The Real Estate Espresso Podcast

Today’s show is about how a bad appraisal can adversely affect your business.  Appraisers determine the value of your property in the eyes of a lender and they help the lender independently justify the loan to their loan committee and to the bank regulators. This independence prevents the kind of loan manipulation that unfortunately became far too commonplace in the 1970’s and 1980’s.  The banks have the right to choose their appraiser independently, and the borrower is not to influence the appraisal process. There is a significant incentive for the borrower to get a high number for their appraised value. The higher the number, then perhaps the more the bank may be willing to lend. If the appraised value is artificially high, then the bank ends up taking on much more risk. Appraisers use three principal methods to value a property. These methods are: Replacement cost Multiples of net income Comparable sales Generally speaking, the appraiser needs to apply their professional judgement on which of the three methods to give the greatest weight to. If the property is unique and there are no comparable sales, then they may have to rely on one of the other methods. If the property has no income yet, then the income multiples method doesn’t apply. If the property consists of vacant land, then the construction cost won’t apply. On today’s show, we’re going to focus on what to do when the appraiser for your lender gives a value that is far from what you believe the true value of the property to be. There can be several reasons why the appraiser comes to a surprising conclusion. In 2017, many cities started accepting carriage houses as legal accessory dwelling units. These separate buildings would be treated the same as an in-law suite located in a residential home. Here too, there were few if any examples in the market, and appraisers struggled with how to value them. They had no comps. None of the appraisers I spoke with were willing to blaze a trail and take the personal risk of setting price precedents in the market.  In another case, an appraiser valued a parcel of land as if it was agricultural land, instead of valuing it with the improvements that had been approved by city council. It happens that sometimes you get a bad appraisal. It first happened to me back in 2012. The result was that instead of a refinance taking 3 months, it ultimately took 9 months and three separate lenders to complete the transaction. Bad appraisals were at the root of the issue in each dead-end loan application.  So what can you do to prevent a bad appraisal? As a property owner, you don’t get the opportunity to direct the appraiser. They have to do their work independently.  However, I believe it is perfectly fair to show the lender your analysis at the start of the project. To show the lender you’ve done your homework and that you have a good understanding of the market. Include all of the relevant data in your executive summary that forms part of your loan request. Not all real estate transactions are advertised on the MLS. Private sales which are transacted outside of the public eye are no less real. They too should count when considering the landscape of transactions considered in the market analysis. You can include all those off-market transactions that you might be aware of that the appraiser is unlikely to find because they’re not advertised.  The impact of a bad appraisal can be significant delays. It can put a borrower in the impossible situation of having to seek an emergency extension of a loan while they complete a refinance. Show the lender your analysis and it may increase the chances of a fair and accurate appraisal.

Today’s show was inspired by something that happened recently. I was at a party and I met someone who said they knew who I was, but I didn’t know them. That happens often when you speak frequently as I do. She was asking me about the projects we have underway. She was telling me about the ideas she had for flipping houses in our local market, something she had never done before. The ideas she was suggesting sounded risky to me. The path to success is filled with land mines and she really would need to work with someone who has a lot of experience and help her avoid the many pitfalls along the path. At that point she offered to invest passively with me in some of my projects. Now I don’t know if she would even qualify to invest in our projects. That’s not the point of the story. The point is that it was clear to me that she had not developed a clear idea of what constitutes a good investment. The idea that she would part with large sums of money without having that clear criteria is the part I found disturbing. Sadly, I encounter this situation very very frequently. So on today’s show we are talking about the importance of developing a clear investment criteria. Making an investment decision requires discipline. It requires a formal due diligence process. I see of people making insanely rash and poor investment decisions all the time. Frankly it’s hard to stand by and watch it happen.  Due diligence requires a separate focus on three areas. These are: The local market conditions  The people running the project  The specifics of the deal itself.  The idea here is that you develop your own due diligence checklist. The step that most people miss in that exercise is to have some clear pass/fail criteria for each of the checklist items.  I look at the overall supply and demand situation to confirm that the market conditions are truly favorable for investment. If there is much more supply than demand, it’s going to be difficult to create value in the market. Business is all about solving real problems. If there is excess supply, whether it is because people are leaving or it has become overbuilt, the outcome is the same. If there is an excess of supply, there’s no reason to invest. When it comes to the team, I look deeply at the people who are sponsoring the project. I look at their track record. I want to see projects that have experienced adverse situations to see how the team handled those situations. The deal itself also has to meet very specific criteria. My own due diligence checklist consists of about 60 items. Your list doesn’t need to be excessive. But I believe a due diligence list of between 40 - 60 meaningful questions is about right.  The questions should be categorized by grouping. Within each subset list some questions can allow for some grayscale in the answers. Others will require a black or white binary pass or fail answer. If you color code the answers to the checklist you will be able to see in a couple of pages whether the deal is going to work or not. You will see if there are a few solvable problems, or if there are too many problem areas to overcome. If the problems are confined to a few areas. You may be able to have a meaningful negotiation with the deal sponsor. Maybe an additional piece of collateral, or an additional process step can eliminate a risk item. Ask other more experienced investors to review your checklist and provide both ideas and input.  It will take several iterations to develop a checklist that you feel truly confident in. You may refine that checklist over a period of months or years. That doesn’t mean you should wait until the checklist is perfect before you make an investment. But the simple act of having a checklist and a defined process for making decisions will put you ahead of the vast majority of investors. 

Patrick Francey is CEO and Managing Partner of The Real Estate Investment Network. He can be reached at reincanada.com. 

Matthew Sullivan is the CEO of QuantmRE.com, a firm that specializes in a different form of financing for property owners. Chances are that you've not heard of this business model before. It's a fascinating twist on how to take advantage of the equity in a property.

We tend to think of most investors as rational beings who think through each situation and look for the best economic solution for a given investment.  But if that were true, there would be very few good deals on the market. There must be something else in play.  The root cause of good deals is a human emotion called pain. There are two types of pain. There is acute pain. This is the kind of pain that results when you hit your thumb with a hammer by accident. In that moment, the throbbing pain in your thumb is all you can think about. Your child asking for an ice cream cone won’t get your attention. The phone ringing won’t get your attention. Your entire world is your thumb.  That’s acute pain.  The second kind of pain is chronic pain. This is when you have a pebble in your shoe. It’s annoying. You might limp a little or rotate your ankle a certain way to avoid the pain. But it’s not bad enough to consume you. It’s not even bad enough to get your focused attention.  Chronic pain is not usually enough to cause people to take action.  So what does this have to do with real estate? One of the fundamental human needs is for certainty. If a human is experiencing financial stress, they are probably experiencing uncertainty along with it. They might be able to pay the bills this week, but what about next month? What if there’s an emergency? Will they have the funds to cope with an emergency, even a small one?  That feeds directly into their decision making process.  Let’s look at a purely fictitious example. Let’s say Fred owns a couple of rental properties. His wife is undergoing medical tests and may have to take an extended medical leave of absence depending on the outcome of those tests. He has a decent amount of equity in the rental properties, but they have not been producing a lot of cash flow. In fact, he recently had to replace the water heater in one home, and the air conditioner in another. Then Fred gets the news that a tenant is going to be moving out. That’s going to mean spending more money on paint, cleaning, carpet replacement and dealing with at least a month of vacancy. Fred is feeling financial stress.  Fred decides that he’s going to sell one of the homes. We think that investors make rational decisions that are based on maximizing investment returns. But in Fred’s case, his return on investment isn’t even on his radar. His over-riding concern is bringing certainty to the situation. That’s more important to him at that moment than maximizing his return. He is experiencing acute emotional pain. That pain isn’t real. The origin of that pain is his own mind. He doesn’t know what’s going to happen. His wife might be fine. He might find a tenant quickly who is looking for a home in a great location. But Fred is consumed with fear. His mind is projecting into the future all the things that could go wrong and he is experiencing them very vividly as if they are happening right now.  Fred probably won’t even evaluate a spectrum of solutions to his financial predicament. He could refinance one of the properties. But he doesn’t know how much more equity he can pull from the property. He’s pretty sure he can get some, but will it be enough? He is likely to pick the first solution that will restore financial certainty to his life.  The marketplace is full of vultures who are waiting to pounce all over guys like Fred and take advantage of them. They’ll play mind games with them and further exploit Fred’s fragile emotional state to get a lower purchase price. Fred is what the vultures call a motivated seller.  Make sure you are sitting on some cash and have the ability to maintain financial certainty for yourself, and have the ability to restore financial certainty for someone else should they need it.

Last week I was in Toronto and my meeting was right downtown. Hotels were incredibly expensive, and the hotel where my meeting was being held was advertising rooms for $600 per night. So rather than stay near the airport and fighting rush hour traffic, I decided to look at short term rentals. I came across a listing for a penthouse apartment that was only two blocks from my meeting in the downtown. Better still, it was only $78 per night. The chances of finding a comparable hotel offer were pretty slim. So I jumped on it and seconds later I had a firm reservation. When I received the information about the accommodations, there were very strict instructions to enter the building only through the parking garage, and not to interact with the building’s concierge staff. Under no circumstances should I mention Air BnB. The key was located in the laneway behind the building in a lock box. The instructions for locating the key were pretty clear. There was nothing saying explicitly that I was in a prohibited short term rental. But I suspect that I was. I am an owner of short term rentals. I do this as a business. So staying in another short term rental was interesting from the perspective of someone who is in the business. This particular unit did not live up to the standards of what we provide our guests. The unit was clean and everything was in working order. I have no complaints. But the apartment was minimally furnished. The quality of the furniture was minimal. The apartment had not been painted since construction and had the original builder’s white paint on the walls. There were no decorations or art work. It looked very bare. Definitely not the kind of product we would offer our guests. But the location was amazing and the price was right. Short term rentals have been controversial in many cities. In Toronto, there are new rules that govern short term rentals. But the city has said they’re not going to enforce them until late into 2019, and only after the next consultation hearing which is scheduled for August. The owners who claim a right to rent to whoever they want often do not realize that they are not just renting out their unit.  They are, in effect, renting out the common elements and all of the shared facilities.  The other occupants now have to share the lobby, pool, sauna and gym with strangers and have to deal with increased traffic in their garage. The guests are not informed of the condominium rules and by-laws, and they often impose an additional burden on the rest of the building residents. They are less invested and less concerned about the security and comfort of the rest of the occupants.  After all, they view your home as a hotel. One building in Toronto sends a legal letter to owners who violate the rules of the condominium corporation. According to the bylaws of that building, the condo board has the right to charge the owner for the legal cost of preparing each letter. This can amount to $500 - $600 per letter. Some home owners simply choose to pay for the cost of the letter and keep doing what they’re doing.  All of my short term rentals are zoned for short term rentals. They are in buildings that embrace short term rentals, and they fully comply with all the rules for short term rentals. There’s no grey zone, no bending of the rules, and no breaking of the rules. If you’re going to be in business on a sustained basis and you’re truly a professional, how could you imagine to do anything otherwise?

On Monday the Social Security Administration issued their annual report. This story was relegated to a back page of the paper. Somehow the one and only story that’s going to affect every person in the country was less important than the optics of Mike Pence’s tax returns, which ultimately affects nobody directly.  This 270 page report lists a number of issues. I’m going to read directly from the report and expand on some of its findings and what it means to us as real estate investors.  When social security was brought into being by Congress on August 14, 1935 and then president Roosevelt signed it into law. At that time there were 13 people in the workforce for every one person who would ultimately collect on social security benefits.  The average life expectancy in the US was 60 years of age in 1935. Today average life expectancy is 78 years of age. Today there are 2.8 people in the workforce for every person collected social security benefits. Over the next decade, the number of workers to beneficiaries is expected to decline from 2.8 today to 2.3. We will have fewer people contributing and more people collecting, a lot more.  Together Social security and medicare accounts for 45% of US Federal Government Spending. Interest on the federal government debt accounts for 13% of spending, and military accounts for 17% of total spending.  Last year 63 million people received social security benefits. 47 million retired workers and dependents of retired workers, 6 million survivors of deceased workers, and 10 million disabled workers and dependents of disabled workers. We have known for some time that social security is running out of money. It’s been reported for years. It’s not a surprise . It’s simple demographics. But by law, the social security administration is limited in how it can invest its approximately 3 trillion dollars in reserves. That nest egg is expected to be depleted over the next 15 years to zero. The interest it earns on that 3 trillion dollars is a measly 2.8%. The only investment approved by the social security legislation is for the administration to invest in US treasuries. That’s right, the only permitted investment is US government debt. Let me get this straight. The US government prints money, then pays interest to itself on the money it printed in order to help fund its obligations. Does anyone else see a problem with this logic? As investors, I expect that virtually everyone listening to this podcast knows how to consistently earn more than 2.8% on their money. The private sector knows how to do this with a high degree of confidence.  So let’s look at the options available to the government. I don’t envy those in government. They really don’t have a lot of great choices, regardless of who is elected.  They can increase taxes. They can lie about inflation, by under-reporting the real rate of inflation and thereby reduce the actual cost of living adjustments. That means that as time goes on, the revenue increases with the real rate of inflation and payouts are indexed to the reported rate of inflation which is less. That’s a way of reducing benefits without changing any existing rules. Or they can do the politically unpopular thing and explicitly reduce benefits. They could do this by raising the age of eligibility as has been done in many European countries, or by reducing the actual amount paid out. They could redirect revenue from other sources into social security. Finally, they could change how they invest the remaining 3T dollars and hope for a higher rate of return on their money.  That’s about it. There aren’t really many choices left.  Politicians are still 15 years away from the system being completely 100% bankrupt.  I predict they will kick the can down the road again.

Virtually everything we buy emits sulphur to get it to the destination.  On today’s show we’re talking about a major shift in shipping that is not capturing major headlines, but will have a significant and measurable economic impact on global trade. 90% of the world’s trade is carried by ship. So anything that affects shipping is going to have an impact on the global economy.  One of the least regulated and dirtiest fuels has been the fuel used by cargo ships around the world. New global environmental regulations are requiring ships to use low sulphur fuel and ships are being forced to reduce their emissions starting Jan 1, 2020. Low sulphur fuel is more expensive than the predecessor bunker fuels.  Most bunker fuel burned on ships is derived from the left overs, from the ”residue" that remains after all of the more valuable light fuels such as gasoline and diesel have been removed from crude oil in a refinery. The tighter pollution rules by the International Maritime Organization, called IMO 2020, are set to take effect Jan. 1, 2020, resulting in the sulphur content limit of "bunker" fuel on ships dropping from 3.5 per cent to just 0.5 per cent. That means ships will have to either switch to alternative fuels, which could include marine gas oil, liquefied natural gas or biofuels, or install scrubbers to remove sulphur from exhaust gas. It is estimated he emissions mandate taking effect at the start of 2020 will affect at least 60,000 vessels and cost the industry up to $50 billion, according to shipping industry insiders. Cargo owners expect a significant jump in freight rates, which over the past five years have been hovering below break-even levels for vessel operators as a result of a glut of ships in the water and numerous price wars. “If the extra costs related to low-sulphur fuel go to shipping companies and end there, it would result in bankruptcies,” according to Soren Skou,  CEO of Moller-Maersk A/S, the world’s biggest container ship operator. Shipping executives expect to pay 25% to 40% more than they pay for bunker because of the higher cost for producing the fuel and setting up new distribution sites.  Be prepared for economic impact that will be either reflected in higher shipping costs, and ultimately higher prices at the checkout. 

This weekend I spent a couple of hours in a flight simulator. My sister is the chief pilot for a major executive jet manufacturer.   Together we practiced take-offs, landings, ground taxi, instrument landings, avoiding thunder storms, low ceiling conditions, cross-winds, and engine fires. I’m talking one of those $20M machines that is cheaper than the $80 million dollar aircraft it imitates. It sits in one of those large bays with a 60 foot ceiling. Every aspect of the aircraft’s cockpit has been replicated. The outdoor view of the windscreen was incredibly realistic. The avionics, the seats, the power systems, the air vents, the communications systems, the landing gear. Everything was made to feel and sound like the real aircraft. When you lower the landing gear, the sound of the wind rushing past the the open wheel bay is clearly audible in the cockpit, just like on the real aircraft. The entire simulator is on 3 axis hydraulics and is capable of replicating most of the physical aircraft attitudes.  When you taxi on the ground and the turn is too radical, you feel the forces and the skidding of the nose wheel.  If there is a rut on the runway, you feel it in the shaking of the entire simulator. When you make mistakes, the systems on the aircraft. When my son simulated a landing with an engine failure, the hard landing was physically jarring, just like a hard landing on a real aircraft.  Pilots use simulation to replicate test conditions that are not easily found in the real world. If you are training and practicing how to land with a nose gear failure, the simulator is the perfect tool. Using the real aircraft would be difficult, unsafe, and incredibly expensive.   The learning process requires us to make mistakes. That’s how we learn.  I was on a final approach and my sister advised me to pull up. Her direction put me above the glide slope. It was her mistake, but it could have been mine. We reset the simulation about 4 miles back and re-ran the landing sequence. When I had control of the aircraft, I was routinely making small mistakes in controlling the aircraft. But I was able to correct them easily and the consequence of these mistakes was that I made fewer and fewer of them as I improved.  Flying a plane is full of metaphors for real life.  On the investor summit at sea, we had a group of about 40 people playing the game Cash Flow together, under the direction of Robert Kiyosaki, the inventor of the game. Cash Flow is a simulation.  It gives you the chance to make offers on properties, to borrow funds, to sell assets, to spend money on luxuries, all the things that are present in real life. In the game, errors in accounting cause delays in the game, just like in real life. In the simulation, the increase in interest rates can cause financial hardship, just like in real life.  In the game, some people thought the idea was to compete against the others, more like in the game monopoly. They were going to do it all by themselves. Others had the idea to collaborate and help each other. Just like in real life, whatever beliefs you have at home show up in the game as behaviours, and they show up in business. How often do we run simulations in our own business to train ourselves? I see rookie investors go out and randomly buy a property. There is little in the way of guidance. It reminds me a lot of jumping into the cockpit of a live aircraft with little to no instruction, and hoping for the best. 

Peter Schiff is a well known author, economics commentator, fund manager, and radio host. His show, the Peter Schiff Show is consistently among the top business and economics shows. He's a frequent guest commentator on TV. He's the principal at schiffgold.com and now lives in Puerto Rico with his wife Lauren and his two children.