The Real Estate Espresso Podcast

On today’s show we’re examining the idea of seeing over the horizon.  The horizon is the distance that you can see before the curvature of the earth obscures what is just a bit further away.  Generally speaking For an observer standing on the ground with h = 2 metres (6 ft 7 in), the horizon is at a distance of 5 kilometres (3.1 mi). You can’t see over the horizon. But that’s not the only horizon that exists. We as humans construct many artificial horizons. There are horizons in time. There are financial horizons. There are career horizons.  There are horizons in the game of chess. Some chess players only think one move ahead.  World class grandmasters can see anywhere from 15-20 moves ahead.  It is said that Garry Kasparov knew he had lost a game 11 moves before he was ultimately defeated. The horizon for Garry Kasparov is substantially further than for most other chess players.  You may know some people who only plan a few days ahead. That is their planning horizon. The real horizon is what is within our line of sight. If you’re lying on the beach you may be able to see only a few hundred yards or meters. Someone standing upright at a height of 6 feet or a couple of meters, they can see about 3 miles or 5 km. But for an observer standing on a hill or tower 100 feet (30 m) above sea level, the horizon is at a distance of 12.2 miles (19.6 km). How hard is it to find that higher vantage point so you can see further? Often all it takes is a conscious decision to seek out that higher vantage point so you can see further.  Often all it takes is a decision to plan further into the future. There is no real obstacle. Yes, you may have to make some assumptions about how the future will unfold, but these can often be reasonable assumptions.  But then there are people who seem to have the ability to see around corners. Do they have supernatural powers?  Not really. What they have is experience. They can draw upon a history book of past projects that have similar metrics in terms of cost, schedule, resource requirements, and risks. They have relationships with experts, mentors and consultants that they can draw upon to help double check their assumptions. Each one of these steps creates a higher vantage point enabling you to see further, to extend the horizon, and to ultimately see past the horizon. 

This month’s book is a 600 page classic called “The Creature From Jekyll Island”. The subtitle is “A Second Look at the Federal Reserve”, by G. Edward Griffin. The subtitle really tells the story of what the book is about.  The fact is, very few people really know what the federal reserve is. Most think it is an arm of the US government. The fact is the Federal Reserve Bank is neither federal, nor has any reserves.  If you’re going to be a player in this game called business and you care at all about money. Then you might want to invest some time into learning about what money is, where it comes from, and what some of the rules are that govern our financial system. If you’re playing a game and you don’t know the rules, well then, you probably won’t win the game. In fact, you might get crushed.  I know what you’re thinking. “I know everything I need to know about money”. How complicated can it be? How will knowing a bit of history help me with my money problems today? I’ve had the pleasure of getting to know the author G. Edward Griffin over the past several years. He’s one of the gentlest of gentlemen you could ever meet. He has been a documentary film maker for much of his life.  This story begins late at nigh in a New Jersey railway station in 1910. The trains at that time consisted of coach cars immediately behind the locomotive which belched out massive quantities of thick black smoke that would infiltrate the guest accommodations through the unseen cracks. After that was the dining car, and then after that were the sleeping cars with the hard upper and lower bunks that made up the better class of service. At the very back of the train was a private car that was a 5 star rail car with the finest in furnishings and mahogany paneling. The name Aldrich was stencilled on the side of the car. Aldrich was senator Nelson Aldrich from Rhode Island. Aboard this last car were 7 men who represented about one fourth of the wealth of the entire world at the time. Nelson Aldrich was chairman of the national monetary commission, a business associate of JP Morgan and father in law of John D Rockefeller Jr. Some of the others aboard the train were: Abraham Piatt Andrew - Assistant Secretary of the US Treasury Frank Vanderlip - President of the National City Bank of NY Henry Davison - Senior Partner at JP Morgan Charles Norton - President of JP Morgans First National Bank of NY Benjamin Strong - head of JP Morgan’s banker trust  Paul Warburg - a representative of the Rothschild banking dynasty in England and France. His brother was Max Warburg who was head of the Warburg banking consortium in Germany and the Netherlands. This clandestine trip to Jeckyll Island in Georgia was for the purpose of creating a new solution to the banking system’s problems, but this time owned and controlled by the banks, and legally sanctioned by the US government.  The genesis of the book was a quest to create a documentary on the origins of the Federal Reserve. As Ed Griffin researched the works of prior authors, he became more fascinated with the topic. This culminated in Ed making his own trip to Jekyll Island in Georgia. There is a small museum on Jeckyll island where you can visit and see some of the original documents that date back to 1910. It was here that the uncomfortable truth was laid bare. The story of the history of the Federal Reserve is an unpopular one, because its uncomfortable. But unless you know that what we call money isn’t actually money, you won’t understand the rules of how to play the game. 

Joe Quirk is one of the founders of SeaSteading.org and the author of the new book "Seasteading". I got spend time with Joe over the past few weeks and learned more about his project. The first fully autonomous seastead is now floating 12 miles off the coast of Thailand. This idea is groundbreaking and is at the frontier of human and societal exploration. While it's not mainstream yet, the concept challenges many closely held beliefs. I believe that expanding the mind is always a valuable exercise. Check out this very special episode.

On today's show we're getting George's perspective on two of the latest stories in the news. 

Jonny asks: "I invest in single family rentals in several different US markets. Most are midwestern conservative and stable environments with steadily growing populations and economies - there's modest appreciation, but solid and dependable cash flow. The outlier is Chicago. I enjoy the very strong cash flow I receive from Section 8 tenants, but the impending pension crisis presents a precarious situation in the future. Chicago's pension situation looks abysmal with a future reckoning not far away. While I see this down the road and pause with concern, I also know that there are few states and municipalities without a pension dilemma. The perenial question "Compared To What?" comes to mind. Also, even if there is a pension crisis that becomes fully actualized, people will still fundamentally need housing. Is this a matter investors do need to consider regarding long term buy and hold strategies or is Chicken Little saying the sky is falling?" Jonny, that is a great question. My response is based on my personal experience and you should take my response as a point of view , or an opinion, not as the gospel. With that disclaimer, here goes. One of my cardinal rules is to invest in growing markets. I like influx of jobs and influx of population. Both Chicago and the State of Illinois have lost population in the last several years. Illinois lost 115,000 population last year. That means that both the state and the city are experiencing a falling tax base. Cities like Chicago are struggling with meeting the obligations of their entitlement programs, whether they be public housing, pensions, education, infrastructure maintenance, or public transit, all of these aspects can place huge demands for money on the city. The City of Chicago has been so desperate for cash, that they sold their parking meter business to a private company. The private company paid a little over $2 billion for the right to collect parking revenue in the city of Chicago for the next 20 years. Shortly thereafter, parking rates in Chicago skyrocketed. Anyone with basic math skills figured out that the city did a bad deal and that the buyer of the parking meter business is on the path to tremendous riches. I had some section 8 tenants in my properties in Chicago. The Chicago Housing Authority does pay a premium over market rent to landlords who except tenants with CHA vouchers. However, while these numbers look great on a spreadsheet, the extra $150 per month in rent did not cover the higher costs associated with meeting the extra ordinary demands made by CHA inspectors, nor to cover the much higher property maintenance and property damage costs incurred by many section 8 tenants. We had experiences that should never happen. We had tenants who would smash the electrical cover plates on the outlets and then lodge a complaint with the housing authority that we were not properly maintaining the property. The Housing Authority with then fine us one month rent and refused to pay rent until the repairs were made. So we would lose $1,500 in rent because the tenant intentionally damaged about five dollars worth of electrical cover plates. That was one of many situations that made no sense whatsoever. The tenant did not benefit financially from this action. It was purely destructive action and we could not find any financial gain for any of the parties. When cities are strapped for cash, they experience deferred maintenance. People don’t like to move into cities with crumbling infrastructure. Its not just about pensions. It's about how the city will manage itself financially, and will people leave as a result.

We’ve all heard about the benefits of diversification. Don’t put all your eggs in one basket. You might have heard a family member preach about it. On the other hand, if your eggs are in one basket and guarded really well, then you will have a greater amount of control over your investments. I had an in depth conversation with an investor this week who had made the decision to diversify his holdings across nine assets, many of them in separate geographies. All of a sudden, within a short period of time, several of them were under-performing at the same time. Diversification was supposed to protect him against that.  I’m a big believer in diversification, but only as a secondary strategy. It’s lower priority than making sure you have a critical mass of assets under the watchful eye of a competent management team.  Another investor I know well purchased multiples properties at the peak of the downturn. They were all bargains. But here too, they were spread across multiple markets. It wasn’t long before all five properties were performing poorly. Eventually it took hurricane Sandy to hit NYC and Atlantic City to create a success. The city was so impacted by the hurricane that suddenly her property which was undamaged, became in high demand. By comparison, I’ve always believed in concentration of assets until you achieve optimum performance. The key item in the success of a property is not the property. It’s the management of the property. All too often I see investors focus on the physical asset. I can tell you from first hand experience that my worst investment experiences were bargains that were mismanaged. Management quality trumps asset price almost every time. If you own rental property, even if you have it professionally managed, you will need to get the attention of your property manager. The relationship you have with your property manager is a critically important relationship. I like to talk with my property managers every week, sometimes multiple times per week. But if you only have one or two units with that property manager, that frequency of communication will be burdensome for the property manager. They will look at you like you’re a nuisance.  I believe that the ideal ratio of units to property managers is somewhere between 75:1 and 150:1. It’s somewhere in that range, depending on the type of asset. If you have 75 units with a property manager, then it’s perfectly acceptable and appropriate to speak with them once a week. You can focus your energies and your attention on that single property management relationship. 75 units starts to look like critical mass. Once you grow beyond a single multi-family property with a large number of units, you can then consider diversifying.  If you look at much of the real wealth that has been created in the world, there has been very little diversification. The Zuckerberg family is firmly focused on Facebook. If they had divided their time and attention between Facebook, real estate, oil and gas, and restaurants, they would be nowhere close to having accomplished what they have.  Diversification is important, but it’s a distant second in importance to having the business properly managed.  

Last week the federal Reserve announced its interest rate guidance for the current period and for the remainder of the year. Back in December the federal Reserve increased short term interest rates by 1/4 of one Percent. At the same time chairman Powell also forecast three rate increases for 2019. In a stunning reversal, the federal Reserve is holding rates steady and is forecasting no further increases in 2019. Last week the Bank of Canada also announced that it was holding rates steady.  The European Central Bank also has kept rates study at essentially zero or negative interest rates.  All of this is against a backdrop of slowing economic activity on a global basis. The growth forecast of the US economy has been revised to 1.75% to 2% this year, down from the last estimate of 2019 growth at 2.25%.   Central bankers have been using interest rate policy to engineer the so-called soft landing. Briefly raising interest rates would prevent the economy from overheating. It would also give the central bank a tool with which to stimulate the economy should it slow down.  Europe has lost the ammunition to stimulate the economy. By maintaining rates low, they have nowhere to go. Printing money is the only tool they have left. They’re going to try it, but it hasn’t worked so far. I see no reason for it to work now.   Here in North America, all of this is good news for real estate developers. One of the biggest risks that we face as developers is the uncertainty of interest rates once a construction project is completed. However, a period of interest rate stability makes it much easier to budget and model in the future. Construction projects are typically funded by construction loans only during the construction phase. Upon completion of leasing, the projects are typically refinanced into permanent fully amortized loans. Without knowing what interest rates will be in 18 months time when the project completes, it is difficult to forecast the operating model for the project with permanent financing. Now is the time to take advantage of these low rates and lock into permanent financing for as long as you can. 

Today’s episode is the story that started for me back in 1974. For two years in a row in 1974 in 1975 I visited Caracas Venezuela. I was 11 years old and I was struck by the huge contrasts in the city of Caracas.  The city is in the centre of a valley surrounded virtually on all sides by tall steep hills.  In the centre of the valley floor was a bustling modern city with freeways, and tall modern buildings. Surrounding the city lining the Steep hill sides were thousands and thousands of makeshift shelters where the poorest people were living in absolutely horrible conditions.  Our family became friends with an older couple who lived in Caracas and we traveled with them on several trips over the subsequent years. One of the frequent topics of conversation at that time was the inevitable social, economic and political unrest that would likely result if the economic disparity in the society was not properly addressed.  Fast forward to today and Venezuela is in economic collapse. The gross domestic product has fallen by more than 60% in real terms. The government has been trying to solve its financial problems by printing money. Inflation has been replaced by hyperinflation. In January of 2019 alone, inflation was 345%.  Today a school teacher earns enough money in one month to afford a carton of eggs and 2 litres of milk. About 3M people have left the country. Those who have left are sending money back to family members who have remained in the country. On average, the Wall Street Journal is estimating that the average money going back to family members is about $80 per month. But those funds are in US dollars which is rapidly becoming the black market currency of choice.  It took 45 years for the economic collapse to happen. We foresaw saw it back in 1974. Venezuela was a relatively vibrant country with lots of natural resources.  It’s really easy to be complacent and dismiss Venezuela or Zimbabwe as distant lands with their own issues.  Zimbabwe was previously Rhodesia. My family lived in Rhodesia before things became politically unstable there. We need to be students of history. Every time a country has debased its currency, it has ended in disaster. It happened to the Roman Empire. It happened in Germany. It happened in the United States prior to the signature of the US constitution.  It has happened in Zimbabwe, Argentina, and now in Venezuela. The headwaters of those disasters look just like the conditions in the US, Canada, and the European Union.  I don’t know if we have 45 years until the runaway train of inflation and economic contraction happens here in North America. 

The more you know about your potential customers, the better you can target your offer to the needs of your customers.  People make a number of life decisions that alter their demand for housing. Housing is so much more than a dry roof over your head. Children grow up and move out on their own. Some will move to be walking distance from a university. Maybe they lose their employment and move back home. The decision to get married and start a family. Sometimes its the decision to end a relationship. People sometimes move due to the loss of a loved one. They move to experience a different climate. They move to experience a different culture. They move to escape persecution. They move for employment. They could move because of a health reason. They sometimes move to create a fresh start. They may move to care for an ailing family member. They could move to be closer to friends. They could move to be closer to the action. Maybe to be closer to recreation. They could move to get away from the pace of the city. They might move to save money. Some will move to create the home of their dreams. They might move to make room for a growing family. They might move to start a garden. They might move because they’re tired of caring for a garden. They might move to have a home that can be left vacant during periods of extended travel.  Every one of these reasons could bring housing requirements unique to the reason for moving.  The averages are a fog that make it impossible to see what is really happening at a tangible granular level. If you’re looking at a 5% vacancy rate in the market, that number could obscure what is happening in each of these specific market segments.  You have no idea whether there is a shortage of housing within walking distance of the university if you’re stuck in market averages? You don’t know whether there is a surplus of 3 and 4 bedroom units and a shortage of 1’s and 2’s.  The more you know about the needs of your clients, the better you can market to them. Someone with health problems might not be able to navigate steps and would prefer a single story home. The averages tell you nothing about homes with stairs.  If you’re looking at cancelling your commercial office lease and working form a home office to save money, you may need a larger home. The averages tell you very little about the suitability of a property for a specific customer.  When you understand who your target customer is, you can better package your final product. The features of the finished product can be tailored to meet the needs of your customer. If your target is families with aging parents, a separate accessory suite might be the perfect feature. The market might have 5% average market vacancy, but absolutely zero inventory for properties with accessory suites.  Averages are for businesses that don’t care to know their customers. When you go to the average grocery store for average customers and buy a head of lettuce, they know how many lettuce they sell per day on average. They know how many cases of Coke they sell each day. These are completely anonymous transactions They don’t know who is buying it.  But when you go to whole foods and you give your amazon prime number for a discount, they know that if you bought a head of kale lettuce, you’re probably going to buy tofu. They know that you won’t buy a Coke, and they know where you live. That’s a level of detailed knowledge about the customer that few other businesses have, and it’s the reason why Amazon continues to grow so quickly and virtually dominate every segment they choose to enter. They dominate because they know their customers so much better. 

Todays' episode is a discussion on whether to build versus buy.