Five Lessons Washington Could Learn From Real Estate Investors

With all the news about the debt ceiling crisis, it’s hard not to think about policy making. And while we think there are some great lessons available for real estate investors, we also think the politicians would benefit from looking at the situation like a real estate investor.

Since we recently interviewed two presidential candidates (watch for those interviews to be released soon!), maybe some policymakers are paying attention to our lowly blog?  Who knows.  But you’re here (which we appreciate), so let’s get on with it.

Lesson #1:  Add New Customers

For a real estate investor, this means acquiring more revenue producing units.  Notice that this isn’t “raising rents”. Raise rents in a weak economy and you LOSE customers, not gain them.  In fact, if you tell tenants you’re thinking about raising rents, new people won’t move in and existing tenants will start looking for someplace else to live.

For Washington, businesses are “customers”.  Like tenants, businesses and the people they employ get up every day and go to work.  Then they send a portion of their earnings to Uncle Sam (in the form of taxes) just like a tenant sends a real estate investor a portion of his earnings in the form of rent.

So if a new tenant will not move in or an existing tenant will move out if rental increases are being hinted at, is it any surprise that businesses aren’t being formed, won’t hire, or move out of the country when higher taxes (or other similar government imposed burdens) are being threatened?  Consider how General Electric and Google have organized themselves (legally) to move their profits off shore, or how Amazon recently canceled contracts with all their California based affiliate marketers.  Did those companies want to invest time and effort to do those things? No.  But they decided is was the lesser of evils.

As a landlord, if you want to attract new tenants, you must provide a safe, affordable place to live. If Washington wants to “create jobs”, the focus needs to be on providing a safe, affordable place to do business.  We look to acquire rental real estate in places that are friendly to business.

Lesson #2: High Overhead Slows Growth

The bigger your real estate portfolio grows, the more people you’ll need to help you manage it.  These include your tax advisor, estate planning attorney, asset protection attorney, insurance broker, mortgage broker, etc.  You’ll also have property managers, maintenance people and a bevy of sub-contractors.

All these people must be supported by your rental income.  But you have to add tenants before you add team members.  If you get it backwards, you go broke, even though you have a “big” business.  “Big” isn’t necessarily profitable.

When you watch the news coming out of Washington, ask yourself if Uncle Sam is growing government in response to a growing number of businesses, or independently of economic growth.  In other words, private sector employment should be growing first and faster.  If not, then expenses will go up and revenues won’t and you’ll be hemorrhaging cash.  And if you think raising rents on your tenants in a soft economy is the answer, go back to Lesson #1.

Lesson #3:  Cash Flow is Not Profit

As a real estate investor, it’s important to make payments on time.  It preserves a strong credit rating, which is a very useful tool for investing.  But if your rents decline and you’re using credit lines to make your payments, it may seem to you and the outside world that you have everything under control.  However, you’re headed for disaster.

At some point, you’ll run out of credit.  And even if your lenders are dumb enough to keep raising your credit limit, all you’re doing is delaying the inevitable because each month more of your available cash flow goes to interest until that’s all there is.  The real problem is that you’re not running a profitable business.

When an investor is faced with this problem (and it happens all the time), he has some choices:

  • Increase revenue.  This can be done by raising rents on the existing tenants (if the economy will permit it – see Lesson #1) or by acquiring new profitable tenants (if you act before you’ve depleted your remaining cash and credit).
  • Decrease expenses. This is hard to do, but it’s going to happen anyway if you don’t fix the problem, so better to be proactive.

When we mentor investors, we encourage them to act like they’re on a space ship in trouble (think Apollo 13).  To survive, you have to make a limited amount of resources last until you can get out of trouble.  This means cutting all non-essentials quickly and deeply.  If you just lost your job, using your “free time” and credit cards to repaint the house, put on a new roof, re-carpet and update the plumbing is probably not the kind of “investment in infrastructure” that will lead to long term prosperity.  Better to go acquire more revenue producing doors.  To survive, you have to keep the main thing the main thing.  And the main thing is to increase revenue (acquire more customers) faster than you increase expenses (hire more employees).

Lesson #4:  Inflation is Not Wealth

In a financial system that is designed to inflate (a topic too big for this article), it’s easy to be deceived into thinking your successful when you’re not.  WARNING: Math Ahead. 😉

For example, if you own a rental property that has 10 units renting for $100 a month in 1960, your gross income is $1000 a month.  So the building might be worth $12,000.  Assume for now it’s paid for, so that’s $12,000 of equity for you.

If in 2010, units in that same building are renting for $1,000 a month, your gross income is now $10,000 a month.  So this property many be worth $1.2 million.  Again, it’s paid for, so it’s all equity.  Are you richer?

Well, think about that.  Let’s assume that you could buy a new car in 1960 for $2000.  So your building is worth 60 cars. ($120,000/$2000 = 60)

What about in 2010?

If a new car in 2010 is $20,000, then your building is still worth 60 cars. ($1,200,000 / $20,000 = 60)

Hmmm….in 2010, the building still houses 10 people and is still worth 60 cars.  So in terms of relative value and utility, it hasn’t changed.  But now you’re a “millionaire”.

If instead, over the years, you re-invested the income and equity (see Bob’s Big Boo Boo in Equity Happens), and you acquired 10 more buildings from 1960 to 2010, now you have a properties which will house 100 people and is worth 600 cars.  NOW you’re richer.  Why?  You have more property.

More property, not more dollars, make you rich. This is very important when dollars are losing value.  For an extreme example, think how many trillionaires there are in Zimbabwe.

So for Washington to measure economic growth in terms of dollars is very confusing.  And you can’t run a business with confusing numbers.  Did the economy grow or didn’t it?  Our we in recovery or aren’t we?

Think about it this way.  If an economy produces 1 million widgets at $100 each, then you have a $100 million economy.  If the price of the widgets increases to $120, you have a $120 million economy.  But did your economy really grow 20%?  The dollars say so, but production and employment say you didn’t.  You’re still only making 1 million widgets.  And your’re still only employing however many people it takes to build 1 million widgets.  So you didn’t grow at all.

Not to belabor the point (but we’re going to anyway), what if the widgets are $120 and you only make 900,000 of them and then lay off a corresponding 10% of your workforce?  Your economy “grew” from $100 million to $108 million (900,000 widgest at $120 each = $108 million).  An 8% increase!  But you produced less and have higher unemployment.  That’s called a jobless recovery or staglflation.

In real estate, if you own 1 property now and in 50 years you own 1 property, you might have a higher dollar denominated cash flow and net worth, but you aren’t any richer if everything else around you also inflated.  You don’t have any more property.

More property means more tenants.  Tenants who work (produce) means more productivity.  More productivity (not inflated dollars) is what makes you (and a country) richer. A wise real estate investor will focus on acquiring more tenants. See Lesson #1.

Lesson #5: Not All Jobs Are Equal

When a real estate investor considers a geographic region as a place to invest, jobs are the single most important factor.  Tenants have a much easier time paying rent when they have jobs.

But not all jobs are created equal.  And the difference is where the money comes from.

So businesses (the source of jobs) can be divided into two categories: Primary and Secondary.

A “Primary” business is one that sells products (derives revenue) from OUTSIDE the region.  That is, a Primary business pulls money in from elsewhere and funnels it into the local economy through their local vendors and employees.

So when a Primary business uses local business for office supplies, printing, temporary help, insurance, maintenance, utilities, sub-contract work, etc., they are effectively distributing the outside money into the local economy through these “Secondary” or support businesses.  Then all those employees further distribute the money as it passes through their hands and into the local economy.

But the key to a region’s prosperity is having a strong base of Primary businesses.  As investors, we avoid markets which don’t have a strong base of Primary businesses. Without Primary businesses, the Secondary businesses can’t thrive.  And each time a Primary business is lost, you lose not only the Primary business’ jobs, but many of the Secondary business’ jobs as well.  It weakens the entire regional economy.

It would be a like a family of brothers all living in the same house.  If one brother has a good job outside the home, he can hire one brother to wash the cars and mow the grass.  He can hire another to cook and clean.  He could rent another brother’s boat for a fun day at the lake.  He is the Primary earner and he can then trade his outside money for various goods and services within the household.  But he is really supporting the whole family, though no one is getting charity.  The prosperity is distributed to each brother according to his contribution.  However, all the brothers would be wise to be nice to the Primary earner.  If he moves out, everyone loses their jobs.

So imagine that one day, the Primary earning brother finds out that one his other brothers took some money out of his wallet without working for it.  He gets mad and decides to move, taking his primary income with him. Now all the remaining brothers are sitting home trying to figure out that to do next.

One brother decides to use his credit card to get an advance and then hires one of his other brother to mow the lawn.  Then that brother uses his “earnings” to hire another brother to cook and clean.  And that other brother uses his “earnings” to rent the boat.  To the outside world, and maybe to the brothers themselves, it looks the same as before.  But now they are simply trading with borrowed money.  How long can that last?

Sooner or later, that credit card has to be paid.  And someone better get a job outside the home and bring in some real money in, or everyone will eventually be broke and homeless.  A higher credit limit might put the problem off a while, but it isn’t a long term solution.  You can’t lose your Primary earners and expect to be prosperous long term.

A country, like a state, like a local region, like a family, better have some Primary earners. And the more, the better.  Without money coming in from the outside, deficits pile up and everyone is just passing borrowed money around and feigning prosperity while a financial time bomb is ticking in the background.  See Lesson #1.

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The Great Debt Ceiling Debate – Part 3

This is part 3 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”.  You can download the episode on iTunes or find it on our Listen page.

In our last installment, we explored the bond market and how interest rates are established in the open market.  Bonds are debts and the interest rates are set by risk, reward, supply and demand.  Now we will explore how the Federal Reserve Bank affects interest rates.  You should already know how interest rates affect you. 😉

How the Fed Influences Interest Rates

The Federal Reserve

The Federal Reserve Bank (the Fed) is the bank of the Treasury.  The Treasury is the government.  The Federal Reserve is NOT the government.  If you want to learn more about the Fed, we highly recommend reading The Creature from Jekyll Island, which is conveniently located in The Real Estate Guys™ Recommended Reading area.

The Magic Checkbook

For now, you only need to know that the Fed can write checks on itself that will not bounce.  In other words, it doesn’t need money.  It creates money simply by writing a check.  That may sound unbelievable, but for now, just take our word for it.  This isn’t an expose on the Fed, so you can look it up in your spare time.

Now that we know how the Fed’s magic checkbook works, let’s imagine that Uncle Sam shows up to hold a Treasury bond auction.  But there isn’t enough demand, so interest rates start to go up.  In prior installments, we discussed what happens to the value of all the existing debt out there when interest rates go up (it goes down), but to toss in some extra motivation for the Fed, the current Fed leadership believes that low interest rates stimulates borrowing, which stimulates spending, which stimulates production, which stimulates hiring.  This is a “Keynesian” view of economics.  That is, that borrowing and spending is the key to growth and job creation (how’s that working out so far?).

Side note: For an opposing viewpoint, may we recommend you look into “Austrian” economic theory, which puts forth the idea that one must actually produce before one can consume or borrow, and that production and savings are the keys to economic growth.  In other words, in its most rudimentary terms, before you can eat, you need to grow or hunt food.  And if you have more food than you need, then you have something of value to trade with.  If you don’t have anything to eat and nothing of value to trade with, you need to either beg, borrow or steal from someone who actually does produce.  And the only way to have trading partners is if they produce more than they consume, so there’s something extra for you to trade for.  The bottom line is that production, not spending, is the key to prosperity. That’s why printing money or stimulating consumption doesn’t create jobs.  And as real estate investors, we want to invest where jobs are being created.  Because unless you’re renting to people subsidized by the government, your best tenants will need jobs to pay you rent. Now, back to our main feature….

Now if you, like Big Ben Bernanke, believe that borrowing is the key to prosperity, where do you think interest rates need to be?  Hint: LOW interest rates attract borrowers.  Sorry, was that hint TOO obvious?

Let’s get back to our Treasury auction.  Uncle Sam is there holding his bonds out for sale, but not enough buyers show up. So Uncle Sam has to start lowering his price (increasing the yield) and interest rates start going up.  Big Ben thinks this is bad.  So he gets out his Magic Checkbook and buys, say $600 billion of Uncle Sam’s bonds (does the term QE2 some to mind?), to help create some extra demand.  Shazam! Interest rates stay low.

Well, if you’re a government addicted to debt, deficits and spending, this makes you very happy.  Just like when the interest rate on your growing credit card balance stays low.  With low interest rates, you can borrow more for the same payments.  No need to cut spending. Let the good times roll!  The only thing better than low interest rates is an increase in your credit line (isn’t there some discussion about that?)

To summarize, when the Fed buys Uncle Sam’s Treasury bonds in the open market, the extra demand drives the bond prices up and their yields (interest rates) down.  Then, the ripple effect of interest rate pricing kicks in, as all riskier debt pivots off the interest rate of Uncle Sam’s “safest debt in the world”.  That is, if Treasuries pay x, then a riskier debt pays x plus a little bit more (usually denominated in “basis points”, which are 1/100 of a percentage. So 25 basis points is 1/4 of 1% or .25).  The farther away you move up the risk scale, the more expensive the debt is for the borrower.  This is why everyone has their undies in a bunch over Uncle Sam’s credit rating.  It he loses his coveted super-duper AAA rating, then interest rates go up….and Big Ben may need to step in with his Magic Checkbook.

But what happens when Big Ben uses his Magic Checkbook?  Are there any side effects we should be considering?  Hmmm….?  Inquiring minds want to know!

So join us next time, as we delve into How the Fed’s Purchase of Treasuries Affects the Money Supply.  Hint: “Trickle Down” isn’t just for supply-siders any more.

8/15/10: How Capitalism Will Save Us – An Interview with Steve Forbes

The Real Estate Guys™ sit down and talk with Steve Forbes about jobs, the economy and real estate.

We don’t know about you, but any time a billionaire, a CEO of a major company, a best selling author or a legit presidential candidate is willing to sit down and chat, our response is always, “Yes!”.   In this case, our special guest for this episode, Steve Forbes, is ALL of those things wrapped into one.  So we’re super jazzed to bring this exclusive interview to you.

In the broadcast booth at the Freedom Fest conference in Las Vegas:

  • Your Host and interviewer extraordinaire, Robert Helms
  • The just-happy-to-be-here Co-host, Russell Gray
  • Special guest, Forbes Magazine CEO, Steve Forbes

 

 
Mr. Forbes was the keynote speaker at the Freedom Fest conference and remained in attendance for the entire event.  In spite of a recent neck surgery, he was very accommodating and so Robert was able to sit down with Mr. Forbes for an impromptu interview.

Steve Forbes with Russ and Robert at Freedom Fest. Russ wrestled Steve into doing the interview, which broke Russ’ glasses and injured Steve’s neck. But the interview went well and we were all smiles afterwards.

We decided to ask him about his latest book, Why Capitalism Will Save Us – Why Free People and Free Markets are the Best Answer in Today’s Economy. Mr. Forbes’ thesis is that too much government is bad for business because it increases costs, diminishes productivity and takes too many resources away from creating jobs for an ever-growing population.  He calls for “sensible rules of the road” to provide a basic framework in which free people can conduct business.  Of course, the great debate is over what’s “sensible”.  His position is that less is more.

What we’re really interested in is jobs. Jobs are where our tenants get their rent money.  It’s where home buyers get the income stream to make the mortgage payments that prop up the property values that create passive equity.  Jobs are near the top of our due diligence check list when evaluating a market to invest in.  It’s one of the reasons we like Dallas right now.  Among U.S. markets, it’s doing pretty well.  Ironically, another great job market is Washington DC, but if there’s a changing of the guard over the next couple of elections, that could change.  But we digress…

So Mr. Forbes shares his thoughts on the economy, job creation and the role of government in real estate, specifically Fannie Mae and Freddie Mac.  In his position as the CEO and editor-in-chief of Forbes Magazine, he gets to talk with many of people who shape, interpret and respond to public policy.  We really enjoyed our time with him and hope you will too!

On a side note, Steve Forbes is the nicest billionaire we’ve ever interviewed.  Actually, he’s the only billionaire we’ve ever interviewed.  But he’s still a very nice guy.  So, if you’re a billionaire and want to come on the show and be nice to us, just give us a call.  Our door is always open. 🙂
 

 
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