Jason talks on why the US real estate is vastly better than the European market and also answers a listener question from Pam. Gary Carmell is the author of The Philosophical Investor: Transforming Wisdom into Wealth. He talks to Jason on what is a philosophical investor, the reason why there was a 2008 real estate crash, inflationary pressure and much more.
Key Takeaways:
[6:20] The US real estate is still better than the Euro real estate for income investing.
[17:10] Jason answers a listener question from Pam.
[20:35] Jason introduces Gary Carmell
[23:00] What is the philosophical investor?
[30:50] Jason breaks down the real estate market into three types: linear, cyclical, and hybrid.
[39:10] Why does the typical institutional investor always go for the class A properties?
[51:20] There isn’t a lot of demand right now for borrowing money.
[53:50] How does Gary feel about deflation?
Mentioned In This Episode:
http://www.cwscapital.com/who_we_are/carmell.aspx
Tweetables:
“The pricing data in the US is so much better than it is around the world.”
Transcript:
Jason Hartman:
Welcome to the Creating Wealth show, this is your host Jason Hartman. This is episode number 517. 517. Thank you so much for joining me today. I am coming to you from beautiful Dubrovnik, Croatia. Yes, it’s my second time here. I actually talked to you on the show from here before. I remember it distinctly. Just about two years ago on my last visit and it’s great to be back here. This is really a beautiful place. It’s not super easy to get to though. You know, it’s not a major European hub. It was for a long time kind of this undiscovered place.
You know, the beautiful Dalmatian Coast and when it first began to get more popular as the climate became more peaceful. There’s been a lot of conflict in this area, you probably know that all too well and I remember reading a lot about it in all of these international and offshore real estate investing newsletters and got back then years ago and I really wanted to check it out and I actually came here two years ago to look at property and once again, I gotta tell ya, a friend of mine here on this trip with us today was asking me, he’s rented a place in London for two months and he asked me about investing in European real estate.
This stuff sounds sexy, but so far and as of yesterday, I went to my 76th country, yes, that was Bosnia by the way. I went over to Bosnia Herzegovina yesterday and took a rather long day trip there. It’s right next door to us here in Croatia. You know, in looking all around the world, I tell ya, the American real estate market is really special. We have definitely talked with local market specialist, we’re going to call them that. We call them the LMS, the local market specialist by the same name in many parts of the world from Australia to many South American and Central American countries to several European countries, even in China, and I tell ya, American real estate is pretty special for many, many reason. Not the least of which is, you know, of course and I’ve talked about this before, it’s been subsidized by the government since the great depression.
We have this very mature, as corrupt as it is, banking and mortgage market; the secondary mortgage market and of course I’m referring to Fanny Mae and Freddie Mac, but also in the US, that’s really the only major country that has a really good multiple listing service, an MLS, not to be confused with an LMS, a local market specialist. I know those two could be confusing, but the MLS system in the United States is very, very mature and in all of these foreign countries around the world, pretty much. I know there are inklings of MLS systems in many countries, but it’s just not like it is in the US. Most the business is this sort of off plan, it’s called many times, off plan development and off plan deals and you know, you just don’t have good data.
Let’s even forget about the multiple listing service, the MLS, for a moment. Let’s just talk about these highly developed, very old county recording systems and they are kind of primiative as you look around the Us, you know, many of them are very different, but you have data, you have pricing data in the US and you just don’t have that around the world. You certainty don’t have Zillow, you don’t have Trulia, with all of their flaws. You don’t have Realtor.com with all its flaws, but, you know, given all of that, the pricing data in the United States is so much better. It is so much better than it is around the world and that makes me feel that the US market is much safer.
Now, let’s throw all of that I just said out the window and let’s talk about something else. The prices are lower in the United States. You can’t buy a decent property in any, now, I could be wrong about this, but I’m just going to throw it out there. I do not have total facts. I just want you to know this might be a reckless comment slightly, so I am making that disclaimer, please feel free to call me out on it, okay, but I’m just going to say, you can’t buy a decent quality property comparable to the types of properties you can find at JasonHartman.com in the property section in any European capital city for a $100 a square foot.
And I’m going to go not just one step further, I’m going to go two steps further. I’m going to say you can’t even buy a comparable property to what you’ll find at JasonHartman.com in any second tier European city for a $100 a square foot and wait a moment, wait a moment, okay. Someone may well call me out on this, I just, you know, I’m talking a bit of a risk here, okay, I don’t think you can find a comparable property in a third tier European city for $100 a square foot and, of course, you can go to JasonHartman.com and you can find these properties for quite a bit less for a $100 a square foot, alright.
So, the properties are just less expensive in America an why is that? Well, it’s because the building industry is more developed and more mature and the supply chains are more developed and more mature. So, all of that, now, let’s throw all of that out the window. Let’s throw out that we’ve got a mature banking system and a mature mortgage marketing and the best mortgage financing in the world.
I didn’t even mention that one yet and let’s throw out the fact that we’ve got the best quality of data in the world and let’s throw out the fact that we’ve got the cooperating real estate system through the MLS that really, you know, Canada, I’ll make an exception for Canada and there’s a few inklings of others around the world, but really, it’s not like it is in the US, okay, even in Canada, it’s not quite there in that way.
We’ve got these cooperate system among different real estate licenses where the vast majority of them have to cooperate to sell properties through their association of realtors and their multiple listing service. Let’s throw all of that out and let’s just talk about rule of law and corruption and standardized practices, okay, and all of that is, you know, I know there’s some other great places around the world, for sure, I love to travel. I was not born in the United States, I was born in Europe and I love coming here, but I just think the US has a very unique real estate market. It’s really pretty special real estate investment market.
So, I think it’s much better and believe me, if we thought, if I thought it made sense to be investing around the world. I would be doing it. I would setup deals with local market specialists in markets that I recommend and we would be recommending to you on this show and this all could change in the future, but so far in the past, really, 11+ years of me being in the nationwide real estate business, I haven’t found anything that even comes close to the United States real estate market. So, that’s my thought.
So, yesterday I visited Bosnia Herzegovina. Wow. What a beautiful coast line. I mean, of course, the Dalmatian Coast here in Croatia is just stunning, it’s spectacular. Beautiful, beautiful place. We talk a lot about currency exchange rates and inflation and so forth and yesterday I was talking with a couple of my guides as they were showing me around Bosnia and they were talking about, you know, one of them was Croatian and she was talking about how high the taxes are in all of these places, you know.
They basically take half of your income and just how hard it is to get ahead and admittedly maybe that’s getting harder in the US. I certainty have my complaints, but just the economic opportunity too is another thing that’s huge, but none the less, beautiful, beautiful place. Really interesting some of the stuff I saw yesterday and I’ll try to talk about that on another show, but I’ve got a bunch of listener questions I want to get to and I want to make sure I get to those for you.
So, first of all, a couple of shout outs to our listeners, first of all, Marge, thank you for sending me the link about the $150 house. I’ve seen things like this before. You know, you do an essay contest, you send in $150 to enter, you get a 1,000 people to enter and suddenly you’ve got a $150,000 and a bunch of essays to read. Maybe you don’t even read them all, I don’t know, and then you give someone a house and say they’re the winner. It’s a great publicity stunt. I actually thought about doing it myself, maybe someday we will, but anyway, it’s an interesting gimmick. It’s an innovative idea, for sure.
Roger, you asked a good question and you were listening to the Flashback Friday episode recently where, well, maybe it wasn’t a Flashback Friday, maybe it was just a prior episode, sorry, where we talk about the next ten commandments of successful investing, yes. I started with ten, then I added ten more. I thought about adding another ten, you know, having 30 commandments. I don’t want to make it all too confusing anyway.
There are more commandments because, you know, there’s more to it, right? Anyway, number 11, Thou Shalt Not Be a Sucker. I’m reading what you wrote me by the way. I’m not reading it from my own content, so you know, assuming you got it all exactly as I did it. Thou Shalt Hold Thy Tenants Accountable. Number 13, Thou Shalt Understand the Theory of Relativity and number 14, you said you didn’t catch it in that prior podcast, so here it is for you, you ready? Okay, Roger here we go, commandment number 14, Thou Shalt Benefit from Mother Nature, Father Time, and Socialism.
Well, what do I mean? You know, as real estate investors I say look, we are finally on the right side of all the things that most people complain about or at least most people paying attention who are thinking about it complain about these things. Most of these things are considered bad, right? So, mother nature. What is mother nature do? Mother nature gets angry sometimes and causes disasters and that puts upward pressure on commodity prices and we are package commodity investors. We are simple commodity investors.
If you don’t know what I mean by that, go to JasonHartman.com, use the little search bar in the upper left and type in packaged commodity investing and you’ll find all sorts of references in my blog post and in prior episodes in the transcripts about it and that puts upward pressure on the prices of these commodities that are the ingredients to the properties, the houses and apartments in which we invest, so that’s great.
How about father time? Well, you know, most people the bemoan the passing of time, you know, aging is not a terribly popular idea. Most people like youth and you kind of got to surrender a lot of the great things about youth as you age. One of the great things about aging though is wisdom and perspective and I just love that with each passing year. I’m sure all of you listening do as well, but you know, a couple of gray hairs are starting to show up and Obama told me there’s no recession yet. I don’t know, i look at my hair line and, you know, I think there is one and a few more wrinkles of wisdom here and there, but you know, father time is great for the real estate investor, because as we invest in real estate we put time on our side. I don’t need to explain too much about that, because, you know, we talk about it all the time, right, how time benefits us as investors.
But what about socialism? You know, most productive people, most thinking people who are earning their keep and not leeching off the system, they don’t like socialism. The people who feel generally insecure about their ability to produce and provide and earn a living and maybe aren’t that motivate, you know, kind of like to kick back and relax and have the big social safety net and so forth. You know, those people, they benefit from it, but the productive class.
People in Ayn Rand’s book in – by the way, we’ve got a really interesting show coming up. It’s going to be on the Jetsetter show. I might even play it on the Create Wealth show about foreign investing. Kathy by the way, I did a really interesting interview with a guy you referred, so Kathy, one of our listeners, referred him and it’s about this development called Galt’s Gulch turned into a big scandal in Chile, South America, but that’ll definitely be on my JetSetter show. I might play it on the Creating Wealth show too.
It’s a pretty fascinating thing, but you know, the John Galt ideology right in Ayn Rand’s excellent book Atlas Shrugged about the productive class just going on strike at some point right, but socialism as real estate investors really, it does benefit us. Why? Because when the government becomes irresponsible and they spend too much it creates inflationary pressures and it also creates things like section 8 houses and free loading renter to get the rent paid by the government and a lot of investors specialize in that type of renter. Some love it, some hate it. We’ve talked about that many times, but ultimately government spending creates inflation, so commandment 14, Thou Shalt Benefit from Mother Nature, Father Time, and Socialism. Alright. So, there you go. Thanks for asking the question, Roger and that is your answer.
Now, Hannah also had asked a question before about private lending and hard money lending and again, she said, I’ve got a $150-200,000 maybe that I want to lend and I think she owns some good real estate properties if I recall correctly, you know, she wants to do some lending too and the lending again is not as good as actually owning the property, but it is simpler and it’s just a different kind of thing. You might want to diversify, do a little bit of both. The lending is a little bit hard. It’s getting a little bit competitive.
The rates have been driven down a bit, there’s more competition amongst lenders and fewer burrowers or at least burrowers that are getting their needs satisfied for burrowing and so the rates have declined a little bit, but to answer your question, Hannah, really, if you have about $75,000 or more, you can get into the lending game with us and we can refer you people and I already know I refer people to you, so you are already talking to them and then we’ve got my favorite way to take a question, please use this and that is our voicemail system at JasonHartman.com. So, here’s a great question from Pam.
Audio:
Hi Jason, I have a quick question for you. Your last podcast you interviewed one of your clients and he said he bought these properties with cash and then did a cash out refi, that seemed like a terrific idea, because it seems like the rates are much better if you do a cash out refi and I just wanted to know if you could speak to that. Thank you. Your podcasts are great and I appreciate everything you do.
Jason:
Okay, so Pam, first of all. Thank you for the kind words and that’s a great question and, of course, you’re talking to a guy who loves leverage, properly used leverage, of course, but cash out refi is a phenomenal plan. Some, including myself, call it equity stripping. You’ve heard me talk about the refi till you die plan, which is an excellent game plan as a way to extract wealth from your properties, but cash out refi rates are not necessarily lower at all.
You may have been saying that just because the client might have mentioned that when they brought the properties they had a higher rates and rates overall declined and then they did a cash out refi and happen to take advantage of the lower rate, but they’re not going to be lower in the same time frame if you’re comparing apples to apples that way, but still I think the cash out refi is an excellent thing to do. In fact, I would do it whenever possible, whenever it makes sense.
You know, when it makes sense is sort of a complex question, because it depends on how much equity you have and what you’re going to do with the money. Hopefully you’re going to buy more properties and this really is the great thing, well, one of the many great things about income property investing is that, you know, we don’t pay our own debts. We outsource our debts to our tenants and so our debt becomes a self-liquidating debt. That’s a term you really want to keep in mind. A self-liquidating debt. Self-liquidating debt. Remember that one. It’s a good term.
So, when we do a cash out refi, one of the great things that we get to do with our properties and it may take a little bit of time, because you have to build up some equity in the property first, but many times, you can acquire the property, let it appreciate a little bit, let a little bit of mortgage pay down happen, you do cash out refi, you could get all of the money you put into the property back so you’ve now got zero in the deal, yet you still have the asset. You still own the property and even after a cash out refi, the property could still potentially perform at a breaking even or a positive cash flow.
So, income property has very special wonderful characteristics and it is the most historically proven asset class in the world. Remember, I used to just say in the United States, if not the entire world, but I’m going with the entire world. Okay. So, that’s what I’m doing. Anyway, hey, this intro, as usual, is gone a little long. Let’s get to our guest, Gary Carmell as we talk about the philosophical investor transforming wisdom into wealth.
It’s my pleasure to welcome Gary Carmell to the show. He is President of CWS Capital Partner. He’s author of The Philosophical Investor: Transforming Wisdom into Wealth. Gary, welcome, how are you?
Gary Carmell:
I’m doing great, Jason, thank you so much for having me.
Jason:
Good to have you on the show. I was going to turn that title around and say transforming wealth into wisdom, which is unfortunately the way it goes for so many investors, right?
Gary:
That is correct, yes, I think there’s an all Wall Street addage that says something like, if you’re unwilling to change your mind, you’ll have no change to mind.
Jason:
There’s a lot of quotes around this. You know, one is experience is the best teacher, unfortunately you can’t get the lesson until you get the experience or something. I can’t remember it, you know, but kind of go along those same lines.
Gary:
Yeah, it’s like, you know, what the wise do at the beginning, the fools do at the end or something like that.
Jason:
Exactly, yeah. A fool and his money are soon parted. Boy, we could have cliche for many minutes. One I’ll tell you is, you might really want to comment on is, you know, what happens when a general partner and a limited partner meet? At the beginning of that relationship, the general partner has all the experience and no money. The limited partner has the money and no experience. At the end they change places.
Gary:
Sadly that’s true and we are in the business of being a general partner and there is no greater responsibility and honor than the trust and fiduciary requirements you have to manage other people’s money and it really upsets me when I see that violated and we’ve been in business since 1969 and cultivating just many, many wonderful individual investor relationships over the years and you have to be a trust worthy, creditable firm built on integrity, values, and deliver results.
Jason:
There’s a lot of bad apples out there, certainty. In fact, I just saw one in the paper yesterday. I can’t remember the story, you know, this was a trader like Wall Street trader taking off with a bunch of money. You know, these are cliche. You know, it’s almost one scandal a day on Wall Street, you know, which is why I like real estate better, for sure. You know, tell us a little bit about the Philosophical Investor, if you would, and what is sort of the thesis behind it, if you will?
Gary:
Yeah, essentially, I don’t think it’s a big surprise for people that are students of investing, but you know, I have seen the enemy and it’s in the mirror, so it’s often times ourselves and what I have found is essentially, it’s very hard to overcome, you know, human nature that is susceptible to bouts of fee and greed and often times we do the suboptimal thing and if you kind of look at the average investor return versus different asset classes.
They tremendously under preform because they go in at the top and fell at the bottom and so, a philosophical investor to me is someone that learns from others. People like Warren Buffet, Charlie Munger, George Soros, even Shakespeare, and I even tap into some musicians and artists and philosophers and then you learn from yourself. At the end of the day, what you try to do is marry the seminal experiences in your life from the wisdom that has been conveyed by others in a way that hopefully like Ulysses did, you can tie yourself to the mast and avoid those terrible decisions.
Jason:
The sirens song.
Gary:
Yeah, at the end of the day, I would say one of the great quotes in the book is from a philosopher Schopenhauer, German philosopher, he said, you know, the task at hand is to not see what no one else sees, but to think what no one else thinks about that which everyone sees. So, how do you prepare yourself to think very independently and control your emotions and make good decisions?
Jason:
You know, that’s such a good point. There’s so much psychology to it, you know, we are our own worst enemy. We’ve met the enemy and the enemy is us. Boy, we’re full of cliches today, aren’t we? Don’t worry, listeners, we won’t do that the whole episode, okay, I promise, but this really happens, you know, the most toward the end of a bull market in any thing and maybe that’s what’s going on in the stock market right now. You know, the tips of the shoe shine boy type of thing where people, it’s just so tempting when you see all of these people around you and you hear all of these stories about these big capital gains.
Right now, you’re in my old home town, you’re in Orange County, California. I mean, look at the real estate market there and in other high priced cyclical markets. I mean, you know, prices have been going crazy the last couple of years and I used to play in that game and now being a little older, wiser, more conservative, I just like the cash flow markets, you know, where properties appreciate in a more linear fashion and they just cash flow.
So, they are susceptible somewhat to the economic ups and downs, but it’s not a major swing. I’m not investing for appreciation, but that is the really tempting story, isn’t it? Whether it be stocks, real estate, gold, Bitcoin, anything, right?
Gary:
Right, especially like you alluded to when you hear about others doing well and you have this sense of maybe you’re falling behind, you’re so susceptible to want to jump in with the fray and I think if you take a step back, respond, and reflect rather than react, you develop certain investing cardinals like you mentioned about cash flow. These cash flow is a metric that can allow you to value assets sort of within a kind of relevant range. You don’t have to use your imagination so much and so I think kind of sticking to things that you feel comfortable that have worked for you and you believe it will continue to work. I think that makes a lot of sense.
Jason:
I love the way you said that. Sticking with things where you don’t have to use your imagination. Like your imagination says, oh my gosh, I’m going to make 30% in capital appreciation on this deal in a year. You know, that’s not sustainable. Can’t we learn from history? Everybody is susceptible to it, aren’t they?
Gary:
Yeah and that’s where the opportunity is too. If you can recognize those bouts of collective madness and I like to say monetizing the madness and stay out of the fray when everyone is going crazy and jump in when there’s a lot of fear and despair, then one can really prosper, but we really do have to check ourselves to stay out of it when it gets crazy.
Jason:
Yeah, we certainty do. Tell us about the Munger moment. Munger is Warren Buffett’s number two main, right?
Gary:
Yeah, he is such a brilliant man and at 90 or 91 he continues to just produce incredible thinking and investment results. So, there was something he said he was describing a situation where they avoided a problem, which everyone else fell prey to and what happened was there was so much carnage that they had money and courage to step in when others didn’t. What he said was, there are these very few opportunities that present themselves in ones life, but if they are recognized as such where you, through analysis and using different variables and looking at the world sort of holistically and comprehensibly, you can determine that the odds are overwhelming in your favor then all you need is the courage and the capital to take advantage of that opportunity and that capital has been generated because of patience and prudence in the past.
So, when everyone was jumping in and you stayed out of the fray, they lost money, you kept your money. Now you have one of these moments that I call a Munger moment and there’s not – they don’t happen all the time, they are very few and far between, but when they occur, in the words of George Soros, you go for the jugular and you really load the boat and it can make a huge difference in one’s life, you know, financial outcomes in their life.
Jason:
Can you give us an example of that?
Gary:
I can. So, our business, we own, operate, build apartment communities around the country. We have about 23,000 unites or so, worth about $3 billion, so that’s our business. So, in the after math of the sub prime debacle, we had seen there was so much excess going into housing finance that we kept saying that people are renters, but they don’t know it, because they started owning homes with no money down and once those homes started losing value, they had negative equity.
They were basically renting the homes from the bank and we knew this was going to turn into a big problem and that when we hit the recession, almost a near global depression, our indicators and way of looking at it the world told us that renting was going to be not only, it was going to be necessary and the only form of new household formations, because no single family housing was essentially being built. You couldn’t get mortgage credit and yet people needed to form new household and they needed to build and rebuild their credit and they could do this through renting and they had the flexibility to go where the jobs were, so that to us was a Munger moment.
We said, we aren’t going to see conditions like this for a very, very long time that are going to be so favorable to owning income oriented apartment communities, because the supply was contracting and even though the demand was done, once the economy started to recover, the demand would explode and there would be a tremendous imbalance and our thesis has generally turned out to be correct.
Jason:
Okay, so in hindsight you were correct, but here’s the problem. Just like in any cycle, if we’re looking at this graph and what mostly talking about here, by the way, you may not know this, but I differentiate real estate markets into three types. The linear market, that’s the market that just sorts of chugs along and does it thing, you know, averages 5-6% appreciation annually over time, then there’s the cyclical market that would be, you know, pretty much all of California, any high land value are, South Florida, the North East, those types of markets are cyclical. You know, they have big swings. You catch them right, you can make a fortune, you catch them wrong, you’re dead, okay.
Gary:
High beta market.
Jason:
Yeah, high volatility, high beta market. Sure. And then there’s the hybrid markets and Phoenix would be a hybrid market where, you know, it kind of acting in a linear fashion for decades and then in the last go around when we saw all this California money flowing into Phoenix and Nevada or Las Vegas and Phoenix, I do know the difference between cities and states by the way! You know, those markets became really cyclical and really nutty, you know, just as California did and, you know, in these different types of markets, the problem is when you’re in the doldrums, when you’re in that troth, you don’t know that that’s the problem, no body does, right. It’s sort of easy to say now looking back, gosh, you know, we scoped up a bunch of deals in the worst part when all the news was bad and so forth, but how do you know when you’re there? You know? I mean, after things went depreciated by 30-40%, sure, great deal, but how did you know they wouldn’t go down another 10 or 20% beyond that, right?
Gary:
Yeah, that’s a very, very important, you know, question, and true insight and one of the reasons I wrote the book or one of the things I convey in the book is, in my career at CWS, which has spanned nearly 30 years, I have been a fairly consistent writer of letters to our investors over the particular last 15 years and when I read investment books, just like you’re saying, hindsight is 20/20, of course, but what were people thinking in the moment and the book conveys in a lot of our thinking in the moment about how we were looking at the world.
It was a deep dark time, there was a lot of fear and despair and you didn’t know if the light was the train coming at you or the light at the end of the tunnel, so you know, what were going to happen to multiples for real estate. Were they going to expand dramatically because the capital that exited? So, we went through a lot of this thinking and basically, I mean, I went back and tried to draw parallels to the 1920s and 30s and see how valuables responded back then.
We looked at indicators, so by doing that, I actually got a level of comfort. I even looked at evaluations of New York real estate in 1932-1933-1934 and they were very similar in their cap rates as to what they are today and they didn’t move much. So, I thought, okay, this is the depths of the depression, valuations actually held up okay, but what we saw was a dramatic drop in transaction volume. You know, most people didn’t sell. You didn’t have the distress from the banks forcing foreclosures.
So, we then take a step back and said, one of the metrics we wanted to look at was replacement costs, you know, can we buy properties below replacement cost and that gave us a level of comfort that we couldn’t see much new supply until rents were significantly higher, so that was kind of check the book there. We were able to burrow at rates that offered us positive leveraged, so we could buy a property at a 5-6% yield and burrow it at 3 and we felt like there, you know, you were talking about cash flow, that felt pretty safe to use.
So, even if we over paid a little bit in the first couple of years, we could kind of earn ourselves or earn our way out and there was such pessimism there and there was no new supply of apartment, because the banks were cutting bank and they weren’t lending to developers, so we just felt like there was, the margin of safety was evolving and the risk reward was so favorable. So, you don’t, you don’t always know, of course, but we kind of put this mosaic together and said the odds were surely in our favor.
Jason:
That makes sense to me. Now, let’s talk about replacement cost issue for a moment and then I want to make sure I don’t forget to ask you about institutional investors and why they like certain types of properties over others, okay, but on the replacement cost issue, I think you are completely right. That’s the same thing I was saying to my investors. In fact, I coined a new phrase for that and I kind of try to make a distinction here between the concept of appreciation and what I can regression to replacement cost.
So, when you’re buying below replacement cost. In other words, when it cost more to rebuild that property, in many cases a lot more, you know, then you can buy it for, you can buy it for much less than the cost of construction. I think that’s a pretty safe bet and apparently you do too. Do you want to just comment on my regression to replacement cost idea maybe? To you is that different than appreciation? I think it is. I think appreciation is when you’re at, we’ll call it par where cost of replacement is equal to the cost of the property, but when it’s below cost of replacement, I think that’s really different than appreciation.
Gary:
Yeah, I would tend to agree. I think it’s important to not use that as, it has to be somewhat of an adjust indicator, because if you have a property that’s 20 years old, of course that should be below something new, because it’s just is not, you know, as amenitized or it has functionality, right, so adjusting for age is very important.
Jason:
Yeah, it’s not new. I understand.
Gary:
Right, that’s just, we just feel so much safer knowing that a developer is going to have a hard time financed unless and earning the economic returns to justify the risk unless the income in that area or the rents have gone up and so if our rents are 20-30% below replacement cost and the asset value is significantly below our price. It’s just a very good place to be. You’ve hedge your risk and the up side should kind of take care of itself with the apartments filling up. The rents growing to justify new construction. You know, by those events occurring, as I said, the appreciation should materialize.
Jason:
Yep, I would agree. So, let me ask you about the appetite for institutional investors. So, first of all, you would consider yourself an institutional investor, right? Your company?
Gary:
Yes. I would. I would say, well, we have institutional capabilities, depth, track record, strength, but we’re generally financed by private investors. So, when I think of institutional investors, I think of them being, you know, them getting their money from the public markets or pension funds and endowments and things like that. So, subtle distinction there, but sophistication, yes.
Jason:
Fair enough. I sort of put it by price point, you know, amount of money. In the apartment world, you know, a lot of people in the lending side sort of consider anything over $7-8 million to sort of where you get into that more institutional type stage where it’s, you know, it’s the rich guy, you know, the millionaire next door type, right. Thomas Stanley wrote about that’s buying those things, it’s just too big for him. Why is it, and it’s always perplexed me a little bit.
I think it’s just because a sort of safety and simplicity, why is it that the institutional investors always go for these class A types of properties with low cap rates, low yields, you know, that’s what you guys do, you do luxury apartment complexes and you know, look, you’re in the Bastian of the Irvine company, right, one of the biggest apartment owners in the country and it’s always, you know, the class A type stuff where you’ve got these low cap rates. Are institutional investors just not into, you know, little bit of handy work, re-tenanting, raising value, they just like that higher quality always, but it has lower yields, you must admit, right?
Gary:
Right. I think it has something to do with generally the very long term horizon that they have in terms of the money or the liabilities that they’re responsible for generating turns against and there is a lot of historical data that shows apartments generally offer fairly compelling returns with less volatility and they can store their wealth in these really high-end communities that tend to generally do, you know, reasonably well over time.
So, I think that the historical data tends to support that strategy for them and they have a lot of capital to place. They like quality. It’s just not – they’re big and they don’t have a lot of time and man power to manage these very creative, complex opportunities often times and so it really is a risk reward, you know, profile. So, I don’t know if that answered, but that’s our experience.
Jason:
Sure, sure. I understand. So, the demographics coming at the rental market, you know, at my company we like housing. The demographics coming at the rental market over the next decade are, in my opinion, pretty phenomenal. Maybe the best they’ve ever been in history. I mean, you’ve got generation Y, the largest demographic cohort in US history, slightly largely than the baby boomers by about 4 million and the baby boomers just changed the planet, you know, an amazing spending curve.
You’ve got – that generation is largely saddled by over one trillion dollars in student loan debt that is not dischargeable in bankruptcy. They are literally debt slaves and I have a whole philosophical opinion about that, but that’s another discussion maybe and then they are delaying family formation, they’re delaying marrying. They like mobility as I always say, the best thing you can have on a resume is mobility.
To go where the jobs are and those and many other factors make them kind of like ideal renters. One more factor I’ll throw in and you can comment on, is that a lot of them, they were going through sort of formative years at a time where they saw their parents get burned in the housing market and the recession and they’re like, you know, I don’t really care about a house with a picket fence and being tied to one location so much, you know, I think, and also, there’s just kind of a technological component that makes people very mobile obviously nowadays.
I mean, I can run my business from any place in the world. Less than a decade ago, I kind of felt like I needed a big office and a big staff and a location and a sign on a building and I don’t feel like I need that at all nowadays and I think a lot of people, you know, there’s a lot of mobile entrepreneurs nowadays. So, those and other factors if you have any you’d like to add to it. I think make a pretty great opportunity for land lords, right?
Gary:
Yeah, what described is exactly – I mean, I think you covered every positive characteristic of that, you know, I talk about in terms of the long wave that should be benefiting renting and land lords, I would, yeah, I guess with the student loans, you know, you mentioned about the debt slaves that basically, it’s very difficult to get mortgages.
The mortgage market is still is not anywhere what it was in terms of how open it is and, as you mentioned, delayed marriages, there’s also an interesting, I guess, demographic or sociological statistics that there are so many more women who are graduating from college and have graduated from college than men that there’s this big educational gap, which supposedly might be contributing to delays in marriage. It’s kind of an interesting thing to think about.
There’s the whole re-urbanization phenomenon where people want to be in these city centers and there’s a lot of walkability and early on there’s not much home ownership down there and as you said, I think the return on mobility and flexibility has never been higher. It is as, I’d like to say that apartments prosper from insecure growth. In other words, the economy is growing, it’s producing jobs, households are being formed, but people just feel a little bit insecurity about how long they’re going to be somewhere and do they really need to be tied down. You know, what if I have to sell in two years and all those transaction costs.
Jason:
And all the hassle. I mean, don’t under estimate the hassle. You know, for literally almost all my life except one portion. I was a home owner. I owned many homes in Irvine, Newport, you know, I lived in all those areas, right, Newport Coast I mean to say; you know, it’s a monumental hassle to, you know, put your house on the market, have your privacy invaded, keep it clean every day, I mean, it’s just, that’s a job. You know, living in an apartment, you just give 30 days notice and you’re done. It’s so easy.
Gary:
It’s really true and we think about, when we upgrade an apartment, we could literally have it done in five days or something. Imagine doing that to your house. I mean, of course it’s yours and there’s pride ownership, but it’s just so efficient too and there’s just some of these stories of people that they took a risk with their carer or starting a business, because they weren’t tied down by a mortgage. There’s actually a line in the movie Thank You For Smoking that says, I’m just going to paraphrase, but he says something like, all problems can be traced to having a mortgage and it was a very, it was kind a very funny line in the context, but it really does tie you down and it’s, of course, it’s right for certain people at their stage in life, but boy, when you’re younger and you want to advance in your career and you want to show how flexible you could be, it’s highly valuable to an employee.
Jason:
Yeah, no question about it. Are there any holes in my theory? You know, see, the funny thing is, you know, like the Thank You For Smoking line that you paraphrased, you know, all problems stem from having a mortgage. See, I think it’s great to have a mortgage on income properties that you rent to other people, but oddly renting can be a very convenient for oneself. I mean, those would seem to contradict each other, but I don’t think they do, you know, I own lots of properties and I’m personally a renter and I like that. I think it’s great.
Gary:
Right, I would agree with you. I think it’s one you have something that limits your flexibility and the options you can have in life, by, and look, some people can easily handle a mortgage on a primary residence, I don’t want that to apply to every single person, but the point is there’s a time in your life where the last thing you want to do is limit your optionality and on mortgages on income producing property makes sense all day long. Yeah, there’s no leverage in the actual benefits.
Jason:
I love leverage and I love what I call inflation-induced debt destruction where and I want to ask you your outlook where in an inflationary environments, basically the inflation pays off the debt for you, you know, it’s not only your tenants that are paying down your debt, but your inflation is, so that’s a great thing too, which leads me to another question for you. Where do you think we’re going? I mean, what’s your forecast for the economy? Is it mainly on the monetary side, inflation, deflation, stagnation, some other hybrid, what do you think?
Gary:
Well, I was never in the camp and I might have been a minority in 2009-2010 when we had trillion dollar deficits for a few years that was going to lead to a real spiral to inflation and higher interest rates. I felt like there was such demand destruction in the economy that actually government had to step in and be kind of a source of demand. It’s not an ideological argument, it’s just a how I saw how the economy works and so we clearly come out the other side.
There’s this, the global economy is so competitive. I think there was a C change in 81-82 when Reagan took over and the tax laws were changed and we’ve become such a share holder focused economy and financialized economy that it tends to come at the expense of wages and the feeling of security in one’s job and you add to that the global forces and the competition that arises there and I look at global yields right now and I see, you know, Germany, 10-year yields at 30 points or whatever and Japan at a similar rate. Switzerland at negative rates.
And we have some of the highest rates in the world and we’re seeing already what’s happening to the dollar as there’s, you know, concerns towards indications the fed might start raising rates and it starting to impart our export industries. The price of oil coming down while beneficial for some is hurting other areas of the economy now that we’ve been producing so much oil. So, I am still in the camp that rates are going to remain quite low for a considerable period of time. I just don’t see how the fed presses on, you know, the brakes without doing some damage. So, yeah, that’s kind of my macro thinking right now.
Jason:
So, does that have to – like you said at the time, it was okay to have the QE, you know, you felt that way because the powers that be just had to step in, but I mean, do you think that ultimately that has to show up in inflationary pressure or is it just different, you know, where the government can print, print, you know, the government and the fed, I guess. It’s sort of this little dynamic between the treasury and the fed and they can do that without any real consequences, inflationary consequences or does that ultimately at some point have to rear its ugly hear or it’s profitable for investors with debts and real estate.
Gary:
Well, I actually talk about that fairly extensively in my book, the thinking behind why did he think rates were going to go higher and I do think that people misread the situation. It does appear on the surface that it was printing money, but really all the fed was doing was doing an asset swamp. They would press buttons on a computer and people would sell their treasuries to the fed and the fed would exchange that for cash. So, suddenly you’re taking interest income out of the economy and now the people had cash and they could do what they would with it.
So, a lot of this money is sitting in reserves in the banking system, but the banks, the only reason they don’t lend, they’re not – they would have to either be capital constrain, which they’re not, they have plenty of capital now or they really need qualified burrowers, you know, to compensate them for the risk and we’re not seeing just a lot of demand out there for burrowing.
I mean, there is in the junk bond world and all that stuff, but a lot of the capital is going to paid dividends and to buy back stock and it’s not necessarily going into the real economy, so I guess if there were profitable opportunities for business to really invest aggressively and that created – now, on the other hand, when they do that, that creates more supply capacity in the economy and to me you really start having inflation when demand far exceeds the supply capacity to the economy.
And so, I know I’m getting a little technical there, but I don’t see it on the horizon. I think if businesses wanted to burrow more aggressively and the banks would be willing to do that. Or said differently, if the banks had qualified burrowers on the consumer side and on the business side there’s plenty of capital to do that.
So, it’s a complicated topic, but it’s something I’m not really fearful of right now and let me add one more thing as to why I believe that to be the case, the demographic structure of the developed world is really aging and we’re seeing a slow down in labor force growth and that is generally not an inflationary environment.
If you look at how rates perform in the late 70s, early 80s, that was the same time we had tremendous numbers of new people entering the labor force who were not very productive and they suddenly had all of this demand in the economy and then you overlay the oil spike with OPEC and I just don’t see a lot of those same conditions.
Jason:
Yeah, interesting, very interesting. We shall see, we shall see which way it goes. Give out your webiste if you would, very interesting conversation.
Gary:
Yeah, thank you. So, there’s two of them. The firm is CWSCapital.com and then I have a personal one GaryCarmell.com and it’s got a lot of my blog – I write something every week and then the book is available on Amazon and Barnes & Noble and, as you said, it’s called The Philosophical Investor: Transforming Wisdom into Wealth.
Jason:
Good stuff. Gary, I just want to ask you on that last note. It looks like you’re not fearful of inflation, at least not for a while, you know, in terms of investor strategy related to inflation, deflation, stagnation, are you fearful of deflation?
Gary:
Well, not necessarily. To me, deflation would result if you had a material depreciation of asset values, because there has been a lot of burrower for, you know, real estate, and junk bonds in order to pay dividends and share by back. So, if there were some C change in the credit markets where suddenly this debt couldn’t be repaid and the asset values drop. I actually, that’s kind of the deflation I would ultimately be fearful of. Not so much consumer prices dropping, you know, I think they are kind of click along. Maybe they’re, you know, 1-2% level, so because we’re so financialized and a lot of people have their net worth tied to investments, that’s the risk that I see.
Jason:
So, financialized. Like, you said the share holder economy, I know, we have to wrap up, but I just want let you explain that thought if you would.
Gary:
So, there are businesses that are very profitable, a call calm, for example, and yet they, you know, they’re buying back stock, they’re paying dividends, they have high profit margins. Their business is a little under pressure and they’re probably going to restructure and layoff people in one of the more profitable business and it’s the activist investor. It’s the pressure for high returns on capital and capital efficiency and global choices where you can put your money and higher a labor, hire people.
So, that is a scenario that I keep saying creates this insecure growth where, being apartment oriented, I do think it gives people a tendency to rent or longer periods of time than they otherwise would and I just think it reduces maybe the bargaining power that labor has, generally speaking, and so, which keeps those inflationary pressures maybe lowered than the otherwise would be.
Jason:
Okay, so, in terms of investor strategy, I think the real estate investor, especially the one with leverage hits a home run in an inflationary environment. I mean, that is just a home run, huge home run. In a deflationary or stagnationary environment, I think it’s really just a game of yield. You know, that’s what we’ve seen to some extent over the past couple of years. I mean, it sort of like we’ve got all these different things going on at the same time, but it’s a game of yield largely and that yield, there’s just no place to get it. I mean, the real estate, the cash flowing real estate, is really one of the few places you can get yield, right?
Gary:
Yeah and that’s where we are probably maybe a little counter intuitive or controversial is we have been going very, very aggressively using viable rate amounts and most people that are in the real estate world including most home owners.
Jason:
That’s one where I would just think you’re crazy, but go ahead and explain.
Gary:
Right, right. So, I have a chapter in the book that says Go Variably Young Man and all the reasons why, but in our world, there is, when you burrow at a fix rate, it general starts off, the fixed rate is about roughly 2 points higher than your variable rate starting off. So, of course, you are taking interest rate risk, but that 2%, makes a big difference, especially if you’re burrowing, you know, 25 million dollars like we manage, but I do this on my personal investments as well. So, I’m meeting my own ticket. So, all my personal real estate has variable rates financing on it.
Jason:
Wow, you’re one of the few. I mean, no body in the industry agrees with you on that, do they?
Gary:
Right, right, that’s right and I’ve kind of like that. The Contrarian in me, but really what, I don’t want to get too technical, but in our world when you burrow at fixed rates and you want to pay that loan off early, you’re often are subjected to very large pre-payment penalties, because the lender wants to be compensated as if they had the money out the entire time. They don’t want to get it back early. On variable rate loans, there’s a very insignificant pre-payment penalty. So, we have a lot of optionality in terms of selling or refinancing and a lot of our variable rate loans can be converted to fixed.
Jason:
I want to make that distinction for the listeners, if we could. I own apartments and single family homes and on large apartment loans, they very often come with big pre-payment penalties. In fact, we just paid one on a deal we sold for over $8 million in Arizona. That’s not the case in the typical 30 year fixed rate Fanny Mae, Freddie Mac type mortgage that a single family home or a fourplex buyer would get. So, I think you do need to make that distinction. So, there is some real logic behind your philosophy there. Yeah, okay.
Gary:
Yeah, sure, you’re absolutely right that in the single family world, you know, one to four unites, you’re not nearly as constrained with pre-payment restrictions as we are, but what I would still say is often times, you know, the average ten year in a home is clearly less than 30 years and often times less than 10, but with that, there are other options like a five year fixed and then adjustable or seven years. So, I really don’t, you know, for me, and one of the things I say in the book is I talk about courage and courage is knowing what not to fear and for me I don’t fear materially higher rates. We buy interest rate caps and I feel like the positive leverage that I am getting is worth the risk and I can use that excess cash flow and do other things with it. So, it is not for everybody. I do explain why it’s for us in the book and our thought process, but I completely understand why we be in the deep minority.
Jason:
Gary, very interesting discussion. I know we went a little long, but you were interesting. I hope you don’t mind and again, thank you for joining us. You gave out the websites and we just appreciate having you on the show.
Gary:
Well, thank you so much it was my sincere pleasure.
Announcer:
This show is produced by the Hartman Media Company, all rights reserved. For distribution or publication rights and media interviews, please visit www.hartmanmedia.com or email [email protected]. Nothing on this show should be considered specific personal or professional advice. Please consult an appropriate tax, legal, real estate or business professional for individualized advice. Opinions of guests are their own and the host is acting on behalf of Empowered Investor Network Inc. exclusively.
