The Real Estate Espresso Podcast

Brad Smotherman specializes in notes and creative financing. His take on how to use creative financing to generate revenue streams out of properties that are in financial distress is utterly fascinating. You will definitely want to pay close attention to what Brad has to say. You can reach Brad at bradsmotherman.com.

How would you like the government has your home ownership partner? This week the Canadian government announced a new program that as far as I know is the first of its kind in the world. The measure would make it easier for first time home buyers with household incomes less than $120,000 per year to buy a home. But in this case, the government would register a lien against the equity in the home, and not just the debt.  Under the program, the buyer would bring a 5% downpayment in the form of equity. This is the same as the ratio loan currently offered by our federally owned mortgage insurer. The Incentive would allow eligible first-time home buyers who have the minimum down payment for an insured mortgage to apply to finance a portion of their home purchase through a shared equity mortgage with Canada Mortgage and Housing Corporation (CMHC). It is expected that approximately 100,000 first-time home buyers would be able to benefit from the Incentive over the next three years. Since no ongoing payments would be required with the Incentive, Canadian families would have lower monthly mortgage payments. For example, if a borrower purchases a new $400,000 home with a 5 per cent down payment and a 10 per cent CMHC shared equity mortgage ($40,000), the borrower’s total mortgage size would be reduced from $380,000 to $340,000, reducing the borrower’s monthly mortgage costs by as much as $228 per month. Terms and conditions for the First-Time Home Buyer Incentive would be released by CMHC. CMHC would offer qualified first-time home buyers a 10 per cent shared equity mortgage for a newly constructed home or a 5 per cent shared equity mortgage for an existing home. This larger shared equity mortgage for newly constructed homes could help encourage the home construction needed to address some of the housing supply shortages in Canada, particularly in our largest cities. The terms of the announcement are not completely clear. From what I understand, Functionally, it's more like an almost interest-free loan — one where the repayment plan doesn't require any payback until years in the future. The Government budget document is far from clear on how much the buyer would owe; is it the same dollar amount the CMHC provided up front, or does the bill go up based on how much the house has appreciated in value?  Government officials say details of the plan will be hashed out in the coming months. I really don’t know how I would feel about having the government own a portion of my home. In my case, I am not eligible for this program because I’m not a first time home buyer. 

David from Seattle asks. Your recent episodes on the Fed and the worrying size of their balance sheet are timely but also quite unnerving. Given the potential strong inflationary pressure in the coming years, two popular hard assets come to mind: gold and real estate. In terms of cash flow, gold bars generally don't cash flow, whereas apartments can cashflow very well. Moreover, fixed rate mortgage carried by most real estate also works for the owner under high inflation. On the other hand, physical gold is free of counter party risk, whereas real estate might have some limited counter party risk (e.g. from the mortgage). Which one is "better" in hedging against inflation? How should investors think about their asset allocation between gold and real estate as we head into inflation or even stagflation?  I like how you've addressed gold and real estate in depth separately in many other episodes. I know quite a few investors have this gold vs real estate debate, and hence the question. David, that’s a great question. I’m left feeling like it’s a little like asking which is better for you Broccoli or Tofu. The truth is you need both vegetables and protein. It’s not really a choice between one or the other. Rather it’s a question of proportion.  You are correct in stating that gold has no counter party risk. For those who don’t know or don’t remember what counter party risk is. If I loan you money, that loan shows up as a liability on your balance sheet and as an asset on my balance sheet. However, it remains as an asset as long as you repay. That asset is said to carry counterparty risk. The reason the financial system nearly collapsed in 2008 was because of counter party risk. Holding the physical metal has no counterparty risk. If you hold gold certificates, you are holding a claim on gold. That claim is subject to counterparty risk.  In terms of creating long term wealth, real estate is an effective hedge against inflation. As you pointed out in your question. I firmly believe that governments are under-reporting inflation. Not only are there multiple reasons for them to do so, there is ample evidence that they are in fact under-reporting inflation.  We don’t typically leverage our ownership of precious metals. Whereas real estate is much better suited to leverage. Here too, the leverage must be responsible. Too much leverage would expose you to financial risk. But generally speaking, with income producing assets, leverage can be your friend. Inflation increases rents. Inflation pumps up asset prices.

On today’s show we’re talking about a strategy for creating value in expensive markets. In some of the most expensive cities in North America, cities are increasingly charging development fees or impact fees for new construction. These fees pay for paving new roads, for the cost of expanding water, sewer and public transit infrastructure. The rationale is that urban expansion costs money long before the new properties are completed and contributing to the expanded property tax base. So development charges, levied against the developers makes sure that the cost of these expansions are covered by those who stand to profit the most from the growth. In these expensive markets it can sometime be difficult to make the numbers work for new construction. When you add the cost of the development charges, a new home can be extremely expensive compared with resale homes in the marketplace. This is particularly true for the smaller player who doesn’t have the economies of scale of a larger builder. The methods to make money in these conditions requires much more creativity than a simple flip project.  The first strategy is the increase density with accessory dwelling units, sometimes called in-law suites. This might be a basement apartment, or sometimes a carriage house if your local zoning allows for a separate building on the property that takes its utilities from the main house.   But remember, the development charges only apply to an increase in density. If the property had a single family home on it, and the finished product is still a single family home, then no development charges apply. You haven’t increased the density.  Some single story ranch bungalows simply don’t have the flexibility to be transformed into a modern home that the market would embrace. Many investors consider a complete tear-down and rebuild if the existing home is functionally obsolete. There is a middle ground solution that can save a lot of cost and still deliver a new home. That is the so-called pop-top. This is where you cut off the roof, demolish the interior and utilize the existing foundation and footprint of the home as a basis for a new two-story home.  You get to re-use the foundation which saves about $40-50k off the cost of construction. By re-using the utilities coming to the home, you save about $20k-30k in utility servicing costs. Compared with new construction, the savings of the foundations and utilities can generate considerable profit for the home builder.  The ground floor layout will be completely redesigned. You can create large open spaces that are consistent with a new home of today’s vintage. The structural supporting walls, columns and beams for the upper level can be easily incorporated at this time. The second level will house the bedrooms and bathrooms.

Today’s show is focused on the consequences of the shrinking middle class. If you go back to the 1960’s and 1970’s it was possible for a single income family with blue collar employment to join the ranks of the middle class. Today, the number of two income families has grown and families are finding it harder than ever to make ends meet. The shrinking middle class has enormous economic and social consequences. It’s has given rise to a new wave of socialism as the average person feels like they’re getting the short end of the stick.  The Organization for Economic Cooperation and Development defines the middle class as comprising households with incomes between 75% and 200% of the median. Across member nations, the proportion of the population who are in the category has fallen over the last 30 years, from 64% to 61%. Today the middle class makes up 50% of the population.  That definition of middle class doesn’t really tell the full story. It neglects family size and local cost of living. The fact is there has been an continual erosion of our purchasing power over the years. Those on fixed incomes are the ones who are losing the most. We can learn a lot from history. We are facing a growing class warfare where those with less blame those with more for their situation and for exploitation.  I don’t believe that entrepreneurs are to blame for the plight of those who are struggling. Entrepreneurs and business owners struggle too. The vast majority of them suffer setbacks on a regular basis. Only a few manage to rise above water to build sustainable businesses and sustained wealth. The problem with the tax the rich approach is that it works to a point. Once you reach a threshold of pain, the ultra-rich have the financial means and the incentive to organize their affairs in a manner that legally minimizes their tax liability.  Many will simply relocate to a lower tax jurisdiction.  There is no question that people who have succeeded in business have attracted envy, admiration, and most importantly jealousy. It’s that jealousy, combined with the genuine hardship that many families are experiencing that has fuelled the latest round of anti-rich sentiment. Increasingly, newly elected left leaning politicians want wealth taxes, dramatically higher income taxes, corporate taxes, surtaxes, and so on.  The amount of economic activity has been a larger contributor to tax revenue than the actual tax rate. As individual investors we don’t control the political climate, nor do we control the tax rules.  Entrepreneurs generate economic activity, they give people employment, they create better living spaces for families to grow and thrive, and they should be rewarded for taking those risks along the way.  The tax code does not tax you on your income, it taxes you on the manner in which you receive your income. Pay close attention to not only your income, but how it comes to you. Be prepared for lots of changes to the tax rules in the coming years as governments become increasingly desperate and creative for ways to pull more revenue.

Today is another Ask Me Anything episode. Robin from Ottawa asks. “How do you build relationships with high net worth individuals? In your book Magnetic Capital, this is one of the primary factors you touch upon. Let's say you meet an individual at an event and exchanged cards/contact information, what are the next steps?“ Robin, This is a great question. It’s one that I get frequently. In fact, if I do an updated edition of Magnetic Capital, I will certainly dedicate an entire chapter to answering that question.  Let’s go back to the fundamentals of raising capital that are clearly outlined in my book Magnetic Capital. Relationship Trust Results Compelling Opportunity Alignment  If you don’t have a perfect fit between the goals for the money and the goals for your project, it’s not going to work.  The main thing to remember about high net worth people is that they are people too. They have different perspectives and different values because of their circumstances. They recognize that their most valuable resource is not money, but time. As a result, high net worth people tend to be much more time conscious than the average person. They don’t want to develop relationships with people who want them just for their money. They don’t want to be used.  They also don’t want to waste time with people who can’t help them with their mission.   High net worth people are slow to develop relationships. High net worth people know how to make money. They know how hard it is, and they don’t want to have to go back and do the hard work to make it back. As a result, they are much more focused on safety and preservation of capital. You will face a lot of scrutiny and due diligence from high net worth people. These relationships take time to develop and do not happen quickly.  In terms of how I build these relationships, it comes down to one simple characteristic. I approach high net worth people as peers. I approach them with confidence and with humility. I work quickly to establish rapport with them by showing them that I understand their world, but not in a presumptive way. That’s a subtle but important distinction.  One thing that helps me in that regard is that I’m incredibly well traveled. I’ve been to a lot of places in the world and chances are good that I can start up a conversation about somewhere we’ve both explored. That’s a pretty safe bet. I do my research and find out as much as I can about a person before I meet them. We probably know some people in common.  People who don’t have money look at the ultra-wealthy as having it made, as if they don’t have a single care in the world. Nothing could be further from the truth. They too are constantly learning, evolving, developing, figuring things out. The ultra-wealthy circulate in a community that spills opportunity at every turn. These people are inundated with opportunity. If they don’t focus, they will become time and energy bankrupt due to 1000 inquiries. They have to become very good at saying no. It’s a matter of survival. The key to breaking through that barrier is to show that you’re mindful of their time and energy management challenge. If you have a phone call with them, keep it to 10-15 minutes, no more. Communicate in a way that pierces through the noise and gets to the heart of the matter. It won’t be rude. They will respect you for it. You’re speaking their language. That doesn’t mean skipping steps in the relationship building process. That’s creepy. It means communicating in a concise and insightful way. 

Today's conversation is a lunchtime discussion about how to negotiate development projects and some ideas on how development deals can be structured.  Enjoy...

Brien Lundin is the publisher of The Gold Newsletter, the foremost publication and oldest on precious metals. He's also the promoter of the New Orleans Investment Conference, the longest running investment conference in North America, now in its 45th year. Today we're talking about interest rate policy, government printing of money (quantitative easing), and the demand for gold on a global basis.

Today’s show is my perspective on the college admission scandal that has been grabbing headlines across the US. At the center of the scandal is a Rick Singer, a former Canadian football League player who has more recently been in the speaking circuit and working as a college admissions consultant. Fifty people, including 33 parents, were charged last month for their alleged roles in a scam by which California college-admissions consultant William “Rick” Singer said he helped get their children into selective schools either by creating fake athletic profiles and bribing coaches to list the students as recruited athletes, or boosting their ACT or SAT scores by having someone fix their wrong answers.  Here’s the problem with the whole story. Who was really harmed by all of this? Some people say that the students who legitimately should have been accepted to these elite schools are the ones who were harmed.  I have a different view. The parents who engaged in this deceit have hurt their own children. I believe that children learn by modelling the behaviour they witness. Rather than teach their kids to work for their accomplishments, the parents are leaving the field open for their kids to create several unhelpful interpretations. You can take a shortcut in life when things don’t work out the way you want them to. The parents don’t have faith in their child to succeed on their own. The kids could spend their entire lives thinking they’re a screw up and will never measure up. The optics of graduating from an elite school is more important to the parent’s ego than the substance of living a happy and fulfilled life. At that point the kids stop being human. They become an object for the purpose of satisfying the parent’s ego.  There is so much about this story that is screwed up on so many levels.  A university education is a valuable step in many people’s lives. But it’s not everything. In fact, numerous studies have shown that graduating near the top of the class from a smaller lesser known school results in better life outcomes than graduating in the bottom half of the class from an elite school.  It comes down to reinforcing beliefs. If you are doing well in high-school, you might represent the top few percent in your class. When you get accepted at Harvard, you might be at the bottom of your class and still represent the top 0.1% of the global student population in terms of academic achievement. But if you spend 4 or 6 or 9 years at the bottom of your class, the message is you’re a screwup. When kids are in their formative years, developing self reinforcing patterns of high self esteem is incredibly important to constructive life outcomes.  Let’s frame this story in a larger context. In 2017, Kessler international published a study based on a survey of 300 students. The survey found: 86 percent claimed they cheated in school. 54 percent indicated that cheating was OK. Some said it it is necessary to stay competitive. 97 percent of admitted cheaters say they have never been caught. 76 percent copied word for word someone else's assignments.. 12 percent indicated they would never cheat because of ethics. 42 percent said they purchased custom term papers, essays and thesis online. There is something wrong with our culture that places more emphasis on the appearance of credentials than the substance of actual education. The education is the real knowledge, wisdom, perspective, and resilience that comes from integrating experience gained on the journey of life. 

On today’s show we are asking the question is flipping a legitimate form of real estate investing? A lot of people enter the world of real estate investing because they are drawn by the lure of mailbox money. They are drawn by this thing called passive income.   Well folks, money comes in one of three ways. Earned income Residual Income Capital Gains Most of the wealth in the world has been created through a combination of #2 or #3. The simple test of whether what you’re doing is earned income is to ask a simple question: "If you took two months vacation, would the business come to a stop?"  If the answer is yes, then you’ve just purchased a job. It might be a job with greater freedom than being chained to a desk. But it’s a job nevertheless.  It gets confusing because sometimes a job requires investment of capital to do the job. Just because it requires investment doesn’t make it the same as investing. It’s the presence of that active component that makes it more like a job.  I know a number of professional volume flippers. They perform anywhere from 20 to 1,000 homes per year. Once you put some scale behind it and it becomes a self sustaining business, there is dedicated staff in each of the key roles. You have acquisitions specialists, construction managers, sales people, a legal team. At that point the business owner can step away from the business and the business will continue to run itself. The cash generated by that business falls into the category of residual income. But it’s business income, not passive investment income. The properties are held for as short a time period as possible. The profits are unlikely to be considered capital gains.  So is flipping investing? My answer to that question is no. It’s a business, like any other active business that produces a product. It’s the same as a bakery, or a business that manufactures children’s toys. It takes in raw materials and manufactures a new product which gets sold. That product happens to involve real estate and buildings. The raw materials consist of an existing property that is in some level of distress. You add new materials, some design sensibility and transform as property that was less desirable into one that the market really wants.  You need money to fund the inventory for the manufacturing business. If you’re baking muffins, you need to buy flour and yeast and all the other ingredients. If you’re product is toys, you may need to invest in the manufacturing capacity, and purchase the raw materials. Flipping houses is exactly the same. It’s more like a manufacturing business than an investing business. Yes, the numbers are bigger because the sale price is not under $10, the sale price is in the hundreds of thousands. It’s a high price low volume business. An effective bakery would probably be a low price high volume business.