How to Reduce Investment Risk, Part 2

How to Reduce Investment Risk, Part 2

In the second part of this three-part series, Jason Hartman breaks down the different parts of a house and the parts known as “the improvement.” Jennifer, the insurance agent from our last episode, discusses the key to understanding the land versus improvement value. George Gammon gives his experience with a subdivision development.

1374: Reduce Investment Risk With The Jason Hartman Risk Evaluator (Part II)

Jason Hartman 1:09
Thank you for joining me for Episode 1374 1374. It is an amazing time to be alive and floating on the ocean. Once again, I’m recording from the ship in the state room here and you can probably hear the howling winds outside and the splashing surf. It’s just great. You know, what’s really interesting is how air I mean, do you ever appreciate air? Enough, right? There’s so many things that we have to be grateful for. But in this in these tropical climates, when the air is just warm and it’s humid and it just sort of, it’s like taking a bath in the air, no water Water not needed. Just the air feels so nice. It’s really great. But then again, you know, another kind of air when we were on the cruise the venture Alliance cruise a couple months ago in the New England area, the fall foliage cruise Princess Cruises there, that air was beautiful in a different way because it was so fresh and crisp. And that full air, they’re both great. Air is just great. I’m going to form a new society called the air society if the real estate thing doesn’t work out, Okay, anyway, today we are going to explore part two of the Hartman risk evaluator again, we are taking a deep dive into the Hartman risk evaluator on these three episodes, a three part series here, remember my definition of an investment. To qualify to earn the word to earn the term investment. What does an asset have? Do it has to produce income, it has to produce income. If it does not produce income, it is not an investment. It is a speculation, George, who is interviewing me on this show that we’re replaying here on this episode, that we’re replaying all three of these. He says that his definition is to be an investment, it has to pay you. If it doesn’t pay you. It’s not an investment. And I agree with that. Essentially, we’re in agreement, we’re saying the same thing. So as we dive into this further, we’re going to talk a little bit more about the appraiser Eric, who came over and appraise my house twice, and see what he has to say as things progress here in the story. Remember the ingredients of the property, the ingredients of that improvement, the improvements sitting on the land, that’s what we are really investing in. Because we are what are we, we are packaged commodities investors, we invest in a set of commodities that is packaged in the form of a house or an apartment building. Maybe if you don’t want to call it packaged commodities, you can use the other phrase I came up with assembled commodities. They are commodities that are brought together and assembled on a work site into a usable, single commodity housing that everybody in the world needs. It has absolute universal need. So package commodities, investing, assembled commodities investing, a very, very good investment, and a very good way to think of our investments in those two components, land and improvement and the ratio of value between those two value drivers. The LT I ratio, the land to improvement ratio. That’s what determines the value and the risk level of any real estate investment. So that’s what we’ve got to think of. Now remember, the LTI ratio is very out of whack. It’s wrong. It’s bad. It’s too high in terms of L or land in cyclical markets. The markets we don’t like the expensive markets, whether they be Honolulu, the west coast of California, on up to Seattle, in Canada, it’d be Vancouver. These markets are all in trouble right now, as we know, it might be Miami, New York, it might be across the pond, it might be Paris, it might be London. even further to the east. It might be Hong Kong or while before you get to Hong Kong, Dubai, right. could be any of these places and several others around the world. cyclical markets have bad LTI ratios. Well, what about the LTI ratio of unimproved or vacant land? What if it’s just a piece of dirt, a parcel with no improvement? What is the LTI ratio on that? Well, it’s 100% l, right? Or 100%, land, land to improvement, there’s no improvement. So it’s all land. So that would be a highly risky investment, because it’s all speculative. Now, as an aside, I want to say one more thing before we go into the Hartman risk evaluator, and this isn’t really related. It’s kind of tangentially related, even saying that might be a stretch, but I don’t want to forget to mention this. I was having a conversation here at my conference it See that’s, that’s what I’m doing this week at this. On this eight day cruise. It’s basically a floating conference. And so we had two sessions today, a morning and an afternoon session.

Jason Hartman 7:06
And yesterday I was having a conversation with a marketing person who’s here we were talking over dinner. And he says that he does marketing and sales leads to a company that we’ve had many of their people, including the founder, Bill Bonner, my favorite financial writer. on the show before I’ve interviewed bill Bonner, that was a real honor. And that is a Gora financial and what’s fascinating is the way they brilliantly I mean, this is an extremely successful company. I love their work. I often disagree with their final conclusion, which largely is by gold, their gold buggy, and I’m not I’m not a gold bug at all. I like income property much more. But what is really fascinating is this and want you to think Think about this as it applies to you as a real estate investor. Here’s what he told me. And this was quite fascinating. He said that they will pay on a cost per action basis. Now in the internet world, many of you know what I’m talking about a CPA cost per action, meaning if the person clicks the mouse and buys the product, how much is that worth, to the seller of the product? Right? That’s the concept. You know, you might think, well, if you’re going to sell a $50 item, a $50 product, you don’t want to pay maybe more than about a third of that cost, in cost per action, or commission, essentially, to affiliates. Hold onto your chair because this is going to blow your mind. Imagine being so good at knowing your numbers, and being so well capitalized. And being so intelligent, that you could literally pay a very high, seemingly very lopsided cost per action to buy that action, because you understand something that all of you in business have probably heard of, hopefully you’ve heard of it, the very important concept of the lifetime value of the customer for lifetime value of the customer. Now, think of this if this were applied to income property investments, okay, the lifetime value of the customer two ways I want you to think of this number one, think of it as though you need to attract a new tenant. And typically to attract a new tenant if you have a property manager and you’re not self managing You might pay 50% or 75% or 100% of one month’s rent as your equivalent of a cost per action. So the tenant signs a lease, they pay to move into the property. They might pay your first month’s rent plus a security deposit, maybe some junk fees, application fee whatever to rent the property from you. Here are the numbers on the aghori example $50 cost per action, how much will they pay for that? Hundred and $82 I was shocked and odd when I heard that number. Imagine paying more than triple what you get. Because you are so good at long term thinking playing the long game, and you understand the lifetime value of that customer will be dramatically More than that first cost per action. So in other words, you receive $50 today, but you pay $182. Today, to get the $50 you lose money, you lose a lot of money on that deal. So imagine if your tenant was renting the property from you, and you paid more than triple what you received, would you do that deal? You’d probably say absolutely not. No way. Well, how about if it was just purchasing the property? Right? What if you bought a property and it was $50,000 yet, you know, the lifetime value of that $50,000 property was so good, and so valuable to you? That you were willing to pay $182,000 to get it

Jason Hartman 12:01
I doubt anybody listening would agree to that bill, right? I wouldn’t agree to that deal. But it is pretty incredible. When you think long term when you play the long game, and how you can be very, very successful with that idea. Just something to consider, I didn’t want to forget to mention that to you. Because it absolutely amazed me think about how that might apply in your thinking about your investment properties. Kind of an interesting thought experiment. I’ll let you noodle on that one. As we dive into part two of the Hartman risk evaluator, then of course, tomorrow, we’ll have part three and we’ll wrap it up on this deep dive into this topic this week. So here we go with part two and if you want to see some good properties with good LTI ratios, go to Jason Click on properties. And better yet, contact one of our investment counselors, subscribe to our property tax. Where you will get those properties sent to you, just like new podcast episodes, but they will be PDF files, written in files, not audio, with the information, the full details about all of our newest properties as they become available. So whatever podcast platform you’re using, type in Jason Hartman property cast, and you’ll get that subscription for free delivered right to your computer or your mobile device, whatever you like. Okay, part two of the risk evaluator Here we go. Let’s look at these ingredients of a house, just a few of them, okay? The raw materials cost that influences the cost of the improvement in 2004. And this is kind of a good year to pick because as housing prices were just skyrocketing right before the Great Recession and inflation they were telling was only 3.3%.

George Gammon 14:05
Yeah, right. Is that the CPI? Or is that the actual broken down raw material cost?

Jason Hartman 14:10
No, that’s that’s the CPI numbers. Okay. So that’s what they were telling us was inflation. I mean, it could have been quarter rate versus CPI, but I think it’s CPI, okay, as I recall, but look at this piece of steel and iron went up 34% In the same year, more than 10 times the rate of stated inflation. Okay, lumber was up 17% the prices of wallboard. 20% increase when they told us inflation was only 3.3%. Are you kidding me? This is, you know, it’s so stated. It’s absolutely ridiculous

George Gammon 14:49
and just connecting the dots for the viewers. Guys, if you’re watching this, the reason Jason has all these listed out is because that’s the materials that you need to actually build a home. Right. So all the materials are going up going back to the builder, and his profit or her profit, then this is going to force them to sell these homes that they’re building at a higher price in order to make a profit. That means if you already own a home, if you can’t have any more supply come online, if there’s more demand through population or through excess liquidity, then that’s most likely going to bring up the value of your home.

Jason Hartman 15:26
Right, right. What’s interesting about what you just said, is that I remember I was doing a speaking engagement in Phoenix. And it was right around 2004 or five, and I had a heckler. I’ve had like two hecklers in my life in the audience. And this guy just thought he knew everything. He was so smart, and he was going to outwit me, right? And, you know, Heckle me there in front of the audience. And so, you know, we were talking about the Houston market, and many of our investors including myself, have made a great amount of money in the Houston market. It’s been awesome and you We’ve been involved in hundreds of transactions in Houston, Dallas, Austin, and a little bit in San Antonio too. And then, you know, North Carolina, Indianapolis, many other markets, right? But he kept saying, well, you’re telling people to invest in Houston, but Houston has like, really lacks zoning laws. They have very little restriction. And builders can just keep building. And I said, so what? I don’t care. I’m not that concerned about the cost of the land it when land is cheap. I think that’s great. Well, I want to be the commodities investor and I’m going to show you why in a minute. But that’ll that’ll come back in just a moment. Okay, so let’s let’s go on

George Gammon 16:42
on that point, too. And this is what I tell people. And I want to emphasize that when you’re looking at an income property, I think it’s in correct me if I’m wrong, but when I do it, I don’t take it from the starting point of do I think the value or the price is going to go up or down. I look at it as though I’m buying a stream of cash flow. You’re You’re a yield investor cheap or is it not? And then, okay, we can talk about it, the price goes up or down, but I don’t really care about the price too much, because I’m not looking to sell it tomorrow. I’m looking to hold it for the long term. So it’s more about that income stream.

Jason Hartman 17:15
Absolutely. You are a yield oriented investor. Really, I think both of our philosophies, even though we’re using a different asset class, very much mirror, the philosophical beliefs of what many think is the world’s greatest investor, Warren Buffett. Okay. Yes, it’s value investing. you’re investing for yield for cash flow for dividends, if you will, not speculation, hey, listen, if the price goes up, I can spend that appreciation just as well as the next person. But I don’t care if that happens. This is not lunch money for tomorrow. Okay. This is long term wealth building. And the way that wealth is going to be built is through all that. Those multi dimensional characteristics through the self liquidating debt, the tax benefits everything else. And look, we all know a lot of people who have become very wealthy owning income property, yet we probably know one or maybe know people that have become very wealthy buying stocks, you know, if you’re starting in the same place, right? So it’s obvious that this is the greatest asset class. Now let’s just reduce our risk when we invest in it. Okay. Okay, so the other thing, labor cost, right? The cost of labor definitely increasing. And that’s a huge thing. Do you know I was just watching a video for the Economist magazine on their YouTube channel. And they said that the average age of a construction worker in I don’t know if it was Europe in general or one of the European countries. The average age of a construction worker in Europe or one of the countries is 40. eight years old. Wow, that is shocking to me. Yeah, I can’t believe it. It was in Germany. I think it was Germany they were talking about. And it just goes to show you that there was just a massive shortage of this kind of labor. Now, I have seen all those cool little videos floating around Facebook, just like maybe some of you have about the 3d printed houses, and about, you know, new materials and this and that and living in a little pod. And you know, I hope all that happens, but so far, it just seems like a fantasy like, I don’t know, any 3d printed houses anywhere, and they still take materials to build. Now I’ve also seen George, the articles on Business Insider and the wall street journal about how you can buy a house on for $19,000. So I looked and by golly, there are houses on Amazon for $19,000. Go check it out. But I call that company and I called a couple of those other companies. But those houses, first of all, they’re just a kit for the walls. They don’t include any plumbing, any engineering, any hbic. Any appliances. They don’t, of course, they don’t include land. And I asked, I totally grilled this one woman who was talking to me, I mean, in a nice way, but I just kept asking till I got the answer to my question about how much does it cost to actually live in one of these houses, if I want to really build one. I mean, there’s all kinds of lots available for single family homes in Florida. If I buy a lot, and I order your house, and I do the engineering, and I have the plumbing people come in and do the plumbing and electrical people come and do the wiring and everything. And she said she kept telling me the same thing. She said, our house competes with traditional new home construction costs. And she kept repeating the same phrase. And I said, Give me the dollar figure. I need to know how much that is. How much do you think a new home cost? And she’s finally told me the answer. $200 a square foot. Right?

George Gammon 21:25
Right. Okay. Yeah, just I mean, you gotta, you gotta think about, well, they’re not using any different materials. So what would be their cost savings, like how manufacturers having all this cost, it’s the same material, they got to ship it to you. So if anything, there would be a higher cost to that. It doesn’t really make a lot of sense.

Jason Hartman 21:44
I mean, you think that it’s more efficient to manufacture the components of a house in a factory I would definitely agree to that. Waiting

George Gammon 21:51
by trust is the big thing when I was a construction worker I’ve ever told you that in college. I was on a framing crew and the One of the ways I worked my way through high school was working in high school, but then worked my way through college as well. And as a labor, I remember a lot of the homes that we would build in Oregon, in Portland, and some of the cheaper homes, they would just have trusses. And most people probably don’t know what those are. But that’s where your roof is already built. And they just kind of deliver it to you and you just bam, bam, bam, kind of tack it in and you’re done. It’s almost the same thing.

Jason Hartman 22:24
Right? Right. So they just, I believe they should manufacture more and more the house in a factory. But there’s a real stigma to that in America. I don’t know if that’s true in other countries. But in the US, nobody wants to live in a manufactured house. It’s a weird thing. I think it’s really dumb. Actually, I think you could build a house better in a factory and assemble it on the lot. But even if you do that, according to all of those cheap kits on Amazon, by the time you do the engineering and the permitting and all that stuff, it’s 200 bucks a square foot. That’s no joke. I mean, you can go to Jason Hartman calm right now and get properties for far less than $200 per square foot. Okay?

George Gammon 23:00
Yeah, take that a step further. I want to put that into perspective for everyone. Because this goes back to what you’re saying with the steel price surging in the lumber price. I built a home not myself, but I did a deal in Portland, Oregon when I first got into real estate investing, where I subdivided a lot, I bought a crappy home and a great neighborhood fixed up the home subdivided the lot, had the new lot, and I had a new brand new home built on that lot. And that’s where we made all our profit. But back, this was 2013, maybe something like that. And excluding the land, just the cost of the improvement value. We spend about 120 hundred and 30 a square foot. So that just goes to show you how much the cost of building has gone. Oh, yeah, just in the last call it seven years.

Jason Hartman 23:51
Yeah. And you know what, what else? It’s not just the first point up here, the environmental and building restrictions, but it’s also the Constant burden that they’re adding two builders to the cost of construction. Because before it was every house had to have a smoke detector, then it had to have a smoke detector in every bedroom and a couple other places. And now it’s got to have a carbon monoxide detector. And you know, this is all well and now it’s got to have like low flush toilets and you know, special showerheads and it’s got to have LED lighting and you know, they just keep throwing on the regulations and making it for them to build and you know, then it’s got to have smart home features and smart thermostats. And you know, all this stuff is great. I mean, I love technology. Okay, I’ll be the first to say, but all I’m saying is it just makes it more expensive to build

George Gammon 24:42
Yeah, not but I think that’s a great point. Most people don’t understand why the supply of homes especially in a lot of areas is so low right now there Why don’t these builders just go out there and and make it happen? Would love to? Yeah, I taking it back to that exact same house. that I was talking about in Portland, Oregon, in order to subdivide that lot, keep in mind, I’m doing this they’re going to make a lot more in property taxes. They’re actually encouraging people to subdivide these lots to bring the population in from the suburbs to revitalize this downtown area. So I’m doing them what they want me to do, but they’re making it really tough,

George Gammon 25:19
right? tough. It’s an understatement.

George Gammon 25:21
There was a side road there that this lot was on. They made me out of pocket out of my pocket repave the road, put in gutters, and this old lot It was run down it was an eyesore, but it had all these trees on it that we’re going to go in there and just level to build this new home. Well, they they made me hire one of their arborist, which is a tree pro tree person. Yeah. This guy three grand coming up and tell me what all these trees are. Oh, yeah. And then I had to build a median on Well, not really medium, but you know this right? Walk, got the row for the trees, I had to build that into the sidewalk. And then they told me the trees that I had to plant and the specific like types in order to make up for the trees that I knocked down on the lot where I built a new house that made the neighborhood 10 times better. I mean, all the regulation, it just got more and more and more and more to the point where it took me a year a year of meeting with them, and probably $25,000 out of pocket, just to do them a favor. I mean, it’s insanity. So

Jason Hartman 26:34
it’s absolutely that’s

George Gammon 26:36
why we have a housing shortage. That’s why

Jason Hartman 26:39
that’s why that’s why you have a homeless problem, because you’ve made it really tough to build and, and I didn’t even mention fire sprinklers, which are hugely expensive. And any developer of a tract will tell you that whenever there’s a cul de sac, or you know, the planning of the roads within the development that they’re building of attract home development That turnaround area for the fire truck keeps getting bigger and bigger and bigger. Somehow, I don’t know, these fire trucks must be just bigger and bigger. Now I need a bigger turning radius. Because every developer will tell you, it’s just become ridiculous. You know, it’s the burden is so insane. Look, all of this is increasing the cost. And then the last one that I put on there, of course, is the cost of energy, right? energy is probably the world’s most valuable commodity of all potentially right or energy or land, I guess, one or the other. Or maybe water waters in there too. You know, but energy costs definitely increase the cost of construction, right? Because energy is in everything. It’s, you know, everything is energy, right. So let me show you something. Remember I told you that I was buying two properties at the same time. I was buying one property to live in, in Orange County, California, and I was buying the other property across the country. That was my first or maybe it was my second because I don’t know which one I actually closed on from I was buying one in Austin, another one further in Georgia right? in buying these two properties right around the same time I was buying this house for myself, it was a very interesting experience. I’m going to show you this is the tax bill for the house I was buying to move into. Okay, orange, good. Yeah, this is in Orange County. Now, look at the magnifying glass here. And you’re going to see the land value. This is according to john Moore lock the Orange County treasure tax collector, right? Because the tax collector segments the value the two components, the land value, and the improvement or the buildings, right, and this house altogether was $815,000. Okay, you see that right here. And the way that divided up approximately was 659,000 in land and 155,007 53 I guess in improvements, okay. That was the equation. Now, your listeners or viewers might be thinking, Well, how do I know the land value versus the improvement value? There are three ways. Number one, the tax collector, on every tax bill, they always divide the land and the improvement up, okay? Because it’s taxed differently in probably every area of the country. You know, if it’s vacant land, the tax is different than improved land. So they got to know that value, right? So they always make an estimate of what that value is. The other source is, like I said, your insurance company, Jennifer, my insurance agent told me that that house across the country, they were given me $135,000 in insurance. So by deduction, I knew what the land value was. Okay. The third source is just having appraisal. The appraiser will always divide those two components of land versus improvement. So you know what you’re getting. Right. Okay. So, here’s the way that look. Okay? That’s my house that I bought to live in. And I lived there for seven years in this house. Okay, it was 815,000 total 156. I’m rounding just a tad 156 or 19% improvement value.

Jason Hartman 30:20
And 81% $660,000 in land value, just so you know, that was a brand new house. It was built by California Pacific homes. And they’re sort of related to the biggest land developer in the country, or at least one of the biggest the Irvine company. Many people have heard of them. And here’s what happened. Okay, I had this girlfriend at the time. Her name was Monique and Monique’s mother was in new home sales. So money was thought she was an expert. Right? We ended up breaking up clearly. And she told me not to buy this house. Now Monique really was vehemently trying to talk me out of buying this house. I’m glad I didn’t listen to her. Okay, here’s what happened. I owned the house for just one short year. And I couldn’t believe my luck. I didn’t consider this to be any great investment. I didn’t consider this a stroke of genius. But it’s kind of amazing what happened, okay? Because one year later, I saw the values climbing like crazy. And I thought, you know, I better refinance and get my money out. I always try to engage in a practice I call equity stripping, because equity is stuck in a property is always at risk, number one, and number two, it’s not working for you. I want to put that equity to work. So I call up my lender, and I said, Send an appraiser out, I want to do a cash out refinance, and I want to buy some more rental properties. Okay. So the appraiser came out. His name was Eric. And I’ll tell you, Eric came out a year later and appraise the property again. And then Eric came to one of my conferences where I told the story about him. Which was pretty funny. Okay, so here’s what happened. Eric came out and said, congratulations, your house is now worth $1.3 million. Wow. And I thought in one year, that house went up by $485,000. I am so lucky. Thank God. That was that was a great deal. Okay. But the question is, if the tax collector were to send me another tax bill, how would they have divided up the value in the LTI ratio, the land to improvement ratio? What would the tax collector have said about the new value? Where did it increase? We know that it increased by $485,000. We know that now the value is 1.3 million. But the question is, how would you allocate that value between the two primary components land and improvement.

George Gammon 33:07
Duty, he just increased the land value when he

Jason Hartman 33:10
why this will be continued on the next episode. Thank you for listening and happy investing. Thank you so much for listening. Please be sure to subscribe so that you don’t miss any episodes. Be sure to check out the show’s specific website and our general website Hartman Mediacom for appropriate disclaimers and Terms of Service. Remember that guest opinions are their own. And if you require specific legal or tax advice, or advice and any other specialized area, please consult an appropriate professional. And we also very much appreciate you reviewing the show. Please go to iTunes or Stitcher Radio or whatever platform you’re using and write a review for the show we would very much appreciate that. And be sure To make it official and subscribe so you do not miss any episodes. We look forward to seeing you on the next episode.