317: The Jason Hartman Risk Evaluator with George Gammon

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Today we've got Jason Hartman, the real estate expert, and we are going to talk about something that's extremely important to your investment portfolio and that is how to properly measure risk. Let's dive right into the episode. All right, guys, welcome to the Rebel Capitalist Show. We've got my good buddy Jason Hartman here. If you haven't listened to any of our videos in the past, I don't know what you're doing because if you're interested in making money at all, this is the guy to go to. He's got the most popular podcast for real estate investing in the United States, the Creating Wealth Show. My buddy, Jason Hartman. Thanks for being here.

Hey, George, it's great to be back on your show and 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. So thanks.

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. So today I really want to focus on that. And I think You've got a PowerPoint presentation for us, is that correct?

Yes, I do.

And 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, quartered, because they're lying. Okay? They're just totally lying. Right. Maybe not drawn and quartered, but put in jail. How's that sound? Yeah. No such thing as a passive investment.

In fact, of course, 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, 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.

Even I would assert that even a.

Bank account is not a passive investment. 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, 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've 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.

And after 19 years in the real estate business, I 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 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.

And 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 multi dimensional strategy is better. Income property is beautifully multidimensional. It's great like that.

Then you go to two dimensions, dividend.

Paying stock, you know, 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 makes income property multi dimensional?

A whole bunch of things. 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.

Beyond those commonly known things, there's the.

Things 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.

Okay, so let me just tell you.

This story of how this came about.

And 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. Right? 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.

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, you know, 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. Okay.

The amazing thing I discovered is I.

Got this call from my insurance agent.

Her name is Jennifer.

She worked at an insurance brokerage in Irvine that I had used. Irvine, California.

So I was buying two properties right.

Around the same time.

One was a home in which to live.

Okay. And that was in Orange County, California, was, you know, fairly expensive home compared to the rental properties we look at.

And another was a rental property across the country, okay.

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 I'll show you. We're going to get back to this in just a moment.

Okay, so if you're looking at the screen now, you see these two component parts.

When you buy a property, land value, improvement value, okay?

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. Then they're going to just stop building because the machine doesn't work anymore. Right. So they've got to make that work.

Now let's look at some of the factors that increase improvement value. Right. 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 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 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.

These sites, like Upwork and these different.

Sites, contractors in the gig economy, you know, 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 in California just to get by.

Yeah, totally.

Especially in la. And also I think what's amazing to me, I don't wanna get off on too much of a tangent, but it's amazing to that these politicians think that, oh well, it's a big company, it's Uber. So they've got to just be printing money hand over fist.

Uber.

I mean, they haven't made a.

Profit losing money in the last quarter. They lost $4.5 billion in one quarter. In one quarter. How do you incinerate that much money? And so now they've got this on top of these billion dollar losses that they have quarter after quarter after quarter. I mean, they're in deep trouble. But anyway, I don't want to give on a tv.

This stuff is just epically stupid, right? It's a mess.

But 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.

Oh man, he's my personal hero, other than my father. Yeah, he's just amazing.

Thomas Sowell was on my show and.

Of course he's a Harvard professor or I guess former one and an author.

Of many great books and he used.

To write for magazine. He's a real intellectual, he's a real thinker. And we were talking about this environmental building restriction thing, and I coined a new term during that podcast.

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. 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, right.

Not just other races. Just. 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. It's just like, you know, they're just the demand for these commodities, for copper.

That. 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.

Hopefully that works out.

And this rising tide around the world.

Through globalization is really impacting this.

But it's also making materials and commodities.

More valuable and putting upward pressure on the prices of them.

And 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 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 very favorable tax treatment. We get all of these benefits when they're packaged.

We 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, right?

The 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, right?

Of a cash flowing company. And to be clear, when I'm doing my live streams or on my channel, 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. 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.

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.

Adam Smith in the wealth of nations, he talked about specialization, right?

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're a professional. You're a professional.

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 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, in that sense, it's sort of like the unpackaging, but it's, it becomes a Specialized thing. Right. 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 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, right?

Yeah, 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?

No, that's the CPI number.

Okay.

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.

Okay.

Lumber was up 17%.

The prices of wallboard, 20% increase when they told us inflation was only 3.3%.

Are you kidding me?

This is, 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, 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.

What's interesting about what you just said is that I remember I was doing a speaking engagement in Phoenix and it was right around 2004 or 5, and I had a heckler.

I've had like two hecklers in my life in the Aud, and this guy just thought he knew everything. He was so smart and he was going to outwit me. And heckle me there in front of the audience.

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. 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.

But he kept saying, well, you're telling people to invest in Houston, but Houston has like really lax zoning laws. They have very little restriction and 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 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 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. 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.

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.

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? So 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.

Right?

The cost of labor definitely increasing.

And that's a huge thing.

Do you know, I was just watching.

A video for the Economist magazine on.

Their YouTube channel, and 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. I can't believe it. It was in Germany.

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 new materials and this and that and living in a little pod.

Listen, 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 asked, I totally grilled this one 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 if I want to really build one? 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 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. And she said, 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, Right.

Yeah.

Just, I mean, do the math. You got to. You got to think about, well, they're not using any different materials, so what would be their cost savings? Like how manufacturing all this cost. It's the same material, they got to 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.

You can just buy 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. And 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. And as a laborer, I remember a lot of the homes that we would build in Oregon, in Portland, and 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? Right.

So they just.

I believe they should manufacture more and more of 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 even if you do that, according to all of those cheap kits on.

Amazon, by the time you do the engineering and the permitting and all that stuff, it's 200 bucks a square footage 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. Yeah.

And to 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 and 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 and 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 back this was 2013, 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, 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 before it was every house had.

To have a smoke detector. Then it had to have a smoke detector in every bedroom and a couple other places, devices. 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 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 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.

They're.

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

They can't. They would love to.

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

A tree person. Yeah.

Three grand to come out and tell me what all these trees are. And then I had to build a median on, well, not really media, but, you know, on the sidewalk. How they've got 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. I mean, 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. The burden is so insane. 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. Right? 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 costs definitely increase the cost of construction, right? Because energy is in everything. It's, you know, everything is energy. Right.

So let me show you something. 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. 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.

I'm going to show you. This is the tax bill for the house I was buying to move into.

Okay.

Orange County.

Yeah, this is in Orange County. Now look at the magnifying glass here.

And you're going to see the land value. This is according to John Morlock, the Orange County Treasurer tax collector.

Right?

Because the tax collector segments the value, the two components, the land value and the improvement or the buildings, right? And this house altogether was $815,000.

Okay? You see that right here?

And the way that divided up Approximately was. Was 659,000 in land and 155,753, I guess, in improvements.

Okay?

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, okay? 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, right? 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. Okay?

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. Right? Okay.

So here's the way that looked.

Okay? That's my house that I bought to live in. And I lived there for seven years in this house. Got it.

Okay. It was 815,000 total. 156.

I'm rounding just a tad 156 or 19% improvement value and 81%, $660,000 in land value.

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, okay?

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.

Okay, 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, okay? 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. Okay? 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, okay?

So here's what happened. Eric came out and said, congratulations, your.

House is now worth $1.3 million.

And I thought, in one year, that house went up by $485,000. I am so lucky. Thank God.

That was a great deal.

Okay, 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?

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

Why?

Yeah, that's the puzzling thing. Right?

Okay, so I always ask my audience.

This question when I'm doing this live and 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. Okay? 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. You know, it was a nice 1800 square foot house, you know, nicely designed with a nice view of the city lights and the ocean in the distance. And it was a good house. Right.

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. 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.

Okay, that's a good thing.

But in the old days, that's the.

Way they did it, right? They just had an appraiser on staff for one that they commonly used, and they'd send them out. Right.

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, with 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, okay.

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. 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 going to cost a lot. Right. It was expensive to landscape this house. 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, and 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. Okay, 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.

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.

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 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. We're talking like $5,000, like $10,000 on a home that's now worth 170. 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 on the screen now is a very childish looking, poorly graphically designed. I really need a better graphic designer, clearly. So don't make fun of me. I was going to do this on a whiteboard, it would have been worse.

Than this was the value of the house I moved in into the story.

I just told you, that's how it looked.

Mostly land value, very little improvement value. Okay, the house, 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. 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 it seven years earlier.

Okay.

Yeah, you gotta 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. 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. It's worth 200,000. That means the land is worth 1.1 million. Okay?

If that land goes down by 50%.

I'm going to lose $550,000.

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.

But if you think it's gonna 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. Okay?

But the cheap house, that was 159,000. That's a sustainable property.

Okay?

I can rent that and afford to keep it where the Expensive house.

I can't rent it and afford to keep it.

It 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, you that.

If it is a cyclical market, your rent to value or RV ratio is going to be terrible. I'll tell you a contemporary story quickly about that.

One of my contractors, a guy named.

Charles, he's a great guy, 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.

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?

And because that 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.

Okay, but otherwise, that RV ratio is.

Always the same in every cyclical market 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 has, 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.

House.

Taking out the equity, going into a linear market and let's say, $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 already owns 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, okay?

And you'll get somewhere in the neighborhood of $4,000 a month.

Why would you want just $2,300 a month. Month. When you can get 4,000amonth?

And he says, well, you know, 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%, 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, yeah, but the bottom line, 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 how the majority of people rationalize it, at least the people that I talk to, is they won't admit it. They won't admit it, but deep down there, 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. And 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 up human biases.

The other bias that's probably influencing him is what's called sunk cost bias, right?

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 a sunk.

Cost in it, right?

Then there's this bird in the hand worth two in the bush.

Certainty bias, Right?

So there's all these different things, Right?

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.

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.

Okay. 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. The point is, low land value equals low risk. High land value equals high risk. 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.

It took me 19 years to figure that out. It was all because of that call from Jennifer and that aha moment, that epiphany. Really interesting. Yeah. Yeah.

All right, Jason, well, just to let everyone know that I'm super stoked because this episode of the Rebel Capitalist show is probably airing on Sunday morning. So I want to let everyone know that Jason will actually be joining us tonight on the live stream.

Yes, that's going to be fun.

Yeah, it's going to be awesome. So if you got questions that you want to ask Jason directly, make sure you write those down. Join us on the live stream tonight. It's going to be 7pm Eastern Time and Jason can answer all those questions for you. It's going to be absolutely awesome and let everyone know Jason's going to be with us probably once a month or a couple times a month. Once a month on the live stream. At least once a month on the Rebel Capitalist show to continue to educate you on real estate investing and really help you out and help you make wise investments in an economic situation that we're in right now where it's very precarious, to say the least.

Yeah, it is. It is an uncertain time for sure, George, and I appreciate you having me on and it's been just great to talk about this with you. So happy investing to you and your listeners. And hey, we'll talk to you tonight on the live stream for sure.

And Jason, let everyone know that if they do have more questions or they want to contact you, how should they go about that?

The best thing is my website is.

Jason hartman.com, just jason hartman.com and then my podcast, the Creating wealth show, you can find on any podcast platform. And I'm happy to say that George Gammon has been a guest on my show and that was an excellent, excellent episode you did with me recently. So check it out. The Creating Wealth Show. Type Jason Hartman on any podcast platform, itunes, Stitcher radio, whatever you use.

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