Greg Crabtree - How To Escape The Business Black Hole of Growth

I would say that 90% of the listeners have no idea where they truly stand on their tax obligations as of this moment in many respects. Many of them don't know their tax obligations for '21, which is bad, or even some reasonable close estimate. Many of them don't know, okay, well, my accountant gave me estimated payments. Well, great. Well, how are you performing relative to those estimates? Are you up or are you down? If you paid in your estimates and paid ahead, well, that's bad. I mean, you're leaving money on deposit with the IRS that you might need for some other things later. If you're ahead of last year, you're sitting there thinking, I'm good, I'm good, I'm good. No, you've built up, you know, part of this cash that you're sitting on does not belong to you, and you need to know how much that is to a reasonable estimate. Doesn't have to be to the penny, but you gotta have some idea. And we just make all this stuff way too hard.

Welcome to season 2 of Owner Occupied on the business of property management. Owner Occupied is a show about property management in the real world. I'm your host, Peter Lohmann, co-founder and CEO of RL Property Management. For season 2, I have a different guest each week and we go deep into conversation about what actually works when trying to build and scale your property management business. Thanks for listening. Now let's go. Welcome back to Owner Occupied. I'm very excited today to introduce Greg Crabtree. I've been a fan and a follower of Greg for a number of years now. He's an author. Among many other talents. So Greg, if you wouldn't mind taking just a minute or two to introduce yourself, a little bit of background and what you're up to today.

Yeah, yeah, thanks. Well, I'm a practicing CPA, so I'm the managing partner of the Huntsville office for Carr Riggs and Ingram, one of the top 25 CPA firms. We merged with them 2.5 years ago, but I had started my practice back in 1986 and for many years kind of did the standard, do anything to help your clients in traditional work and all those things, but developed really a love for just servicing entrepreneurs and really finding what is it that the entrepreneur needs. And for me, probably the biggest catalyst of why I do what I do today and why I wrote the books is I joined a group called the Entrepreneurs Organization back in 2001. I was in the Atlanta chapter for many years and in the Birmingham chapter now, but really I kind of consider myself a global member because I've served on the EO Global Board for 3 years, traveled the world with them. I do teach several of their executive ed programs around finance. And really it is an area where, you know, as a profession, we don't do a good job of really focusing on how to help the entrepreneur. We're selling them what we do instead of doing what they need. And I get it, you know, there's requirements for consistency and all those kind of things, whether it be financial statement presentations or tax preparation, all those things. But what's lacking is generally a greater, bigger picture strategic idea of what's needed. And then think of it as kind of like a, you know, head football coach, you know, what's the playbook? What is I can run different plays. Everybody doesn't have to run the same plays, but essentially, I have to be true to the resources that I have. I can't be a running team when I have passing talent. I can't be a passing team when I have running team talent. A lot of it is really studying my successful clients, studying my unsuccessful clients, and figuring out why was this one unsuccessful, why was this one successful, when they really probably can't tell you truly why. It is kind of amusing. I've had clients that have gotten interviewed and it's interesting for me to see the things that they talk about that led to success in their business. And no, they actually were successful for other reasons, they just didn't know it. So a lot of it is really trying to crack the code of this and help people understand it and use it. And really, the instinctual entrepreneur will always be successful. That is that person who always figures out kind of how to do things. What I want to do is broaden the availability of being successful as an entrepreneur to more people that may not possess that instinctual skill set, but they can run an effective set of plays. They can be an effective executor. We're entering into an interesting time in the marketplace where it's going to get probably the most challenging we've probably seen in quite some time.

I really appreciate that. Something I've always enjoyed about your work, especially with my engineering background, I'm kind of a numbers guy. It sounds obvious when you say it, but it's not something I see often, which is like, hey, you're seeing the financials for dozens and dozens and hundreds and hundreds of small businesses. It just makes sense that you would do some analysis there and figure out what are the characteristics that the successful ones have in common and what are the characteristics that the unsuccessful ones have in common. We can avoid those things.

You would think that, but Yeah, but see, we don't get paid to do that initially. And so that's really where the problem is. And I'm crazy enough that I actually decided to study it with the long hope of it adding value, which it has. It has added immense value. But you strike on the heart of the issue, is that in many professions, people do not do research unless it's paid. If you go to a college professor who teaches finance and say, hey, I've got access to all this data, would you like to study it? Well, who's going to pay me to do it? I mean, that's the first question out of their mouth. They don't study it for the love of study. Maybe I'm stupid, but it's paid off. And, and, but, but I will tell you that, but this exactly what you're saying came from my EO forum mates who I couldn't do business with. I was using them as kind of my focus group. First year I was in my EO forum, you know, 9 other entrepreneurs that I would love to do business with, but I can't because of forum rules. And so, you know, I said, well, how many of you would recommend your current CPA? And the answer was zero. I mean, on a Net Promoter Score, those of you that are familiar with that, for other score, I mean, that, that's a pretty bad score. That's called a zero. As a profession, we ranked a zero. And I said, okay, well And it's not that they hated them, it's like, eh, yeah. It's like there was nothing there to say, I wanna recommend them. I said, okay, what are we not doing that we need to do? First thing was, I don't want the April 15th tax day surprise. He says, okay, well I get that. I don't like delivering that news and there's a way to do it if you have enough resources, but you have to pay for it. And if you don't wanna pay for it, then I can't help you. I knew how to fix that problem. Says, what else? Says, we don't like being billed by the hour. And fortunately, you know, one of my clients who was actually the guy who introduced me to EO and got me in, he and I had a lot of theoretical discussions. He said, all you accountants are the same, you know. I ask you how much something's going to cost and you say, well, it depends on how much time we have in it. And he says, time is not a unit of value, it is a unit of cost. And he's exactly right. And when I do my presentation, I got a presentation I do now called Simple Numbers: Pricing Strategy and Inflation Management, which is a pretty hot topic at the moment. I remind people, this is, if you bill by the hour, there's only two possible outcomes. I either give away my expertise or I charge for my ignorance. You never reach economic equilibrium billing by the hour.

I love that analysis.

Yeah, and, and that, and that applies outside of the profession. But here, but here's the, the last piece of that, the, the thing that was the, the winner said, oh my, exactly what you just said, says, oh, by the way, you see hundreds of businesses' most intimate details more than any other practitioner in, in the business marketplace. You ought to know what works and what doesn't. And they're absolutely right. Here we are with the most sensitive information going right in front of our face that we're doing something else with., but we could study it. We could learn from it, and we don't.

So the sort of simple numbers philosophy that's sort of at the core of your message has resonated very well with the property management world. So I'm a property management business owner. We manage about 600 units. And I'm curious, what is it that— what do you think it is about your outlook, your philosophy, the simple numbers approach that's working so well for property management company owners that's caused it to kind of spread like wildfire?

Well, it's a very straightforward business in the sense that, I mean, it's not an easy business, but it's very much an executable business. So you find that businesses that really rely heavily on consistent execution, they've got to study the numbers. They've got to be on top of the numbers. Oh, by the way, it doesn't take a lot of capital to start one, and if you run it the right way, then it's got one of the simplest metrics ever that we use that really came out of the first book, the overall labor efficiency ratio. I gotta get $2 of billable revenue for every dollar of labor regardless of what that labor does in my business, and I'll be successful. There's just not enough other stuff that goes on in the business. Now, if you're unsuccessful and you get a 2-to-1, I'm looking through your books saying, what kind of stuff are you running through your business?

How many Ferraris did you buy last year?

Yeah, yeah. And we've seen a couple of those. But actually, even the ones that do that, they're wasting money on labor chasing other things. I always say that, you know, in the real estate industry, real estate industry is probably the most likely to face the shiny object syndrome of any industry out there because there's multiple aspects of what happens in the real estate world. And, you know, you can get lured into being a temporary developer. You can be lured into being a construction manager, you can get lured into being a property manager, you can get lured into being a landscaping contractor, you can get lured into being an investor in the building, you can get lured into running a maintenance business. All of those things, it's like, well, understand one thing. I mean, stick to what you're good at. And I like, you know, and the nice thing about the simple numbers philosophy is even if you chase multiple of those activities, Keep everything in its lane. Account for everything in isolation of its own business unit. I don't care whether you chase any of those things or not, just be honest with the data and don't have one income-making activity that funds a losing activity.

Let it stand on its own two feet. That's something that's really, I think, improved my outlook and the way I go about making decisions in my business was when I truly internalize the idea that, yeah, we could go make money doing this other thing, but first of all, is there a good return on invested capital, which I know you're big on and we're going to get to? And two, is it actually making money or am I subsidizing the labor, the office, the rent, the pay? So I love that. So when you look at many different financials of small business owners, what are some of the— what's the low-hanging fruit here? What are the common mistakes you're seeing most often with businesses from like $0 to $2 million in revenue?

Well, it starts out as we don't have a common language of finance. And so when I do presentations and have a group of entrepreneurs, I said, what's funny is unless you guys are one of my clients, if we have every one of you take out your P&L and put it on the table in front of you, they're all going to look different. And it's like, how can we have a logical discussion if they all look different? They shouldn't look different. There should be one language. So we're all talking different languages and don't understand the different terms.

Now, is this because we're not big enough to be under GAAP? What is the reason that they're all so different?

I challenge you, go find 10 GAAP financial statements and they won't be presented the same way either. It's a weakness of the profession in that— this probably gets me in trouble with my accounting peers, but I honestly think generally accepted accounting principles does more to hide the truth than to illuminate it. The thing is, You will not find any successful entrepreneur that says, "Oh, if it wasn't for GAAP accounting, I wouldn't have been successful." No entrepreneur has ever uttered that statement. And it's like— and I'll give you another clue. Just look at publicly prepared financial statements and look in the appendix section of the financials. That's actually where all of the relevant business-related information is now going because that's the That's the language of industry. What is my metrics? What's my key performance indicators that have no grounding in GAAP? Those are things that operate outside of GAAP and International Financial Reporting Standards. And so when you see, just hand a banker an audited financial statement and see if that answers every question that they need to get your loan approved. And the answer is no. They call you back with an incessant amount of questions of trying to get the information that they really need. And so what we've tried to do is like in our client services that we do with our Simple Numbers Consulting, we have a custom model that really is our way of taking all the data and looking at it in a reasonable basis. Whatever makes the most sense of trying to match up revenue creation to the directly associated costs that produce that revenue. Operating expenses, they kind of fall where they fall. And so the structure that we use in Simple Numbers allows us to rearrange analyze the past to get patterns and then forecast forward. But then you're forecasting not only profitability movement, but you're forecasting balance sheet activity and cash flow. And you've got to be able to put all those pieces together because if I create profitability, I've got to have— sometimes that profitability comes early, sometimes it comes late in terms of forms of cash. And then, oh, by the way, biggest impact of cash showing up is I owe taxes. And it's one of the biggest impacts of cash flow management. And you got to piece all these things together. And unfortunately, we don't do a really good job as a profession of the seamless connection of all of those needs and guidance of the entrepreneur to know. We're sitting here today, mid-July, and there's a vast majority, I would say that 90% of the listeners have no idea where they truly stand on their tax obligations as of this moment. In many respects. Many of them don't know their tax obligations for '21, which is bad, or even some reasonable close estimate. Many of them don't know. Okay, well, my accountant gave me estimated payments. Well, great. Well, how are you performing relative to those estimates? Are you up? Are you down? If you paid in your estimates and paid ahead, well, that's bad. That— I mean, you're leaving money on deposit with the IRS that you might need for some other things later. If you're ahead of last year, you're sitting there thinking, I'm good, I'm good, I'm good. No, you've built up, you know, part of this cash that you're sitting on does not belong to you, and you need to know how much that is to a reasonable estimate. Doesn't have to be to the penny, but you got to have some idea. And we just make all this stuff way too hard. But there's a lot of forces in the systems of how things work that really create some challenges, but you got to try to overcome it. And what we find is, is The people who want to know where they stand, those are the ones that will gravitate to following a better process, which really helps in that.

You're a huge advocate for clarity in financials. Your book talks about this quite a lot, your book Simple Numbers. If you're listening to this and you haven't read the book Simple Numbers, highly recommend it. We'll link it in the show notes. One of the things you talk about specifically in there is around basically not playing games to save money on taxes at the expense of clarity in your financials. Can you talk a little bit about— because this is different than almost all the advice we hear as small business owners. Can you share a little bit about why you're such a proponent of that and specifically how that plays out in practice?

I just want to get to truth. Can we just get to truth in financials? And the thing is, I mean, whether it's news media or entrepreneurs just talking to themselves, everybody likes to spin a story. I just want the truth. And the truth is, starts off with you as the owner are generally the greatest distorter of the data. And most of the time that's because you're not taking a market-based wage. And I just always start there because if you're an S corporation, those people have a tendency to do it more so than anybody else because they're trying to save some payroll taxes. And I go, listen, I'm batting 1,000 on this, guys. Everybody that I've convinced to take a market-based wage, pay the payroll taxes, they've made not only more wages, they've actually made more profit on top of those wages because they're looking at truth. I've often said if I was going to go back to college and get a degree, I'd get a degree in behavioral economics because ultimately my goal, and this is probably what I do every day more so than anything, How do I take data and get you to perform at your highest best self? And the thing is, is when you don't have to do mental Olympics to get to the truth of the outcome of what your business performs to, you are more likely to execute on the things that that business needs to do. And so if I can get you to look at truth and respond to it, then one, you're going to defend your salary more than you'll defend the bottom line profit. That's just hardwired. But once you're looking at true profitability that you can truly trust and you know when the cash shows up. Now the thing is in your audience for a property management company, cash shows up really quickly. I mean, you don't have a cash lag. I mean, cash, unless you're letting your people you manage, give them terms to pay you, which is a bad idea. I mean, you should get cash, you know your profitability as it happens. And so, you know, so from that standpoint, you have a little better motivation. People tend to struggle if you're carrying receivables or if you gotta, you know, carry stuff. If you, like I said, if you got involved in, say, doing construction in addition to property management and you didn't structure your draws against the construction line correctly to where you're carrying part of the cost of the construction and not drawing on that as it happens, that's a bad cash flow model. And it existed for a long time, but most of our construction clients have now gotten to where pretty much cash on cash, but we had to teach them, we had to show them, we had to keep reminding them of, hey, you know, you can't wait till next week to do that draw against the line. You need to do that today. That becomes the highest, most important need. And then once you fix these systemic problems, then you start to see things. The second one is, you know, everybody talks about, well, you know, I run stuff through the business. I got news for you. If you go out and hire a hired gun CEO, you hadn't even thought about how much stuff somebody wants to run through the business. So I get it. I mean, granted, it needs to be relative to the business. It needs to be deductible. We're not talking about people who are trying to hide money and take non-deductible things, although there are people who do that. But what you're really trying to do is be truthful. And in many cases, if something is somewhat discretionary, we've got a technique of where we'll take it and put it below the net operating income line in the presentation of the data so that I'm trying to remind you that the business produced $100,000 of profit and you chose to spend $50,000 of it for something that was deductible but not necessary, or it might have had questionable possibility. So are you good with that? As you said, I mean, this is in the first book, why would you spend a dollar to save 40 cents in tax? I mean, that, that, that's, that's just the dumbest idea I think I've ever heard. And you spend money to create leverage, to spend money to make more than that dollar that I spent back in profitability. And if it doesn't do it, stop it.

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It's funny. For years, I fought with clients to not live off of a line of credit. But a fully capitalized business to us is someone that has 2 months of operating expenses in cash, and zero drawn on a line of credit. So to us, that's the definition of being fully capitalized. And what's funny is, is once you get somebody there, they actually start lobbying, well, maybe I should keep 3, or maybe I should keep 6. And I go, no, no. And I said, now, if you're— I don't care if you know what to do with it or not. I mean, the vast majority of our clients who've gotten profitable, I mean, they struggle to figure out what to do with it. It's, it's more, more a question of how to deploy it, but What we started to do, and most of our S corps and LLCs can freely move money back and forth between personal and business, and so I want you to keep the excess above 2 months outside of the business. The business is at more risk of being sued for some random thing that happens in the business world. So keep that excess money outside of the business and just put it in a savings account and put it back in if it happens to need it. We've been using this technique for about 15 years now.

I've yet to see anybody need more than 2 months, even during, even during COVID Keeping those 2 months, keeping the excess above 2 months outside the business, I think does something else, which is when it comes time to decide how to allocate that capital— so we're getting into like a capital allocation question here— it, it really sets it up nicely, which is like, okay, I have this money in my personal bank account, there's an opportunity to open a new office, open a new product line, go into a new geography. Is it worth me taking that money out of my personal account, which hurts a lot more than just, oh well, we'll spend the money, it's already in the business, it'll save us on taxes. It helps you think more rationally and intelligently about whether it makes logical sense to take money from your personal account and deploy it into your personal business. And I know you love to use return on invested capital as a metric here. Share a little bit about how that works in practice and what the minimum threshold you like to see is.

Yeah. When I wrote the first book, I opined that 5% profit was life support, 10% was good, 15% was great, anything above 15%, take it while you can get it because the market will generally compete you back. That actually works still for about 70% of the businesses, but I didn't set it based on some mathematical approach. I set it based on just observation. But the other 30% bugged me that, okay, I need to know why. And so, as I kept studying it, one of the things I get to do in EO is I get to chair an executive ed program at Wharton Business School with a couple of the real professors. And so, I get to hang out with them. And one of them I really owe this to, David Wessels, who's our lead professor for that project. He was the first time we did the class 7 or 8 years ago. He was talking about return on invested capital and I'm thinking, I'm sitting in the class noodling on it and I'm going, hmm, well, I've done that calculation in school, but I've never done it for a client because invested capital is different than equity. Most people think of equity. Well, equity is a slippery number because I can be undercapitalized and my equity's not the right number. I can be overcapitalized and equity's too big of a number. I could have trash on my balance sheet. Oh gosh, am I talking to the right crowd that maybe has non-business associated assets or liabilities? On their balance sheet in their business, yeah, that's like most entrepreneurs. Your business is the one who had the money, so you decided to do a transaction with the business's money that was booked as a loan. So it's just kind of one of those that you end up having to clean up in that process. And so essentially invested capital is taking equity and removing any asset or liability that's not necessary to run the business. And in my case, I adjust cash to the 2-month number whether you have it or not, because that's what I'm holding you accountable to, that number, whether, whether the cash is there or not. And if you have excess of that number, I'm taking it out because that, that's not active cash in our opinion. The fascinating thing was, is we found a high, high correlation to say the minimum acceptable profitability comes when you're at 50% return on invested capital. That's the minimum. And so I question viability of any U.S. business in a developed marketplace that has reasonable terms. Now, some of my international clients, and especially developing countries, you sometimes get hit with those to where you might actually be down in the 20s to low 30s in those countries because it's just a capital-intensive environment to where you gotta have money to turn over transactions because there's not a trust relationship in business. But for U.S. businesses, it's 50%. Now, for low capitalization required businesses— real estate management companies, IT management businesses, businesses that get to collect upfront and then perform a service, especially the ones that are on monthly recurring revenue type businesses— they have really low capital requirements. Therefore, in those businesses, you should be targeting 75% to 100% return off of that core equity number. But what it turns out to be is most of our property management clients, we think if you'll hit the 2 LER for revenues, service revenues to all labor, you're going to be at 15% to 20% profit. I mean, it's just wired.

Robert Leonard: Just to make sure I'm thinking about this correctly. Let's take an example where you have a steady-state operating property management company and you're trying to make a decision around whether to sign a very expensive radio advertising contract. And it's going to cost you $100,000 a year to advertise in your tri-state area on, on a couple radio stations. For you to— if we follow your example of like a 50% return on invested capital, you would want to set— you would want to feel confident in being able to say I can spend $100,000 today and within the next year or two, I'm generating $50,000, not of revenue, but of profit directly tied to that advertising.

Is that the right way to think about this? Or more profit. It's hard to directly associate it with it. Yeah. What you're touching on is a concept we call launch capital. Launch capital, there's 3 types of capital that exist in every business that we've taken the balance sheet and said, Listen, here's your buffer capital, which is cash minus line of credit. So that's the cash component. Infrastructure capital is fixed assets minus debt associated with it, which your business model would have little to none. And then the other is trade capital, which is accounts receivable, inventory minus accounts payable and deferred revenue. Well, once again, you don't sell on account, so therefore your trade capital ought to be as close to zero as possible. And so therefore, your core capital number is mostly a little bit of fixed assets, maybe, plus the 2 months cash. Now, that's on the balance sheet, but where 99% of entrepreneurs grow their business is on the P&L. They spend money before it creates value. And nobody sticks a gun to their head, and marketing is the perfect example of this. And if you look in the the launch capital chapter of the Simple Numbers 2.0 book, the second book, that I walk through this example of a client of ours that grew from $700,000 a year in revenue to $5 million in revenue in 5 years. I mean, I'm sorry, $10 million in revenue in 5 years. And only through marketing spend was the catalyst. So they would catalytically spend marketing, get results, backfill operations. And they did that successfully. And so the idea being, It's a bet. If I bet $100,000 is going to pay off, well, what I want to be able to do within 12 to 24 months at a minimum, sooner is better, but some bigger non-response marketing type stuff takes a little while. But if I spend that money, then I want to see profitability go up by 50% of that bet. Now, what that means is I not only created profit to cover the $100,000 spend, but I made $50,000 on top of it. And that's the goal of what you're trying to do. And the thing is, the reason why you're aiming for that 50% return is you're going to miss it sometimes. You're going to have some misses. But the example I put in the book, I mean, they had some phenomenal wins too. And so that's the whole point.

That's the gamble that you take in business. I was listening to you on another podcast, and we walked through an example of opening a new location. You talked about, "Oh, you put 20% down, and then the revenue from the new location covers basically the rent," which is what it is. In that example, you would still want to see a 50% return, but you wouldn't have to back out the purchase price of the asset because you actually are getting an asset.

You're not speculating. If there's an underlying real tangible asset, it's a building, it's a sellable franchise, it's a piece of equipment that has some residual value, I'm looking at the tangible asset value minus the debt associated with it. That payment, and this is kind of where I'm deviating from GAAP, I'm looking at that payment as an expense in reality in my return calculation. And so this is something all your audience gets, which I really love, is I'm just taking an operating business and turning it into a cash-on-cash return calculation. That's all I'm doing. Now, the thing is, what I don't agree with is if you're purchasing some intangible asset, goodwill on a business, mm-mm, sorry, that's a different bet. —there's no residual value. There's probably not residual value there. Just be careful. I love that. Be careful in the over-application of that idea.

I want to transition and talk about growth here, although we've been touching on growth. One of the things you discuss in Simple Numbers is the concept of a black hole, which, if I remember right, is businesses, once they pass that $1 million in revenue per year, there's a black hole until you get to $5 million in revenue. Share a little bit about what you found there, why you think that exists, and maybe some strategies to bring us through.

[Speaker:ROBERT_LEONARD] Yeah. And it's very prevalent in the property management world. I would say that number's probably from a million has drifted up a tad just with inflation and labor costs going up that you're probably looking at around a million and a half now. But essentially up to about a million, million and a half, as the owner of the business, you can cheat. You can wear a bunch of hats. You can get away with really low-cost help and you're running around with your hair on fire, but you can be profitable. And the key is, this is where I'm pushing you to say, okay, for all of those hats that you're wearing, what percentage of the time are you doing all these jobs? What's that annual pay for those people? That percentage times that annual pay for that role, that's really the job that you have. You can't just pay yourself the CEO pay because you're actually working down rate the vast majority of that time. So you only get to count as your pay the actual function that you're doing. And so this sometimes will always help pushing people to actually delegate. But once I delegate, the person I delegate it to has to be able to produce it at a good return. And I have to then shift to higher value and get return on those higher value now time that I have to, you know, typically it's going to be go win more customers and go, go get more, more work that you're running through the system. Now here's the, here's the hard, here's the painful part. When you start to delegate, it's usually around that million to million and a half stage. And the problem is you're delegating to someone who I can't fully utilize when I delegate it to them. I got to pay for them, I got to get total 100% of them. And unfortunately, it's like, I've got— once I start to delegate, I've got to keep running faster. Well, the problem is when you— we say the black hole starts at about a million and you cleared at about 5 million. Well, the deepest, darkest moment of the black hole is at 3 million. And if anybody's listening to this, you know exactly what I'm talking about. Yeah, yeah. At 3 million there's one of two possibilities. You're either profitable and you really are running with your hair on fire, and which I'm good— that's actually the most successful strategy, but you can't stay there. You must run through and get to 4 and clear 4 and head towards 5, or else you will, you will just burn out. Or you're at $3 million, you've invested and delegated in staff, but you're now not profitable. Because I'm not at a 2 LER, I'm at a 1.7 or 1.5. And this is where we run into a lot of property management companies that we have to kind of give them the bad news of going, it's either grow or you gotta cut. And let's face it, I mean, a lot of times you attempt to grow and you're gonna have to back up and then try to grow again. But you can't keep growing with a bad idea or the wrong people. And unfortunately, I mean, it's a tough labor market to where even as much as you'd want to go hire that right person, they may not be available at a price you can afford. And those are the challenges. Plus you've got a marketplace too that this is kind of the convergence of the market at the moment that my labor costs are going up and labor productivity in real terms is going down. There's a report came out a couple of weeks ago that said US worker productivity was down 7.5%. I have no idea how they calculated that, but I agree with the sentiment. And I actually would tell you it's probably down closer to 10 to 15%. And so when you have a shrinking labor force to pick from and lowering productivity, you got two bad forces that really makes a pricing challenge for you in a marketplace that is very narrow band of pricing. And there's a few things that you can do in pricing in the property management world, but a lot of times, you know, you're really held within a pretty narrow band, you know, in terms of what you can charge.

And that, that becomes a challenge. Yeah. And I'll share my own experience here because we're, we're deep into this black hole. There's really two big challenges around hiring great talent. One is it's very, very expensive. And I caution— what I experienced as I started to need to hire top talent is that when I first tried to do this, I wanted to be cheap. I wanted to get a $150K value person and I only wanted to pay $90K. And that just does not work at all. You're actually better off sticking with the $40,000 and $50,000 employees and just hiring a few more of them. When it's time to bring in a manager, you need to bring in a real manager, especially as a small business owner, because you need to get things completely off your plate. So that's the first challenge is that's a very painful check to write. I mean, run the numbers on $150,000 a year salary, what that monthly burn rate is. The other challenge is, and this was very true for me, you don't know what top talent looks like because you've never been around it. You may have started your business right out of college, or I worked as an engineer for a few years, but I wasn't around the executives at all. So I had no idea what to look for. I didn't know what was possible. I didn't know what was normal. When I would interview someone, I didn't know where they sat on the scale of what you could get for that salary. So that's a big challenge, too. It's very, very difficult through here.

Well, and this is a subtlety that we show in the client's data. When you hire somebody purely in management, they're not a producer. Well, for you to grow to support their labor, it requires you to hire other direct labor people that need to do those functions. And so even though the overall labor efficiency ratio may be a 2:1, to add that management labor person, the top line has to grow. Our data shows it's a low of a 6, high of a 10, the average is 8. And so I would tell you, if you— for anybody you hire in management, I would work off of a 10-to-1 ratio, saying, I, you know, if I go hire a $100,000 person, my thinking is, what's my million-dollar plan to justify this hire?

Wow, that's intimidating. That's serious. Yeah, it is. Yeah, but I'm sure that's—

but that's where you got to go, because you've got to hire other people to do stuff, to do the accounting, to do the, the the property, the actual hands-on management, all of those other things. And that's just not something that happens. But there again, you also, when you hire that $100,000 person, I didn't write a check for $100,000 right away. I'm writing 1/12 of that number. And so I gotta get on my horse and I gotta run fast. It's like, okay, let's have that plan to keep bringing in, integrating, and go through that growth phase. And then typically you're going to plan a pause and a little bit of a rest of going, okay, let's get these integrated, let's fine-tune, let's optimize. Because when somebody's not profitable, I mean, the number one playbook that works is we call it get profitable with what you got before you try to grow. To try to grow to get profitable is really a losing proposition most of the time. You know, you've gotta— if you can't get profitable now Granted, if you're below a million, that's a different discussion. But once you're past that million, million and a half, you better be profitable with what you got and do that before you try to grow it and think, oh well, if I get to another million, you know, I'll be profitable. No, it's because you're chasing all this other stuff. You need more people. And I gotta tell you, more people are less efficient, not more efficient. And like I said, we're faced with a labor market right now that just isn't very efficient, period.

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Yeah, and so it's generally, we generally base it off of a term we call gross margin. So think of revenue minus any cost of goods sold. Well, so for property management businesses, you have little to nothing in cost of goods sold, so it's revenue for you. But I still want to refer to it as gross margin because you might find something that you pass through to your customers and you may have third-party services or things in which do happen, it's been a growing base in the property management world, is where you're reselling things in addition to property management. And so gross revenue goes on the revenue line minus any cost that I have for a third-party service that I'm passing through, and that net gross margin is my top line. My denominator is labor, and it's all wages, and it's not loaded for payroll taxes. I want to keep it simple. It's just the wages that you pay somebody. And oh, by the way, It's their base plus a bonus plus any incentives, you know, everything. Those are all just techniques of compensation at the end of the day. And so a dollar's a dollar's a dollar. And so you're thinking, and previous to us coming up with this concept, I would say that, you know, the vast majority of labor analyses took labor as a percentage of something. And to me, that's just a dumb calculation. You turn it around. Labor, and this leads to some bigger ideas that I'll share in a second, labor is required to create productivity. And so labor should be the denominator, the bottom number of the fraction to say what does it produce, not the other way around of saying, oh, revenue's the bottom number and labor is the top number. No, revenue didn't produce labor, labor produced revenue. So your denominator has to be the catalyst and the numerator has to be the output. That's the correct way of looking at it. So the idea is when you look at this as a multiplier effect, some of our clients in real estate do multiple activities and we start segmenting what that group's producing in margin versus their pay. You got some LER numbers that are less than 1. That's not good. And so you quickly start to look at that going, well, that sounded like a great idea. I guess we really need to rethink that because they can't consistently— yeah, they might have a pop here or there, but can they consistently perform month in, month out, quarter in, quarter out? Or is it a transaction? And I think that's really a lot of the brain damage around real estate finance is there's transactional activity and then there's operating activity. A real estate management company is an operating business. Involved with a syndication of a sale of a property, that's a transactional business. If you're selling real estate, representing buyer or seller, that's a transactional business. The broker might be an operating business, but for each of those brokers, each of those real estate salespeople, that's transactional, and it's sometimes there and sometimes not, as we're feeling at the moment. But in this bigger picture, let me speak to this. So here's the thing, and everybody in your audience needs to understand this. So when we started tracking this data for the book, I decided to keep going with the tracking. So we have this 100-company model that our clients are all different industries all over the country. So we, we don't have a particular industry that we focus on. I mean, we have multiple clients in a lot of industries that gives us insight, but I like having a touch of the overall market. There's probably not an industry we don't serve. And so in this 100-company model, it's about $1 billion of revenue. It's a good data set. And what it tells us is We were in the most expansive economic growth period in US history from 2009 to 2019. But in October 2019, we hit the wall. We ran out of labor in October 2019. And we sensed it, but COVID came the next quarter and just totally destroyed everybody's focus. And you had people that stopped, dropped in labor, people stayed out because of extended unemployment benefits, but everybody's back that's going to be back. I mean, so stop thinking that, oh, when are these people going to come back to work? They're already back at work, folks. This is it. But we were at historically low unemployment in October 2019. And here's the reason why they ain't coming back is because they ain't there to come back. We're at a 1.7 replacement birth rate roughly, which, oh, by the way, that means the 20-year crop of humans aren't coming. My generation is the end of the baby boomers. All of my peers are retired. I mean, I'm the idiot that still keeps working because I like what I do. And so that group is gone, and they'll be professional consumers for the next 15 to 20 years. But guess what? They're consumers now. And what do you do In retirement, you consume less. And that consumption will— there'll be some wealth transfer, obviously, but it's not wealth transfer that drives the economy. It's consumption that drives the economy. I mean, if people don't spend on consumption, you got all kinds of things, you know, that start to go out. And so we've got to understand that in terms of real economic terms, we're not going to have an expansive economy unless somebody figures out how to solve the labor problem. And good luck with that. I mean, you can't even get either political party within their own party to agree on immigration. So it's not being solved by birth. It's not being solved by immigration anytime soon. AI ain't getting there fast enough. I mean, we've had significant gains in technology, but remember what I said earlier. I mean, we've already measured that AI is not helping labor productivity right now. We're going backwards in labor productivity in real terms. And so I got news for you folks. It's going to be a bumpy ride for a while. And then you got a Federal Reserve that is running a 1960s playbook on money policy management where they think that they can solve inflation. It's like, no, you can't. You can't solve inflation other than wrecking the economy. I mean, you can create excess labor if you just wreck the economy in total, which is where they're headed with it. But when you don't have extra labor, I got news for you. Every one of us is— of the people we have, they're wanting more money. And if you don't give it to them, somebody else will. And you're going to see some excess labor down at the bottom end of the marketplace that is construction companies and anybody in the real estate sector starts to get softer and softer. But I mean, you're still seeing it in retail to where Stores aren't open. Restaurants are still limited hours because they can't get labor. It's going to be an interesting ride.

[Speaker:TREY_LOCKERBIE] I'm trying to play this out. Shouldn't it be the case in a free market economy that given a shortage of workers, which we have right now— The response to businesses is going to be over time, and they're going to resist this. But over time, they're going to raise their prices so that they can pay their workers more. And if you follow that chain, What's going to happen now is consumers are going to look now at the new marketplace of higher prices, and they're going to cut out things that are of the lowest value to them. And maybe it's they only go out to eat once a month instead of once a week or something. And then those businesses will go out of business, and that'll free up more workers, and everything will kind of restabilize. Is that—

well, but what you're going to see, but if, if all of that happens, what does that do to GDP, gross domestic product? Well, it means we live in this state of decline. When do you hit that state of equilibrium to reset? Well, it's going to happen unevenly throughout the country. Throughout the South where I live, I mean, nope. Yeah, there's not enough— I live in Huntsville, Alabama. Nope, things still pretty good here. And yet there's still restaurants that can't staff it and we don't have enough laborers. But I was in Chicago a couple of weeks ago, that's a different story. Downtown is not as busy as it once was. My clients who have buildings there, they go, "Hey, I need some tenants." That's not good. People who live there say there's vacancies in those high-rises in the residential. And when you walk the streets, it's mostly tourists that are there. It's not the daily workers. Those guys didn't come back to the office. You start to create this implosion of some of those retail shops that require workers and residents and vacationers to survive. There's got to be a great reset in the major urban areas that have had those people leave.

I love the idea that the Federal Reserve, with their dual mandate, one of which is low inflation, I feel like maybe they should be coming out with promoting opening the borders and telling everyone to have babies, because that would actually be an effective way to fight inflation rather than raising the interest rate.

Elon Musk is not wrong. I mean, he's had several tweets on, "Hey, it's the population, stupid." I mean, one of the most known data points that exist in our government database, and nobody is correctly calculating the slope lines of where that's going. It's like, come on, people.

A third grader could predict this. [Speaker:TREY_LOCKERBIE] I think what's lost on a lot of people is this very, very basic concept, which is that each incremental human is a net gain on everything— productivity, GDP. If America was half the size it was today, we would all be worse off. So, it follows that more is better, basically. It's kind of a weird thing because we're not used to thinking in such a finite—

[Speaker:TREY_LOCKERBIE] If you want to scare yourself to death, just go pull the— The Wall Street Journal had an article on Latvia a couple of months ago. It's the picture of a dying country that has this older population. Of the young people they do have, which isn't above replacement birth rate, even they're leaving because there's not opportunity. But there's denial of service. Of what the older generation needs because there's no one there to do it.

Yeah, that is terrifying.

And, you know, but there again, you think about, I mean, a significant part of our economy are things that you could arguably say, is that necessary? Do you actually need that?

Yeah, and that's kind of what I was getting, getting at with my earlier line of thinking is, I mean, there's no dispute that we have enough humans to sustain a minimum standard of living for everyone in the country. Now, whether how you think that should be distributed and everything gets political, but we have enough labor to support everyone living without being in poverty. So then how do you allocate that extra, that surplus, right?

Yeah, but I mean, you look at Japan. Japan dropped 600,000 in total population last year.

That's not good. It's not. Well, sticking on inflation here, so business owners small business owners especially are very resistant to making price changes. And you made this point on another podcast I listened to. How can we— or let me say it this way, how important is it to be doing this in an inflationary environment? Is this a wait-and-see thing, or is this something where we need to be raising our prices now?

Well, yes, you need to be raising prices now. But here's the hard data. So our 100-company model is we're showing 3% to 4% decline in gross margin from last year to this year. So that's already 4% right there is your—

Is that the first time you've seen a decline in margin since 2009?

Yeah, other than 1% up and down. Wow, scary. But that tells you how much everybody's struggling to reprice. And some people can reprice, But I mean, most people have not had market resistance against price changes. Their resistance has been, can you get something? Can you sell it? Can you sell the product? Can you deliver the service? And price has been less of the issue. But there's a lot of brain damage about people, they're scared. They don't know where, I mean, there's no bright line that says, hey, charge this. And that's a scary thing for most of them. But we've got plenty of them who were 2 years ago signing 5-year pricing agreements and feeling pretty spiffy about it with inflationary increases of 3, CPI of 2 and 3% a year. It's like, how's that working for you? Because real inflation's probably closer to 15 in reality. I think that is stalling a bit. I mean, you've seen energy prices drop here in the last week or 2, and guess what? It's because people are not driving as much. Guess what? When people don't drive as much, what happens? They don't spend as much and everything just kind of, and it just feeds off of itself. And I think when it comes to pricing, you've got to stay adaptive. Now, here's the good news about if you're talking to our property management audience. Well, if rents escalate the way they should, Guess what happens to your fees? They go up. So you're an industry that doesn't necessarily have to change prices unless you were poorly priced to begin with. And, you know, we've got a few that if you buy another property management business that has been a little on the cheaper end, you got to push that up, those kind of things. You got to make sure that you don't let One of the biggest cancers of finance for property management is the management company eats costs that really should be passed through to the property owner. And those are ones you've got to watch out for. But that's not a pricing issue, that's an execution issue. But really at the end of the day, you should be fine staying relative because that percentage works. And everything that we see, I mean, there's reports the other day that people are paying massive premiums for rental property right now to rent because they've been a little bit a little bit locked out of buying, and they don't know what the future looks like. So we've become even more transient in terms of a big sector of the residential marketplace, of saying, because they can work from anywhere, they're not as committed to where they live.

Now, I will say our property management company charges a flat rate, so we don't get those automatic price increases as the rent goes up. We have to manually adjust our pricing almost every year, which we have fairly consistently done. But it is a scary thing to email all your existing customers and say, "The renewal price, you were paying X per month and now it's Y." On the other hand, we've done that for years. Most of our clients are used to it and most of them don't even blink because, "So you raise the price $10 a month per unit, $20 a month per unit." It's almost negligible in the grand scheme of the annual cost or the annual profit of owning a rental property.

Yeah, and the fact that your job is to also help them reprice. And once again, their, it ain't broke, so let's don't fix it. And that property owner is not staying relevant to the return on that property value. 'Cause this is kind of the case where, I think for property managers that are managing other people's property that you don't own, This is really akin to the replacement return decision discussion that I put in the 2.0 book for people selling a business. You should always be doing a calculation to help your property owners understand that their rent is not based on their basis value and recovery or their debt. It is what is the appropriate rent relative to the value of that property that you could liquidate it for and sell it. Those numbers have become so easy to get now with online market values and those things. You may have some concern about thinking, "Why would I want my rental management customer to consider selling the property?" Part of it is, I don't think they're going to sell it if you give them a reason to just keep raising it because what else are they going to invest in? One of the classic errors that I see all the time is people say, "Oh, well, you can do a 1031 exchange." Well, great. Is the property you're rolling it into better? Than the one that you had? I'd say 9 times out of 10, it's not.

You should have kept the property you had. And I can't tell you how many times I run into old-timers and they'll say, "Oh, I used to own this. I used to own that." You'll be walking down the street and you say, "Well, why'd you sell it?" And they're like, "Well, you know, I thought I could— I wish I still owned it," right? You hear that all the time. "I wish I still owned it." Yeah, that's right.

And so, the thing is, is you give them a refreshed value at what the net after-tax proceeds are and then look at that investment. Because it's not based on what you could sell it for gross, it's based on what you could sell it for net after tax implications. That's what you base the new cash-on-cash return on, not what you have in it.

Clay Finck: Now, would you have that discussion in terms of return on equity or a cash-on-cash? Which do you think is more relevant?

Robert Leonard: It would be cash on theoretical cash. If I sell it, and pay the tax on the gain, what's my net proceeds that I have left over? That becomes the basis that I'm trying to get gain calculated on. That becomes the denominator, and then my net cash flows, ever how I have it financed or not, becomes the numerator.

Yeah, and something a lot of our clients— something that a lot of them forget is just how expensive it is to sell a property. I mean, everyone knows about the 6% realtor fee, but there's many other costs associated with transacting in real estate that make it generally a bad idea in the absence of something really compelling. Okay, let me wrap up here. I want to ask you just kind of a totally random question that's been on my mind recently. When does it make sense to bring that finance function in-house? So we partner with Profit Coach. I love Profit Coach. And a lot of what they do, from what I understand, was built in collaboration with you. I can't speak highly enough. But at a certain point, we're not going to be outsourcing our financing when we're a $10 million company or whatever. In your opinion, when does it make sense to outsource that function? When does it make sense to bring it in-house? When you do bring it in-house, what would be the job description or the job title of who you would bring in first?

I think you're always just doing trade-off analysis. I always like to remind people, when you do your, your accounting in-house, you need 4 functions. I need a CFO an hour a quarter. I need a controller 1, 2 days a month. I need an accounting manager 1 day a week. I need a bookkeeper 1 or 2 days a week. Well, none of those are full-time functions. I mean, for a fairly sizable business. And so accounting has become a very— because of remote access technology enhancements, connected systems, there really isn't a theoretical number. It's always a trade-off of, do I have a capable provider? What do they cost me if I build out the team of people for whatever underutilization potential I would have of some people that would be a skill set? And, and to say those 4 skill sets, if I brought it in-house, I may not bring all 4 of those skill sets in-house. I may bring 2 of them and leave the higher-end functions remote or fractional. So there's not really a bright line, but I think— I mean, we can sell outsourced accounting services all day long, but it's a tough thing to do and it's not exactly the most profitable thing to do. And even the people that we've referred out for projects that we don't want to do or doesn't fit our scope of where we want to serve, they still struggle. I mean, they're struggling to hire people. It's a difficult process. And I think it's only going to get worse as the labor market shrinks and people want more money and do less for it. So it becomes a challenge. So it really becomes a super premium to be— you've got to lead with systems, processes, and training. And so when I do my inflation management discussion, I say the labor winners are the people who can hire at the lesser expensive talent level and rapidly train for task-specific deployment.

In a very quick fashion. That's a powerful sentence right there. I might have to rewind and, and play that back because I, I think there's a lot encapsulated in that.

There is. And, and we have clients who are successful in doing that, but, but it's like, okay, you got to be willing to live with the consequences of it. Uh, you know, it can be a little messy as you bring on that lesser experienced person to grow them into a very focused job-specific thing. And accessing international labor wherever possible. I mean, every call we have clients right now, we're talking about, okay, what jobs do you have that can— yes, if you've got technical people in the field that have to be physically present, that's great. What can you offshore that's back office? Yeah, I mean, it's a huge, huge deal right now. And there's even indications that some of the offshoring people are struggling as well. I mean, they would love to tell you that there's an endless supply of labor. There's not. I mean, there's only one country in the world of a major population that is above the replacement birth rate, and that's India.

And they'll be below replacement birth rate before 2030. Interesting times ahead. Well, I really appreciate your insights today, Greg. This has been a fantastic conversation. If people want to follow along with you, learn more about what you do, what's the best place for them to do that?

All of the book material is simplenumbers.me. So that's the the site, you know, for the book and all that content. The firm is Cricpa.com and it's like we've got 60 offices pretty much throughout the southern band of states, but we've got business all over the US. But certainly the easiest for people focused on simple numbers, I go straight to the SimpleNumbers.me site because that, that's the focus of the two books. Any resources that we have, videos, got several presentations that are recorded there that people can follow as well.

Perfect. We will link that in the show notes. Thank you again, Greg.

This has been great.

Yeah, appreciate it. Thank you for listening to Owner Occupied. I hope you have enjoyed this episode. If you like the show and want to get connected to the community, you can follow me on Twitter @PSLohmann and subscribe to my email newsletter on my website, peterlohmann.com. I try to share as much valuable property management content as I can on a regular basis.

Thanks again for listening and have a great week.