As a follower of real estate investing expert Jason Hartman, you’re most likely convinced by now that investments in the world’s most historically proven asset class are better than any other. And you’ve started following his 10 Commandments of Successful Real Estate Investing, especially the first, which is “thou shalt become educated.”
Hartman’s most recent “Creating Wealth” podcast was aimed at those of you who are ready to become more educated, meaning you’re ready to become advanced real estate investors.
The podcast centers on what Hartman calls “the vital side of investing that is construction cost.” As an investor within real estate, it’s important that you know that the cost to build a house includes such matters as how much you pay contractors to match the economics of the area in which they work, he says, or, knowing just how much the replacement costs to your property would be compared with the actual cost or price.
Along the way, you’ll learn in the podcast such terms as land to improvement ratio and regression to replacement cost.
Construction Costs Differ by Regions of the Country
As an experienced investor who leads the Empowered Investor investments network, Hartman and his company have offered clients properties in 11 states and 17 cities, so they have come to understand how the construction cost to build a house or other structures can help you evaluate risk on a deal.
“As you know, my very unique risk evaluator model relies very extensively on construction cost and land cost as a way to determine how to minimize risk when investing in real estate, and it took me 19 years to discover that,” Hartman says in his recent podcast.
“So far as I know, it is completely original thought, and my insurance broker at the time helped me discover that on one of my first nationwide property purchases. Before that I had pretty much been confined to investing in California and I did not realize there was a whole new wonderful, beautiful world of investing out there.”
As a Hartman follower, you already know that over time, linear markets tend to do just as well as cyclical markets—or even better in many cases. Real estate prices in linear markets stay steady over a period of years, while cyclical markets are those that can fluctuate widely up and down in price.
Hartman and Empowered Investor say that cyclical markets leave investors too susceptible to heavy losses when there are sharp market downturns—as occurred in the real estate fallout of 2007 and the financial crisis of 2008.
Hartman before has given the example of Kansas City, Missouri, a linear market, as compared to Orange County, California, which is a highly cyclical one.
“You would think high-flying Orange County, my former home town, would be the one that would win because they have such extreme upsides in the market,” Hartman says.
“Over the course of 18 years, Kansas City actually outperformed Orange County. In the example I gave, Orange City averaged depreciation of 5.2 percent, and Kansas City was 5.8 percent average … and remember, the devastating things about these cyclical markets is that you give so much back when there’s a downtime.”
When you have a higher cost of living place where you’re hiring contractors and sub-contractors to build a house, such as Orange County in its cyclical market, you have to pay them more, Hartman notes. That’s because they have to be able to afford to live in the place in which they work—so that does drive up the cost to build a house a lot.
Hartman in the podcast talks at length about a study conducted by the National Association of Home Builders (NAHB) about construction costs per square foot, or what it costs to build properties in various areas. For the study, the NAHB looked at contract price per square foot of new, contractor-built, single-family houses, specifically those on which construction started in 2013.
The 2013 median price for the entire country was $93 per square foot per property built, according to the NAHB survey. But it showed that prices varied widely by region.
In the Pacific region, which included California, Oregon, Washington and Alaska, the median price per square foot was $145. In the Mountain region, including Nevada, Arizona and Colorado, the median price per square foot of a single-family home was $107. In the West North Central region, as described by the NAHB study (and it includes Hartman’s example of Kansas City, Missouri), the median price was $103 per square foot.
Other regions in the NAHB study and their costs to build a house were: The West South Central region, which included Texas and all the states around it, with a median construction cost of only $85 per square foot; the East South Central region, which would be states a little bit east of Texas, at $84 per square foot, and, the South Atlantic region (Florida, Georgia, the Carolinas) at $88 per square foot.
Also: The mid-Atlantic, just above the South Atlantic, at $103 per square foot; the New England states, which go way back up, just like the West coast and Pacific region, to $143 per square foot; and the East North Central region, near the Great Lakes, at $90 per square foot.
Hartman and the Empowered Investor Network like to invest in the linear-market-rich West South Central and East South Central regions, where the prices were in the mid-$80-per-square-foot range.
Prices in the NAHB survey, as you can see, vary significantly around the country. But what do these construction costs mean to you as an investor?
Using Birmingham, Alabama Property as An Example
Hartman in his podcast cites a property that he and Empowered Investor had available a few years ago in Birmingham, Alabama, as an example to further detail construction costs and other factors, such as regression to replacement cost.
The Birmingham property was 1,104 square feet and was priced a few years ago at $70,900, which was built at a cost of $64 per square foot, as noted on its proforma. A proforma is a standard document, form or financial statement that you get as part of a real estate transaction.
“Now, let’s take the land value out of it,” Hartman says. Not knowing the exact land value, he roughly estimates it at $25,000. (There are three ways to determine actual land value: Either through a property tax assessor, by getting an insurance quote, or through an appraiser.)
“If the house burns down,” Hartman says, “they (your insurance company) will have to pay at least some portion to rebuild that house after you haggle with them and possibly have to hire a lawyer to haggle or even to sue them to pay the claim.
“You know how those can go sometimes and that’s why I always say the best insurance is a high loan balance. Let your lender haggle with them. Let (the lender) work with your insurance company to protect your collateral.”
Hartman now takes the purchase price of $70,900 for the Birmingham property and subtracts the $25,000 for estimated land value, leaving a value of $45,900. “Let’s look at $45,900 as the value of the structure or the house sitting on the land—the value of the improvement,” he says. “Let’s divide that by the square footage of 1,104, and that means the house cost is $41.58 per square foot.”
Going back to the National Association of Home Builders study, you might remember that it costs $85 per square foot to build a house in the East South Central region part of the country, where Birmingham is located. This particular Empowered Investor house wasn’t brand new but it had been recently renovated, so it’s “brand newly renovated,” as Hartman describes it.
“To rebuild this house, if it burned down, an insurance company would probably spend about $85 per square foot, according to the NAHB,” Hartman says.
“They have lots of members that build homes, so they should know. If we take $85 per square foot, their number for construction, and we multiply it times the square footage of 1,104, we can see that it would cost $93,840 to build this home today. Well, you can buy it for $70,900, so right there you’ve got about $23,000 of potential gain already.”
Generally, an insurance company wouldn’t pay you for the value of the land when it burns down in a fire or suffers some other catastrophic loss, because the land itself won’t burn and will remain. But, as an investor, you’re curious as to what the total replacement value might be if the land were included in the total value.
This is known as land to improvement ratio.
To get that ratio, Hartman says, “Let’s add back in $25,000—our potential lot value estimate—and then we add those two together: $93,840 to build the house, plus $25,000 for the land, and we get a grand total here of $118,840, so we’ll just call it $119,000.
“That means when all of those construction materials are worth what they actually cost … when a piece of wood is worth what a piece of wood costs … when it regresses toward the actual replacement cost, you have a gain potentially here, of $47,940,” Hartman says.
“That’s pretty great. That is pretty darn awesome.”
Hartman also wants you to remember this about cyclical markets: “You really increase your risk when you invest in high land value markets, but you also massively decrease your tax benefits and, of course, your cash flow. And, of course, we are prudent cash flow investors. We’re not the gamblers, we’re not the speculators, we’re on the conservative side.”
Will Rogers Aside, Hartman Likes These Parts of the Investing Game
“As you have heard me say on prior shows, I don’t even really like real estate that much,” Hartman says in the recent podcast.
“What I like is investing in what I call ‘packaged commodities’ or ‘assembled commodities.’ That’s really a major portion of the game for me.
“Now, the land is OK. I believe it was Will Rogers who said, ‘Invest in land, they’re not making any more of it,’ and you know, that’s true.
“But the fact is there is a lot of land in the world, and if you have flown over the United States recently, there’s a lot of land. Granted, there’s not much land that’s well located, but there’s still a lot of land. So these two things are very important to understand … the improvement component and the regression to replacement cost component.”
Of course, Hartman had computed out other components of the Birmingham property as well. For example, the debt coverage ratio with 25 percent down on the property, if it still were available, was a 2 at the time, he says. “That means your property could go badly half the time,” Hartman explains, “and you’ll still cover your debt service on this property because you’ve got a debt coverage ratio of 2.00.
“A lot of our properties, they’ve had debt coverage ratios of 1.4, 1.6, 1.8, something like that. I’ve actually been looking for one for you that is a 2 and we’ve found it. What a champ.
“This property (in Birmingham) has a projected cash flow of a little over $3,400 annually, and that’s with your maintenance, your property management, your vacancy, all imputed into that equation, so make sure you really know how to analyze these deals, folks.”
Ready to Learn More as an Advanced Investor?
So, now that you’ve learned about the construction cost to build a house and such matters as land to improvement ratios and regression to replacement cost, you’re ready to learn more as an advanced investor.
Hartman recommends that you advance to learning about a property proforma, which as Mentioned earlier, is a standard form or document you receive in a real estate transaction.
To learn how to read a property proforma, he suggests that you watch a You Tube video he produced on that very subject.
The video includes a visual demonstration via computer, and you can follow along on how to read the proforma’s details. Hartman calls a proforma “a fantastic tool,” which, once you become educated, will make you a more informed and better investor.
