’s cash injection for the airlines runs out on September 30 and there is no new money on the horizon that would seek to prevent a massive shrinking of the airline industry. United Airlines is letting 16,000 people go. American is letting 19,000 people go on October 1. Boeing is cutting 10% of its workforce. That’s going to have a trickle down effect to the hundreds of companies that supply parts to Boeing. But it’s not just airlines and hotels. Ford Motor company is letting 1,400 people go through early retirement, a reduction of 5% of their workforce. Daimler, which owns Mercedes Benz may cut up to 30% of its global workforce. Coca-Cola is offering buyout packages to 4,000 people. We don’t know yet how many will take up the offer and how many will be forced to leave in the end. Salesforce.com is letting 1,000 people go. LinkedIn has cut 6% of its global workforce. Warner Media is letting 600 people go starting in August. NBC Universal is expected to cut about 10% of its workforce. The big issue for most of these businesses is the massive amount of debt that is being carried on the balance sheet. When revenues are a fraction of the pre-pandemic levels, these businesses are insolvent. They had the ability to withstand a few months of bleeding, but we’re now 7 months into the pandemic with no clear end in sight. Frequent listeners to the show will know that I went on record early this Spring and predicted an 18 month economic winter. If my prediction is correct, then we will start to come out of this mess sometime in mid 2021. We are in the middle of an election campaign in the US. Despite this, there are signs that the government will not be able to prop up the economy through the length and breadth of this pandemic induced downturn. They can prevent distressed properties from coming on the market by artificially freezing evictions and foreclosures. But they can’t do that indefinitely. Otherwise they create an environment where there is no consequence to defaulting on debt. The Fed simply won’t buy all the toxic debt in the world. This means that there will be a downturn in real estate. We’re seeing the beginnings of it in the hotel industry, in retail and in  office asset classes. Eventually the job losses will cascade the pain into the residential housing market. That’s unavoidable, even if the short term metrics show a hot market. These job losses will ripple through the economy and real estate prices will not be immune. Your job is to start amassing cash to rescue the right projects when the time comes. That will be an exercise in patience and waiting for the opportunities to arrive.