HI 91 - Evaluate Your Deals The Right Way with the Hartman Risk Evaluator

Welcome to the Heroic Investing Show. As first responders, we risk our lives every day. Our financial security is under attack. Our pensions are in a state of emergency. A single on duty incident can alter or erase our earning potential instantly and forever. We are the heroes of society. We are self reliant, and we need to take care of our own financial future. The Heroic Investing show is our toolkit of business and investing tactics on our mission to financial freedom.

Hello and welcome to episode 91 of the Heroic Investing show where we focus on the challenges unique to members of the armed services. Veterans first responders, including firefighters, police officers, EMTs, and everyone else out there that goes in harm's way 24, 7 to keep the rest of us safe with our families. My hat's off to all of you, ladies and gentlemen. I used to stand beside you, but I'm glad you stand there for me now because I'm enjoying my time with family and my new pursuits in life. You might have noticed a little bit of a motivated 91 there. I graduated from the class of 1991 from the U.S. naval Academy. And when we were plebes, we would have to show some motivation when we yelled out our class of 91. And now my classmates across the globe, every time something with the numbers 91 show up, they take a photo of it and put it on our Facebook page. So it's still alive and well with our class. But I'm sure anyone else out there that's a service Academy graduate, I brought back some memories for you. So 91, sir. Thanks everyone for persevering through my quirks, I guess I would call it. Today we're gonna listen to Jason talking about one of the most fundamental things, I think one of the things, I guess unique, that he has come up, talked about educated people on with respect to purchasing of rental properties. And he calls it the Hartman Risk evaluator. And what he's doing is he's basically highlighting the land to improvement ratio, which again, is another term that he has. Certainly he's trademarked it. I think he created it. And it's another really important concept, specifically that if you can keep a low land to improvement ratio, then the risk is low on the Hartman Risk evaluator. And really there's a certain amount of money that you have to put into construction, the cost per square foot of construction, right? And that's the bricks and sticks, the commodities that go into building a house, plus the labor, and that creates the cost per square foot of building any property. And so if you can buy below costs of construction, then you probably have a pretty safe investment. So here's an example. Jason talks all the time about properties he'd purchased in California that went up a few hundred thousand dollars, right? And they could just as easily go down a few hundred thousand. Well, my example is similar. About six years ago, we were looking to purchase a house here on the east coast on the Jersey Shore. And we found a house that was about 560, 570,000 and a couple of others that were, you know, in the ballpark. And I was just looking through Zillow and I found a property that was 425,000. And I thought, oh, my gosh, I found it. It was real close, right in the same neighbor, you know, in the same area within a block or two. I went to the overhead aerial photo. It was raw land. And so I chuckled a little bit. And that brought back the Hartman Risk Evaluator. There's no way that I can make the numbers pencil out on this coast or any coast. California, Seattle, you name it. I mean, Seattle's not really the coast, but it acts like the coast when it comes to being a very, very cyclical market. But you get within sight of water, pretty much any of the oceans, and we'll throw Seattle into that. You are going to be in very high land cost area. And the issue is that that $425,000 plot, half acre plot that I looked at could easily be $100,000 or $50,000. Just ask Detroit. It's very difficult to lose $400,000 in the structure that's put on top of a property. I mean, it's possible if you built a $2 million mansion, you could certainly lose quite a bit in that, but difficult when your cost of construction is maybe $120 a square foot or something, it's tough to lose several hundred thousand dollars in that scenario. So that's the Hartman Risk Evaluator in a nutshell. Jason does a much better job of talking through some numbers and explaining its impact on ensuring that you're not getting into a risky investment. So please enjoy this. This is one of Jason's early, early, early ones as he was starting up podcasting. Oldie but a goody, right? That phrase that my father used to say all the time when he talked about 1950s music, it still rings true. And this is an example of an oldie but a goodie. Please enjoy Jason with the Hartman Risk Evaluator.

Today, I want to share a live clip from one of my recent seminars with you on the Subject of The Hartman Risk EV folks, it took me 19 years to discover this. It is totally new thinking in real estate investing as I have never heard anyone else talk about it, I have never read about it and I've read lots of books on real estate investing, been to lots of seminars and spoken with lots of people. So I think you'll really find this refreshing. It is new thinking, it is cutting edge and innovative and I sort of stumbled on it by accident. What this is is is the Hartman Risk Evaluator, which is something that allows you to basically limit any downside risk in a real estate investment to make sure of course we follow all of the other rules we teach here in terms of making sure the properties make sense the day you buy them, making sure the metrics work. Don't buy anything on a speculative basis. No gambling. Follow the 10 commandments of successful real estate investing that is in a prior podcast I believe that might be number 15 or 16 and by the way, while I'm thinking of that, I want to mention to you, many people are listening to our podcast now, but they are listening to only the more recent podcast. And I tell you we have some terrific content available on the podcast in the past. So please go back and listen to the last few at least starting with number 14 or number 13 and go forward. You know, go all the way back if you have the time. Anyway, today the Hartman Risk Evaluator let's talk about limiting any downside risk and maximizing upside potential of our real estate investments. This very cool thing which is based on what we call the LTI ratio. LTI ratio and that is the land to improvement ratio. This is a hard one to demonstrate without the visual aids used at the seminar. So so if you have questions, contact any of our investment counselors here at our office. The number is 949-640-0505. Again, that's 949-640-0505 and any of our investment counselors would be glad to explain it in further detail. If you want to come in and meet with them, provide visual aids to help convey the ideas in this podcast or any of our podcasts because we realize that the podcast is audio format and does not give you all of the visuals which are quite extensive in our seminars.

Remember, you're listening to Flashback Friday. Our new episodes are published every Monday and Wednesday. Anyway, listen in, enjoy and for further information also be sure to visit jasonhartman.com our website where we've got lots of interesting articles, videos, PowerPoints, just a load of information and other audio content. So that's jasonhartman.com at your convenience. And enjoy this small vignette from one of our recent LIVE seminars. Let's listen in. So this is the risk evaluation model. There are several things here. Remember we talked earlier about bifurcating your investment into two components, Improvement value and land value. This is something that took me 19 years to discover. And what happened is this. My insurance broker, Jennifer, called me. I was buying this house in Georgia. It was my second out of state property. Remember, before two and a half years ago, I never purchased a property outside of Orange County. I owned several here, made lots of money on them, but never before. Two and a half years ago outside of Orange County, I was buying the second one in Georgia. Insurance broker Jennifer calls me up and she says, jason, we're going to give you $135,000 of insurance on your Georgia property. And I thought, wow, as an insurance company, you only insure the improvement, not the land. Because the land can't be destroyed, right? The land can't burn down. The house could flood. It could burn down. It could be vandalized, Whatever. The house is what they insure, they don't insure the land. $135,000 insurance on the house. I realized, wow, I only paid 159,000 for the whole thing, including the land. So the land value was only $24,000. And that really made me aware of something that for the prior 19 years in the real estate business, I never understood. I understood then that this was a way to minimize any downside risk, almost eliminate downside risk in my investments. Here are the things that go on here. The improvement value is determined by the cost to build it and the builder's profit. Those two components go into the cost of the house sitting on the land. That's the improvement value. Now, what affects the improvement value? Well, environmentalism and building restrictions affect it. Why? Because when the environmental movement gains more steam and it becomes more restrictive to build out existing plots of land, improved land that already has a structure and the associated entitlements to build that structure on it becomes more and more valuable. And the old riddle for this is, what do you call a developer? Someone who wants to build a house in the woods or at the beach? What do you call an environmentalist? Someone who already has a house in the woods or at the beach. Isn't that convenient? Hypocrisy there. As this environmentalism continues to grow in strength and power, improved real estate becomes more and more valuable, kind of to what you were talking about industrialization of China and India. This is huge. This has never ever before happened in human history. You might want to look this article up on the Internet. Richard, who's sitting in back, who is my favorite pessimist, emailed me this article thinking it would be negative probably a while back. But I really drew something really positive out of it. It's a BusinessWeek article. I'm sure you can find it on the net. I don't have a copy you for. For you, but it's called a Boomer bust. And the date is April 27th of 2006. And they interview Jeremy Siegel and Michael Milken. Remember Michael Milken, the junk bond king, AKA Crook? Okay, the guy that spent some time in jail? Well, he's definitely a brilliant guy, criminal or not. And here's what he said. He said this. He said, now look at wealth. Most accumulation of wealth has been in the last 200 years. Technology has driven it. Many people predicted a more serious problem would be who would buy the assets of tomorrow. In the 70s they predicted mass starvation. That didn't happen. Now we see people that have moved out of farms into cities. Because agriculture has become so efficient. Each farmer today feeds 350 others. The idea we can't produce enough food to feed humanity is no longer in vogue. Okay. We constantly underestimate life expectancy In Japan today. The quality of life lasts longer than anywhere else in the world. They have 73.6 healthy years before becoming disabled by old age. So people are working longer. He talks about two major trends going on in the world today. And I'm skipping back actually. One is that there is a growing middle class population outside the US where, which is where most of the world's population lives. And two, there is a chronologically aging population in the developed world. So what is he saying here? I'll just kind of sum it up for you and then I'll quote a little bit more later. Milken says that basically there are two huge generators of wealth around the planet. Now. One is that people are living and working longer and being healthier longer. So they are creating more value in world economies. All agree with that number two, technology. Technology is creating more and more prosperity around the world. Now the next one is globalization. And this is me talking. You've got two and a half billion people in China and India that are approaching, no matter how fast or slow they are, a middle class lifestyle. Think about what happened over the last hundred years. And this is just me talking. This is not the article over the last Hundred years. If you take the free developed economies of the world, you take Western Europe, you take the U.S. you take a few others scattered around the world. You had what, maybe 400 million people, 500 million people that were really the major contributors to the economy. And those people in those economies caused the price of every commodity on earth to get to where it is today, basically, whether it be oil, copper, glass, steel, concrete, lumber, whatever it is, those are all commodities. Gold. Several years ago, it wasn't Chinese people weren't allowed to own gold. Now they are. What happened to the price of gold went up? I'm not saying that's the only reason, but I think it's a contributing factor. Now, instead of having four or five hundred million people, we've got two and a half billion potential consumers of resources and commodities. My mother went to China just about a year ago and she said, I couldn't believe it, Jason. You know, you fly into these Chinese cities, it's like flying into 10 New York cities. It's unbelievable. They just go on forever. There's just skyscrapers as far as you can see. And then you get on the ground and you look up and you see there are cranes everywhere and more and more building going on. In fact, the national bird of China should be the crane. So then you look around the streets and 10 years ago, everybody in China was driving what, a bicycle? Now they're all driving a car. Lot more traffic, a lot more consumption of materials that build cars. And what else? Oil, of course. What's happened to the price of oil? You've got more demand. The basic theory of economics, of course, is supply and demand. So now you've got all of these consumers that are constantly increasing the demand on existing supplies. Look at what happened. Raw material costs. The government tells us that in 2004, inflation was 33.3%. How do they tell us that? The Consumer Price Index, the cpi. But look at what happened to steel and iron prices. They went up 34% in the same year. 10 times. Well, no, 11 times. Almost the rate of inflation. Lumber went up 17%. Wallboard. This stuff went up 20%. Think about what is happening. How many of you know someone who builds houses or offices or is a contractor? Anybody? You do it yourself. What's happened to the cost of construction materials? They've gone through the roof. I did my landscaping on my current house a couple of years ago, three years ago, and I couldn't believe the bids. I'd done landscaping jobs numerous times on other houses I've owned and I couldn't believe how the prices were so high. I said to every contractor I got a bid from, I said, why is it so expensive? He said, china, huh? Well, they've driven the cost of concrete through the roof. So think about what happens when you buy a house today. Houses are made of simple low tech bricks and sticks, glass, copper wire, petroleum products, steel maybe, certainly lumber, wall board, all of the concrete. All of these materials are getting more and more and more expensive because you have two and a half billion additional people starting to drive up the prices of them. A very good thing for us because think about what really happens when we buy a house today. What do we do to our construction costs? We lock it in, don't we? We lock it in. For how long? Well, depends how long you think the house will last. I say five decades. I say a good 50 years is how long a house lasts. IRS says 28 years, whatever. Depends on the tenant, you know, I don't know. But the point is we lock in our cost and everybody that comes after us has to pay a higher cost for these materials because of the massive consumption of them. Just a reminder, you're listening to Flashback Friday, our new episode are published every Monday and every Wednesday.

A lot of petroleum products go into a house. Copper goes into a house. Copper's got to be mined. Petroleum products have to be. They have to come out of the ground. So that goes up. What's happening to the cost of labor? Is labor cheaper today or cheaper 10 years ago? Labor is going up. Certainly if you build anything or know anybody who does, they will complain about the cost of workers compensation insurance. Right? Really expensive for those people. Energy costs are going up. Every time the cost of energy goes up, really, the price of your assembled house goes up that you own? I don't like to invest in commodities, you know, I like, I don't buy commodities on the exchanges and things like that. But you know what I do like packaged or assembled commodities, where they bring it to the land I own and build the house on it. All of these commodities, these materials. I'm basically a commodities investor in a way. And the better thing about my type of commodities investing is I get the bank and the tenant to pay for it. For me, mostly, when the cost of energy goes up, the cost of your house goes up. I was complaining to my mother, who's quite a stock market freak, when the price of gas started to escalate so dramatically, I was complaining to her and she says, jason, quit complaining. Just buy some oil company stocks. I made a fortune on Valera that's the thing. Hedge your bet. When the cost of other things go up. Just make sure you're investing in that commodity so that you're making money off of it, too. So, two components. Improvement value, land value. Let's look at what this means in real life to us. Here's a copy of my tax bill. Now, look, I'm a single guy. I could afford a better house, but I don't want a better house because it's going down in value. Frankly, I'd like to rent a better house if I had time to think about moving. Here's my tax bill. When I bought my house just over three years ago, I paid 815,000 for it. Okay. Why do I show you my tax bill? Because our tax collector divides the improvement or structural cost, the house from the land cost. And here's what the tax collector said. They said that the land was worth worth $660,000 and the improvement or the building sitting on the land was worth $156,000. What's this going to mean to us as an investor? Well, a lot, I think. Here's how it looked when I bought my house. 81% land value, 19% improvement value, total of 815. A year went by. I got concerned because I noticed a lot of sold signs in my neighborhood. So being in the business, I kept tabs on the values. And I noticed that the value of my house seemed to be increasing dramatically. And I got very concerned about this. Now, why would I be concerned that the value went up? Well, because I know that if the value went up, I've got what? Equity. And I don't like equity. The reason I don't like equity is because it's not FDIC insured. The best insurance is a high loan balance. And I know it's earning exactly, exactly 0% rate of return. Nothing. I want to put my equity to work. I call up the bank. They send out this appraiser guy. Appraiser guy says, Mr. Hartman, congratulations. Your house is now worth a million. 3. Wow, do I love real estate. Only a year goes by and I make $485,000.

Nothing beats real estate. Did I know that would happen? No way. Had no idea. I got lucky. When you're investing in bubble markets, you get lucky sometimes. But I can't hang my hat on that. That can't be my strategy to be lucky. So I want to take that money out, put it to work in investments that you don't have to be lucky in. That just make sense. This investment doesn't make sense. The question I have for you is when it went up 485,000 in a year, what went up, land or improvement? Improvement. Who votes improvement?

Structure. Okay, who votes land? We got more land voters. You're right. Both went up. Look at. It's more expensive to build my house today than it was three years ago. No question about it. My house today, instead of costing 156,000 to build, probably cost 2, 200,000 to build. Most of the increase was in the land. Now, most people agree that the market in Southern California is going down.

We know what went up the most. But when it goes down in value, where does the decline come from? Does it come out of land or improvement?

I say that when it goes down in value, the risk area is the land. See, the land is where is the only place the decline can come from, in my opinion, because the improvement keeps getting more expensive to build. Look at the great thing about houses is they're low tech. Why is that great? Because, you know, this laptop, the next one I buy, is better and cheaper and faster. There's always new disruptive technology in the tech world, but in something low tech like a house where it's just made of simple sticks and bricks, there can't be any big innovation. I mean, at least not that I can see. Unless we're going to start living in, you know, like a force field. You know, I just come home and turn on my house and it, you know, is a force field. Maybe that could happen someday, but I don't see that anytime soon. Right? So if we know that the risk area is in the land now, I'll tell you something interesting about this. I called the appraiser again one year later, and it was the same guy from the same lender. And you know what? He came to my seminar and he sat right where you're sitting now, vj Just about two months ago, he was sitting in that seat and I'm telling this story. He came over again and he said, I hate to tell you this, a year later, your house has now declined in value. It's only worth $1,215,000. It went down 85,000. I'm still up 400, still pretty good. But I hated to give back the 85,000, but where did it come from? It came from the land. So what do we do with this knowledge? Well, if we know that the risk areas in markets with high land value, all we have to do as smart investors is stay away from this kind of market. This is all by the way the bubble markets around the country now, did you notice that this is Miami, California. It's Vegas. It's all of these overvalued bubble markets. This is Hawaii, Arizona, Nevada, Oregon. It all looks like this. We want to stay away from this and go to areas that look like this where the ratio is largely improvement. See my Georgia house. 135,000. Improvement. 24,000. Land. If the land value gets cut in half on the Georgia house, how much am I going to lose? Oh, $12,000. I can live with that. What if I lose half in California? $500,000. That's going to hurt. A simple way to minimize downside risk. Took me 19 years to figure this out. And if it wasn't for that call from my insurance broker, I would have probably never seen this. I just suddenly discovered it that day. New thinking, huh? Bet you never heard that before. Okay, give me a hand.

Just kidding. So here's what Milken says at the end of this article that's really interesting. He says, with all this wealth, the problem is not going to be who's going to buy assets. The problem is, are there enough assets for people to buy with all this liquidity around the world? Take housing, for example. We don't have efficient mortgage markets around the world, but we've had a twin $20 trillion increase in housing assets between 1997 and 2004. If developing countries can fully borrow, what are they going to buy? Where are the assets for them to buy? That's Michael Milken's words. He's a bright guy. Criminal or not. The Milken Institute does a Global Capital Access index every year, which shows China and India still very low on the rankings. Imagine what will happen when these two and a half billion people get access to capital. Their economies are already growing at a rate of 8 to 10%. Without efficient mortgage markets. Imagine when they can borrow. I mean, folks, the type of prosperity that will be created over the next couple of decades I think is going to astound all of us. I think 6% appreciation in real estate assets with the commodities issue is like nothing. And that's been 6.4 is the average for the last 38 years in the United States. The real issue, Milken says, is rate of return. If that increases, it solves the problem. In other words, attracting investors to invest and loan money. In these economies, the issue will be where can I invest? Not who is the buyer.

The trend has already begun. Already we're seeing ads saying, help wanted. We need older workers. The only offense nowadays is calling someone age 60 older instead of midlife. Think about that. The rest of the world is growing so quickly they'll be looking for anything they can to buy. I couldn't believe it folks, the global economy and how incredibly pervasive it is. I'm sitting in a realty executive's office. I'm looking at that market about a year and a half ago. I'm sitting with a realtor there. Very experienced, very intelligent guy. He's with realty executives in Knoxville, Tennessee. He said that a lady from St. Petersburg, Russia came to Knoxville. Not exactly a first tier city. It's not New York or LA or Chicago or even Dallas, which is kind of a first year city and bought 37 houses from him. Yeah, the money is just sloshing around the world. There is so much capital out there looking for a place to sit, looking for a place to go. This is going to drive up the value of your assets in the years to come, and I think it will be a lot more significant than that we've seen in the past, especially when you add inflation and all those other things into it.

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