The Real Estate Espresso Podcast

We are living through a moment in history where circumstances seem to be changing almost daily. With that less certainty, there’s less that you can count on. When you’re negotiating a transaction between two parties, there are three sources of uncertainty. There’s the uncertainty that I bring to the transaction for items that are within my control. There’s the uncertainty that the other party brings to the transaction through items that are in their control, and then there are factors contributed by third parties to the transaction where it’s outside the control of both parties. We’ve seen first hand, and second hand cases where investors have decided to pull back from commitments and sit on cash, choosing to do nothing for the time being. If you’re raising money in today’s environment, you have to assume that you’re going to get some investor attrition. It might not be large numbers, but you might plan on losing 25% of your investors just because of the uncertainty in the current market conditions. In my conversations with other developers, I’m aware of cases where the drop in stock market values has directly made less capital available for investors to deploy into real estate transactions. This is real and I have to tell you that raising capital just got harder in the past few weeks. For the moment, this hasn’t impacted the lending environment. But that too could change. Lenders come in all shapes and sizes. If you’re relying upon financing for a project, you may want to consider taking a more conservative approach in your negotiations. In at least one case, we’ve added a financing condition to a transaction, even though we have no indication that there are any changes to the financing commitment. We’re living in a highly interconnected world where counter party risk exists all over the place. You might have a private bridge lender who is fully on board with your project. You might have a term sheet, a good appraisal, and green lights everywhere. Then at the closing table the lender might not come through. This happened to us with a reputable bank back in December. In that case, it was a situation where the bank was missing the paperwork for a partner bank that was co-funding the deal. It took a couple of weeks to resolve and everything was good. But we had no visibility of the fact that a second lending institution was involved in the loan. This is an example of the types of complexities that exist in the financial system. This stumble was nothing more than a benign administrative error. Fast forward to today where we have a highly fluid situation that is changing from one day to the next. I believe that you should not be signing any purchase agreements without a financing condition. You might have a lender failing to perform at the closing table at which point you need additional time to secure alternate financing without putting investors monies at risk in the form of non-refundable deposits. I also believe that you should be much more conservative and unless you have the cash in hand to close, your earnest money deposit should be in trust with a lawyer, a title company a real estate brokerage, or other appropriate trustee for those funds.

On today’s show we’re talk about the Everything Bubble. Bubbles have formed throughout history and all it takes it a pin prick to burst a bubble. On today’s show we’re talking about all kinds of bubbles and how they form. The year was 1554 and tulip bulbs were sent from the Ottoman Empire to Vienna. By 1593, a botanist in the Netherlands figured out how to create a varietal that would be hardy in colder climates. The tulip mania was on. By 1636, there was a derivatives market trading in Tulip bulb futures. Tulip mania reached its peak during the winter of 1636–37, when some bulbs were reportedly changing hands ten times in a day. No deliveries were ever made to fulfill any of these contracts, because in February 1637, tulip bulb contract prices collapsed abruptly and the trade of tulips ground to a halt. It sounds silly in retrospect. But at the time, those in the Tulip trade took it very seriously. Back in 1997, 98 and 1999 we had the dot com bubble. Any business that had an internet component was worth gazillions. Some of those businesses had no revenue, only a promise of bringing internet technology to some aspect of commerce. Buying pet food online made no sense. We can see that in hindsight. But at the time, investors flocked to buy up those shares. In 2004-2006 we had the housing bubble. In that scenario, it wasn’t really a housing bubble, but a debt bubble. Irresponsible lending practices in the subprime market caused stated income loans to be written against real estate using valuations that had been bid up beyond the level of affordability. The increase in asset prices was fueled by the lending practices. If you couldn’t get an appraisal at that higher value, then the bank shouldn’t lend you the money. Over the past two years we’ve had numerous bubbles forming. We’ve had businesses that have not generated a penny of positive cash flow like Tesla, Netflix, Uber, Lyft, and WeWork getting valuations in the tens of billions of dollars. Companies that haven’t demonstrated their ability to have a profitable business model were worth gazillions. We have another bubble in the shale oil business. Shale oil wells have a very steep decline in production volume after they start producing. After 12 months in production, they are typically producing about 15% of the oil that was gushing on the very first day of production. That well might continue to produce for another 20 or 25 years, but at very low volumes. The problem is that the break-even on the debt for that well is a function of the price of oil. At prices below $45 a barrel, these wells will never break even in their lifetime. The only way these oil companies stay afloat is to drill more wells at increasingly higher levels of debt. We’ve had oil prices fall nearly 40% in the past week. These companies will not be able to service the debt on those bonds for long if the price war between Russia and Saudi Arabia continues.  Well here we are in March of 2020. Central banks all over the world have been pumping liquidity into the system during supposed boom times. These are the actions to be taken during a crisis. But they were being taken during good times. We’ve known for a while that there would be a breaking point eventually. I thought the trigger event would be a sovereign debt crisis. I was wrong. It turns out that the trigger was the outbreak of a virus. The impact of that additional liquidity was to for cash to make its way into the debt markets which in turn was used by companies all over the world to buy back stocks through additional leverage and in turn increase the asset prices in the stock market. Even now, after the pin has burst the balloon, the central banks think they can re-inflate the balloon by pumping more cash into it. This bubble was not a single asset bubble like before. This is the Everything Bubble. 

What a difference a few weeks can make. A month ago we were in an economic boom. Unemployment was low. The stock market was at all-time highs. Sure there were a few cases of Covid-19 in China, but all was good in Europe and in North America. In a few short weeks we’ve seen the travel industry’s world turned upside down. The first airline casualty was FlyBe, a regional airline in the UK that represented about 38% of domestic air capacity in the UK. They flew to smaller centers like Manchester, Birmingham and Liverpool, serving 139 routes. They declared bankruptcy and likely won’t be returning to the air. Oil prices started to fall when it became clear that economic output was going to be disrupted from China. There’s a direct link between one unit of economic output and one unit of energy consumption. OPEC was trying last week to propose production cuts in order to prevent a glut on the market and to protect oil prices. Russia refused to comply and now we have an all out price war happening in the oil industry. In response, we’ve had oil prices fall nearly 40% in one week and 25% in just one day. If there is a protracted drop in oil, we can expect bankruptcies in the oil industry. Stocks have fallen 20% in value in a couple of weeks including a 2000 point drop in the Dow Jone Industrial Average, the largest single day drop in history. We know there are supply chain disruptions that are going to ripple through the economy over the coming months. So that’s all happening in the broader economy. So let’s say you have a market report in front of you that’s two months old, or six months old. Is it any good? How do you plan? Do you assume reductions in employment? How many of your tenants will be impacted? Do you assume that there will be disruptions in the bond market which will ripple through the banking industry? You see we’re used to thinking linearly. When there are massive dislocations and there is a delay between the warning signs and all the downstream consequences to the economy, it’s hard to connect the dots. I was reading the Marcus and Millichap Office market report for 2020. It’s only a few weeks old. But as I was reading the report, it was clear that the report was written in a completely different environment. That was then, this is now. Would the report be written the same way if it was published today, only a few weeks later? We think about cities like Dallas, Houston, Nashville, Toronto, that have been attracting tremendous growth in population. Will that growth be disrupted? If it is disrupted, will that disruption be temporary or longer lasting? There are too many questions for which there are no answers. The only answer is to wait and see how all of this shakes out. The web of interconnected dependencies in our global markets are incredibly complex and the relationship between them hasn’t even been modelled, let alone understood. I was watching a TED talk that Bill Gates gave back in 2015. In that talk, Bill Gates predicted that we are globally unprepared for the outbreak of a virus. We have spent trillions on military preparedness in order to protect against a catastrophic global conflict, but our health care systems have not adopted the same wartime footing to prepare for a surprise attack. The problem isn’t that our system for handling these outbreaks is breaking down. The problem is that we don’t have a system at all. Our system of testing in the US required medical samples that have a shelf life of less than 6-9 hours to be sent to a central lab in Atlanta. Even if you could get the sample to the airport by courier within minutes, the 5 hour flight to Atlanta, through the backlog in testing, the chances that the test sample is still viable diminishes rapidly. Nobody can tell you the impact of what happens when you mass quarantine 60 million people, or 700 million people.

The Corona Virus is making headlines all over the world. Many people are out there thinking that it’s an over-reaction. On today’s show we’re going to take a departure from real estate and talk about the major factors that you need to consider during this unprecedented moment in history. There’s no question that the disease and the threat of the disease are having a major economic impact. Events have been cancelled all over the world, quarantines and large scale lockdowns are underway in a number of areas, employers have asked people to work from home, and health care workers are sharing some harrowing tales. On today’s show we’re going to break down the three major conflicting factors that individuals, governments and communities alike need to balance. The need to confine the spread of the disease Keep the economy and society running as smoothly as possible Protect the health care system from being overwhelmed Let’s go into these three areas one by one. I’ve seen many statements on television, on the internet, including from doctors that this isn’t any different than the influenza. All these quarantines are an over-reaction. Let’s look at the numbers for the corona virus and see if we agree. The influenza does kill a number of people each year. It’s usually in the range of about 0.1% of cases result in death, and these are heavily skewed towards older people with other health issues and compromised immune systems. If we look at the data from the current outbreak in Italy, there are a total of 7375 people known to have been infected as of March 8, and increase of almost 1,500 compared with the day before. So far the disease has claimed the lives of 366 people. There are 622 who have recovered and 650 who are in serious or critical condition. So if you were to measure the case fatality rate you would divide the number of deaths by the number of cases where you know the outcome. They either got better, or they didn’t. You can’t include the number of new cases where people just tested positive because you don’t know the outcome. You only know the case fatality rate retrospectively. The WHO is estimating the case fatality rate at 3.4%. I frankly don’t see how they get that number. If you accept the WHO number, then the case fatality rate is about 34 times higher than the annual influenza. But if you look at the actual numbers from China you get a different picture. Their case fatality rate is running at about 5%. If you look at the numbers from Italy, you get a very different picture. If you do the math you get a case fatality rate of 37%. That’s a huge number. It’s possible that the number will come down in the future, but we don’t know the outcome of the newly reported cases so its too soon to include those new infections in the statistics.  Let’s move on to number 2, the need to keep the economy moving. If the entire economy came to a standstill and you couldn’t get food to the grocery stores, you would start to see mass famine, social unrest, anarchy and the impact of that could be worse than the coronavirus. So you clearly need to keep the economy moving. That’s important. Number 3, is protecting the health care system. If the hospitals become overwhelmed, then you end up with health care workers coming down with the disease. They get taken off the job and now you’re dealing with a major staff shortage, and you also lose beds that would be needed for the numerous other ailments. This is the difficult balancing act that governments have to orchestrate. I predict that you will see an increasing amount of triage taking place. In a triage environment you are only handling the most severe cases up to your capacity. Everything else gets pushed to the back of the queue. Make sure you have a plan for your family that includes the possibility of lockdown for 30 days or more.

Matt Faircloth is the author of "Raising Private Capital: Build Your Real Estate Empire Using Other People's Capital". He can be reached at the DeRosa Group. www.derosagroup.com.

Eric Bowlin comes to us from sunny Puerto Rico where he is looking out over the water during our interview. On today's show we're talking about how Eric designed his life to manage his investments remotely and live in the location of his choice. 

On today’s show we’re talking about the fallout from the gold rush in Cannabis. As more and more states and countries have decriminalized marijuana, investors have rushed into the market to plant acreage, build greenhouses, and create indoor manufacturing using vertical hydroponics. All of this was in anticipation of an increase in demand. To be clear, in states like Colorado, Washington, and California, we have seen an increase in demand. I have to say, even though it’s been legal for a while, it is still a bit jarring to me to be walking down the streets in Manhattan and smell marijuana. I’m not a user, and this podcast isn’t intended to speak to the merits of cannabis use. I’m merely covering it from a real estate perspective. California's legalization of cannabis for adult recreational use was expected to be massive. Back in 2016, industry investors claimed sales could top $6.5 billion by 2020. And by the end of 2019, California is indeed home to the world's largest cannabis market, totaling close to $12 billion in estimated sales. But here's the problem: $8.7 billion of that is changing hands in the underground market, leaving only about $3B coming through licensed channels. It seems that prices for growers have been falling significantly and many businesses are laying off staff. CannaCraft recently laid off 20% of its 240-person workforce. Smiths Falls Ontario based Canopy Growth is one of Canada’s largest indoor grow operation and occupies the site of the old Hershey Chocolate Factory. They are orchestrating a massive overhaul involving a layoff of 500 workers, and a writedown of $700 - $800 million dollars, the closure of two greenhouses and the cancellation of plans to operate a third. The two greenhouses based in British Columbia were opened in February 2018 and represent about 3 million square feet of greenhouse space. The company, has struggled to create free cash flow as the cannabis market did not mature as fast as it anticipated and federal regulations permitting outdoor cultivation were introduced long after Canopy had begun investing in their greenhouses. Constellation Brands is a major share holder in Canopy having invested about $5B for a 38% share of the company. Canopy now operates an outdoor production site that's made cultivation more cost-effective. It believes that site will play an important role in meeting demand for products necessitating cannabis extracts. Over the past 4-5 years, farmland throughout several states and provinces was sold at top dollar in anticipation of the growth of the cannabis industry. Many of these investments are being written down as the money has failed to materialize. The industry has struggled to grow because the opening of legal retail outlets is very tightly regulated. The number of retail licenses issued has not kept pace with the increase in supply at the production level. Getting the product to market doesn’t work if the retail channel hasn’t been developed. This too has been a major impediment to the industry growth. Like many new markets that are still developing, it’s sometimes hard to anticipate where the inefficiency is going to appear in the market. A quick survey of licensed farm land for sale, shows that prices for licensed land have been falling as oversupply has hit the market. Let’s be clear, there is still big money making investments in Cannabis. AB Inbeve, the world’s largest beer company recently made a $50M investment in Tilray to research infused beverages. Constellation Brands is also betting big on the infused beverage market. While beverages are still a growing segment of the market, the volumes are low. This segment is expected to represent about $5B in revenue annually by 2026.

On today’s show we’re talking about how to make sure the budget for a construction project has integrity. I regularly receive questions from new developers looking to grow from buy-hold investment into new construction. The first thing I ask for is to see their budget and the pro forma. On today’s show we’re going to highlight the most common mistakes that I see in a construction budget. Understand that when you’ve made mistakes in the initial analysis, there’s very little that can save you apart from a miraculous increase in rents. The number one mistake that I see is having an incomplete list of construction expenses. This is where you need to adopt the discipline of a pilot and use checklists for your budget. If you’ve ever flown an aircraft you’ll know that everything that happens in the cockpit uses procedures and checklists. Whenever there are a lot of items that need to be taken into account, the human mind is bound to miss a bunch. That’s when mistakes happen. If you don’t have a system, you’re going to make mistakes. The key is to have a systematic way of ensuring nothing gets missed. When budget mistakes happen, they can come from one of two possible sources. The first is that things were more expensive than originally estimated. This is where people expect to find cost over-runs. Maybe there’s a material shortage and all of a sudden prices are higher than you originally forecast. These types of mistakes can result in modest increases in your overall budget. But the biggest issue is when you have an expense that was missed from the budget altogether. You’ve budgeted zero for that line item and in reality, the number is not zero. That’s a huge problem because the entire amount is offside, not just a small mis-estimation of say 10%. The most important thing you can do is make sure your list of budget line items is complete. In addition, on today’s show I’m going to highlight 7 of the most often missed budget line items. The first three relate to costs associated with the construction loan. 7) Title Insurance. Most lenders will want a title insurance policy issued in their name for the construction loan. Depending on the value of the project, this can add up to a lot of money. 6) Loan Fees. Most investors remember to include the lender’s origination fee, but often forget to include the cost of preparing the loan documents. When you convert from your construction financing to permanent financing there will be additional fees associated with the permanent loan. These need to be part of the project budget. 5) I often see new developers underestimate the cost of the architectural work. Architect’s fees can vary widely depending on how the project is structured. They sometimes hire the engineers for mechanical, structural, civil, plumbing, and electrical as subcontractors and simply pass through those costs. Unless you’ve got a quote for the engineering work, you can be fooled. 4) Site related work. This encompasses everything from drainage to landscaping. The number of times I’ve see a project fail to include the cost of removing the material excavated from the foundation is astounding. I’ve seen so many projects include the budget for the building, but fail to include any money for landscaping. 3) Draw Inspections. When a lender loans money for construction. They advance the funds in draws. At the end of each phase of the construction, the bank sends an independent 3rd party inspector to verify that the scope of work included in the most recent draw request was in fact completed. These inspection fees can vary widely from a few hundred dollars each to a few thousand dollars. 2) Initial Operating Deficit. This is when property takes longer to lease than you planned for. 1) I’ve seen many budgets where the borrower fails to include an interest reserve in the budget to carry the cost of the construction loan.

Yesterday the Federal Reserve cut interest rates by 0.5%. As real estate investors who are about to refinance a project, we can raise a glass and make a toast to Jerome Powell.The Fed has been saying for some time that they intend to address a downturn with aggressive monetary policy. Today’s announcement was not at their regularly scheduled meeting that happens every 6 weeks. The last time the Fed took extraordinary action like this was during the financial crisis in 2008. Today’s move will lower the cost of some borrowing, but not all. Long term rates are linked to the yield on the 10 year treasury which is determined by market forces, more than the actual short term lending rate set by the Fed. Still it’s a positive step for real estate investors. Some home owners and investors will choose to accelerate their planned refinance to take advantage of the lower interest rates. That lower rate will create more free cash flow in the economy that could eventually make its way back into the economy. Some will choose to maintain their payments constant and increase the principal portion of the payment to accelerate the amortization of the loan. In terms of the broader economy, and the economic slowdown, like we talked about last week, this tool is completely useless as a counter-measure to the corona virus induced slowdown in the global economy. I cancelled two trips in the past week because of concerns flying in a Covid-19 environment. I caught the H1N1 Swine flu when traveling in Japan back in 2009 and I know exactly what that’s like. I have no desire to be laid up in bed for a few weeks or worse. I also have no desire to be in a mandatory quarantine situation for two to three weeks. I have no desire to accelerate the spread of the disease. It’s not like the lower interest rates would stimulate me to travel again. The interest rates have no influence on my decision to travel or not. Economists don’t really have a vocabulary to describe this situation. They tend to think in terms of price elasticity of demand. The concept of price elasticity describes how sensitive demand is to changes in price. For example, if my flight to Italy last week was to increase in price to, say, $2,000, I probably would choose not to travel based on price and of course the risk of corona virus infection. But if the price were to drop to, say $300, I would definitely travel under normal circumstances. But we’re not in normal circumstances and I would still choose not travel because of the risk of corona virus infection. So while the demand might be elastic with price, it’s highly inelastic due to corona virus. The two are not connected in any way. So that’s the demand side of the equation. Let’s look at the supply side of the equation. A recent report published in the Harvard Business review last week speaks directly to the question of supply chain disruptions. If you wanted to go buy a new Fiat automobile, they’ve shut down their factory in Serbia due to parts shortages. Perhaps you are looking for a new Hyundai or Kia SUV. Here too, manufacturing plants in Korea have been shut down due to parts shortages. So perhaps lower interest rates might stimulate some to go buy a new car. For the time being, there’s ample supply. But in a few weeks, we can expect that some models will be more difficult to source. Some buyers may substitute for another product. Then again, some may choose to wait until conditions normalize before making any major financial decisions. Suffice to say, that the attempt to stimulate the economy where the supply chains have been disrupted won’t help if the manufacturers can’t get their product to market. A half point drop in the interest rate won’t create more surgical masks, manufacture more Tylenol or bring more container ships from China.

Just in case you thought being the owner of a retail storefront location wasn’t difficult enough, the City of San Francisco is going to punish those bad landlords who are responsible for the vacancies in retail. That’s right the government is here to help you with additional incentives to run a successful real estate business. According to a report in the Wall Street Journal, the City of San Francisco is voting today on whether to impose a punitive tax on commercial storefronts that remain vacant for more than 6 months. They’re hoping this new measure will put an end to the blight of empty storefronts. According to the wording in the proposal, the tax is intended to "reinvigorate commercial corridors and stabilize commercial rents, thereby allowing new small businesses to open and existing small businesses to thrive”. We’re in an environment where there are major shifts happening in the world of retail. 2019 saw about 10,000 retail store closures across the US. A similar number of closures are expected for 2020. At the same time that 10,000 stores closed, the industry opened about 3,500 new stores across the nation. Under the San Francisco initiative, building owners would have to pay $250 per foot of linear frontage, which could rise to $1,000 per linear foot in the future. Think about it, a grocery store goes under with 100 feet of frontage and then all of a sudden the owner gets an extra bill for $100,000 through no fault of their own, because their tenant went out of business. It’s outrageous, and frankly I hope this gets challenged in the courts. In my home city of Ottawa Canada, there has been an excessive amount of retail construction in my opinion. The West end of our city has been well served over the years by shopping malls of all types. I never would have considered that there was a shortage of retail in my area. We have had three new supermarkets open up. Recently, a new outlet mall opened with 78 new stores about a 10 minute drive from my house. The impact on existing shopping centres has been clear. Another shopping district that is about 5 minutes from my house is suffering. Are vacancies the result of irresponsible landlords failing to keep their properties full? New York City Mayor Bill DeBlasio has proposed a similar tax in the past month. In his State of the City address that Mayor said, “If a landlord leaves that storefront vacant, hurts the community, makes the community less whole, deprives someone from having that storefront so they can be part of our community, then that landlord needs to pay more in taxes,” In 2016, Arlington, Mass., passed a bylaw that requires owners of vacant storefronts to register the vacancy and pay an annual fee of $400. Proponents of the approach would argue that the measure has worked. Vacancies in the central business district in Arlington fell from 6.4%—when the bylaw was passed—to 2% today. Retail space is subject to the laws of supply and demand. There are a lot of forces that are affecting this aspect of the business. There’s new supply coming into the market making older properties comparatively less desirable. Our society has a tendency to discard older properties and allow them to fall into disrepair. This is particularly true when you have a major anchor tenant disappear from the market. We have seen many traditional anchors including Sears, JC Penny, Target, and Macys closing vast numbers of stores. We have seen supermarkets closing across the country. Walmart’s experiment into neighborhood markets has not been very successful and many of these stores have closed. When a retail shop closes down, there is not a lineup of new small businesses waiting in the wings to take over that space. You can only have so many coffee shops in a given area.