1712: How the Hartman Risk Evaluator Protects Your Real Estate Investments with George Gammon, Part 2

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 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 1712. 1712 and today we have part two from Monday's episode where we are talking about risk evaluation and mitigation. Very, very important topic for investors and also a couple announcements before we get started. This Sunday evening we have our inner circle, our empowered investor inner circle monthly meeting and we have one of our attorneys back to talk about asset protection. And we are going to go into a totally new area of asset protection, one that you probably haven't thought about and it is really important and that is the area which is becoming sadly all too common.

Civil forfeiture. Yes. I have done some shows about this over the years, mostly on my holistic survival show, but I think we've talked about it here on this show as well. This is just a super scary topic. It is becoming more and more prevalent and needs to be something you are planning for. We're also going to touch on gun trust and some other interesting areas of asset protection. I've asked our attorney to test take a deep dive into these topics. I asked him to develop some special vehicles that can help you with this. It is somewhat unlikely, especially on the civil forfeiture side, but I tell you, if it happens to you, it is devastating. It ruins lives. And if you type that in, just type it in on a search engine and watch some of the videos about the stories of this A little old lady that owns a restaurant in a nondescript town. Civil forfeiture. The government just raided her bank accounts, ruined her life. Absolutely devastating stuff. You got to protect yourself from this possibility. It's a thing that is just becoming more and more common. And of course all of this stuff applies to general asset defense and estate planning as well. So we're going to talk about that Sunday evening, the 18th. So if you are not a member of the empowered investor inner Circle, be sure to go to empoweredinvestor.com and join right away and join us for Sunday evening. That is really, really important stuff. Also, we have our event. It is definitely confirmed. We were just making some final adjustments to the ticket page. So to register for our event on the page that's not quite done yet, but you can go check it out. Empowered Investor.

Empoweredinvestor.Com conference and join us for our September event. And without further ado, let's get to today's topic and take a deep dive into risk evaluation and mitigation.

Here we go. Remember I told you that I was buying two properties at the same time? I was buying the one property to live in in Orange County, California, and I was buying the other property across the country. That was my first, or maybe it was my second because I don't know which one I actually closed on first. But I was buying one in Austin, another one further in Georgia. Right. In buying these two properties right around the same time, I was buying this house for myself. It was a very interesting experience. So this is the tax bill for the house I was buying to move into Orange County. Yeah, this is in Orange County. Now, the land value, this is according to John Morlock, the Orange County Treasurer tax collector, because the tax collector segments the value, the two components, the land value and the improvement or the buildings. And this house altogether was $815,000. And the way that divided up approximately was 659,000 in land and 155,000, 753, I guess, in improvements. That was the equation. Now, your listeners or viewers might be thinking, well, how do I know the land value versus the improvement value? There are three ways. Number one, the tax collector on every tax bill, they always divide the land and the improvement up because it's taxed differently in probably every area of the country. You know, if it's vacant land, the tax is different than improved land. So they got to know that value. So they always make an estimate of what that value is. The other source is, like I said, your insurance company, Jennifer, my insurance agent, told me that that house across the country, they were giving me $135,000 in insurance. So by deduction, I knew what the land value was. The third source is just have an appraisal. The appraiser will always divide those two components of land versus improvement, so you know what you're getting. So here's the way that looked. It was 815,000 total, 156. I'm rounding just a tad 156 or 19% improvement value and 81%, $660,000 in land value. Now, just so you know, that was a brand new house. It was built by California Pacific Homes, and they're sort of related to the biggest land developer in the country, or at least one of the biggest, the Irvine Company. Many people have heard of them. And here's what happened. I had this girlfriend at the time, her name was Monique. And Monique's mother was in new home sales. So Monique thought she was an expert. Right. We ended up breaking up, clearly. And she told me not to buy this house. Now, Monique really was vehemently trying to talk me out of buying this house. I'm glad I didn't listen to her. Here's what happened. I owned this house for just one short year, and I couldn't believe my luck. I didn't consider this to be any great investment. I didn't consider this a stroke of genius. But it's kind of amazing what happened, because one year later, I saw the values climbing like crazy. And I thought, you know, I better refinance and get my money out. I always try to engage in a practice I call equity stripping, because equity stuck in a property is always at risk, number one. And number two, it's not working for you. I want to put that equity to work. So I call up my lender and I said, send an appraiser out. I want to do a cash out refinance, and I want to buy some more rental properties. So the appraiser came out. His name was Eric. And I'll tell you, Eric came out a year later and appraised the property again. And then Eric came to one of my conferences where I told this story about him, which was pretty funny. So here's what happened. Eric came out and said, congratulations, your house is now worth $1.3 million.

Wow.

And I thought, in one year, that house went up by $485,000. I am so lucky. Thank God. That was a great deal. But the question is, if the tax collector were to send me another tax bill, how would they have divided up the value in the LTI ratio, the land to improvement ratio? What would the tax collector have said about the new value? Where did it increase? We know that it increased by $485,000. We know that now the value is 1.3 million. But the question is, how would you allocate that value between the two primary components, land and improvement?

He just increased the land value, wouldn't he?

Yeah, that's the puzzling thing, right okay, So I always ask my audience this question when I'm doing this live. I have them vote. Raise your hand if you think it's land value. Raise your hand if you think it's improvement value. And the reality is, George, both people are right. Both things went up in value because construction costs were increasing, okay? And land values were increasing. So both things went up. But what went up the most? Definitely land. There's no way it cost $485,000 more to build that house just one year later. It was an 1800 square foot house, you know, a nice house, but no big deal, just an 18. It wasn't the best house I ever lived in, for sure. But, you know, it was a nice 1800 square foot, brand new house, you know, nicely designed, with a nice view of the city lights and the ocean in the distance. And, you know, it was a good house. It was mostly land value. So here's what happened. Another year later, I wanted to refinance because the rates went down. So I call up the same bank, the same lender, and they send the same guy. The same appraiser comes out. Eric, good old Eric comes out. Now, after this, during the Great Recession, they changed all this. And probably it's very good thing they did. Now they have to use what they call appraisal management companies. So the likelihood of you ever getting the same guy twice would be extremely rare because they don't want the lender to be in cahoots with the appraiser. Good thing. But in the old days, you know, that's the way they did it, Right? They just had an appraiser on staff or one that they commonly used, and they'd send them out. So Eric gives me some bad news the following year. He says, hey, I'm sorry to tell you, your house is now only worth $1,235,000. It went down by $65,000. So now the question is, where did the decline come from? Land or improvement?

Yeah, it's got to be land again, isn't it?

Absolutely. You're absolutely right. Land. You got it. Because look, the improvement value, it doesn't cost $65,000 less to build that house another year later. Exactly.

And plus inflation. Even if the. Even if you have asset deflation, typically because wages are so sticky, you're still going to have the CPI go up, right?

Absolutely. And the fact is, construction costs were still rising. It's interesting, as a little aside, I had purchased many new homes over the years before I purchased this one. So always in California, the New home never came with a yard. You always had to hire your own landscape contractor and do your own landscaping job. So I've done many landscaping jobs. I've hired many crappy contractors. I had to sue one of them, and I had to file a complaint against another one who thankfully lost his license. He was so bad. Oh, it was awful. So I'd done many landscaping jobs. Now, this particular landscaping job on this house, George, it shocked me how much the cost was. I couldn't believe it. Like, I could not get a decent bid. I had so many bids. I had a bunch of contractors come out, and all of them told me, it's just gonna cost a lot, right? It was expensive to landscape this house. And I kept asking them, I said, why is it so expensive? I just landscaped another house about a year ago, year and a half ago. And they said, china. And I said, what? And they said, all the concrete has become very expensive because China is using it for all these infrastructure projects. You know, they're building freeways and bridges and, you know, skyscrapers, and concrete just became very, very expensive. So that drove the cost up. So you're right. The decline came out of the land value. So what can we learn from this? Well, this is a long winded thing here, right? What can we learn from this? We can learn that the risk, when investing the risk.

I can already see where this is going. And this is really cool. Really, really cool.

The discovery after 19 years in the business, Jennifer caused me to discover it. I got to call her up and thank her because I never realized this before. I have followed every real estate guru. I have read a zillion books. I've been to a zillion seminars. Nobody ever taught me this. It came out of my own head this way. Okay? The risk is in high land values. Okay.

Right.

Now, you know, George, because you listen to my podcast and we talked about on the show that I think there are three types of markets. Linear markets, cyclical markets, and hybrid markets. Right? Guess what? The markets that I don't like to invest in, that I consider to be high risk markets that I shy away from and recommend our investors, our clients avoid are cyclical markets. And guess what? Cyclical markets always have.

High land values. Okay? And guess what? Linear markets, the markets I like always have, they always have low land values.

Super low. And when he's saying low, guys, I know that my land value. I don't know this for sure, but I would. Back when I was investing heavily in Kansas City, when I was buying all these homes, which A lot of them. I still have cheap land.

Cheap.

We're talking like $5,000, like $10,000 on a home that's now worth 170.

Yeah.

It just shows you how that equation is so lopsided in the other direction.

It's lopsided in a very good way for the investor. So this was the value of the house I moved into. The story I just told you, that's how it looked. Mostly land value, very little improvement value. The rental property I was buying across the country looked more like this. Right. Very low land value and high improvement value. Let's go back to Jennifer, the insurance agent. She calls me up and she says, jason, we're going to give you $135,000 insurance on this house. Well, what I didn't tell you yet is what I paid for that house. The price of that house, I will now tell you, was $159,000. So I knew by deduction that the land value was $24,000 and the improvement value was 135. Here's the thing. Ultimately, that house I moved into, I sold it for a lot less than 1,235,000 because I stayed in Orange County. The Great Recession happened, and guess what? Land values plummeted. I ended up selling that house for. I think I sold it for 917,000. Just a little bit over 100,000 over what I paid for seven years earlier. Okay. Yeah.

They got to include the property taxes and the maintenance.

Yeah. Oh, hey, my overall bill on that house for hoa, property tax, mortgage, Remember, mortgage rates were much higher back then, was $11,000 a month. That's what I was paying to live there. Okay. So, yeah, California. Outrageous. Right? So here's the thing. If the land value drops by half, let's estimate the land value, though, at the peak of the market, on the house I lived in, it was 1.3 million. Remember, the original improvement cost was $155,000. Okay. Or 156, rounding correctly. So let's say that the improvement is now worth. The house is now worth 200,000 because it costs more to build it. The construction costs, labor costs have gone up.

Right.

It's worth 200,000. That means the land is worth 1.1 million. If that land goes down by 50%, I'm going to lose $550,000. Yeah. But on the house, the rental property across the country, where the land value is only $24,000, I'm only going to lose $12,000, and I can live with that plus there's another huge thing. When I sold the house I lived in before selling it, I also put it up for rent, and I was asking $4,500 a month in rent, yet my payment was $11,000. Not a very good deal at all. Right. But you know, if you think it's going to go up in value again or something like that, you can rationalize it away. But not a good rationalization. So I'm glad I sold it. But the cheap house, that was 159,000, that's a sustainable property. I can rent that and afford to keep it. Where? The expensive house, I can't rent it and afford to keep it.

There's one cash flow positive, one cash flow negative.

Yeah, absolutely, absolutely. So low land value equals low risk. High land value equals high risk. That's the moral of the story, period. This is true everywhere on planet Earth that you have a cyclical market where you always have high land values. Dubai, Paris, Tokyo, London, Hong Kong, New York, L.A. san Francisco, Seattle, Miami, it doesn't matter. You can name any city on the planet Earth. And I will tell you, if it has high land values, it is definitely a cyclical market. And I will also tell you, if it is a cyclical market, it also has high land values. There's no exception. Those are always true together anywhere on Earth. And I will tell you that if it is a cyclical market, your rent to value or RV ratio is going to be terrible. And I'll tell you a contemporary story quickly about that. One of my contractors, guy named Charles, he's a great guy and he's been doing some good work for us, he lives in Seattle. And he tells me just three days ago, he says, hey, we bought a new house, we're moving. And I said, oh, congratulations. We got into the conversation, what are you doing with your current house? And he says, well, we're going to rent it. And I said, how much is it worth? Seattle in Seattle? Yeah. Well, Seattle, metro area. Not exactly Seattle, but metro area. Metro Seattle. And I said, how much is it worth? He only had to tell me one number. And I've done this many times, George. I only need one number. And I can tell you the other number because the ratio is always the same. He says, it's worth $400,000. And I said, oh, so you're going to rent it for 2200, huh?

Yeah, I was going to say.

And he says, well, 2300.

I'm pretty close with only knowing one of the numbers, right? Because that ratio holds up all around the world. The only time it ever changes is when there's some funny government intervention with rent control or something. But otherwise, that RV ratio is always the same in every cyclical market, and it's always the same in every linear market. And in the hybrid markets, it'll be somewhere in the middle of the two.

And not only is his RV ratio horrible, but if he sells, then he's going to be cash flow negative. And to your earlier point, with the land value, if he's got a $400,000 house in Seattle, the land value is going to be, let's say, 75%. So he's got so much more risk than by taking that house, taking out the equity, going into a linear market, and, let's say two $200,000 homes or, you know, maybe not even that.

No, what I do, what I told him is, I said, look, Charles, through our network. I mean, look, he works for us. He knows what we do. He's been to our conferences. He listens to the podcast.

You should know better than that. Then what's he doing?

People get a little funny when it's their own. You know, it's. I mean, he's a logical guy. You know, he wants to buy rental properties, too, but he loves this one, and the view is like a bird in the hand. So I'll tell you the rationalization, Okay? I said, look, you can sell that house, and you can buy four $100,000 houses, and you can be diversified into, you know, maybe two different markets, two houses in each of them, and you'll get somewhere in the neighborhood of $4,000 a month. Why would you want just $2,200 or $2,300 a month when you can get 4,000amonth? And he says, well, our loan balance is pretty low, so we're actually going to have positive cash flow. And I said, yeah, but then you're going to have a bunch of equity not working for you. And, you know, he gets it, but, you know, it's the land value.

And if you. And if you did what you said, where you took that 400 and bought four houses with it, the land value would go from being 75% of the cost to call it 10%.

Yeah, maybe 20%. You know those Kansas City houses you mentioned? You know, those lot values are probably 20 grand now. They're probably not 5,000 anymore.

Yeah, but the bottom line is it would be far, far lower. So he'd be getting more cash flow, and he'd be reducing his downside. You know, Why I think people or how the majority of people rationalize it, at least the people that I talk to is. They won't admit it, but deep down they're like, I don't want to sell it because it could double in price over the next three or four years. It's the gambling component. They've seen it go up. It's recency bias, where they're like, oh, man.

Yeah.

But in the back their mind, they're thinking, you know, four years ago, five years ago, this house was only worth 200 and it doubled in price. And if I sell it and go into those linear markets that Jason's talking about, I'm not going to have the opportunity to double my money. Your mind starts playing tricks on you. You got the devil on this side and the angel on this side. The devil keeps whispering in your ear that you got to keep that because you could get another home run on this equity, and then you could be rich. And, man, if you get 800,000 out of this house, think about what you could do with that. And then they don't say that, but that's the underlying.

I'm so glad you mentioned recency bias, George, because we should all look up human biases, right? Or is that how you say it? Anyway, we all have these biases. The other bias that's probably influencing him is what's called sunk cost bias. So he's lived there, he's spent money on that house, he's taken pride in that house, so is his wife. And, you know, they have, like a sunk cost in it, right? And then there's this bird in the hand worth two in the bush. Certainty bias, right? So there's all these different things. You know, I don't fault them for it. Millions of people have that same bias, okay? It's just part of human nature. But it's really interesting. The point is, get the equity out of your property. The property will perform. It'll go up in value by the same amount or down in value by the same amount, regardless of how much equity you have in it. You will get the same amount of income regardless of how much equity you know. Have you ever had a tenant come to you and say, hey, what is your loan balance and what is your mortgage payment? I want to make sure I cover that for you. They never say that. Or if it's a low loan balance and a low mortgage payment, they say, hey, give me a better deal. You know, they will say that, okay? But the property will perform the same regardless of the amount of equity in the property, get the equity out of the property. It's just not a good place to keep equity. And I've talked a lot about that on the podcast. We won't. That's a whole nother topic, really. But the point is, low land value equals low risk. High land value equals high risk. And yeah, that's the Hartman risk evaluator in a nutshell.

That was really cool. I've kind of come to that conclusion in a roundabout way, but never through that type of analysis. Really, really neat.

Yeah, it took me 19 years to figure that out. And it was all because of that call from Jennifer and that aha moment. Thank you so much for listening. Please be sure to subscribe so that you don't miss any episodes. Be sure to check out this show's specific website and our general website, hartmanmedia.com for appropriate disclaimers and terms of service. Remember that guest opinions are their own, and if you require specific legal or tax advice or advice in any other specialized area, please consult an appropriate professional and we also very much appreciate you reviewing the show. Please go to itunes or Stitcher Radio or whatever platform you're using and write a review for the show. We would very much appreciate that. And be sure to make it official and subscribe so you do not miss any episodes. We look forward to seeing you on the next episode.