The Real Estate Espresso Podcast

Today’s show is the book of the month. On the first day of each month we review a new book. In order to be considered for book of the month, the book needs to meet a very simple criteria. It needs to be impactful enough that it can change your life, or your perspective on the world.  The book this month definitely meets the criteria for book of the month. It is called “The End of Food” by Paul Roberts. The book breaks down how our food system works. It chronicles the history and the evolution from the most basic agrarian economy to the thousands of new convenience products introduced each year that now line the supermarket shelves. Paul Roberts’ work is extremely well researched and frankly is a riveting book to read. I simply could not put it down. Every page had some new insight. I don’t think I will ever see the contents of the supermarket shelf the same way again. Our current system of food supply is not at all related to consumer demand. It’s being driven by the need for the major food suppliers to grow their revenues and their earnings. As margins have fallen in various parts of the supply chain, the response has been to introduce innovations that restore the margins. But in order to get a return on those incremental investments, a higher volume of sales is required to recoup the investment. Imagine that a farmer is being squeezed on price for, say, wheat. The buyer tells them that if they go out and spend $400,000 on a new combine, they can reduce their cost per bushel. But in order to recover the $400,000 investment, they have to plant more wheat which brings more supply into the market. That increase in supply, selling into relatively unchanged demand has the effect of lowering the price at market. So the business case for fancy new piece of farm equipment is in fact somewhat flawed. Back in the late 1940’s fishermen in the Hudson River North of New York found that the fish kept getting bigger and bigger. Fishermen are rarely ones to complain about that. It turns out that upriver there is a pharmaceutical factory owned by Lederle that manufactured tetracycline, an antibiotic. At first the company thought it was the Vitamin B12 that was a byproduct of the fermentation process. But in the end it turns out that these micro-doses of antibiotics were enabling the fish to expend less energy fighting bacteria in their gut and allowing more energy to go into growth of muscles and bones. It wasn’t long after that the food industry discovered the same effect in chickens, pigs, and cattle. Mixing antibiotics into the feed meant that the growth rate of baby chickens was increased by 25%. It increased the growth in turkeys, pigs and calves by almost 50%. Of course, now we face a situation where antibiotic resistant bacteria are increasingly infecting entire herds of farm animals. Fast forward to today. Major food companies like Nestle are struggling to achieve major growth in the mature markets in the US and Europe. The emerging markets in Asia and Africa represent an opportunity for growth. But they require customization of products to local tastes. Nestle’s new R&D center near Shanghai has divided the country into regions based on flavour preference. The relentless focus on price has resulted in food that is of lesser quality and nutritional value; a food culture that is increasingly defined by value pricing and portion size; and a global production system so lean and just-in-time that it is simultaneously more likely to be disrupted and less able to absorb the impact of a disruption, as we have seen in recent weeks.

If you’ve been listening to this podcast for a while, you’ll know that I’m a junkie for Economics 101. What I mean by that is that so much of the market can be simply understood by watching the balance of supply and demand of any commodity. But markets are not always that efficient. They stumble from time to time and get temporarily out of balance. Prices can be highly elastic when it comes to short term imbalances of supply and demand. We’ve seen it in all forms of products. We’ve seen it recently in oil. We’ve seen it in surgical masks, some medications and toilet paper. One of the great illusions is that we operate in a truly free market economy. That’s true part of the time, except when it’s not. We know that multiple bids for a product result in a higher price. Fewer bids transfer the negotiation leverage to buyer. This is exactly the same in real estate. We know that if a multi-family project has 20 offers, it will sell for more than if it has only one. It’s a true market when there are multiple buyers and sellers. Increasingly, large buyers like Walmart create “perfect competition” where suppliers conduct a reverse auction bidding down the price to win a contract with Walmart or Costco, resulting in the perfect “free market” monopoly. We have experienced decades of falling commodity prices as global supply chains, consolidation, and increasing specialization have enabled that reverse auction to bid the price down. Our commodity economy continues to function as long as supply chains operate without disruption. But now, we’re experiencing an unprecedented collapse in both supply and demand. But not for everything. The market is operating in a very inefficient way right now. Normal demand patterns are disrupted. You only need to go to the supermarket to see this effect. People are staying at home and favouring canned food, packaged food over fresh fruits and vegetables. We are at the height of the strawberry season right now. Yet we are now experiencing a surplus of strawberries and a shortage of canned beans. North Americans consume most of their potatoes in restaurants in the form of French fries. With restaurants closed down, potato stockpiles from last year are overflowing. Farmers are having trouble selling potatoes and they are reducing their planned 2020 crop size. Naturally, potato prices have dropped. Markets all over the world are going to be experiencing these kind of disruptions. It means that we may see local price increases for certain commodities. Today I purchased some precious metals for my own portfolio. The premium for bullion coins charged by the dealers was 35% compared with the normal premium of about 10%. In fact, the licensed dealers in my home were 100% out of stock. I placed the order with the bullion desk at my local bank and the bullion will be delivered in less than two weeks. The dealers are quoting much longer delivery times and are charging a much higher premium. Again, this all relates to supply and demand. Real estate is no different. I’m starting to see distressed sales on the market. The disruptions here too are creating market inefficiencies. The big question is how long will the imbalance persist. Is this a short term condition, or a medium term condition? If the surplus is for retail space, it might indeed be a long term surplus. Look at all these conditions through the lens of supply and demand. 

On today’s show we’re talking about the difference between Main Street and The Fed. The bailouts of the economy have been making headlines over the past month. The Federal Reserve has agreed to buy back hundreds of billions of in mortgage backed securities from the banks and from the mortgage insurers. They have allowed banks to temporarily drop their deposit reserves from the traditional 10% reserve to zero. Under normal times, that would mean the bank is insolvent, but not today. The Fed has their back. The US Federal Government has pledged $2.7 trillion in bailout money since the end of March. The big question is who is getting the money, and more importantly, who is getting left behind? Today in the Wall Street Journal, FHA director Mark Calabria was quoted as having said that he doesn’t plan to do much to help mortgage lenders outside the FHA umbrella where Fannie Mae, Freddie Mac, have a potentially large exposure. Mr. Calabria, who heads the Federal Housing Finance Agency, is resisting pleas for help from lenders seeking relief as millions of Americans stop payments on their home loans, sending shock waves through the $11 trillion mortgage market. He has said he is willing to stand aside even if some of the mortgage lenders fail, and he says there is plenty of capacity to move business out of failing firms and into healthy ones, if necessary. His position offers a stark contrast to the rest of the federal government. As part of the emergency stimulus package approved by Congress in late March, homeowners affected by the pandemic were allowed to suspend mortgage payments for up to a year without penalty. As of last week, 3.4 million people had suspended payments, representing about $754 billion of unpaid principal, according to Black Knight, a mortgage-data and technology firm based in Jacksonville Florida. That represents about 6.4% of all residential mortgages out there. If you look at the breakdown even further, we can see that Fannie and Freddie make up less than half (precisely 46%) of the loans where borrowers have stopped making payments. FHA and VA loans have the highest rate of non-payment at 8.9%. The remaining 22% of the loans in forbearance are made up of loans where the lender is a privately held or portfolio held. I don’t have a problem with the notion that a bailout is coming. What I do have a problem with is the inconsistent application of the remedy. How can you protect 78% of the lenders, and then leave 22% of them out to dry? It’s not like the 22% private lenders did anything wrong. They took the same general risks as anybody else in the market. Arguably, they took less risk because they don’t have the leverage of being a bank where the banks loan out the same deposit another 9 times. Mortgage investment companies only loan out the money once. The same is true for issuers of bonds and insurance companies. What Mark Calabria is saying is that he doesn’t care if individual main street investors lose money. The banks will happily purchase those distressed assets for pennies on the dollar. The FHA position is alarming. If government isn’t going to help all lenders, just the ones they arbitrarily choose to help, this looks like a transfer of wealth. I don’t want to see equity investors lose money in these market conditions and I don’t want to see private lenders lose money either. Let’s say that a lender doesn’t get their interest payment for a month, or two, or three. Does that automatically mean that the lender is at risk of having a bad loan and losing their loan principal? Not necessarily. The question then becomes, how can private lenders work with their borrowers and stakeholder investors to provide the appropriate level of loan forbearance without risking the investor capital. This is clearly uncharted territory on a large scale.

One of the most powerful approaches to bring to any analysis is zero based thinking. Quite simply, it helps eliminate the emotions that often cloud our judgement. Zero based thinking means going back to the starting point of a decision, but armed with the knowledge and perspective of hindsight. Knowing what you know now, would you rush out today and purchase those shares of General Electric, or Boeing? Those Boeing shares have fallen in value over 60% so far this year. If you wouldn’t rush out and buy them today, then I guess the question is, why are you holding those shares in your account today? Oh I see, it’s because you already hold them in your account and you don’t want to crystallize a loss. By holding onto them you remain in the hope that the stock might bounce back. But that’s not investing. That’s speculating, that’s hoping, not investing. A speculator speculates, a gambler gambles, and an investor invests. So if you wouldn’t rush out and buy those shares today, then why are you still holding onto them? It’s not because the brokerage commission of $5 is holding you back from trading out of the stock and perhaps buying them back at a later time when they actually meet your investment criteria. The logic of the hold argument is often confounded by the emotion wrapped up in the consequences of the decision, not the decision itself. Let’s say that you have an offer out on a property and you have passed through your due diligence period. Perhaps your earnest money deposit has gone from refundable to non-refundable. Your lender is no longer offering the same terms as before. The viability of the project is unknown at this point. This is a moment to apply zero based thinking. Applying what you know right now, if you were making the decision all over again to buy that property, would you rush in and buy it? How do you handle the negotiation with the seller? The seller doesn’t just want your deposit money. They ultimately wanted to sell the property. A 1% deposit isn’t going to really help them. You have a few choices. Would you try and close the deal as planned? Would you walk away from the deal altogether and forgo your deposit? Would you renegotiate the terms of the deal? Delay the closing, but not just by a few weeks. We are talking scheduling a new deal several months out when it becomes clear that the economy will justify the project. The seller may legally be able to argue that the buyer failed to perform. But in truth, the failure to close has nothing to do with the buyer. It’s the result of the market conditions that have clearly changed dramatically in a matter of weeks. We don’t know if the easing of social restrictions will cause a resurgence of the disease and another lockdown situation in just a few weeks from now. Other places around the world that have attempted to ease restrictions have re-imposed them shortly thereafter. Here’s what few people are talking about. Government handouts are very easily accepted, and they breed dependence faster than you can say the word paycheck. Those who have laid off employees will be slow to re-hire them. Those who have taken government checks will be equally slow to give them up voluntarily. If you knew that 25% of the tenants in this apartment building have been laid off and are receiving unemployment benefits, would you buy that building? If you knew that there was going to be a 150 day moratorium on evictions, and rent collections were running at 2/3 of normal, would you buy that building today at the same price? If the answer is no, then difficult as it might seem, now is the time to renegotiate the deal.

On today’s show Anna from silicon Valley asks Is now a time to be investing in multi-family real estate? Surely there are deals coming up on the market. Anna, this is a great question. Some people have adjusted their criteria in terms of what is a deal as the market has heated up over the past decade. I’m a believer that the criteria for investing should not vary dramatically with market conditions. That is to say, you should be conservative in your underwriting. But the truth is, virtually nobody under the sun who is syndicating multi-family apartment deals would have realistically designed a project to withstand the kind of economic shock we are currently experiencing. No rational risk manager would have assumed a continent wide 75% drop in restaurant revenue in a 5 week period, nobody would have assumed a jump in the unemployment rate to over 20% in less than a month. There are now more than 33 million unemployed, or a real unemployment rate of 20.6%—which would be the highest level since 1934. The fact is, investors want certainty. Lenders want certainty. The process that both investors and lenders use is to point to history. If you have a seller looking to sell, they’re assuming the value is based on a historical metric which clearly is no longer valid, despite the fact that the history is no more than two months old. The buyer on the other hand is looking forward at what is, and what is likely to be the case in the coming weeks and months. Because of these two perspectives, there is currently a wide gulf in expectations between buyer and seller on how to value a property. It’s going to take some time for sellers to readjust their expectations of what their properties are worth The lender performs three forms of due diligence, the same as any investor should do. They need to qualify the borrower, the asset, and the submarket. All three of these require some history. But in today’s market, there is no Covid-19 market seasoning. We don’t have 12 months of history deep into this economic downturn from which to predict the future. The problem is that there is simply no modern day precedent for what has happened. A lender is really asking one simple question. If I lend you money, how am I going to get it back. How will I get it back if things go well, and how will I get the money back if things don’t go well. The key question is whether things will go back to normal when this pandemic is over? Or will there be a new normal that doesn’t resemble the way things were? Knowing how to value a property in this new normal is the key question. We simply don’t have enough history accumulated to be able to say what the new normal is going to be. In the world of multi-family apartments, the demand is the same now as it was two weeks ago. The population is largely the same. Very few people have moved during this period of social isolation. So the demand hasn’t changed. What maybe has changed is tenants’ ability to pay. With 26 million job losses in a matter of weeks, combined with moratoriums on evictions, politicians calling for rent boycotts, the ability to pay is highly questionable. But when you have a high economic vacancy, such as we have right now, establishing the net income becomes difficult. So then establishing the value becomes impossible.  It’s going to take time. Don’t be in a rush.

Loe Hornbuckle is founder and CEO of The Sage Oak Assisted Living with multiple locations in Texas and Louisiana. Loe shares his perspective on what the pandemic means from the perspective of an operator who truly has first hand contact with staff and residents.  You can learn more from Loe at loe@thesageoak.com and he has a free book "The Sage Oak guide to Residential Assisted Living" available for download at goodhorncapital.com.

Russell Gray is co-host of The Real Estate Guys Radio Show, now in its 24th year. He's a financial strategist and today's show is part two of a multi-part conversation on the economy and how to understand what is happening out there.  If you haven't heard part one, you may want to go back and listen to last Saturday's show first. 

On today’s show we’re trying to get inside the mind of your tenants and figure out if they want to pay rent in a little more than a week on the first of May. The messages from politicians have been confusing to say the least. Whatever your taste, you’re sure to find a politician who is saying something you resonate with. There’s Senator Mike Gianaris, deputy leader of the Senate in NY state calling for tenants to undertake a rental payment boycott. Governments have created moratoriums on evictions on foreclosures. In that environment, tenants may be genuinely unable to pay their rent. Others may simply choose not to pay their rent. There are federal programs designed to help families that have lost their employment. For landlords, April 1 saw a drop in rent collections across the US. But still rent collections were fairly strong, having experienced a 12% drop compared with the previous month. The real test will be the months of May and June. Even when you have a long term lease, tenants are making a buying decision every month to pay their rent. If the property is being well maintained, cleaned, and most importantly they feel like the staff really care, they will feel an emotional connection to the property, and the landlord. But if the mail room hasn’t been cleaned in days and there is trash on the laundry room floor, tenants will start to feel like the landlord doesn’t care. If the landlord doesn’t care about the tenant, then why should the tenant care about the landlord. Let’s be clear, there is no real causal connection between trash on the laundry room floor and tenants paying their rent. It’s not like the landlord put the trash on the laundry room floor. But you have to remember that your tenants are people, they’re human. Humans live their life in stories. I remember the CEO of a major airline telling their employees that if the tray table is dirty, then passengers assume that the engine maintenance isn’t being done. Here too, there is no connection between the tray table being clean and the aircraft engine maintenance. So if you want your tenants to behave normally, then they need to believe that things are as normal as they can be. The property needs to be well kept. There needs to be extra care taken to sanitize the railings in the stairways twice a day, to make sure the door handles are sanitized, to unexpectedly deliver a handful of face masks for free to your tenants, to make sure they know you care about their well-being. It’s not enough to be cleaning. Even better would be to communicate the extra steps you’re taking to help keep their families safe. You want the tenants to say “Boy I’m glad I’m living here. I doubt other landlords are taking steps like this to protect their tenants.” These are things that people remember. When tenants experience that the landlord cares, they will reciprocate to the extent that they can. Sure, some will have lost their income, some will have fallen through the cracks in the social safety net programs that are showering the population with cash. These folks may be genuinely unable to pay. But the vast majority who can pay will still face a choice. The choice will be, should they hold on to cash to deal with the unknown? Will government assistance programs be extended if the timeframe of the pandemic gets extended? Would it be better to hoard cash just in case? The landlord can’t evict, so why not? I’m not here to tell you how to run your business. I’m merely putting forward a hypothesis. The word hypothesis means a hypothetical argument, a conjecture. The thesis is that if your tenants will care about paying rent, they first need to feel that the landlord cares about them.

So many people are trying to read the market conditions and restore a sense of certainty in their own minds, despite the current reality. Frankly, it’s hard to make sense of it all. In an effort to gain greater insight, I’ve been in discussion with family offices, and attending invitation only meetings to get a reading on what some insiders are thinking. On Tuesday evening I attended an invitation only session with John Stackhouse, Senior Vice President, RBC and Craig Wright, Senior Vice President & Chief Economist, RBC In their remarks, they shared their perspective on what is happening in the economy. As Canada’s largest bank, they have direct visibility on what is happening since much of the cash in the economy flows through their bank accounts. Examining the value of transactions for both Visa and Debit cards, the bank has observed that after the initial surge of buying at grocery stores subsided, the current dollar volume of Visa credit card and debit card transactions is down by 60% compared with normal for this time of year. That’s at the consumer end of the market. When the economics team at RBC plugged this into their model for the economy, it looks like a 32% drop in economic activity in about a month. The RBC economics team sees a slow and gradual return to work. They don’t see the flash restart of the major sectors of the economy. Music festivals, crowded restaurants and bars, places of intense social interaction will be among some of the last to open up. In the month of March, there were a number of notable, albeit predictable patterns in consumer spending. Consumers spent 88% less on apparel, gifts, and jewelry in the week ended March 30. For the last week in March, department store sales were down 40% versus a year earlier. Spending on software and data was up 30% compared with a year earlier as people outfitted themselves to work from home. After a brief 5% surge in household goods, these sales were off 53% in the last week of March. Sales of books, subscription music and streaming content remained relatively flat compared with last year. Naturally, sales of movies and other entertainment was down 79.8%. Restaurant sales are down 75% as a handful of restaurants attempt to maintain some revenue with take-out meals. Grocery store sales spiked in the middle of March, and by the end of March were down 11%. In real estate home sales, prices were holding firm across Canada except in areas with high economic exposure to the oil and gas industry. Sales volumes were down 14.3% in March compared with February. A sneak peak at the first week of April results showed resales running at about half normal levels across Canada. We expect both buyers and sellers to lay low while extraordinary containment measures are in place. This will maintain a certain balance in most markets and help home prices stay afloat. Inventories have grown in some markets, but not dramatically. I don’t have the exact comparable data for the United States, but the shelter in place policies between Canada and the US are fairly similar and I would expect to see similar impacts in the US economy.

Markets are becoming increasingly hyper-local. That’s more true today than ever. Global transportation has been the great equalizer and has made so many things appear to be commodities. That’s why real estate is hyper-local. You can’t just pick up an office building that has high vacancy and move it to a place where there is a shortage. In the absence of a differentiated value, the discussion always degenerates to price. That’s why a pound of sugar tends to cost the same in Portland, Maine as in San Diego, California. A pound of sugar is a pound of sugar. There is no real dominant brand in sugar that distinguishes one supplier from another. It’s a true commodity. But when we describe real estate we describe the property in terms of its characteristics, its amenities, and most importantly, its location. Yesterday, the futures contracts for oil went into uncharted territory. Some prices went negative. Let me take you through a sampling of prices. Saudi Arabia light and heavy oil are both trading in the futures market at $19.07. Oil in Mexico from the Mayan region varies in price depending on the destination. If the oil is destined for the US Gulf Coast, the price is negative $1.18. If that same oil is heading for Asia, then the price is $21.79. That difference in price is a reflection of differences in both transportation and storage costs. The US has so much oil at the Gulf coast right now, that they have no place to store it. North Texas Sweet Crude is selling at a negative $41 per barrel. Arkansas Sweet Crude is selling for $11.50 per barrel. Central Alberta Crude is at $10.93 These prices are all over the place. The only distinguishing factor is location and the local supply / demand balance in that market. The price difference is a reflection of the cost of storage and the cost of transportation to get the oil to where it is needed. We’ve experienced an unprecedented collapse in global oil consumption in a matter of weeks. When you take transportation systems out of the market, you create inefficiencies all over the place. Those who aren’t paying attention will be surprised. Those who understand the relationship between transportation and price will make sense of the inefficiencies in the market. Now is the time to figure out where the supply chain disruptions are happening. They’re all over the place. Expect a significant portion of the 6,000 independent oil companies to go bankrupt or be acquired in a distressed sale. The oil won’t disappear. The change will be in the ownership. Don’t expect to see prices recover to the $50-$60 range for at least another 18 months. Even the price of commodities vary by location when you take transportation out of the equation.