The Real Estate Espresso Podcast

On today’s show we’re talking about the many impediments to getting stimulus money. One of the newest programs is the Main Street Lending Program. This program is designed to help medium sized businesses that have been impacted by the Covid-19 Pandemic. When you look at any business, there is the basic financial score card consisting of the income statement and the balance sheet. That’s every bit as true today in a moment of crisis as it would be in more normal times. Businesses that have experienced a massive drop in income as a result of the pandemic have taken a hit on the income statement. The income statement speaks only to income and expense. The balance sheet captures the assets and liabilities. How much cash does the company have? How much does the company owe? What cash is expected to come in the near future? What fixed assets does the company own that have intrinsic value. All these items are shown on the balance sheet. If you have an income statement problem, perhaps a drop in revenue or an increase in expenses, the best sustainable solution is also found on the income statement. You need to find a way to increase revenue or cut expenses. All too often, the proposed solution to an income statement problem is to lend the company money. If the problem is truly a short term problem, then a short term loan might be a good solution. But simply taking on more debt may not be the right long term solution. Under the Main Street program, banks will lend between $250,000 and $300 million to businesses that were creditworthy before the economic crisis began. A Fed facility will then buy a 95% stake in those loans, leaving originating banks with 5% of the credit risk. Out of the 11,000 federally insured banks and credit unions, 260 lenders have completed the registration process, while another 174 are still signing up. There are not many lenders in the program. The participation in the program has been very small so far. So I decided to take a closer look to see why the program might be having trouble getting off the ground. I went through the lending criteria for the various main street programs. I have to tell you that the rules are incredibly complex and the documentation required to qualify for the loan is heavy weight to say the least. There are over 30 documentation deliverables that must accompany each loan application. The restrictions are immense. In fact, it took me nearly an hour to fully come to terms with the lengthy list of restrictions. Virtually every sentence reads like another rule that would disqualify a wide category of borrowers. Knowing how businesses operate, I can’t see many real business agreeing to the terms of these loans. Not because the terms are all that unsavory, but because they’re that difficult to meet. I predict that we will see this major loan program go largely unused. The will be a large number of businesses that could use the money that can’t access it and will go into bankruptcy anyway. There are government programs for specific big businesses and industries like the airline industry. There are unemployment benefits for workers that have lost their jobs. The PPP program was a small program that provided a small amount of lifeline stimulus, but not enough to really save a business. The big question is the missing middle. Those tens of thousands of medium sized businesses that each employ hundreds or thousands of people. They’re the forgotten ones that will be left out in the cold. As real estate investors, we’re making daily investment decisions based on what’s happening in the larger economy. If business failures are going to multiply despite government efforts to help, we real estate investors need to pay close attention. Our revenue comes from the combination of demand and ability to pay. Demand is irrelevant without the ability to pay.

That is the question.  On today’s show we’re Talking about one of the strategies that are working in today's changing market conditions. Many markets are experiencing historically low inventories. We've gone through a period of reduced market activity, and this has resulted in shorter days on market, multiple offers and higher prices. These are traditionally the perfect market conditions for buy-fix-sell projects. That is assuming you can make the numbers work. You need to buy at low enough a price, maintain the improvements within the budget, and most importantly make sure that the improvements will be accepted by the home buying community. The worst situation is the one where you perform a substandard improvement. It’s not good enough to meet market demand, and it’s too new for a buyer to rip it out and replace it. But understand, while the market conditions are looking favorable for flips, the market conditions could change quickly. If you’re going to do a flip, who is your ideal customer? Some of the traditional sources of demand like immigration have been severely curtailed this year. Despite the hot market conditions, there are signs of softness. We know there is a large backlog of properties in forbearance. Currently there are 4.3M distressed properties in forbearance in the US. There are also a large number of properties with tenants in default. Unless the government steps in to forgive these loans, we will eventually see an increased number of distressed properties coming on the market. When that happens, the market conditions for selling a slip could change quickly. On the other hand, we could see a return to normal market conditions, a resumption of immigration, and another round of government assistance to protect property owners from foreclosure. There’s no point in providing help in the short term, and then allowing those properties to fall into foreclosure six months later. That investment in bailout funds would have been wasted. We remain in a low interest rate environment and demand for housing is expected to remain strong, as long as the employment market regains strength. Low interest rates are driving demand for homes. So let’s say you’ve decided that the market risk is acceptable. The next question is what kind of property to flip? Much of the price increase in the market has been in the bottom 2/3 of the market. Buyers fear getting priced out of the market. So much of the increase has been at the bottom of the market. At the top of the market, with homes priced above $1M we have seen much less movement in price. Some would say that the more expensive homes have seen close to zero price increase. The result is price compression. The price per square foot for the larger more expensive homes is in fact much less than the price per square foot for the smaller entry level homes. The key to a renovation project in this market is to make sure you get the property renovation done quickly. If a renovation is going to take more than 30 days, I would not take the risk. A flip project that is on a 6 month timeline would be incredibly risky in today’s fluid environment. I would also make sure that when you structure your deal you maintain lots of margin. That means you can’t pay too much for borrowed money. You need to be aggressive on sourcing well priced materials, and you need to negotiate with your subcontractors and clearly define the scope of work so you contain the cost of the renovations. You want to be assured that you’re selling into a segment of the market where there is still an extreme shortage.

The path from A to B is rarely a straight line. As humans, we like things to be nice and neat and orderly. Linear relationships are simple to calculate. They are simple to understand. We’re conditioned to think linearly. We have been conditioned to forecast the future based on extending a straight line from the past into the future. Most investment graphs imply such an exercise even when the usual disclaimer “Past performance is not an indicator of future performance” is attached. We are about a month into the so-called economic recovery. Governments the world over have been pumping money into the economy to prevent economic collapse. But we have conflicting data. The biggest factor affecting the economy is related to confidence. Some restaurants are open. My wife and I observed on the weekend that the outdoor patios had done a good job of spacing the tables far apart. The open air environment reducing the risk of transmission. The warm weather brought people out into the parks. The parking lots were full and the Police were liberally handing out parking tickets to the cars that couldn’t find a legal place to park. The beaches were full. The restaurants were busy. But then in California, the beaches were closed this weekend. The number of infections with Covid-19 keep rising in Arizona, Texas, Florida, Louisiana and numerous other hotspots in the country. The opening of the economy in several states has taken a step backwards as the US is experiencing record numbers of new cases each day. Texas and Florida rolled back their re-opening plan. New York City delayed the re-opening of indoor dining in restaurants. Several locations in Arizona also rolled back their re-opening plans. New Jersey is resuming summer camps and in-person graduation ceremonies. In my home town, the school board is going to be reducing density in the classroom and having students attend classes physically two days a week. The impact on parents who can’t work from home is going to be significant. There will not be adequate child care which will limit the number of people who are able to return to work. As a minimum, some parents will need to stagger their work day so that at least one parent is at home to care for the children. Those single parents who don’t have the support of a partner will really struggle balancing work and raising a family. The US economy recovered 4.8 million jobs in June and the unemployment rate fell from over 14.7% in April to 13.3% in May and to 11.1% at the end of June. 40% of the gains in employment were in the leisure and hospitality sector which includes restaurants and hotels. The stock market is up again sharply in early trading this week on hopes that the recovery is taking hold. The market was up 1.1% on Monday morning. All of these mixed signals are occurring at the same time. The Federal Reserve gave guidance that they won’t be raising interest rates until 2022. Yet the yield for the 10 year treasury note increased at the beginning of the week. There are no foreclosures or evictions happening, but that’s because they’ve been banned. We have 80,000 eviction cases backlogged in the landlord tenant tribunal in my home province. We have 8% of mortgage loans in the US currently in some form of distress. They’re either in forbearance or in default. We have some hospitals empty waiting for the onslaught of cases that never materialized. We have other hospitals in California at capacity. The US has recorded 360,000 new corona virus cases in the past week, that’s an average of over 51,000 cases a day. So far in the past three months, the country has recorded over 133,000 deaths. That’s a terrible statistic. When this started in February, I predicted that the deep economic impact would be at least 18 months in duration. From where I sit today, I re-affirm that prediction.

While the world has been distracted with the Covid-19 pandemic, and while much of the US has been consumed with rage, China as decided to ‘never let a good crisis go to waste.’ On today’s show we’re talking about the sweeping new security laws in Hong Kong and the impact of that on real estate in both Canada and the US. When Hong Kong’s basic law came into effect in 1997, it left some unfinished business. There was supposed to be universal suffrage, the right for everyone to vote. That was never implemented. Secondly, there was supposed to be a new national security law. The first attempt to implement this in 2003 was abandoned when more than 500,000 people took to the streets to protest the proposed law. Last week China’s central government imposed new national security legislation on the city of Hong Kong to stamp out a year of protests. So far in the first week, it is estimated that several thousand people have been detained under the new security law. So who is at greatest risk of being detained? Well, someone with a foreign passport could be charged with aiding a foreign government. Those with foreign passports have also been the ones who have been the most vocal opponents of China’s control of Hong Kong. It is estimated that there are at least 300,000 and perhaps as many as 500,000 people who hold Canadian passports living in Hong Kong today. There are approximately 85,000 people with US passports living in Hong Kong. If there is a crack down, it is reasonable to expect that a significant percentage of those who have the complete freedom to come to Canada or the US will do so. Of course, this is made a little more difficult as a result of the travel restrictions being imposed by the global pandemic. If 300,000 Hong Kong residents were to come to Canadian cities, the demand on housing would be significant. The US has suspended the H1B Visa program temporarily during the pandemic. But if 85,000 Hong Kong residents were to descend upon American cities in a short time period, the impact would be significant We already have market conditions with historically low inventory, rapidly increasing prices and properties routinely selling above asking price. If we see an exodus from Hong Kong, I predict that it will happen quickly. Flights from Hong Kong are significantly reduced, but it will still be possible to have several thousand people a day leaving Hong Kong bound for North America. Despite the worries over Covid-19, I believe that people will fear prison in mainland China more strongly than the fear over catching Covid-19. So here’s the question, “If you knew that there would be an exodus from Hong Kong into your home city, what would you do to be prepared?” Which properties would you get under contract? Which real estate agents would you make sure to communicate with? What financing would you get lined up to take down properties in advance of their arrival?

On today’s show we’re talking about whether markets really need a market maker. But first we need to define what a market maker is. The role of the market maker is to introduce liquidity into the market. The problem in many markets is that too much time passes between the buyer and the seller getting together. This passage of time means that the market price can fluctuate up and down depending on the number of buyers and sellers and the spread between the bid and the ask. Exactly what does the market maker do? They step in when there is no buyer and they buy, and they step in and sell first when there is no seller. The role of the market maker is to ensure that any time there is a sale, there is someone waiting to buy. Whenever there is a buyer, they step in and sell. In exchange for providing this service, the market maker makes a small profit margin. The market maker is not exposing themselves to undue risk because there is an expectation that the market will continue to operate in an orderly fashion. The major stock exchanges around the world work on this premise. When someone buys shares of Tesla on the NASDAQ at the market price, they are buying the shares from the market maker, not the seller of shares. The market maker ensures that when someone put shares for sale maybe two minutes ago, there would be someone available to make the trade without having to wait for the trade to be fulfilled when a buyer materializes. Markets of all types exist throughout the world without the role of a market maker. The real estate market in my local community has no market maker. When you bargain for a bushel of tomatoes at the farmers market, there is no market maker. The Federal Reserve said on June 15 that it will begin buying individual corporate bonds under its Secondary Market Corporate Credit Facility. Let me get this straight, I could be a captain of US industry with the need for additional debt. The banks won’t lend it because there isn’t sufficient collateral. The income isn’t consistent enough to sell the bonds because we have a global pandemic on our hands. So the Fed will step in and buy that debt that is too toxic for real investors to touch. All of this is being justified as providing market liquidity. The central bank also spelled out for the first time how it plans to implement its buying strategy, saying it would follow a diversified market index of U.S. corporate bonds created expressly for the facility. The Fed built the index internally, and a spokesman couldn’t immediately say whether its details would be made public. So here’s the rule that needs to be followed. It’s listed under section 13.3 of the Federal Reserve Act.  An index assures the Fed complies with the spirit of the law under Section 13.3 of the Federal Reserve Act which says emergency lending facilities must be broad based, and provides a mechanism for the central bank to avoid industry concentration. A program or facility that is structured to remove assets from the balance sheet of a single and specific company, or that is established for the purpose of assisting a single and specific company avoid bankruptcy, resolution under title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act, or any other Federal or State insolvency proceeding, shall not be considered a program or facility with broad-based eligibility. So here’s the deal. The Fed is going to make up an index that has a few companies in the index, or who knows, maybe even one company so they can stay in compliance with the letter of the rule in section 13.3 of the act. That explains why the stock market indices are at such crazy levels, despite the economic downturn. The Fed is going to buy corporate America’s bad debt, and they’re going to do it with printed money. That folks looks like a bailout, and definitely not like market maker activity.

Dan Butler has about 3,000 apartments under management in the Memphis market. Memphis is a difficult city from an economic stand point. He shares some insights on the pandemic and how his business has fared during this period of social isolation.   

Gary Beasley is the founder of Roofstock.com, an online marketplace for turnkey rentals.  This fascinating innovation has sold thousands of homes so far. You can reach Gary at Roofstock.com.

Evan from Toronto asks, My wife and I, along with our Real Estate Partner, are looking to buy our first rental property in the GTA by the end of the year! We really like the BRRRR strategy but have some questions since we've never used it before! 1. What have you found is the best way to structure private lending? 2. What are the top three things that can go wrong? 3. How do we find comps in smaller/more rural neighbourhoods? Evan, this is a great question. But before I answer your specific questions, I want to set the context so that you look at the opportunity the right way. You see the prices in Toronto are so high that it’s almost impossible to charge enough rent to recoup your investment in a reasonable timeframe. You end up tying up too much cash in the equity of a home in order for the numbers to make sense. The driver for housing in Toronto has been population growth. The city has added about 125,000 population a year and has only added about 35,000 units of new construction a year. The supply isn’t keeping pace with the demand which is why prices keep increasing, commute times keep getting longer, and the boundaries of the city keep expanding. When you’re paying $700,000-$800,000 for a townhouse, it’s hard to charge enough in rent to cover the cost of financing this project. The ratios are too far out of whack. What is working in the Toronto market is to renovate with a sale to an end-buyer as the exit strategy. You can go to lower density more rural areas, but they’re a long commuting distance from the core of the city. Low density also means low demand. There is so little developable land within commuting distance that the land is worth a lot of money. Construction is cheap by comparison. I personally don’t think the BRRRR strategy works in Toronto. Of course the market is in a strange state right now with the Covid-19 pandemic still affecting the market. We have less immigration which has been a traditional demand driver in Toronto. We also have a lot less foreign investment in the market. The key to buying a suitable property in the Toronto area is to buy at a sufficient discount and to add enough value. You see in Toronto the municipal development charges, what are called impact fees in many cities are incredibly high. For a single family home you’re looking at a fee of $84,000 depending on the area in which you’re building a new home. So two identical houses side by side could differ in cost by $84,000. One is new construction and the other is replacing an existing house. You can do a lot of renovation for $84,000. You could take a single story house, cut off the roof, add a second level and more than double the value of the house, without doubling the cost of the house. You want to see what is working in an area and copy it. Don’t try to be a hero and blaze a new trail on your own. That’s a recipe for disaster. The other main challenge in Toronto is finding high quality subcontractors and trades people that are reasonably priced. The guys that are good are already busy for the next two years with existing projects. Trades people are in high demand. Contractors are often looking for smaller projects as gap fillers in order to keep their people busy. They have to keep their people busy or they will lose them. But the flip side to that is that getting people to come to actually work on your project can sometimes be a problem. Finally, you have to consider the sales tax. There is sales tax on new home sales, but not on the resale of existing homes. That adds another 13% to the cost of a new home in addition to the already exorbitant development charges. So you want to make sure you don’t renovate the house too much so that it is considered a new house. You want to be treated as if you are re-selling an existing house that has already paid the sales tax.

On today’s show we’re talking about the effect of the pandemic on rental markets across North America. The results are somewhat surprising. The biggest worry has been whether tenants would pay rent despite the staggering job losses. It seems that the stimulus money that governments have been showering the country with have been effective in protecting rental payments. The National Multifamily Housing Council Rent Payment Tracker found 94.2 percent of apartment households made a full or partial rent payment by June 27 in its survey of 11.1 million units of professionally managed apartment units across the country. This is a 0.5 percentage point decrease from the share who paid rent through June 27, 2019 and compares to 93.3 percent that had paid by May 27, 2020.  While the rent collections for June were down 0.5% compared with a year earlier, we are seeing that some tenants are struggling to make payments on time and are paying later in the month than previously. But here too the difference from last year is small. The biggest drop in rent collections happened in March and April, before the unemployment benefits were fully rolled out. Collections have steadily improved in May and June with the June numbers being virtually identical to the 2019 numbers. There is one caution and that is what is happening in the smaller self-managed rental market. We’re hearing data that collections in that segment of the market are much lower. We will try to get more data on that segment for a future show. So if rental collections haven’t really dropped, then what’s changed in the rental market? According to a new report on Zumper published in June of 2020, we can see some changes in the rental market. Zumper’s National Rent Report analyzes rental data from over 1 million active listings across the United States. Data is aggregated on a monthly basis to calculate median asking rents for the top 100 metro areas by population, providing a comprehensive view of the current state of the market. The report is based on all data available in the month prior to publication. Covid-19 has shifted demand away from the most expensive markets. When you look at month over month data, all of the top 10 priciest cities either had flat or declining rents. It seems the pandemic has shifted the demand for apartments away from the most expensive cities, since usually demand picks up as we head into summer but now the opposite is true. As more and more companies move into remote work, many renters don’t want to pay the big city price tag when they are unable to use the amenities and are looking for more affordable options outside of large, metropolitan areas. The most expensive city in the nation experienced the largest year-over-year drop since we started creating these reports in 2015. San Francisco one-bedroom rent is down 9.2%. Similarly, the 3 next most expensive markets, New York City, Boston, and San Jose, all had negative year-over-year changes for their respective one-bedroom rents as well. Some cities have actually experienced rent growth during the pandemic. One city in which my team has projects is Spokane Washington. The Spokane Valley is an area where rents have increased 5.1% year over year for one bedroom units and 3% for two bedroom units. Much of that change is recent with rents having increased 3.8% in the past month for 1BR units and 3% for 2BR units. In my opinion, there’s no question that changes in employment are affecting people’s choices of rental accommodations. These choices are being influenced by affordability. If someone loses a job, they’re going to be looking for less expensive accommodation. If they’re going to be working from home for an extended period of time, then they may choose to move from a high cost dense urban environment to a lower cost area where they can socially isolate and continue to work from home with more access to the outdoors.

The book this month is called The Infinite Game by Simon Sinek How do we win a game that has no end? Finite games, like football or chess, have known players, fixed rules and a clear endpoint. The winners and losers are easily identified. Infinite games, games with no finish line, like business or politics, or life itself, have players who come and go. The rules of an infinite game are changeable while infinite games have no defined endpoint. There are no winners or losers—only ahead and behind.   The question is, how do we play to succeed in the game we’re in? In this revelatory new book, Simon Sinek offers a framework for leading with an infinite mindset. Leaders who embrace an infinite mindset build stronger, more innovative, more inspiring organizations. Ultimately, they are the ones who lead us into the future. Infinite games, in contrast, are played by known and unknown players. There are no exact or agreed-upon rules. Though there may be conventions or laws that govern how the players conduct themselves, within those broad boundaries, the players can operate however they want. And if they choose to break with convention, they can. The manner in which each player chooses to play is entirely up to them. And they can change how they play the game at any time, for any reason. Infinite games have infinite time horizons. And because there is no finish line, no practical end to the game, there is no such thing as "winning" an infinite game. In an infinite game, the primary objective is to keep playing, to perpetuate the game.