1711: Mitigating Downside Risk When Purchasing Income Properties & Why the Cost of Construction Keeps Rising with George Gammon, Part 1

Welcome to the Creating wealth show with Jason Hartman. You're about to learn a new slant on investing, some exciting techniques and fresh new approaches to the world's most historically proven asset class that will enable you to create more wealth and freedom than you ever thought possible. Jason is a genuine, self made multimillionaire who's actually been there and done it. He's a successful investor, lender, developer and entrepreneur who's owned properties in 11 states, had hundreds of tenants, and been involved in thousands of real estate transactions. This program will help you follow in Jason's footsteps on the road to your Financial Independence Day. You really can do it. And now, here's your host, Jason Hartman with the complete solution for real estate investors.

Welcome to episode 1711. 1711. Thanks for joining us today. So we are going to take a deep dive into an interview I did with George. You've heard him on the show before and we are going to talk about one of my core principles. I think this one is becoming even more important now than it has been in the past because more than ever we need to be able to analyze deals, make sure they are prudent, that we are buying properties that make sense the day we buy them. From a risk perspective, we want to mitigate downside risk. And now, in light of our recently launched index, the Hartman Comparison Index, the hci, this stuff just applies more than ever. So I'm going to go to an interview that I recorded with George and I think you will enjoy this. You have not heard this on the show before. You've heard me talk about the concept of it, but it just comes out so differently when you have someone you're discussing the issue with. Right. Rather than thoughts just coming out in monologue format. So I think you'll really enjoy this and we will continue it on Wednesday because it is a deep topic and needs a lot of thought and a lot of analysis. And I know that a lot of you have been asking me. You asked on the live streams yesterday. We had two live streams yesterday. Happy Hour livestream with Ken McElroy and George Gammon and also a morning livestream, a coffee talk where Ashley joined me and we took a bunch of your questions. So make sure you check those out on YouTube and on Facebook. Really? YouTube's the best way to do that. We will have a landing page for you to get tickets for our upcoming event, September 10th, 11th and 12th. We've got property tour on that Friday and then conference on Saturday and Sunday throughout the weekend. So it's going to be a fantastic event in Orlando, Florida, and we will have the ticket page for that up soon, and we will, of course, announce it here. Okay, without further ado, let's get to that discussion on mitigating risk or when buying properties.

Got my good buddy Jason Hartman here. Thanks for being here.

Hey, George, it's great to be back on your show. And, you know, you just do such a good job educating. Ever since our client Clay Slocum, who loves your channel, told me that you mentioned my name on your show a couple times, I tuned in and I've been learning a ton with your awesome whiteboard videos. So it's really an honor to be back.

All right, so we've discussed a few things in the past that are extremely important to people who want to get involved with real estate investing. But we haven't gone over everything. And one of the main things that you discuss that is so incredibly valuable is how to assess risk.

One of the most important things to do is manage risk. There's a great idea of getting a return on your money, but the most important thing is getting a return of your money. Right? Get a return of your money first and then get a return on your money after you get a return of your money. So that's what we're going to talk about today. And you know, George, it is amazing that you can really, really dramatically limit your downside risk. Nothing is risk free. There is no such thing as a passive investment income. Property certainly is not a passive investment. Anybody that promises that is a complete liar. They should be drawn and quartered because they're lying. Okay? They're just totally lying. All right, Maybe not drawn and quartered, but put in jail. How's that sou.

Yeah, no such thing as a passive investment. In fact, an S and P index fund is not a passive investment. A mutual fund is not a passive investment. If you're investing in stocks, bonds, mutual funds, you better get educated. You better pay attention. Because the market is dynamic. It's always changing. There's always stuff going on and you cannot afford if you want to get a return of your principal and certainly a return on your principal. And you better pay attention and be educated. Interestingly, and I'm sure your viewers and listeners would agree with this, but by and large, most people in the general public would not. I would assert that even a bank account is not a passive investment. Now, you know, of course you'll get eaten alive by taxes and inflation because the tiny little bit of interest you're going to get on that money, you're going to be taxed on that. And then of course it's the hidden tax is inflation. And your principal value of your investment in the bank account, even a savings account, is going to be destroyed by inflation. Right?

We got negative real rates. Everyone thinks that Japan and Europe have negative rates. So we've got them too. They're just not nominal. They're real, right?

Absolutely, absolutely. So there's no such thing as passive investment. We want to get a return on our principal and then a return of our principal too. Of course, after 19 years in the real estate business.

Discovered a secret on how people can almost eliminate their downside risk on a real estate deal. And I just want to share that with your audience today. So let's dive in and take a look at that. I call this the Hartman Risk Evaluator. And basically what it consists of, George, is most people have heard of the LTV ratio. LTV means loan to value ratio. And that just says that, you know, if you're putting 20% down and you're getting an 80% loan, then your loan to value ratio is 80%. Right. Of the value. Right. That's LTV. Now I invented another ratio and I call that ratio the LTI ratio. And that is the land to improvement ratio. Remember, whenever we buy a property, we're really buying two things. There are two major components. One is land and the other is the improvement or the house or the apartment building or the retail building or the office building or the industrial building sitting on that land. That's the improvement. Okay?

Right.

We certainly don't recommend raw land as an investment because that's highly speculative. It produces no income. That would be just like a non dividend paying stock or precious metals. A single level strategy, a one dimensional strategy which is just buy low, sell high. That's it. That's the whole strategy. Of course, a multidimensional strategy is better income. Property is beautifully multidimensional. It's great like that. Then you go to two dimensions. Dividend paying stock, buy low, sell high, plus get some dividends on the way. Go ahead.

Oh no. That's what I was going to ask you. What were the multi dimension or what makes income property multi dimensional?

A whole bunch of things. There is the income as the name would imply that it produces. Right. The rental income. There's the appreciation, the leverage, the tax benefits and the depreciation. Depreciation meaning the awesome tax benefit you get. That's the holy grail of tax benefits. It's called depreciation. And we can talk about that as well, and then beyond those commonly known things, there's the thing we talked about in that three part video series we did for your viewers and that is inflation induced debt destruction. IIDD I know, it's a mouthful. Inflation induced debt destruction. So let me just tell you this story of how this came about. And this was, this is not an invention, it's a discovery. And I discovered this after 19 years in the real estate business and 18 years as a real estate investor. 19 years as a broker, 18 years as an investor. And here's what it was, here's what happened. I bought my first out of state property. I lived in Southern California at the time and I thought it's a big world, the world is my oyster. I was looking at investing internationally, I was looking at investing nationwide. I had been through a couple of recessions in Southern California. I was getting older, I was getting more conservative. I didn't want to do that again. So I thought, well, the old saying in real estate is that all real estate is local, all real estate is local. So I wanted to take the best asset class income property, but diversify geographically. And the amazing thing I discovered is I got this call from my insurance agent. Her name is Jennifer, and she worked at an insurance brokerage in Irvine that I had used. Irvine, California. I was buying two properties right around the same time. One was a home in which to live, and that was in Orange County, California, was a fairly expensive home compared to the rental properties we look at. And another was a rental property across the country in the southeastern United States. And Jennifer calls me up and she says, jason, we're going to give you insurance on your rental property for $135,000. And you know, George, it struck me at that point that was the discovery, that was the aha moment. That was when the light bulb went on. Here's why. The insurance company only insures the improvement, not the land. Because the land doesn't burn down, the land doesn't get vandalized. The land is not insured. Okay? The lot that the house is sitting on, but the house itself, the improvement, the structure is insured. And so what Jennifer was telling me then is that the insurance company believed that if that house burnt to the ground, the replacement cost of that house would be $135,000.

Right, got it.

This was the aha moment. Why? Because of the price I had paid for that house. So these two component parts, when you buy a property, land value, improvement value, the improvement value consists of the cost to build the house or the apartment or the office building or whatever. I'm just using a house as the example, plus the builder's profit. When the builder can't make a profit, George, they're not going to build the house anymore. Right. They're going to finish out their inventory if they can afford to. This is what happens when you go into a cycle and go into a recession and then they're going to just stop building because the machine doesn't work anymore. So they've got to make that work. Now let's look at some of the factors that increase improvement value. What influences improvement value? What drives the value of that house sitting on the land? Okay. Environmentalism and building restrictions. That increases improvement value. Why is that? Well, it's because if the government makes it very hard to construct new homes, then homes that are already built increase in value. We've certainly seen this in my former home state where I lived most of my life, the Socialist Republic of California.

And California is quite a disaster actually. Last year they did three things that are just going to kill them. I mean, economically, they are chasing people out of the state. They did rent control, they did this new sort of draconian data privacy law, which, listen, I'll be the first to agree that, you know, we need to keep some of these tech companies in check. Right. But the reality is that's hard to comply with, it's expensive, it's going to chase a lot of businesses out of the state, I think. And then they did AB5, which was the gig economy bill, that basically it sort of arose out of the Lyft and the Uber debate. Right, the ride sharing companies where all of the Democrats in their misguided ideas decided that, you know, all these drivers for Uber and Lyft, you know, it's not fair to make them independent contractors. They should be employees and have all kinds of employee benefits. So guess what that's going to do? It's going to make supply go down and it's going to increase cost. Right. Obviously that's what happens every time. And now all of these workers that the liberals said they were going to help are now picketing and they're very upset because they don't have enough work. And all the people that work on, you know, these sites like Upwork and these different sites as contractors in the gig economy, nobody wants to hire them anymore. They're all getting their contracts canceled if they're in California.

So it's crazy and you gotta, you gotta have a side hustle California just to get by.

Yeah, totally.

Especially in la.

So you Know, there's an old riddle. What do you call a developer? And the answer to that is somebody who wants to build a house at the beach or in the woods. What do you call an environmentalist? Somebody who already owns a house at the beach or in the woods. Okay.

Exactly. Right.

I had the great thinker Thomas Sowell.

He's my personal hero. I mean, I can say he is my. Other than my father. I mean, he is just. Oh, man. Anyway, yeah, he's just amazing.

Thomas Soule was on my show. And of course, you know, he's a Harvard professor, or I guess former one, and an author of many great books, and he used to write for countless magazines, times. He's. He's a real intellectual. He's a real thinker. And we were talking about this environmental building restriction thing. I coined a new term during that podcast. And, you know, basically the concept is as soon as someone owns their house there, they don't want anybody else to be able to build a house there. Right. They want to keep them out. Right. That's always the way it works. And they do it under the guise of protecting the environment. But really, I created a new phrase during that interview with Thomas Sowell. I called it environmental racism. And the concept is, the way you keep the people of other races out is you create a bunch of restrictive environmental zoning policies so nobody can build a house. So the house prices skyrocket. Nobody can afford to live there.

Right. Not just other races. Just anyone, period.

Anyone. Yeah, yeah, yeah. You can't have any neighbors at all. Right. So environmentalism and building restrictions definitely increases the value of improved properties. Okay, that's a big driver. Okay, next one. Industrialization of developing countries, namely China and India, of course, are the biggies, but there's many others. And why is that? Because as these countries industrialize, they are just sucking up materials. They are sucking up concrete, lumber, petroleum products there. It's just like the demand for these commodities for copper, that, by the way, is copper wire in your house. Right. The demand for these commodities becomes very scarce as we have the rising. What they coined the term the rising billion, but it's really the rising 3 billion people on Earth that are moving up. They're going to move up into the middle class. You know, hopefully that works out. It's this rising tide around the world through globalization is really impacting this, but it's also making materials and commodities, commodities, more valuable in putting upward pressure on the prices of them.

I think you just hit on a really amazing point right there that very few people Think about. I know I've thought about this, but that's just because I've listened to your podcast for so long and that people see a house as just a structure. It's where we go to eat, where we go to sleep. It's just, it's a house, but it's not, it's just a combination of a bunch of commodities, right?

Absolutely.

And therefore, when you start to look at it as a group of commodities, whether it's copper, glass, concrete, metal, wood, then you look at that from a valuation standpoint and you start to see things much, much differently.

Yeah, you do, you do. Because you know what you really see and you know, just to demonstrate it, right. I bought this house last year and you know, if I go back there and knock on the wall, right. It's what I call packaged commodities investing. As real estate investors, we're really commodities investors, you know, but the difference between buying our commodities packaged in the form of a house versus buying them on the exchange is that we can get leverage, we can get, you know, very favorable tax treatment. We get all of these benefits when they're packaged.

We don't paid to own them, we.

Get paid to own them because our tenants pay for them. And it creates what I call self liquidating debt. That mortgage debt gets paid off by somebody else. It's really a form of, in the corporate world, what they call an lbo, a leveraged buyout. You know, when you buy a piece of property, you're essentially making a leveraged buyout, at least for maybe 80% of.

It, of a cash flowing company. And the way I kind of compartmentalize things is I always tell people that at least my definition of an investment is something that you have to get paid to own it. If you're not getting paid to own it, then in my opinion, it's not an investment, it's a speculation. And I think if people compartmentalize things that way, they do a lot better with their overall portfolio, not just with real estate.

But yeah, I think you're absolutely right. You're getting paid to own it. And that is a beautiful thing. See, when you package the commodities, you take advantage of very special characteristics that are not available in the individual commodities. If you just buy copper on the exchange, or you buy lumber or pork bellies or coffee or whatever, right? It's not a packaged commodity, it's an individual commodity. And Adam Smith in the wealth of nations, he talked about specialization. Of course, you know, we've all studied this book as a hack economist that we are Right. Or at least I'll speak for myself. I'm a hack economist. You, you're a professional.

That makes two of us.

You're a professional. But we look at the specialization of labor, right. And we know that when you make something that's a specialized item, it's way more valuable than it is as an unspecialized item. And I think, actually, if I remember correctly, in that book, he uses the example of a big piece of iron or something, and then he talks about, well, you could make it into this, make it into that, but if you make it into little needles, little pins, it's worth a fortune. Right. That same piece of iron. Right. Because it has. Well, in that sense, it's sort of like the unpackaging, but it's. It becomes a specialized thing. And so the same is true of a house or anything like that, or a rental property.

And I would take it a step further, say, like commercial space or anything. If you can compartmentalize a commercial. Commercial space, you can rent it out for a lot more per square foot. Just like Adam Smith's example of breaking things down into a needle.

Yeah, breaking it down, you know, it becomes more valuable that way. So getting the commodities package is a much better way to be a commodities investor. Okay, I think we've established that. Okay, 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 US was only 3.3%.

Yeah, right. Is that the CPI or is that the actual broken down raw material cost number?

That's the CPI number.

That's okay.

Yeah, yeah. So that's what they were telling us was inflation. I mean, it could have been core rate versus cpi, but I think it's cpi. Okay, as I recall. But look at this. The price of steel and iron went up 34% in the same year, more than 10 times the rate of stated inflation. Lumber was up 17%. The prices of wallboard, 20% increase. When they told us inflation was only 3.3%. Are you kidding me? You know, it's so stated. It's absolutely ridiculous.

And just in 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 if 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, then 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.

Right, right. And you know what's interesting about what you just said is that I remember I was doing a speaking engagement in Phoenix, you know, it was right around 2004 or 5, and I had a heckler. You know, I've had like two hecklers in my life in the audience. And this guy just thought he knew everything. He was so SM and he was going to outwit me. Right. And heckle me there in front of the audience. And so he brought up, 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 we've been involved in hundreds of transactions in Houston, Dallas, Austin and a little bit in San Antonio too, and then in North Carolina, Indianapolis, many other markets. He kept saying, well, you're telling people to invest in Houston, but Houston has really lax zoning laws. They have very little restriction. 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. When land is cheap, I think that's great. I want to be the commodities investor and I'm going to show you why in a minute, but that'll come back in just a moment. Okay, so let's go on and 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 incorrect me if I'm wrong. But when I do it, I don't look at 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 a yield investor cheap or is it not? And then, okay, we can talk about if 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. It's more about that income stream.

Absolutely. You are a yield oriented investor. And 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.

Absolutely.

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 of those multidimensional characteristics, through the self liquidating debt, the tax benefits, everything else. Right. 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 they're starting in the same place. Right. You know, 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. The cost of labor definitely increasing. And that's a huge thing. Do you know, I was just watching a video for the economy Economist magazine on their YouTube channel. 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 48 years old. Wow, that is shocking to me. Yeah, I can't believe it. I think it was Germany they were talking about. And it just goes to show you that there is 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 listen, 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 in the Wall Street Journal about how you can buy ahouse on Amazon.com for $19,000. So I looked and by golly, there are houses on Amazon for $19,000. Go check it out. But I called that company and I called a couple of those other companies with those houses. First of all, they're just a kit for the walls. They don't include any plumbing, any engineering, any H vac, any appliances. They don't, of course, they don't include land. And I totally grilled this 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? You know, if I want to really build one, you know, 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, you know, I do the engineering and I have the plumbing people come in and do the plumbing, and then the electrical people come and do the wiring and everything. 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 costs? And she's finally told me the answer. $200 a square foot, Right?

Well, okay, yeah, just, I mean, do the math. You gotta. Yeah, you gotta think about, well, they're not using any different materials. So what would be their cost savings? Like how manufacture, saving, all this cost. It's the same material, they gotta ship it to you. So if anything, there would be a higher cost to that. It doesn't really make a lot of sense.

I mean, you'd think that it's more efficient to manufacture the components of a house in a factory. I would definitely agree to that.

Trusses, the big thing. When I was a construction worker, I don't know if I ever told you that. In college I was on a framing crew. That's one of the ways I worked my way through high school, while I was working in high school, but then worked my way through college as well as a laborer. I remember a lot of the homes that we would build in Oregon, in Portland, 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, 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 whatever, even if you do that, according to all of those cheap kits on Amazon, you still, by the time you do the engineering and the permitting and all that stuff, it's 200 bucks a square foot. That's no deal. I mean, you can go to Jason hartman.com right now and get properties for far less than $200 a square foot.

Okay, 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 in 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 this was2013, maybe, something like that. And excluding the land, just the cost of the improvement value, we spent about 120, 130 a square foot. So that just goes to show you how much the cost of building has gone up just in the last, call it seven years.

Yeah. And you know 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 to builders to the cost of construction. Because, you know, before it was, well, every house had to have, you know, 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 shower heads and. And it's got to have LED lighting. And, you know, they just keep throwing on the regulations and making it more expensive 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 when you require it, all I'm saying is it just makes it more expensive to build.

Yeah, 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. Why don't these builders just go out there and make it happen?

They 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. And 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. Right?

Tough.

It's an understatement.

Listen, 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 were going to go in there and just level to build this new home. They made me hire one of their arborists, which is a tree pro guy.

A tree person. Yeah, this guy.

Three grand to come out and tell me what all these trees are.

Oh, yeah.

And then I had to replant. I had to build a median. Well, not really medium, but, you know, the sidewalk, 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. It's insanity. So that's absolutely why we have a housing shortage. That's why.

That's why. That's why you have a homeless problem, because you've made it really tough to build. 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 the planning of the roads within the development that they're building of a tract 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 and need a bigger turning radius, because every developer will tell you it's just become ridiculous. You know, it's. It's. The burden is so insane. So, 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. 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. Water's in there too, you know. But energy cost definitely increase the cost of construction, right? Because energy is in everything. It's, you know, everything is energy.

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