The Real Estate Espresso Podcast

Sep is a multifamily real estate investor who has made an unusual transition from multifamily to portfolios of single family homes. When I first heard about the transition, I was a little skeptical. But the rationale for the shift makes sense and is sound.  Sep has dealt first hand with the difficulties of managing economically challenged properties in rough neighborhoods. That learning has shaped his current investment choices. Many investors have made the same mistakes in some form. I love his willingness to share his mistakes so that all of us can learn from them. 

I’m coming to you on location from the 17th annual investor summit at sea. This annual event is like no other. Every night, I’m seated with a new group of investors at my dinner table. One of the frequent questions that I ask people at my table is “What are your goals?” The typical story goes something like this. They have a full-time job. They like what I do, but I’m ready to change careers in favour of something with passive income. So They’ve started buying a few rental properties. They haven’t figured out how to scale up beyond a few properties. Each of the properties are a lot more work than they anticipated. They don’t have the investment capital to buy a larger multi-family project by themselves.   In talking with a number of people at length over an extended period of time I’ve noticed a few trends. I can broadly put the investors on board the summit at sea into four major categories.  there are the beginner to intermediate investors who are still working as employees in their day job and moonlighting with a small rental portfolio, trying to figure out how to transition from their current life to one where passive income has replaced their employment income. There are investors who have decided to become the full-time operator of the business. They have traded their day jobs for the role of a small business owner. They have recognize that owning a portfolio of properties is not a passive endeavor. It takes a lot of work. They have reached the limits of scalability not only based on capital but based on time. They’re still on the hamster wheel, running faster than ever before with a larger number of the small projects. Number three there are full-time investors and developers who have decided to focus on larger projects. He’s larger projects or afford the possibility of hiring dedicated full-time staff in all of the critical roles that are necessary to operate the business on a daily basis. The focus of time and energy goes into managing the project but not the day-to-day operations. The time and energy is put into growth of the portfolio. Once the projects are complete and they are on auto pilot the dedicated staff manage the daily operations with little to no intervention from the business owner. If at some point in the future I decide to take my foot off the gas and either slow down or stop growing the portfolio, it will be a flow of residual and passive income. My role as the business owner focuses on making sure the right people are in the right roles. I’m focused on building the organization. This is not that different from a senior role in corporate America. The fourth and final group have figured out that managing all these projects is a ton of work. We have decided to focus their time and energy on selecting a handful of high-quality operators who they trust the building management portfolio. And that you to invest passively in private syndications. These are the same types of projects and investments that large family offices of the wealthy and ultra wealthy invest in. 

Back in November, Californians voted on a proposition to eliminate the current state wide rent control legislation that was enacted in 1995. California’s rent-control regime is governed by a state law called the Costa-Hawkins Rental Housing Act. It prevents cities and counties from imposing rent control on single-family homes or apartments built after 1995, among other prohibitions. The law also froze rent control rules in cities such as Los Angeles that had policies before Costa-Hawkins was implemented. By repealing Costa Hawkins, it would leave the field wide open for individual cities to implement their own rent control rules.  The defeat of the proposition by a vote of 60% in which voters rejected the initiative and landlords spent $100-million-plus in a campaign to sway public opinion.  The state government is trying again with a new set of measures aimed at weakening the Costa Hawkins rules. About 9.5 million renters — more than half of California’s tenant population — are burdened by high rents, spending at least 30% of their income on housing costs, according to a UC Berkeley Study. The authors of the study are recommending rent control again, at the same time they acknowledge it will not solve the problem of inadequate supply. 

I'm coming to you live from The Investor Summit at Sea. This is an event like no other. It's here that you have the opportunity to learn from some of the biggest brains on the planet. 

On today’s show I want to share a perspective on the world of investing. My mother started an investment holding company back in 1976. She had a portfolio of investments, largely in the stock market. When my mother passed away in 1981, I was 18 years old, I had the task of taking over that investment holding company.  At the time, the conventional wisdom was that you could routinely earn an average return of 10-11 percent. In my world, as a relatively young investor, our target was to invest in primarily high dividend yield stocks like utility companies. They would deliver about an 8% rate of return on their dividends and another 2-3% in long term appreciation. These stable high yield stocks were the so-called granny stocks of the day. We chose these because at the time, my father who would be retiring in the coming 2-3 years would be reliant on the income from the stock portfolio for his retirement income. My sister and I would ultimately become the capital beneficiaries of the portfolio, but my father was the to be the income beneficiary. I was effectively managing a small pension fund for my father as the sole benficary. The market conditions enabled a solid investment strategy at the time. The large pension funds that are responsible for police departments, fire departments, schools boards, public sector employees have had very similar investment objectives as part of their charter.  But the problem is that in the last decade, ever since the 2008 financial crisis, the rates of return experienced by pension funds have been approximately half of what they were in the 1980’s and 1990’s. They’ve been averaging around 5% for the past decade. You don’t need to be a financial wizard to understand that this is a ticking time bomb.  When I talk about stock market yields, I’m not talking about the price of Apple, Facebook, Amazon or Alibaba. Those stocks are not the mainstay of pension funds. They are too volatile and they don’t offer the kind of capital protection that responsible pension fund managers require.  So now if yields in the stock market are falling, investors are going in search of yield elsewhere. In the world of real estate, I can tell you that I would never undertake a project for only a 5% annualized yield. That’s far too risky.  But if you’re coming from the world of public stock investing, and you’re seeing the types of returns that are possible in real estate, you’re probably getting excited. We’ve seen a lot of investors attracted by the stability and the kind of appreciation that is possible through the combination of forced appreciation and leverage. These new entrants have been bidding up the prices for real estate, because by comparison, the stock market alternative is too volatile and less attractive. That’s made it harder for the professional real estate investors like you and I who are not willing to pay too much for an asset. 

This question has been asked so many times by audience members, I'm not going to attribute it to a single person. It's a great question, and the answer is highly situation dependent.  I’ve experienced situations where raising money has been easy, and other times when it has been very time consuming.  The main issue is whether the venture is going to be appealing to the sources of debt financing and the sources of equity financing you are talking to. It’s easy when you get a quick yes. It’s hard when you get a lot of no’s. It means that you need to figure out what is the reason why you’re being declined. Are you talking to the wrong people, or is there something fundamentally wrong with your offer? I strongly believe that if you have a compelling opportunity, your job is to find the money and most importantly make sure you create that perfect fit between the goals for the money and the goals for the project. If you don’t have that perfect alignment, then raising the money is going to be extremely difficult.  For example, sometimes you need to match the type of money to the phase of the project. The cheapest money for permanent financing will almost always be bank debt. The risk premium attached to the debt is a function of risk.  If you’re undertaking a construction project. You might be better off working with a lender who specializes in construction financing. You will pay more for that money in the short term. Once the project is leased and stabilized with an income history, you can then refinance and get very low cost permanent financing on a 25 year, 35 year, or perhaps even 40 year term. But you may not qualify for that financing during the construction phase.  If on the other hand, you look for a conventional lender to fund both the construction and the permanent financing, you will pay a premium because of the added risk, and that higher risk premium might carry forward for the life of the project. You will pay less during the construction phase, but more during the entire life cycle of the project.  Sometimes packaging the investment to have the best possible characteristics during each phase of the project can make the difference between difficult and easy.  Sometimes you may find that you need additional balance sheet strength in order to get a large loan. In that case, you may need to bring a partner into the project with a very strong balance sheet in order to co-sign on the loan. In that case, you’re going to be giving up some equity share in order to secure the debt. That’s different than raising equity money in exchange for an equity share. It’s a fallacy to think that a project is hard to finance, assuming you haven’t made any major mistakes that would make the project broadly unattractive. If a large established developer could do it easily, then so could you. The only difference between them and you is that they have established better relationships than you. They may have more financial capital but they also have greater relationship capital. Relationship capital is the value of their relationships. If an established developer were to lose all their money, it would not take very long for them to make a substantial amount of it back. The reason for that is that they have the relationships.  If you’re like many, you have experienced some success in raising money. But perhaps you have some relationships, but have exhausted the capacity of your existing ecosystem. So you may need to expand your Network of relationships. This means getting out and building relationships that you won’t need next week, but perhaps in 6-12 months, or beyond. 

Quentin D'Souza is a Toronto based investor who runs one of the local Real Estate Investment clubs there. You can reach Quentin at durhamrei.com.  One of his specialties is legal secondary units. These in-law suites are a great way to multiply the revenue and increase the overall value of a property for minimal investment. It's particularly attractive in a high priced markets like Toronto.  

This segment was part of a live meetup in which I shared several real life examples of design decisions that were made to reduce cost without having an impact on quality.   

Today’s show is a personal story of an inner struggle. I’m in the middle of a project and I’m in the process of updating the financial projections based on a revised construction budget, new information about the debt structure, and a more accurate view of the schedule. In the process of updating the spreadsheet I discovered that there were a number of places where numbers had been hard coded into cells, rather than being calculated from variables.  I’ll give you a couple of examples. When you model the effects of inflation on both income and expenses, you could take the numbers from year 1 and increase them by 3% in year 2, or you could increase them by a variable inflation rate. So that if you were to change the inflation rate assumption, you would change a single number and all the inflation adjusted numbers would be updated automatically.  You would want to do the same thing with interest rates for loans, any fees that are calculated as a percentage of another expense and so on.  The other major change was to telescope in on the first three years of the project and model them on a monthly basis rather than an annual basis. There is too much change happening during the first few years of the project for a yearly projection to be accurate.  Needless to say, a lot of the spreadsheet was affected by these changes. The additional layers of complexity come from ensuring that the loan to cost ratio, the loan to value ratio, the debt coverage ratio, and the numerous other constraints of the loan agreement are properly modelled.  These changes took an entire day to implement. I sent the spreadsheet out for review and within a few short minutes, my partner had found a schedule mistake in the spreadsheet. I set about fixing the mistake which meant moving about 20 numbers by 5 months. That’s nearly 100 items that moved in the spreadsheet. At the end of that process, the financial rate of return forecast to our investors looked surprisingly poor.  How could a shift of a few months destroy the financial viability of the project? It didn’t make any sense. My partner and I had numerous phone calls throughout the day to discuss various solutions to the problem. At one point, we were even talking about whether we should sell the project. I spent the next 7 hours pouring over all 10 pages in the spreadsheet, checking formulas, refining estimates, experimenting with different possible solutions. After dinner, I went back to work. After a few more hours I noticed that on one of the pages, inflows of cash used positive numbers, and outflows used negative numbers. But I wasn’t consistent in that convention. On another page they were all positive numbers, and the expenses were subtracted from the income make it all work.  But in the process of converting the spreadsheet to use more formulas, some of the negative numbers started to appear on pages that had previously only had positive numbers. It was at that point when I saw the error in the rate of return calculation. Negative numbers represent an investment of cash and positive numbers represent cash flow back to the investors. Well, my spreadsheet was showing 5 years of negative cash flow to investors. The minus sign was a complete mistake. No wonder the rate of return looked so terrible.  As soon as the minus signs flipped and became pluses, a sense of calm washed over my home, the tightness in my back relaxed, and I could take a full deep breath again. The rate of return to the investors was in the expected range. I sat back and reflected on the past 13 hours spent diligently working on the spreadsheet. I asked myself what would have happened if I had given up after 8 hours of trying to solve the problem. 

If you’re a business owner, would you like to know which country your business is licensed to conduct business in? If you conduct business in multiple countries, would you like to know the rules of engagement for continuing to do so? If you set up your head office in a global financial center hoping and expecting it would act as a gateway to conducting business across an entire continent, would you like to know if that was a good investment? If you live in the United Kingdom and you own a business, you are dealing with all of these questions. In fact you’ve had this uncertainty hanging over your head since June 23, 2016. The day when the Brexit vote took place. The deadline for the UK to complete its exit negotiations from the European Union is at the end of March. On Tuesday of this week the British Parliament voted against the last and final negotiation between the UK and the European Union on the terms of its exit. So we really have no idea what Brexit actually means. We don’t know what it means for U citizens who currently reside in the United Kingdom. We don’t know what it means for British nationals who reside in continental Europe. We don’t know what it means for goods and services that are crossing the English channel. Further complicating matters is the fact that Ireland has chosen to remain within the European Union. There is no hard customs border between the Republic of Ireland and Northern Ireland. This means that for the time being the Republic of Ireland represents a giant back door into the United Kingdom. Many North American companies had set up their European headquarters in London or other cities in the United Kingdom. This has facilitated communications with English as a common language, and has provided companies with a highly educated and skilled talent pool. Here’s the problem that I see with the entire Brexit fiasco. The vote to exit the European Union one by a very narrow margin. It was less than 1%. In the day that followed the actual vote, it was disclosed that the pro Brexit movement had falsified projections and mislead the public on the benefits of departing the economic union with Europe.  After having experienced the steep and dramatic economic fallout over the past three years, it is not at all clear whether the UK population remains in favor of leaving Europe. If a second referendum were held today, I believe a vote to leave Europe would be defeated. So here again we have a political stalemate. The UK is still scheduled to leave the European Union with Ireland remaining. The terms of the exit are unclear. Prime minister may survived a non-confidence vote. But both exit agreements negotiated with European Union were resoundingly defeated by the British Parliament. EU officials have said that the current negotiations represent the best and final offer from Europe.  London lost 93,000 in population in 2016, and 106,000 in population in 2017. In fact over the past 14 years, London has lost approximately 1M in population.  I mean think about that. It’s a huge number. The only other city that I can think of that has experienced a similar loss of population is Detroit. We know what that has done for Detroit. It’s been an absolute disaster.  Since the Brexit vote, real estate prices in central London have dropped an average of 10%. Remember, that’s an average. Many properties have been converted from owner occupied to rentals. The last time I was in London, most of the old homes in central London had been converted into guest houses or hotels.  One thing I can say for sure is that London has not attracted new investment in nearly 3 years. In fact, there has been a marked period of disinvestment. At some point it will represent an opportunity for new investment.