AIPIS 176 - Be Wealthy and Smart with Linda P Jones

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I'm excited to have Jason Hartman back on our show. Welcome back, Jason.

Thank you, Linda. I'm glad to be here.

Oh, this is great. We had such a good interview with you last time and I had tremendous feedback. And this time I wanted to talk about a way that you discovered to reduce risk dramatically in real estate. What can you tell us about that?

Well, Linda, many, many years into my career when I started to become a non local real estate investor, a nationwide real estate investor, I made an incredible, well, what I think is an incredible discovery and many, many of my listeners to my podcast and clients of mine think it's a pretty good discovery too. And I dubbed it the Hartman Risk Evaluator. And it's to really reduce downside risk when investing. And maybe I can just tell your listeners the story as to how it came about. That would be great and kind of just go into it. So what happened is I was always investing in the very expensive Southern California real estate market in Orange County, California. Properties in that market never really made sense at all because they're too expensive.

Oh, I was just there. Yeah, I was there. Balboa Island, Newport. Just incredible pricing. I mean, 1500 a square foot, ridiculous.

It's insane. It's totally insane. And you know, very nice area, very nice place to live, but not a good place to invest. So I called myself an investor there. Looking back, I think I was wrong. I was really just a speculator. As I got a little older, I became more conservative and you know, it's kind of hard to earn your money and you don't want to lose it. I discovered this risk evaluator in this way. I was buying one of my first out of state properties. I was in Southern California, but I was starting to invest nationwide and these properties were so inexpensive around the country compared to Orange county that I just couldn't believe it. And I had a insurance agent in Irvine, California. Her name was Jennifer. And I remember I was buying two properties at the same time. One was a home in Orange county that I was going to live in. And it was $815,000 and it was a little 1800 square foot brand new house in Orange County, California. And you know, it was a nice house. It had an ocean view off in the distance, city lights view and kind of a big yard for the area, not that those yards are very big. And it was a brand new home and that was $815,000. And right about the same time I was buying my first property as a nationwide investor and this property was $159,000. And wow. I was getting insurance from the same insurance broker properties. And I remember her calling me one day and Jennifer told me, hey, Jason, on this property you bought out of state, we're going to give you insurance of $135,000 on that property. And I thought, wow, that's interesting. They don't insure the land, they only insure the structure or the improvement or the house or apartment building sitting on the land. Because the house could burn down. The land never goes anywhere. And so the house is the part that's ins. And so that effectively, Linda, is an appraisal on the value of the house, the cost to replace the house if it burnt down. And by the way, that property was also brand new. And so I got my tax bill on the property I was moving into, the $815,000 property. And they also divide the land to improvement ratio, what I call the LTI ratio on your tax bill. So when people buy a property, they usually consider it to be one component when it's really two components. One component is the value of the land and the other value is the value of the improvement, the house sitting on the land. And you really need to segment these two and look at them as two distinctly different factors and two distinctly different valuations. When I got the tax bill on the property I was living in, it said that the land value was 660,000 doll and the improvement value was $159,000. I'm rounding just a little bit for ease of speed here. But basically that was the equation. Okay, so about 159,000 improvement value for the 1800 square foot house and $660,000 in land value. So obviously a high land value market. What's interesting is when you think about the things that influence construction and whether a builder will build or not, and whether the supply of housing will continue to increase or not, you have to look at it from the builder or developers perspective. Their equation is basically the cost to build and the cost of the land plus their profit Margin. And if they can't buy the land and build the house and make a profit, they're going to stop building and they're not going to increase the supply of housing. And so then you look at what influences the cost of the improvement component of that equation. And you look at things like environmentalism. And if you're in a very restrictive area, which is very hard to build in, the cost of improved land becomes more expensive because it becomes more valuable through scarcity. But that's very hard to evaluate. It's very speculative, and it fluctuates quite a bit. So I don't really like that as a safety net for my investment. And then you look at the cost of construction. Okay, and what influences the cost of construction? Well, development, natural disasters, massive economic growth around the world in places like China and India and the US too. And so when there's more demand for construction materials, and you think about the ingredients of a house simply being basic things, you know, lumber, concrete, copper wire, petroleum products, glass, steel, energy and labor. Those are the basic ingredients of a house. Right? And those ingredients are things that are used around the world. They're not indexed to any one currency. And they have universal need, universal value. Every human being needs those things because they need shelter. So those things are pretty reliable. And they're commodities. They're commodities traded globally, not attached to any one currency. So what I like to call, my philosophy is I call it packaged commodities investing or assembled commodities investing. See, I'm really an investor in commodities more than real estate, because what I like to invest in is very low cost real estate, meaning the land value. And as a ratio, when I talk about this LTI ratio or land to improvement ratio, that's a term I coined, kind of a takeoff on what most investors know, the LTV ratio or the loan to value ratio. When I talk about the LTI ratio, land to improvement ratio, I want that ratio to be very high in improvement value, the house sitting on the land, and very low in land value, because the land value is where the risk is. So continuing my little story here. I bought the house for 815,000 to live in. I bought the other house for 159,000. Jennifer calls, she says, we're going to give you $135,000 in insurance and by deduction, Linda, I know that the land is worth $24,000. And I thought, wow, I'm so unused to that. Being from Southern California, you know, I'm used to land being worth 660,000 dol. It was rather startling for me to really realize that and have it sink in. And so I bought both houses. I moved into the one, rented the other out. And about a year later, I noticed prices in my neighborhood going up pretty dramatically. This was during the crazy boom times when nothing made any sense prior to the Great Recession, in the bust. And so I moved in about 2005, and the values were skyrocketing. A year later, I called my bank and thought, I want to engage in the practice I call equity stripping, where I pull my equity out and I buy more real estate with the equity. I called the bank up. They sent out an appraiser. His name was Eric. And interestingly, Eric, who I tell this story about in all my seminars, actually came to my seminar about a year later. So it's kind of funny. I'm telling the story. And he said, Mr. Hartman, congratulations. Your house is now worth $1.3 million. And I thought, wow, do I love real estate. I bought it for 815,000, and in just one short year, I made $485,000 in gain. Wow. Now, did I know that was going to happen? Of course not. I'm no expert. I don't have a crystal ball. I got lucky. That's about it. Okay. I thought the house was pretty good. My girlfriend Monique, at the time, didn't think it was a good deal. Tried to talk me out of it. Glad I didn't listen. We broke up, and I refinanced the house and pulled a bunch of cash out.

And this is really a 50% gain. I mean, that's 50%. 50% on your 800,000, but better.

Oh, yeah, yeah.

You got leverage, so you made more. You look at how much you actually just put down, you probably made a multiple of that. But 50% gain in your housing price.

Oh, yeah, absolutely. Yep.

Yeah.

Looking at it that way, you're absolutely right. It's. It's actually more than 50%. Yes. That way. And with leverage. And I was leveraged, I made a huge gain. Okay, so the question now for your listeners. Okay, listeners, think about this. When the house goes from 815,000 to 1.3 million, which of the two components increased in value? Was it the improvement, in other words, the house sitting on the land, or was it the land, which.

I would say it was the land.

Yeah. And you are right. The lion's share was the land. Although the improvement probably did go up a little bit, but not much. Okay, so let's just round off, for simplicity purposes, and make an estimate here. Let's Estimate that The improvement that was 159 when I bought it is now worth 200. That's probably a little generous, but let's just go with it. And now the land is worth 1.1 million. Okay, so I had a second loan on that property, I believe. I can't exactly remember. But anyway, for some reason, a year later, I wanted to refi again. Maybe the rates went down. I don't recall the exact reason. And I call the same bank up and they send the same appraiser. Eric, he comes back, okay? So it's funny, you know, you very rarely get the same appraiser the second time around. I'm now two years into the deal. Eric comes back again and he says, hey, I have bad news for you. This year your house went down in value. It's now worth $1,235,000. So, okay, big deal. You know, I lost 65,000, but I'm still up 420,000. I still pretty much feeling pretty good about this, right? So the question now is, if we started at 815,000, went to 1.3 million, and now we're back down to 1 million 235, what went down? The land or the improvement?

Hmm.

Yeah.

Well, I do think that there is a factor each year that the value of the house does go down because of depreciation and things like that.

Technically, you are absolutely right. Because what's better, a new house or an old house? Most people are going to say a new house, right? And you're right, you know, wear and tear, depreciation, sure. The only thing that would change that is really when the commodities market is soaring and there's a massive demand for construction materials like we talked about, that could skew that equation. But, but conceptually you're right. You know, there is depreciation, Okay?

I mean, when it's just a small number like that, it might just be from the house depreciating. But it has to be the land. I mean, the bigger part of it has to be the land.

Yeah, the bigger part of it is the land. Because the house, if it was worth 200,000 at the PE, it's not worth now 135,000 for that 1800 foot house, right? No.

Right.

So the thing we can learn from this, I mean, what's the takeaway? Your listeners might be thinking, well, I don't know. This is kind of an interesting thought experiment, but what do I do? What do I do with this knowledge? Right? What do I do with Jason's big Discovery. So what you do with my big discovery is the same thing I did. You shy away from areas with high land value. That. By the way, Linda, when I was on your show last time, just a little over a month ago, we talked about the three types of markets, the cyclical, linear and hybrid markets. And if your listeners remember when we talked about that, you can tell that every high value cyclical market on planet Earth, this is true in foreign countries, it's true in Hong Kong, it's true in Singapore, it's true in Paris and London, as it is in New York and Los Angeles and Seattle. Okay. Or South Florida. All these are high value cyclical markets. Right? They're all high land value markets and they're very risky because lamb values fluctuate dramatically. But improvement values, although they do fluctuate, it's not as dramatic because a piece of wood will always be worth something. A copper wire that's in your house and glass and steel that it took to build your house will always have some intrinsic value. Now, arguably land will too, but not when it's really high priced land. That becomes a very amorphous concept to try and value land like that. And it fluctuates dramatically. So the takeaway is if you want to be a conservative investor and reduce your risk when investing. The way you use the Hartman Risk evaluator is to simply invest in markets with good LTI or land to improvement ratios, meaning land is a very small component. Because think about it back to my example. My out of state property, the land value by deduction was $24,000. The improvement value was 135, total of 159. The Orange county property, the one I was living in, 815,000 at the start, but then 1.3 million at the peak, right? The land value there was $1.1 million. So if that goes down by half, I'm gonna lose $550,000. If the other little rental property, that who really cares if it goes down in value because it has good cash flow anyway, right? It rents for about 1% of the value. I'm only gonna lose $12,000. That I can handle. I can't handle losing $550,000. That would really sting pretty bad. And so that is the takeaway. Low land value markets are much, much safer markets. Not to mention, do they not only have much softer swings in value because these are the linear markets, they also have much better cash flow, much better income as well.

Interesting. Well, we, as I mentioned, we were just in Newport and the comment that My friend made was he told his friends, you can't sell and get out of this market because you'll never be able to afford to get back in. Which was really interesting because a market.

That by the way, is not true. Okay.

Okay, good.

Well, I'd like to. I lived through three cycles in high priced real estate markets. One when I was a kid and I was not in real estate, but I kind of knew I was going there.

Was that in the 70s?

No, it wasn't that long ago. But I went through a down market as a kid in Los Angeles and I remember when my mom was buying houses, you know, I kind of grew up around someone who was interested in real estate investing. I just saw what happened. And then when I was in real estate again, I went through two cycles. It always, always the people that got hurt were in the high land value markets because they were always investing based on the greater fool theory. No matter what I pay, someone else will come along and pay more. Some greater fool. And that is just a very risky way to invest. Now granted, people certainly have made money in those markets, there's no question about that. But they were lucky. And I'd rather be lucky than good any day of the week. Okay, I totally get it, but you can't count on it. It's just not reliable. It's not predictable. I've never met anyone in all my years in the business who can reliab predict appreciation and depreciation. And be careful believing that someone can. And I'll tell you, here's the trap. Okay, There was this guy in Orange County, California. His name is Gary Watts. Poor Gary Watts, I should probably have him on the show. And you know, for years Gary would come around and he'd speak to all the realtors and go to the board of realtors meeting and he'd always speak and everybody would just fill his sessions. And he was always a super popular speaker and he'd come around to the big real estate offices and do a speech. I owned a real estate office. He came around a couple times and spoke to our group of agents. And in every major city there's like one of these guys, okay, or gals that does this. That's sort of the economist for the local economist, right? And Gary had this great track record. He was always right until he was wrong and then he was wrong and fell on his sword. And you know, I remember in 2005, at the end of the year, he would always make his rounds. At the end of the year he was saying, oh, the market's gonna boom forever here. It's gonna go up. I don't know what he said exactly, but I'm just gonna pluck out a number somewhere around 20% next year. And it crashed. It went the opposite way. Okay. You know, it's easy to think that someone can predict cycles because they might get a couple of them right, but then they'll be wrong and that'll be the end of their credibility. David Lira, the chief economist for the national association of Realtors, you know, he wrote books during the boom about real estate, how it's just going to go on forever and now nobody can find him. I tried to get him on my show and, you know, he's, you can't find the guy. So, you know, everybody's right until they're wrong. And if you ask me, just invest for cash flow. Invest in low land value markets where they have good LTI land to improvement ratios and properties must make sense the day you buy them.

Mm. Makes sense to me. Excellent, Jason. Well, this was very helpful. Where can people get more information from you?

My website is Jason Hartman dot com. That's just my name. J-A-O-N H A R-T-M-A-N dot com and I'm also on Twitter at Jason Hartman ROI like return on investment.

Fantastic. Thank you for coming, Jason. We've got to have you back again sometime.

Happy investing to you and your listeners.

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