The Real Estate Espresso Podcast

DJ Scruggs spent most of his career in the tech industry, much like myself. On today's show we talk about making the transition from startup corporate life into real estate investing. Join me for this insightful and wide ranging conversation.

Everyone needs a place to live, right? That’s one of the arguments that underpins the demand for real estate. But in some markets, that is not an appropriate statement.  Let me take you back to the financial crisis of 2008 and it’s aftermath. There were a few counties in the US that stood out for the very high rate of foreclosures.  Two markets that come to mind are Florida’s Dade county and Arizona’s Maricopa County. Miami is in Dade County, and Phoenix/Scottsdale is in Maricopa County. In fact it’s a long list of communities including Mesa, Tempe, Chandler, Glendale, El Mirage, 24 municipalities in total.  Let’s be clear, a lot of people lost their primary residence to foreclosure in the financial crisis. The scale and human impact of that hard to comprehend.  But both Miami and Phoenix have a few things in common. They are both sun destinations, and a lot of people own second homes in those markets.  Given a choice, people overwhelmingly chose to protect their primary residence and allow their second home to fall into foreclosure. There was a much stronger attachment to the primary residence than a second home. At the peak, there were 42,000 brand new vacant condos in Miami. Most were pre-sold in 2005-2007. When the financial crisis hit, buyers chose to walk away from their deposits rather than get financing on a property that would be underwater. That was then.  Eventually, over time those units got absorbed by the market and new construction resumed.  When I was in Miami a few months ago, I was struck by the large number of construction cranes. It felt like the market was becoming overheated again. Back in 2015, some 80% of condo purchases went to foreign buyers. Today that number is about 20% of buyers come from outside the country.  Again, one of the reasons I believe the demand is highly variable, is the high proportion of second homes. A second home is a luxury. It’s an investment. But it’s not essential to everyday living.  Developers often don’t seem to realize the difference. When units are selling quickly, It’s too easy to assume the demand will persist.   Unlike in past cycles, this time around, developers have been asking buyers for a 50 percent deposit to purchase a condo. Those funds have helped developers pour more equity into their projects, which meant they didn’t have to borrow a lot of money from banks. As a result, their leverage is a lot less than in the past cycle. Back then, projects were over-leveraged and developers had no room for sales prices to drop because they needed every dollar to pay back the construction loans. Also, back then, developers only required a 20 percent down payment, so it was easier for buyers to walk away from the closing table when the market turned. Now, buyers are motivated to close because they already paid 50 percent of the purchase price.

On today’s show we’re talking about a couple of widely publicized articles on the state of the oil and gas industry. Oil and Gas are major drivers of the economy, and as such, the cascade into real estate is inescapable.  The first was a presentation by Steve Schlotterbeck, who led drilling company EQT as it expanded to become the nation’s largest producer of natural gas in 2017, arrived at a petrochemical industry conference in Pittsburgh Friday morning with a blunt message about shale gas drilling and fracking. “The shale gas revolution has frankly been an unmitigated disaster for any buy-and-hold investor in the shale gas industry with very few limited exceptions,” according to Schlotterbeck, who left the helm of EQT last year. Schlotterbeck is not the first industry insider to ring alarm bells about the shale industry’s record of producing vast amounts of gas while burning through far more cash than it has earned by selling that gas. And drillers’ own numbers speak for themselves. Reported spending outweighed income for a group of 29 large public shale gas companies by $6.7 billion in 2018, bringing the group’s 2010 to 2018 cash flow to a total of negative $181 billion over the past decade. Schlotterbeck is right in saying that the price of gas has to rise in order for the industry to survive.  The main issue is that natural gas needs a way to get to market. If not, then there will be local excess of supply and prices will fall. That’s exactly what has happened.  The payback on the investment is often happening far past the initial gusher of oil or gas. Shale wells have a steep production decline curve where production flows fall by 85% in the first year. A well might produce for 20-25 years, but the volumes will be low. About 50% of the well’s lifetime yield is given up in the first 18 months. Since Wall Street always expects revenue growth, companies need to expand drilling operations in order to show revenue growth. But if a well doesn’t achieve break-even in the first 18 months, the only solution is to invest ahead of production. That results ultimately in negative cash flow. The local glut of gas has caused prices to fall which has killed the financial model.  Only when global distribution is in place, prices for US production will normalize. Prices vary widely around the globe and it all has to do with distribution. The end buyers of natural gas will pay the cost of the gas, plus the cost of transportation. The sum of those two is the real cost to the end-customer.  The major investments in infrastructure in Lake Charles are taking advantage of the pipeline infrastructure that is already in place. Tellurian is also adding another 120 miles of pipeline from Texas to Lake Charles. The other plants like the Ethane Crackers are producing the end-product (plastic) without any further transportation. So yes, infrastructure investments like in Lake Charles are key to solving the problems that are referenced in both articles.  If your real estate is dependent on the economics of a major industry, it’s vital that you understand that industry. Otherwise you’re taking a major risk that your revenue projections may not come true.

Can you negotiate with government? The simple answer is yes you can. But the real answer requires an understanding of what the other side wants. When you are involved in a negotiation, any negotiation, having an understanding of what the other side wants is critical to an effective negotiation.  When you are negotiating with a seller, they might be looking for the highest price, or perhaps greater certainty that the transaction will happen on time, or happen at all. They might be looking for a quick closing.  But when you are dealing with government, you are negotiating with people who are not owners. They are employees of the government and stewards of public resources. What drives their decision making is going to be different than a private business.  In one case, we had a regulatory body imposing a different section of the building code upon a project, despite clear specification to the contrary. You might say that you can never fight city hall. I’m here to tell you that a well researched and well presented case can often result in a successful negotiation. Most of the time when you negotiate with government, you are not dealing with elected officials, but with paid bureaucrats.  There are two different circumstances that require a vastly different approaches.  Case falls within a defined regulation or procedure.  Case falls outside a defined procedure.  In the case of a defined procedure, the ability to negotiate can be much narrower.  But often, there are conflicting regulations, and negotiation involves convincing the government official on which set of rules to apply under the circumstances.  Most government negotiations fall into some variation of that idea. This type of negotiating requires deep research and the expertise of those who have an understanding of the inner workings of the government department.  The second case involves circumstances where there is no defined procedure. That involves someone taking a risk and making a decision that they might need to defend in the future.  For many government employees, their job is to keep their boss and the elected official from appearing in the newspaper. Any negotiation will require a risk assessment.  If the government employee is comfortable with the risk, then you can effectively negotiate. But if they’re not, then you might be stopped dead in your tracks.  When that happens, your job is to see if there is an existing regulation that is similar to your specific circumstance, and try to convince the official that that rule should apply in this case. You really want to make the case of no rule look like the first circumstance of conflicting rules, where some discretion can be applied to choose the most appropriate rule to fit the circumstance.  Let me give a specific example. There are two properties that were purchased with federal deed restrictions requiring the building of affordable multi family housing within a defined time. In the meantime, the city changed the zoning to single family.  So here we have two levels of government imposing conflicting rules. Unless both sets of rules are in agreement, the project can’t move forward.  These types of situations arise frequently. There are often experts, many of them are attorneys who specialize in navigating the web of conflicting rules who can help you negotiate a winning solution.  If your issue is zoning, you may consult an urban planner or a zoning attorney.

On today’s show we are examining home buying for the next generation of home buyers. Last week we talked about a bubble forming in the luxury home segment where older home-owners are aging out of the home market, and through a combination of affordability, sheer demographic numbers, and market taste, there is a fall in demand at the top of the market where in fact there is a shortage of homes at the entry level.  On today’s show we are looking deeper at new buyers entering the market for the first time.  We saw home buying rates bottom out in 2011 and 2012 for new home buyers. This was the bottom of the real estate market following the 2008 financial crisis. Young home buyers were taught that home ownership was risky. But the truth is that the opportunity of a lifetime existed in 2011 and 2012. Home prices have increased ever since. They’ve increased as banks started lending money agains, and home buyers came back into the market. Prices rose in response to the supply demand equilibrium at that moment in time. The actual number of young home buyers has increase every year since 2012. It points to a real rebound in home buying patterns. Or does it? According to US Census data, the percentage of home ownership for the age group from 25-34 years of age was at 20% for that age group in 2006. It has fallen every year since and now sits at 15% of that age group. Despite the rebound in home ownership in the millennial group in absolute numbers, the actual percentage of home ownership participation continues to fall year over year.  It would be easy to conclude that millennials simply aren’t as inclined to buy homes as the previous generation. But the folks at Fannie Mae decided to look deeper at the data. They measured the rates of home ownership of specific cohorts and compared them by year.   When I asked Dr. Doug Duncan, Chief Economist at Fannie Mae about this, he had a simple answer. He concluded that Millennials tend to buy houses based on specific life events. They tend to buy houses when they get married or have babies. He is saying that people are getting married and having babies about two years later than the previous generation. But once the decision to have children kicks in, home buying isn’t far behind.  In fact, the data in the Fannie Mae report seems to support that, along with the idea that the rebound in home ownership for a specific cohort is the best measure of current home buying sentiment.  According to Fannie Mae, The conclusion to be drawn is that cumulative age-group rates of homeownership clearly do not represent current market behavior, and it is current behavior that drives current housing market activity. I believe there is another simple explanation which the analysts have overlooked. Student debt in the past decade has exploded. Folks in their 20’s with an average of $39,000 in student debt are not rushing out and buying houses.  If the national home ownership rate is 60%, which is low compared with historical norms, and millennial home ownership sits at 15%, that’s a large gap to make up. It says that the bulk of people are not buying their first home until well into their 40’s.  So what does this all mean? It means that people still need a place to live. It means that if home ownership is falling, the demand for rental housing is only going to increase.  We are already seeing that in some states in the country. California is seeing its rate of home ownership declining. People who grew up living in a single family home will want to live in a single family home when they grow up, even if they don’t own it.

Securities law is one of the fasted moving areas of the law. In fact, even lawyers who practice regularly in this area often have to check on items they may have completed even a week ago.  For example, the SEC had numerous exemptions under regulation D. Exemption 505 was repealed, and as a result we have seen a significant increase in use of exemption 504 and 506.  The Securities and Exchange Commission published a release earlier this week to solicit comment on several exemptions from registration under the Securities Act of 1933 that facilitate capital raising. Over the years, and particularly since the JOBS Act of 2012, several exemptions from registration have been introduced, expanded, or otherwise revised. As a result, the overall framework for exempt offerings has changed significantly. The SEC believes capital markets would benefit from a comprehensive review of the design and scope of our framework for offerings that are exempt from registration. More specifically, the commission also believes that issuers and investors could benefit from a framework that is more consistent and eliminates gaps and complexities. Therefore, the commission is seeking comment on possible ways to simplify, harmonize, and improve the exempt offering framework to promote capital formation and expand investment opportunities while maintaining appropriate investor protections.  The SEC seeks to explore whether overlapping exemptions may create confusion for issuers trying to determine and navigate the most efficient path to raise capital. At the same time, they seek to identify gaps in our framework that may make it difficult, especially for smaller issuers, to rely on an exemption from registration to raise capital at key stages of their business cycle. If you go back to 2011, there were approximately 1T in registered offerings. At that time there were about $1.6T in exempt offerings. In 2018, there were about $1.5T in registered offerings and nearly 3T in exempt offerings.  There are a number of areas where the SEC is looking for input. Here is one of them.  In light of the fact that some exemptions impose limited or no restrictions at the time of the offer, should the SEC revise our exemptions across the board to focus consistently on investor protections at the time of sale rather than at the time of offer? If exemptions focused on investor protections at the time of sale rather than at the time of offer, should offers be deregulated altogether? How would that affect capital formation in the exempt market and what investor protections would be necessary or beneficial in such a framework? The questions they are asking are really great questions, and frankly are not what you typically expect from governments. Which conditions or requirements are most or least effective at protecting investors in exempt offerings? Are there changes to these investor protections or additional measures we should implement to provide more effective investor protection in exempt offerings? Are there investor protection conditions that we should eliminate or modify because they are ineffective or unnecessary? One of the main areas the SEC is looking at is to expand the definition of accredited investor beyond just a net worth test. The report also discussed whether individuals with certain professional degrees or licenses or financial experience, or who are advised by professionals, should be considered accredited investors.  You can find out more about the process by visiting the SEC website. The link to the document is contained in the show notes for the podcast.  https://www.sec.gov/rules/concept/2019/33-10649.pdf

Edna Keep is based in Regina, Saskatchewan. Regina isn't on the radar as a top market, but Edna has built a portfolio of over 500 units over a period of time with an emphasis on cash flow. You can learn more about Edna at ednakeep.com

On today's show I'm talking with George Ross about managing your loan portfolio and negotiating with lenders. 

Wednesday, Federal Reserve Chairman Powell announced the outcome of two days of meetings of the Federal Reserve. The Fed is a board of the heads of each of the regional Federal reserve banks and their board of Governors. The focus is often on the Chair of the Federal Reserve. But the board is really made up of a committee who vote on the policy.  Interest-rate projections released Wednesday showed eight of 17 officials—the reserve bank presidents and board governors who participate in the Fed meetings—expect they will cut the benchmark rate by year’s end from its current level in a range between 2.25% and 2.5%. Seven of those officials see lowering the rate by a half percentage point by the close of 2019, and one expects just a quarter-percentage-point reduction. Eight officials projected the Fed would hold rates steady, and one projected a rate increase. The Fed this week announced that they were holding interest rates steady at this meeting, but signalled strongly that we can expect a rate cut at the July meeting, about 6 weeks from now. The guidance is for a half point reduction between now and the end of the year, based on economic indicators. The fed is seeing a slowdown in economic activity, party due to global economic slowdown, and some linked to the current trade discussions between the US and China.  The central bank’s rate-setting committee on Wednesday dropped language from its policy statement describing its stance as “patient”—which implied rates were on hold. Instead, it said uncertainties about the economic outlook have increased, a phrase it has used during past periods of rate cuts. “The committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion,” the statement said. That’s code for they plan to reduce rates on signs of economic weakness.  So this is a strange situation where no change in interest rates is actually news worthy. In response to the announcement, the stock market seems to have responded positively. But the real news is that low interest rates mean that the government’s out of control spending is going to continue to enjoy low interest rates making their over-spending less unaffordable. I’m deliberately using a double negative here because the spending isn’t affordable at all, it’s less unaffordable with lower interest rates.  For us as real estate investors, short term loans are typically linked to short term rates like LIBOR, and permanent financing is typically linked to the yield on the 10 year treasury. That’s why Wednesday’s news is actually news for real estate investors. Yields on the 10 year treasury fell to the lowest level since November 2016. The rate now stands at 1.98%. That means that the rate for most HUD and agency loans will be solidly below 4% for the first time in a couple of years. Now is the time to position your portfolios to take advantage of the lower interest rates. If you start the process in June, by the time you exit the underwriting process in July, you will likely see an even lower rate locking into your permanent financing.  These financings take considerable time. The lender has to underwrite the deal, the market conditions, and the borrower. The commercial appraisal won’t be ordered immediately. That’s typically one of the last steps in the underwriting process and typically takes several weeks to complete.  So if you want to take advantage of lower interest rates that are here now, and in our near future, now is the time to start the process to rate lock for the long term.

  June 1 marks the start of hurricane season in the Northern Atlantic. Some years are incredibly active like 2017. By comparison, 2013 had no hurricanes make landfall at all. While there were several tropical storms, none developed into full blown hurricanes. The names for the storms in 2019 have already been established, and the first few will be called: Andrea Barry Chantal Dorian Erin Fernand On today’s show we’re talking about the kinds of fraudsters that crawl out of the woodwork whenever a natural disaster strikes. This can be an earthquake, a hurricane, a tornado, any major natural disaster.  There are numerous scams out there. Some of them target unsuspecting property owners. Others target assistance programs and insurance companies. These are the top 5. While many individuals respond to natural disasters with kindness and generosity – opening their hearts and their wallets to those in need, providing aid and assistance when it is needed most – some unscrupulous individuals will take advantage of the situation to line their own pockets through fraud. Here are the top 5: 1) Benefits Fraud 2)  Charities Fraud 3)  Cyber Scams 4)  Loan Modification Scam 5) Repair Scam