1918: The Price of Money and How Powerful It Is To The Global Economy with Ken McElroy & George Gammon

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Welcome to episode 1918. 1918. And greetings from beautiful Scottsdale, Arizona. We've been holding our Collective Mastermind event here this weekend and we just concluded it. It's been a great weekend and I thought I would have a chat with a couple of my good buddies and business partners here. We got, of course, Ken McElroy and George Gammon.

What's up, everybody?

So we thought we'd do a little show for you, but how'd you like the weekend?

I thought it was great. I mean, the weather's spectacular in Scottsdale, people flew in from everywhere and you know, we had an incredible collective as we have had. This is our fifth event, so it's been great.

It was really great. And we did, we did a different thing this time. And I'll tell you, even if you're not interested in joining a formal Mastermind group, the Mastermind concept is so, so powerful. And you know, we did that this weekend and it's just been great. We did kind of a forum training and yeah, to, to get that. Why don't you explain what that is to people? I mean, I think that's a really valuable thing for. You can use this yourself in your own life. You don't need us, you know, so.

Yeah, so what you do is you just break them up into smaller groups, like let's say groups of eight and, and then you share at a deeper level using a system of tools and you can kind of tackle business issues, you know, as they come up, as opposed to. Sometimes it's hard when there's a big group.

Yeah, yeah, absolutely. It's good stuff. And ge. George, it's good to see you again, buddy. You came a long way for this.

Yeah, yeah. But it's well worth it, that's for sure.

Yeah, Good stuff, good stuff. Well, let's, I mean, you know, I want to get your take on what's going on in the world. Obviously a lot is changing. It's changing very quickly. People are rightfully concerned, I think. Ken, what's your outlook? You know, Ken of course specializes in large multifamily properties and so he has a great understanding of construction costs, rents, tenant quality, all of this kind of million other things, of course. But go. I'll just let you tell.

It'S an.

Interesting time because see, construction costs are up, cap rates are up, interest rates are up, labor costs are up, supply costs are up. So it's a rough time, but it's all kind of normalizing. So we're starting to see some of the sellers are starting to adjust their pricing and, and because interest rates going up are creating less cash flow, especially if you have any kind of variable debt or anything like that. So we're struggling a little bit on our renovations that have bridge loans or variable loans. We're solid on anything that's fixed and then any construction. So I think you're gonna start to see some trouble on a lot of these big, large bridge loans or variable loans or short term loans.

So means a lot of these apartment developers have taken out short term bridge loans. And what are those usually about a year or so?

Well, to build a property you might get a three year construction loan. So and that's because there's no property. It's. They can't do a fixed loan and there's no collateral.

Right.

So you know, so you have this variable loan. So if you started building something a year ago when rates were say three or three and a half, now they're seven. That's significant on that same amount of construction principles. So, so, you know, so a lot of that's starting to show up now. So people that don't have really good reserves, a lot of cash, you're going to start to see some things, you know, they're going to have to recapitalize and there's going to be all kinds of things happening here. I think 2023 is going to be very interesting.

One of the questions people are talking about a lot in the multifamily housing market is is it overbuilt? Has there been too much construction the last few years? And then of course different marketeers and geographies of course, but class A, class and no one builds class B or C. Everything that's Built is class A or A plus, right? Yeah. So is there an oversupply coming or are we still okay in terms of demand, supply, demand?

Well, I don't ever believe there was an oversupply, so. And I'll tell you why.

If you take a look at the.

Demand for housing, you know, we're still millions of units underneath that demand. So now you might have a little bit of oversupply in some specific markets for a short period of time. But really, because interest rates are up, construction costs are up, land costs are up, then that, you know, that deal that maybe you could do two years ago, three years ago, you can't really do today. So you're. We're heading into a shortage, in my opinion. The other piece is as, as single family rates go up, then their mortgage payments go up. So they're. In other words, there's less people that can buy homes because their mortgage payments can significantly. And they're sizing to their mortgage payment.

Yeah.

So on how much they can afford.

So.

So you're going to. I think that that's just going to force more people into rental housing and.

I think that's hugely significant. By the way, you know, what I said last week on the show was, you know, buyer's market, seller's market, I don't care, the rent is due. Right. And that was the show I recorded on November 1st. Right. The first of the month. And you know, that's what real investors invest for. They invest for yield. Right. Not speculation. And it's funny that the whole conversation is about our prices going to go up or down. And so little of the conversation is about yield and about rents and about just what you said, which I think is a really important element.

I'll give you one quick example. We had a property in escrow and the cash flow was $3 million. Okay. So it was a big project, hundreds of millions dollars. The debt costs went up while we were in escrow and luckily we didn't have any non refundable money or anything. So we were in due diligence. But the debt costs went up and cut $1 million of our cash flow out. So we went from 2 million or 3 million to 2 million because the debt costs went up. Exact same, one third, exact same property.

Wow.

So, you know, and that happened. And so these six debt, these six rate increases that we've had since March are impactful.

Yeah.

And so it's driven the interest rates up. So you're always trying to size to cash flow. So. So 3 million to 2 million let's say in cash flow is significantly different. So we passed.

Yeah. So now the seller is left with that deal. They basically bought it back from themselves.

Yeah, well, we had it in escrow. We never bought it, of course, but what we did is we just let them have it back and they said, you know, why don't you make us another offer? And we said rates are still going to go up, so we're not going to. But we sized it at about a 20% discount. So from where we had in an escrow.

Yeah.

Based on the, you know, the cost of the debt.

Right, very interesting, very interesting, George. I mean you cover all sorts of stuff in the macro world. He's the self proclaimed macro addict. I love that by the way. What, you know, what would you like to share with our people? You know, it could be anything. I mean the geopolitical stuff, whatever.

Well, I mean, I'm just listening to what Kenny's saying and I'm just thinking to myself how insane it is that we have a small group of 900 PhDs that are literally fixing the price of money.

Yeah.

You think about how this is impacting Kenny's world and that's. You scale that through the entire United States, 350 million people, and you've got them trying to micromanage the economy, you know, from this tops down type of approach that, and they're not just trying to manage it here and there, they're managing the price of money, which is one half of every single transaction.

Right, right.

You see, so that's a really interesting. People always say that, you know, well, how, how should we manage the economy, George? You let prices price, discovery prices are what should manage the economy, especially the price of money. And so if we just had market rates, you know, you wouldn't have all of this just you have all the windfall profits when the rates are super, let's say artificially low. And then you have this boom bust cycle that's created ironically to try to flatten out or smooth out the boom bust cycle.

Right.

But you see how the pig moves through the python. Right. There's a big lag effect with interest rates.

Yep.

They take it from let's say zero up to 3% or 3, you know, 4%. But then that doesn't immediately impact the economy because all this stuff that Kenny's talking about that has to filter through the entire system. And this is why the Fed is always behind the curve, why they always tighten until they break something. And then all of a sudden they're like, oh, we couldn't have seen that one coming.

And then they overreact on the other side of the equation. Right? Yeah, it's always this violent swinging.

Yeah. And it just goes to show you that that's just another proof is right here in front. We're living through a time in history that's proving to us how important the price signal is and price discovery. And they've completely gotten rid of the most important price of all, the price of money.

Correct, Right. So what was interesting is you said the price of money is at least. At least one half of every transaction.

Money is one half of every transaction.

Tell us more about that. That's an interesting story.

Well, even this water right here, you have to pay for it. Sure, of course you pay for it. Money.

But why do you say it's one half?

Because half the transaction is what you buy and the other half transactions the money.

So it's the goods and the symbolic, you know, currency you're trading for it.

Yeah, whatever you buying, whether it's this computer, this hat, you know, or collective outfit here, money is the other half of that transaction. And so they're literally price fixing everything when they're trying to micromanage the interest rates. And so, you know, we're just looking at a microcosm in that story that Kenny just told us. But you. That throughout the entire economy of 350 million people, where there's literally billions of transactions occurring daily, and you think about the economic distortion that's created by a central planning approach to interest rates, and then you just look at the Fed and he's like, what the hell are we doing here? This is insanity.

And we've talked about that a lot. You know, why should some central body like a central bank fix the price of money when the market should determine the price of money, you know, the value of it. Yeah, absolutely.

Well, what's ironic is all economists, whether they're Keynesian or Austrians, they all think price controls are a bad idea, but yet somehow, price fixing the price of money is a good idea.

I can't wait to get into this topic at. Our next event is in Jekyll Island.

Yeah.

So we're gonna be in the Federal Reserve Room.

That's the birthplace of the Federal Reserve. Of course, many of you have probably read the book the Crowd Creature from Jekyll island by the great J. Edward Griffin, who's been on the show a few times.

Yeah, yeah.

And so George is bringing all his.

Buddies, you know, to talk.

That's gonna be.

Yeah, we got Joseph Wang he's gonna be great.

And he's been on the show too.

And Robert Barnes.

Yeah, Barnes. And Joseph Wang. And you know, nobody knows the system of how the Fed works better than Joseph because he was the lead trader at their trading desk in New York. So he was the one that actually did quantitative tightening and quantitative easing.

Right?

Yeah.

And so he'll have some great stories to tell, but I think he would be the first person to say that we should get out of the business of fixing the price of money.

Yeah, okay. But that's probably not going to happen anytime soon. Of course. So how should people act? What should they be doing now? What are, you know, some acts from either of you?

By the way, I'm telling everyone to get heavy in cash.

Yeah, I think that's a great idea. I mean, and it's not just us saying that. You just got to look at the bond market.

Yeah.

And the bond market is historically correct 95% of the time. So you go back and look at when you 1st to 2 year inverted 10 year, everyone knows that's a bad signal. But that doesn't give you much of the help with the timing, you know, in the two year inverts, the 10 year, it tells you okay, we're gonna have a recession maybe 18, 24 months. But just last week, the three month inverted with the 10 year, that's much more powerful when it comes to timing. When the 3 month inverts of the 10 year, usually it's, you're in the middle of a recess when you look back, you know, a year or two down the road or you're going to be in one within, you know, say six to nine months.

So that begs the question, aren't you worried if you're heavy in cash about the cash being just debased by inflation?

Yo, yeah, of course. But I'm also worried about the, you know, the price of debt. So you know, we have to balance both. So if, if our debt costs are going up on our construction projects, our renovations projects, on anybody that's doing any kind of value add over the last couple years and has variable debt, they're in trouble. Maybe not financial trouble, but what's happened is their debt costs have gone up a lot. And the way to solve that is cash.

Right. So what's interesting about that though is it is only applicable to people whose expenses are denominated in dollars.

Hey, tell us about that.

So let's use me as an example, right? I'm living in a world of inflation. But yet for me personally I'm experiencing deflation.

Tell us why.

Because I have dollar cash flow, but yet my expenses are denominated in Colombian pesos.

Because you live in Medellin, Colombia.

That's right. So the dollar has been appreciating so much against the peso that all my expenses are going down.

Right.

It's literally deflation. So, like as.

But you're earning in dollars.

Yeah.

And that's your double arbitrage.

Let's use an example. My YouTube channel. Yeah. With my staff and my payroll, my editors and whatnot. About, let's say six months ago, my payroll was about $7,000 a month. Right now it's like four.

Not because of a layoff or a salary.

More employees.

Yeah, right.

I get more employees and my payroll goes down because the dollar is appreciating. So my point is, it is true that for an American investor, you know, if you got a Treasury, you know, some t bills, that 4% you are losing to inflation, but if you have that geo arbitrage, you coined that phrase a long time ago, you can set it up where you're actually experiencing deflation and having just straight cash, you're actually making a return on that in terms of purchasing power.

For most people, though, that's not something they can easily do.

Yeah, but I think it's. Even if they can't do it, I think it's. It's. If you understand the concepts.

It'S good because you could figure out a way to apply that to your own situation.

Sure. Kenny, what about you and concerns about inflation, debasing savings?

Well, again, I think, you know, I'm.

Looking at.

My debt. You know, that's. Most people that are concerned right now are concerned about variable debt as an example. And so for us, we have to be heavy in cash because we don't know how high that's going to go. In fact, even the lenders are now requiring interest reserves. So they're lending you money and then they're saying, okay, we're going to have a reserve for overage, a contingency, but then we're also going to have an interest reserve to hedge increases in the interest rates. So everybody's hedging right now, including us.

And it's interesting that the lenders are saying, hedge against what we might do to you.

We're requiring you to hedge against what we might do to you.

But your fixed rate debt is a hedge on your cash.

I love that part.

Right.

That's the other side of it. So most of our stuff is through Fannie or Freddie fixed. And you know, so we're sitting at, let's say high twos, mid threes on most of our debt. That now becomes an asset.

Yeah. And it offsets your cash position. So if you're losing to inflation on the cash, you're making it on the other side. Right.

Do you think these rates are going to, to moderate? I mean, they're probably moderated at some point, obviously. But will they go down? I mean, you know, what's next year look like? I mean, I know interest rates are impossibly difficult to predict, but yeah, I.

Think you look at the bond market, they're telling us that interest rates are probably lower in 2023. That doesn't mean that you can get a loan. See, this is, people have a misunderstanding here. They think that if money is cheap, then it's loose.

Yeah. There's a difference between mortgage credit availability.

Yeah.

And mortgage prices.

Yeah. What you notice is usually when money's cheap, it's actually tight. Yeah, it's actually tight. So 2012 was a great example that, you know, I had all these properties that I owned outright and I couldn't get a line of credit at 40% LTV, you know, the bank wouldn't touch it with a 10 foot pole because they thought that, you know, real estate was just going to go down forever. So that's a good example. With low interest rates, tight money.

Yeah, exactly. You know, so I've shared before the charts from the Mortgage Bankers association, the mba and they publish an index called the Mortgage Credit Availability Index that shows that availability, which most people don't think that much about it. They just think, oh, mortgages are cheap, I'll just go get some mortgages. But availability, because what they do is they make it more difficult to qualify and so you really can't get it. It looks great if you can get it.

Yeah. That's what you hear everyone talk about. Oh, I'll just wait. You know, interest rates will go down, the Fed will pivot, then I'll just go ahead and refinance or blah, blah, blah, blah, blah. And that's maybe, maybe not.

Yeah. What are your thoughts on interest rates?

Well, I hope they do go down.

You know, we're going to need it. I, I, by the way, I, I think the only thing that's happening is this bubble that was created prior to this is just now normalizing.

Yeah.

And people are freaking out, you know, but by when the Fed went down to zero or almost zero federal funds rate, you know, that's what created this.

Yeah.

So this is just normalizing. So for me, this is all part of a long term strategy. It's normal.

Yeah, yeah, Good stuff. What else would you like to share? Questions I haven't asked you just anything you're thinking about. Anything that's top of mind should be top of mind for investors.

No, I mean, I think cash is very prudent right now. I think we're going into a time, at least over the next year, where it's more so about capital preservation. So I think today it's all about capital preservation, not necessarily capital appreciation. But the people that have been paying attention, I'm assuming you, most people watching your podcast are paying attention. You could see this one coming from a long way away. When you can't shut down an economy and expect it just to turn back on like a light switch, you know, especially when you create all this artificial demand. It's quote unquote, free money. You know, people's checking accounts are still a lot higher today than they were in 2018. The problem there is that their incomes have not gone up with the rate of inflation. So although they might have a little extra money now than they did in 2018 because the stimulus, not having to pay mortgage or rent or student loan or et cetera, et cetera, that's going to fade very, very quickly because their purchasing power is a lot less because of that delta between inflation and their incomes increasing. So we have had negative real income growth. And so at a certain point they're going to get, you know, they're going to drain their savings and that's when we're going to run into a real problem as far as aggregate demand, I think that's what the yield curve is sniffing out right now. You know, it is true that you have this back and forth between real estate prices and rents, but that is a derivative of income. So if I think we could be moving into a world where, you know, the unemployment rate's gonna go up significantly and I think people with a lot of those a properties, you know, a apartment buildings or like the, you know, houses that are not your starter homes, they could be in a pinch.

Whereas people have to move down the socioeconomic ladder.

That's right.

What do you think about that, Kenny?

Yeah, it's definitely, it's happened before, so it's happened in other cycles. The other thing I think is manage money. Got to think about this. Most people don't think of managed money. So manage money is used to buy and build projects, big projects. So think of Wall street, think of private Equity, think of family office, that money wants its money back, you know, three years, four years, let's say. So they, there's a thing, you know, the value that they thought that they were going to get, let's say one year ago, two years ago versus what they're going to get in a year is going to be different. So that is I think something really to watch.

And the reverse wealth effect.

Yeah, yeah. So you know, you could, you could, you know, even if you had a value add, if you're noi, if you're able to grow your noi through some value add by let's say 20% and your cap rates go from say 4 to 5, which is also 20%, your net effect is zero. So you literally your exit cap rate is higher than your, your buying cap rate. That's going to create a lot of problems for the managed money because they're going to want their money back regardless of what's happening with the property.

And are those mostly pension funds?

They're insurance companies, pensions funds, a lot of syndicators, you know, a lot of, you know, I call it broker, dealer, family, you know, family office.

Yeah. And you know, another thing that's interesting about rates actually going up is it gives large pools of money an option they haven't had for a decade.

Right. They have other options they can invest in, in more fixed instruments.

Yeah. Like blackrock or Blackstone or whatever. You know, they, you know, for the last decade when interest rates are at zero, to get any type of yield.

They had to do, you had to do this curve.

Yeah. That was pretty much your only play was 10 and 50 and toilets to get over, let's say 3 or 4%. But if you've got the 10 year, let's just hypothetically say that the 10 year is trading at 10% or 6% or something. Now does Blackstone want the tenants and toilets for 5% or do they want that 10 year treasury at 6 or 7?

Exactly.

Right. So that could add a little more supply there. That is obviously needed, but there's a lot of volatility right now.

Yeah, it's a crazy time. Sometimes it's more important. The return of your capital goal is more important than the return on your capital. So good thing. Give out your websites, guys.

Www.kenmcelroy.com K-E N M C E L-R-O-Y.com.

Or just George Gammon, the last name is G A m dash O N. You can just Google that, all my social media stuff.

And, and we've got a collective website, quite literally, which is the collective advisors.com as well for our mastermind group.

So yeah, if you're interested in that, we're going to go to Jekyll island next. You know, go to the website, sign up and we'd be glad to see you.

We'd love to see you there. And they'll also be at our event coming up in Scottsdale in January.

So I'll be there via Zoom, via satellite.

Satellite.

I'll be there in person.

All right, happy investing, everybody.

So George Gammon, Jason Hartman and I have, we've created a high level mastermind group called the Collective. The goal of the Collective is for you to learn from the three of us as well as of course the other members on how to build and more importantly, how to maintain your wealth. In this video we're going to go into detail about what the Collective is and what it can do for you. Enjoy. So I'm Ken McElroy. I've been in real estate for over 30 years. Started with a two bedroom, two bath using my own money and now I own over a billion dollars worth of real estate that I bought over the years. Built a big company, we have a construction company, a development company, a property management company, and of course an investment company. And typically now we syndicate and work with large, both private and public institutions for the equity and the debt. And so what I bring to the Collective is how to scale, how to grow. Starting with one really small property with no experience at all and growing it into an organization which I've been able to do that basically runs almost without me. So that's what I'm going to bring to the Collective. We decided to start the Collective because one I met George Gammon and George brings a very interesting perspective about the economy and the Fed and the way money works and Bitcoin and alternative types of investments, which quite honestly, I was super focused on real estate almost the entire time and even I want to be a little bit more diverse. So when I talk to George and to Jason, they're always doing very, very different things. On the investment side, Jason specifically is more focused on the single family housing and what's going on in that market so that we could collaborate and have different viewpoints on different things. And so that's why I thought the Collective would be good because I think everybody's kind of searching for the same kinds of answers. So the Collective means to me basically the collective group, the whole. And I've always been a big believer of team and collaboration. So for me, it really means collaboration of everyone kind of coming into a room and learning from each other based on their individual highs and their individual lows. And to be very, very respectful of all their independent views on things and to be more open minded, transparent and authentic. So I cannot wait for the group to get together each and every quarter because we all have very different walks of life that we're going through. And so it's very, very cool to get into one room with like minded people. I think the right person for the collective is somebody who's into personal development, somebody who's trying to be a better individual, somebody who's trying to have that work life balance, trying to figure out good decision making on the investment side, specifically good decision making on the personal side perhaps certainly on their health and on their wealth. The members that have already signed up are people typically that have businesses that they're growing, businesses that they've started, or businesses that they've sold. So typically they're higher net worth and they're trying to figure out what to do with their money. They're probably a little bit afraid of inflation, they're probably a little bit concerned about where to invest. And they're obviously looking at real estate as one component. Somebody that's trying to do the right things both on the personal side and on the financial side. So some of the experiences that members can expect to get out of the collective are certainly the network. And I think that's always super powerful. I've been involved in groups like this before like EO and ypo, the Entrepreneurs Organization and ypo, which is Young Presidents Organization, which is kind of a peer to peer network. And I that's what I envisioned and I think people are going to certainly.

Get that out of there.

They're going to have lifelong friends for sure from this and they're going to meet people at every single event. But also we're going to have fun. So as an example, things like race car driving and doing all kinds of really cool things and meeting celebrities and things like that and fashion shows are going to be part of it. So it's kind of a how do we have fun and learn together? And we're going to have that at each and every event. So thanks for watching. If you guys are interested, there's a link below you can click on. It'll take you right to the website. Website, which has a load of information on exactly what the collective is, where the next events are, and what exactly you'll be getting if you become a member. Thanks for watching.

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