The Real Estate Espresso Podcast

Thank you to all the loyal listeners. I’m truly astounded that The Real Estate Espresso Podcast now has listeners in 114 countries. Whether you are located on an island in the Pacific, central Africa, South America, Europe or the good ol USA. Thank you for listening.  On today’s show we’re talking about the opportunity trap. We’ve all seen it happen. Maybe some of you have done it. I’ve fallen prey to my own desire to grow faster than I was capable. The picture looks something like this.  You’re in business, you’ve got a great product. Let’s call it super duper. Customer orders are coming in. The growth has been good. Most of the sales have been online and the order fulfillment process is working pretty well. The marketing efforts have grown the company consistently month by month. Then one day Walmart calls and asks if you would like to supply Super Duper to Walmart. Simple math suggests that this one customer could increase sales by a factor of 10. The opportunity is so huge compared with your present business that the only correct answer is yes. It’s a huge stretch. It could possibly break the company, but the opportunity is so great that you can’t say no. You can’t say no for several reasons. You recognize that your product is filling a gap in the market. But there are some competitors who are a little behind you. So far you’re doing well. Walmart has recognized the gap in the market and is asking for Super Duper. If you say no, then Walmart will probably approach your closest competitor, and the explosive growth will go to the competition. Most importantly, the market share will go to the competition. Saying no is not an option. Sure there will be problems. Walmart will negotiate pricing that will hurt margins, but the company will make it up on volume. The team will figure it out. They always do.  Walmart pays their bills, but they manage their payment terms so that most of the time the product spends on the floor in the department store, the inventory is actually being funded by the supplier. That means requiring a huge increase in capital to fund that inventory.  The scenario I’ve described sounds pretty compelling. Almost every business has encountered some version of the narrative that I’ve described.  Now imagine you’re an existing customer of the company. You’re going to suffer terribly when the company starts to supply to Walmart. Walmart will get all the attention. Customer service will suffer. Order lead times will suffer. You were one of their best customers and now you’re a second class citizen. Super Duper is strategic to your business. You can’t meet your business commitments without it. Buying the product off the shelf at Walmart won’t deliver the quantities you need. The company has signed a supply agreement with you and they’re not living up to the terms of that agreement. They can’t be counted on to meet their commitments. They’re not an honourable company. They can’t be trusted. You are angry at the company because they’re harming your business.  Does this scenario sound familiar?

Devin Redmond is with Stessa, a new property management software startup based in the San Francisco Bay area. On today's show we are talking about some of the limitations of many of the established applications in the market and how a bigger picture can help investors manage their business overall.

Tom Krol is a specialist in Wholesaling. He has raised the art of wholesaling above real estate and totally separated it from the science of real estate investing. This is a perspective on wholesale transactions that you likely have never heard before. Check it out.

The Yale endowment is  considered as one the best institutional investors. In 2018 it earned a 12.3% return, beating the average endowment return in 2018 at 8.2%.  For 2019 they are allocating 49% to illiquid / alternative assets (VC, leveraged buyouts, real estate, natural resources). I'm somewhat surprised to see that real estate only takes up 19% of their alternative assets and not more. Their real estate return in the last 10 years was also an anemic 2.7%. In contrast, they've had a lot of success with venture capital (165% in last 20 years.  Given Yale's endowment at a whopping $29.4B, how and what can the everyday investors learn from them and the super rich?  It’s true that they’ve grown the endowment from about $6.6B to 29.4B in the past 20 years. That’s impressive considering that the endowment is the single greatest source of cash for the university programs. Tuition is second.   First of all, there are numerous ways to make money.  I have some first hand visibility into the Yale endowment and where they invest. The Yale Endowment is a major investor in a private equity firm called Golden Gate Capital. They were the firm that was funding my buy-out of IBM’s microprocessor division in 2004.  From my exposure to family offices, and other “old money” over the past while, I can share what I’ve learned. I believe that their goals are different from the average investor.  First of all, they are more concerned with preservation of capital than rate of return. They also employ sophisticated consultants to evaluate their investment decisions.  The line between late stage venture capital and private equity is quite blurry. I don’t believe Yale is investing in early stage startups. These are late stage startups where the capital requirements are larger. These businesses are proven and need funds to scale up. This is not that different in the world of private equity. Generally speaking, private equity firms make low risk bets on re-engineering businesses and executing business turn-arounds.  David Swensen is the chief investment officer at the Yale Endowment. He outlines his investment philosophy in his book entitled Pioneering Portfolio Management. In that book he divides the portfolio into five or six roughly equal parts and investing each in a different asset class. Central in the Yale Model is broad diversification and an equity orientation, avoiding asset classes with low expected returns such as fixed income and commodities.  He also maintains a low cash position. He maintains a low exposure to traditional wall street equity investments, and a high exposure to alternative investments that are not readily marketed. That’s why he’s investing directly in funds like those of the Golden Gate Capital Group. These firms have some of the most sophisticated money managers involved. For example, they routinely use the services of Bain Consulting. This is the consulting division of Mitt Romney’s Bain Capital Group. I can say from first hand experience that these folks  It’s no surprise that Bain consulting recruits heavily each year at Yale University. They have developed a way of looking at the investment world that is different from most. They realize that these are businesses that need to be run, and they know how to run successful businesses.  In your question you mentioned that the real estate performance of the Yale Endowment was surprisingly low. But remember that the measurement notes in the article you referenced is over a 10 year period. Note that the fund would have experienced significant losses from 2008-2012, and these deficits would have started to be recovered only starting in 2012. 

On today’s show we’re talking about how properties disappear from the market. No, they weren’t demolished. I’ll tell you where they went.  Harry Dent is an economist who bases his entire thesis about the economy on demographics. Demographics can predict so much about human behaviour. We know that there is a range of ages when people spend the most money on education. That’s usually between 18 and 24 years of age. We can use the number of live births to predict the number of diapers that will sell in a given year. We can use demographic data to predict housing trends.  As real estate investors we know that real estate is hyper-local. So how do you map the knowledge of the macro economy and demographics to the specifics of your local market? It’s by understanding who your ideal customer is, and then overlaying demographics on top of the needs of your ideal customer. Today we’re going to talk about that huge demographic group called the baby boomers. The oldest baby boomer is 73 years old today, and the youngest is 55. For the next decade we’re going to see that demographic group retire in growing numbers. That’s worth paying close attention to.  This past weekend I was speaking at an investor conference about a vacation destination. I actually met several people who had purchased in the same destination, but not as investments. They chose to live there.  When people retire, they often have certain life goals. They want to downsize. They don’t need such a large house. They don’t want the effort and expense of cleaning and heating a large space that they’re only using a small fraction of.  They also want to travel, so for many that means having a place where they can confidently leave and know that the property will be safe. If the property has a large yard with grass that needs to be cut, or a laneway that needs snow clearing, that’s not as good a fit as a condo in a complex where there is maintenance staff onsite and the majority of maintenance items are the responsibility of the condo corporation.  Some people want to retire to the beach. Some will want to retire to the chalet in the mountains. They want to spend time in an environment that is emotionally uplifting and inspires them on a daily basis.  Some will choose to rent and experiment with a number of locations over a period of 4-5 years before finally settling on a single location. Others will choose their dream pad very quickly. For others, they will maintain multiple residences and move with the seasons.  This particular demographic group is looking for walkable communities with lots of community amenities. They’re looking for desirable destinations. They’re looking for buildings with on-site amenities and strong on-site management. They’re looking for a resort lifestyle where they can walk to the beach, or breath in the mountain air.  These properties were often built as condo’s in resort complexes. They were intended to be part of a rental pool under the hotel management. But the condo hotel model means that an individual owner can purchase a unit and owner occupy the unit whenever they want. Of course, when it’s owner occupied, the hotel can’t rent it out and the owner gets zero revenue for those nights.  The investor will value the property based on multiples of income, where the income is determined by the seasonal factors and the nightly rate. For the owner occupant, their price criteria is based on the value to them as a home.  As you pay attention to the laws of supply and demand, consider that supply may actually shrink in some rare cases where properties are highly desirable. We always look for those special situation where there is more demand than supply. 

On today's show we’re talking about President Trump’s visit to a project located just down the road from several of our own new development projects. The president was in lake Charles Louisiana to promote the expansion and job creation opportunities associated with liquified natural gas. The oil and gas industry in America has evolved over the years from conventional oil that some of the very first oil wells in Texas and California produced. These were relatively shallow wells in fairly porous rock. They produced oil, and virtually no natural gas.  The more recent shale wells produce oil or gas and in some cases both. These rock structures have the oil and gas trapped in the rock which is not very porous, and not very permeable. If you think of the rock like Swiss cheese, the porosity of the rock is the size of the holes in the cheese and the permeability is the ability for oil or gas to flow between the holes in the cheese or in this case the rock. In order to get the oil out of the ground, the drillers push water down into the well at about 2000 psi. That high pressure smashes the rock and allows the oil and gas to flow. The oil gets pumped to the surface and is stored in tanks that get emptied on a regular basis and is then transported by truck to the refinery. The gas is lighter than air and just wants to float away. The only way to capture the gas is to pressurize it and transport it by pipeline to an local mini refinery which gets rid of the impurities to ensure the gas is of pipeline grade before being sent down one of the major pipelines.  Natural gas is a great source of energy. But it’s so inconvenient to handle that the average consumer has trouble dealing with it. Most of the worldwide consumption of natural gas is for the production of electricity or home heating. Natural gas is is one of the cleanest ways of producing electricity behind wind solar and hydro. Much of the electricity in Europe, Asia is turning to natural gas as a cleaner alternative to coal or oil. For example, in 2016, Spain didn’t import any natural gas from the US. In 2018, Spain imported 29 billion cubic feet of natural gas and growing. France is buying from the US, so is Portugal, Italy, and Greece. Last year the US exported 22M tons of LNG. This export capability was only made possible in 2015 when president Obama authorized the export of hydrocarbons from the US. Today, Lake Charles Louisiana is the largest LNG export hub in the US. The export capacity for LNG is expected to grow by huge multiples over the next decade. Lake Charles is undergoing tremendous growth as a result of these energy projects. It’s driving population growth and employment growth. Most importantly, these jobs are not linked to the price of oil or gas. It’s all about global distribution of natural gas. The widening of the Panama Canal in 2016 opened up markets in Asia.  So what does this have to do with real estate?  We look for market opportunities where the demand is growing and there is a shortage of supply. The president’s motorcade passed directly behind our Maplewood Place RV Park. We built that facility over the past year to house the legions of construction workers who will be temporarily in Lake Charles over the next decade to build the mega plants.  This town needs everything from housing to retail, to office and medical. The President’s trip to the area is shining a spotlight on the opportunity. We believe that the additional visibility will make the market more broadly recognized in the financial markets.  The President’s visit will bring attention to this market and may facilitate future investment. Have a lookout for other places, anywhere in the world where major business activity is taking place. As always, look at those opportunities through the lens of supply and demand. 

Today’s show is about protecting rookie investors from making bad investment decisions.  This weekend I was speaking at an investment conference. I had several people approach me and ask advice about buying properties in markets where purchase prices were low and tenants don’t have the funds to pay the rent.  Yes folks, don’t get ahead of me now. I know many of you have seen this movie before. You know the ending.  One investor in particular bought a multi-family property in Chicago. It was clear to me that he did not do his due diligence. He didn’t know which streets were the dividing lines for rival gangs in the area. He relied upon the publicly available heat maps that were available on the crime statistics websites. He didn’t know that the city had cut back on policing in many neighbourhoods and that violent crime had jumped by 60% in a period of months. He relied upon the broker’s information about the property. The financial model he constructed followed what he had been taught in a real estate training workshop. He had allocated 8% of his gross monthly income to maintenance. He chose that percentage in his financial model because that’s what he was taught. He liked the fact that the government subsidies for rent were above the market rent and the property was going to produce strong cash flow.  But here’s the problem with that approach. All of these spreadsheet based approaches neglect the reality on the ground. The spreadsheet approaches neglects the true cost of maintaining the property when maintenance events occur. Some maintenance events are somewhat difficult to predict. You don’t know when a refrigerator will die and need to be replaced. You don’t know exactly when a water heater will die and need to be replaced. But you do know that a water heater costs exactly the same in an apartment that rents for $2,000 per month as an apartment that rents for $650 per month.  The water heater doesn’t care how much rent you are collecting.  You are looking at hiring a plumber to replace it. If it is powered by natural gas, you may also need to hire a gas contractor to disconnect the old one and reconnect the new one.  If the water heater died the way most of them do, you are probably facing a significant cleanup and repair from the water damage. You are replacing flooring, repainting, possibly having mold remediation. All these things happen the same to an apartment that brings $650 per month or $2,000 per month.   If the 8% budgetary number is appropriate for the $2,000 apartment, then it’s way too low for the $650 apartment. You would need to reserve 24% in the case of the $650 apartment to equal the same dollar amount.  When a tenant moves out and the apartment needs to be cleaned, the cost of the cleaning is going to be roughly the same, regardless how much rent was being charged. Your financial model needs to consist of listing all the expected maintenance costs that could come up for an apartment. It’s then your job to estimate how frequently these events will occur. A water heater will need to be replaced every 10-15 years. Carpeting will need to be replaced every 5-8 years. Ceramic tile will need to be replaced every 15-20 years. Air conditioners will probably last 15-20 years. Apartments will need to be painted every 3 years.  When you add all that up, then you can estimate the real dollar value that you need to reserve.  But here’s the other problem that often arises in the financial model. You construct a model where the rents increase with the rate of inflation, perhaps 2% per year. You might model the same 2% for your expenses. I can show you examples where energy costs have increased 10-15% in a single year. If you construct your model using arbitrary percentages, you run the risk of overlooking the real situation on the ground.  

 What can we learn from the Uber and Lyft Initial Public Offerings? Both companies have grown to the point where they have a strong share of the market globally in just a few short years. Both companies have seen Luke-warm demand for their stock post-IPO. Uber and Lyft have never been profitable. One of the stated reasons that both Uber and Lyft have not achieved profitability is that the two companies have been locked in a battle over market share. If one company could achieve commanding market dominance, it could seal their fate for years to come.  Lyft went public on March 29 and their shares are currently trading 42% below the peak achieved shortly after their IPO. The company just announced their first results as a public company. Riders increased by7% in the quarter. But the company lost $1.1B for the quarter.  The picture isn’t that much different at Uber. The company went public this past week and they too are losing a breathtaking amount of money.  So here is why we are looking at these two companies. I speak with investors on a regular basis. I’m trying to imagine myself having a conversation with an investor where I tell them that we are going to have an operating loss of $8B dollars over before we transition to profitability. In the meantime, we’re going to focus on market share and when we have millions of customers we’re going to take the company public. We will all get rich from the IPO as new investors step in and buy new shares. The company will be worth billions.  I’m trying to imagine having that conversation with the most sophisticated angel investors in Silicon Valley and the top tier venture capitalists.  Now I’m perhaps being a little unfair because I doubt that the early conversations truly foresaw a future of $8B in losses followed by an IPO.  But here is what the broader market is saying to the likes of Uber and Lyft. We want to see profitability. The market has been extremely tolerant of companies like Netflix and Tesla, and Uber. Somehow these companies have been able to raise billions of dollars on a promise that hasn’t been proven. Part of that promise is profitability. Delivering the product and gaining market share is incredibly difficult and I applaud all of those companies that have managed to do so. But investors aren’t investing for the product or the service. They’re investing for profit, and profit is at the core. The only way Uber and Lyft can achieve profitability is by raising fares. To maintain market share they need a price advantage compared with the traditional licensed taxis. If the price gap gets too narrow, then the number of riders will fall and we will see revenue fall. The issue always comes down to economic fundamentals. In the case of Uber, the critical concept is price elasticity of demand. If I’m looking for a drive to the airport, I evaluate the cost of the ride to the airport and back and compare that against the cost of parking my own car at the airport. If the ride is too expensive, I’ll take my own car.  Not only do those companies need to achieve operating profitability. They need to generate positive cash flow. I honestly can’t imagine proposing a real estate project to investors with the kind of blue sky dream that Uber and Lyft have been pushing for years.  Raising more money is prudent to extend the runway to profitability. But there are limits to the runway that most investors will consider reasonable. Uber has been operating for 10 years. In that decade they’ve generated 8 billion in losses. How do you spin that into a story for investors? Are you lining up for that investment? It wouldn’t be me.  Now that they’re public, they will come under immense pressure to generate profits and cash flow. When you evaluate your business, focus on profitability and cash flow. 

Kyle Humphreys oversees the building of new construction projects in the high arctic. The considerations there are completely different from the dense urban projects most of us are involved with. Join me for this fascinating conversation.

Rod is one of the most well known apartment real estate investors with a large following. On today's show we had a wide ranging conversation about goal setting and setting life priorities. His upcoming bootcamp in Denver is always widely attended. If you go to rodsbootcamp.com and enter the discount code "espresso" you can get $100 off the admission to the bootcamp.