The Real Estate Espresso Podcast

Today's show is an extract from a keynote address I gave on the 2020 Virtual Investor Summit.

On today’s show we’re talking about the difference between price versus value. So often I see new houses, new apartments that are very “traditional” in design. I have nothing against tradition. But it doesn’t take very much thought to imagine how a family will live in a space. You can tell those who design based on a spreadsheet. They simply maximize the building envelope to what the zoning code allows. They maximize the height, they maximize the number of units and the number of bedrooms without any regard to how the space will live. They put the minimum sized closet that will legally classify the room as a bedroom. After all, the appraised value for a two bedroom apartment will be higher than for a one bedroom. It’s all about maximizing the appraised value. Or is it? Those of you who know me, will know what’s coming next. That’s right. I’m going to bring up the law of supply and demand. But I’m going to focus on a more granular segmentation of the law of supply and demand. It’s not just the supply and demand of houses, or apartments that matter. It’s the supply of features amenities that matter. In a dense urban environment like our projects in Philadelphia, we aim to include parking even if there isn’t much land available. You see there  is so little parking available in the core of Philadelphia that it’s not just the supply of 2 bedroom apartments that matters, it’s the supply of 2 bedroom apartments with parking that’s the differentiator. Unless our society moves to a post-automobile form of transportation, the shortage of parking in Philly is going to continue for decades to come. If there were ever to be an elevated vacancy rate in Philadelphia, those apartments with parking will still always be fully leased. The large garden style apartment complexes are increasingly participating in the amenities arms race. They’re adding a playground for the kids, a dog run, a splash pad for the kids, pickle ball courts. The list seems to grow longer with each passing year. Go back ten years, how many people were taking delivery of goods and services through e-commerce? Is there a place for the delivery of large parcels to be held securely? So back to tradition. The traditional home has a formal living room, a dining room, a kitchen, guest bathroom, master bedroom with en-suite bath, kids bedrooms, a laundry room, and a front closet. But today, the hub of the house is the kitchen, larger than kitchens of previous decades. The living room is usually furnished and never used. The formal dining room gets used once every few months, if at all.

On today’s show we’re talking about a morning after shock. No we’re not talking about an earthquake. This is the morning after the City of Nashville voted in a 34% property tax increase. You’re probably thinking. I’m glad I don’t live in Nashville. Folks, this event should be a wakeup call for cities all over the world. There are a couple of vitally important questions we need to answer on today’s show. 1) Are the issues that triggered such a massive tax increase unique to Nashville or do they exist elsewhere? 2) What will be the impact to Nashville, the local economy, the price of real estate, and the growth that the city has been experiencing over the past decade? So why did Nashville face such a massive tax increase? The Council voted 32-8 to approve an alternative budget proposed by Councilmember Bob Mendes after a night of several failed budget proposals. The Mayor had proposed a budget that called for a 32% tax increase. That motion was defeated. The Council weighed four different budget proposals, each of which called for a significant tax increase. The full 9.5 hour meeting can be seen on youtube https://youtu.be/Mm4a_BIfr4oand the link is in the show notes. At the root of the tax increase was a threatening letter from the State of Tennessee’s financial comptroller.  The letter said in plain terms that if the city didn’t put enough money in their rainy day funds, the state could come in and take over the city’s finances. The state called the failure to act would be considered a surrender of the responsibility to govern which would trigger the state taking over the management of the city. Clearly this is an issue that has been brewing for several months. The new budget faced calls for defunding the Police and redirecting funds to community outreach. In the end, the full police budget was approved and an additional $2.5M Council, in a surprise move, approved a plan early Wednesday morning to reroute $8.2 million from the school district's savings to a contingency fund in order to pay for teacher raises. The budget shortfall was caused by a tornado in March, and the Covid-19 outbreak and over a 16 month period is estimated at a $470 million shortfall. The problem with this tax increase of course is that the city can’t truly count on receiving all that revenue. At a certain point, families on fixed incomes won’t have the extra cash to fork out. Remember, property taxes are indexed to property value. Over the past decade, property values have increased dramatically in Nashville, as they have in cities all over North America. As property values increase, so too does the amount of tax collected. Real estate investors who own rental property sign loan covenants that require them to maintain a minimum debt coverage ratio. The property tax increase will cause tens of thousands of property owners into a technical default situation with their lenders whereby they are no longer in compliance with the terms of their loans. Then there will be those who truly can’t afford the increase. They will eventually lose the property to foreclosure, or at the tax sale for non payment of taxes. The new rate, $4.221 per $100 of assessed value. We have also seen cases where properties that face high property taxes have in fact fallen in value. Some high tax locations like Chicago have certainly experienced this phenomenon. The city can try increasing taxes, but there is only so much money available in the general population.

On today’s show We're talking about the legacy of Covid-19 on the office market. My company used to have an office location in Sunnyvale in the heart of Silicon Valley. My permanent office was near my home in Ottawa Canada. But I used to visit Sunnyvale frequently. I had staff there. The CEO of the company relocated the headquarters from San Diego to Sunnyvale. When I was visiting the Sunnyvale office, I would sit in a spare cubicle outside the CEO’s office next to the CEO’s assistant. When I was there, the CEO would see me and ask me questions, often as frequently as once an hour. My boss had his office next to the CEO. He too would talk with me far more frequently when I was physically no more than 10 feet outside his office door. But if I was in my home office in Ottawa, the CEO would rarely call me. We might speak once every few weeks. The frequency of communication varied dramatically depending on the physical presence. Was that a failing of my CEO, of my immediate boss? No, they’re just being human.

If you’ve been listening to this show for a while, you’ll know that I’m a huge believer in the laws of supply and demand. On today’s show we’re going to look at what’s happening in new construction of senior housing. In virtually every market I examine, I’m seeing signs of saturation. Despite this, new construction projects are everywhere. The projects completed two years ago aren’t full, and there are thousands of more beds coming into the local market.  I’m left wondering what market study the lenders looked at before approving the project. A new report just published by Marcus and Millichap aims to put some numbers behind what we’ve seen intuitively. Units under construction represent approximately 10 percent of existing inventory, limiting the potential for a rapid turnaround in operational efficiencies any time soon. In the most saturated markets, new units represent more than 13 percent of inventory. Frankly, this boggles the mind. I’m asking myself how any self respecting lender would finance a new project with market numbers clearly showing over-supply. I’ve been having direct conversations with senior living operators over the past several weeks to try and understand the dynamics in the market. My take is that operators are vying for market share and are willing to take a hit on operations in the short term in order to be positioned to win the war when the largest wave of baby boomers hit assisted living. The size of the market is expected to nearly double over the next decade. Back in 2012, senior citizens made up 12.8% of the total population. By 2028, they’re expected to represent over 20% of the population. Cap rates have started to compress.  Assisted living assets are highly sought after, which has narrowed the average cap rate relative to independent living levels. Overall, the average cap rate for independent living trades is in the mid-5 to mid-6 percent area, assisted living assets trade for an average be- tween 6 and 7.5 percent, and skilled-nursing properties change hands at an average in the high-11 to high 12 percent area, based on location and quality. Then along comes Covid-19. The truth is that 93% of assisted living facilities have evaded Covid-19 so far. The care facilities most impacted by the pandemic are those long term care facilities and skilled nursing facilities. Many people in the general public don’t know the difference between a skilled nursing facility versus an assisted living facility. The memory of outbreaks in long term care facilities is going to remain in people’s minds for some time to come. Staffing has been one of the largest challenges facing this industry under normal circumstances.  Tens of thousands of employees walked off the job because of fear of catching the disease. Those who remained have demanded higher pay. Labor represents the single largest cost in an assisted living facility. Hourly rate increases in excess of 50% are expected later this year in order to attract and retain quality staff. This fact alone will challenge the economic model for assisted living. We are seeing long lasting economic impact to the sector as a result of the pandemic.

On today’s show we’re talking about the reversal of a two decade long trend in a matter of weeks. The question is, will the trend really reverse? Perhaps this is a short term reversal, to be followed by a continuation of the original trend. The trend we’re talking about is urban intensification. Most major cities stopped developing in the downtown core in in the 1960s. The suburbs began to sprawl and sprawl and sprawl. Farm land was gobbled up and replaced by nicely manicured streets with a single tree planted in front of each house. It would take another decade before the tree would look like a tree. That’s how you could tell the age of a neighborhood without looking at the houses. You only needed to look at the maturity of the trees. The white two story houses of the 1950’s and 1960’s were replaced by more elaborate designs in the 1970’s and 1980’s. The new homes paid tribute to the two-income, two car desires of most households. Between the suburbs and the downtown core most cities had a band of real estate that was neglected for nearly 30 years. These homes were built in the 1920’s through the 1940’s. It wasn’t trendy to remodel a historic home yet. They were just old and out of style. But as the baby boomers have been retiring, they’ve been downsizing. They’ve been selling the four bedroom house in the suburbs and moving closer into town. They might be moving into a new condo, or perhaps into a new semi-detached house with a small rear yard and modern amenities like a roof deck.  That band between the downtown core and the suburbs now has modern new construction town houses.  These boomer buyers don’t want to mow the lawn and they don’t want to shovel the snow. The millennial buyers don’t seem to want the large houses in the suburbs either. It looked like the suburban home was going to become a dinosaur as tastes have changed. Fast forward to 2020. We have a global pandemic on our hands. People are working from home and need more space for a home office. All of a sudden, that four bedroom house that looked too large is now the perfect house with two bedrooms and two offices where two people can be on a video conference call simultaneously without disturbing each other. The lockdown situation meant that there were very few new houses listed for sale during the traditional Spring market. April inventory of houses for sale was the lowest on record. We’ve seen a wave of new listings poised to hit the market in June. Perhaps this is the traditional Spring market, just delayed by a couple of months. For now, the inventory remains low and we are seeing bidding wars in a number of markets. Major home builders have seen a wave of new contracts since the middle of May. Despite the major job losses, there are some sectors of the economy that seem to be booming. New home construction is setting up to be one of them. Record low interest rates seem to be a contributing factor creating a large pent up demand. But there are so few homes for sale that would-be sellers are holding on. They could sell, but where would they move? This was the same dilemma my wife and I faced earlier this year when we made the decision to sell our home. There were only 16 houses for sale in our area, a suburb of 200,000. Even through the lockdown, houses were selling above asking price in multiple offers with only a virtual tour and no open houses. 2020 is shaping up to be one of the busiest summers on record for real estate transactions.

Dr. Amy Novotny is from Sedona Arizona. She specializes in helping entrepreneurs manage their stress level. On today's show we're examining some techniques for reducing stress in our daily lives. Amy can be reached at: pabrinstitute.com.

Ed Rogan is founder of the Penn Capital Group, a tribute to his native Pennsylvania. He lives in Philadelphia, but invests in Houston Texas and Huntsville Alabama.

Lots has been said about the history in the making, how we’re at an unprecedented time in history. My parents grew up during the depression. While they both came from affluent families, my grandfather on my father’s side was a pharmacist, and on my mother’s side was an industrialist and inventor who ran several paper factories. Then WWII broke out and my parents came to NYC in 1939 with next to nothing. Those years shaped a generation. People saved money. They didn’t spend. They kept spare parts that might be re-used someday if something broke. They even kept broken parts that might be re-used someday if a new part needed to be somehow manufactured. I never quite understood that one. My father would save scraps of paper and write the shopping list on them. He would save used envelopes and take notes on them. Here we are in 2020. New patterns are being shaped. People have avoided human contact for nearly 90 days. Use of social media and online services have exploded. We’ve become more disconnected and Attention Deficit as a society. Alcohol consumption has increased in many communities. The powerful lesson from 2020 is that anything can change, dramatically, at any time. Your business might be performing well one day, and shut down the next. You can’t have a plan that you can count on. Over the past 50 years, we’ve had a continual, steady increase of debt. But since debt is borrowing from the future to make money available today, it only makes sense to borrow if you’re certain about the future. Those companies that have the most debt, are those in the greatest difficulty during this period of economic disruption. Some of the largest organizations are entirely debt funded. They felt really certain about the future. But we know the future is uncertain. It didn’t take a pandemic to teach us that. The signs were there before. But only now are people really understanding uncertainty on a large scale. Will people and businesses change their pattern of indebtedness in the future? Our entire banking system depends on people borrowing money. If people start saving and living within their means, how will that affect the economy over the long term? The number of parents consumed by guilt that they can’t handle work and home-schooling  their children. Some students are refusing to go to university until in-person classes resume. Our society has pushed the elderly into care homes when the kids could no longer look after aging parents. The pandemic has injected a wave of fear across the entire industry. Assisted living homes are forcing new residents to quarantine for 14 days before coming into the home. For many who have high needs, a 14 day quarantine is a practical impossibility. The way we care for our parents may change. How it may change, remains to be seen. We won’t know for some time. We have children of school age for whom their schooling experience has been majorly disrupted. Those in their high school years will feel this most acutely. The millions of job losses will impact teenagers getting their first job. Those patterns of enterprising young adults entering the workforce are being disrupted during the formative years. Instead of mowing the neighbor’s lawn, they’re home playing video games or watching movies. Many people are spending a lot more time in sedentary activities. They’re not getting out and exercising. The gyms have been closed and many are scared to go back even when they do open. The swimming pool is now a lot less important as an amenity. These are all new patterns in the making. The longer these patterns take root, the more difficult it will be to establish new healthy patterns.

On today’s show we’re talking about how borrowing is like dating with the intention of getting married. No, we’re not talking about casual dating, or any extra-marital hanky panky.  I know what you’re thinking. That’s a strange analogy. You see at the heart of a loan is a relationship. It’s a relationship that culminates in a signature on several hundred pages of documents. The advancing of funds is like the honey-moon. But before we get ahead of ourselves, let’s talk about the natural progression of the relationship. Imagine for a moment, the you have a friend who is going to introduce you to someone really special. They’ve told you about this person and they sound perfect. They share the same values, they like the same kind of cooking. Your friend keeps passing messages back and forth between the two of you. But the two main parties to the relationship haven’t spoken yet. You haven’t met, you haven’t gone on a date, you haven’t had dinner together, you haven’t been able to ask for yourself what the other person likes and dislikes. But still, your friend insists that this person is the one for you. You can stop looking, you’ve found your future spouse. Look no further. In our example here, your future spouse isn’t really someone you’re going to marry. They’re your potential lender. You friend is the mortgage broker. The broker is in the communication path between you and the lender. You haven’t met the lender yet. You don’t know what the lender wants. You haven’t seen a term sheet, or a closing checklist. Still the mortgage broker insists that this is the perfect lender for you. Not only that, they insist that the lender is going to get you a term sheet in the next day, and they can close in just a few days. Two weeks go by, and you still don’t have a term sheet. You still haven’t met the lender. All communication has been through the broker. When you build a relationship with the hope of marrying someone, there are a series of steps in the natural progression of that relationship. You would want to spend considerable time together. You might travel somewhere on vacation together. You might play a board game together. Seeing how competitive your potential partner is in a game of monopoly might tell you a lot about If you try to skip steps in that process, the risk of the relationship failing go up. If you try and rush it, the risk goes up. I know that in certain cultures there are arranged marriages. The families act as brokers between the ones who are to be married. But here too there is a process. There are a series of steps that culminate in marriage. When you’re contemplating a loan, the term sheet is the very first step. Upon signing of the term sheet, you’re now officially dating. You’re not engaged yet, that comes later. There’s a whole pile of due diligence to be done. You need to find out about your partners finances. Do they know how to manage money? Do they have good taste in food? Have you met their family? Once the term sheet is signed, there might be a commitment letter. This is the point where you’re now engaged. Subject to a few due diligence items, you’re going to get married and you’re going to get the loan, you’re going on a honeymoon. There are a number of items that are an expected part of the process. If one or more of those are missing, you can tell that you’re not heading towards marriage, and you’re not going to get the loan any time soon. Perhaps your future spouse has given you a list of values that they find important in their future spouse. If you haven’t seen your future spouses’ list, then how do you know you’re right for each other? That’s the same as the lender’s closing checklist. I know you’re thinking that the spousal checklist isn’t very romantic. I’ll grant you the possibility that the analogy doesn’t capture the romance aspect.