HOW THE PRESS AFFECTS THE ECONOMY

Exclusive: Jody Tallal explains impact of media coverage on investor behavior

In my last column, we explored the interaction of the economy and real estate cycles and how they are not the same. In that column, we used the graph below to look at the two cycles.

As you can see in the above chart, the ongoing economic cycle, shown in black, does not run simultaneously to the one occurring in the real estate industry (shown in blue), but usually precedes it by as much as a year. Contrary to popular belief, the real estate cycle is not fed directly by the local or national economic cycle, but instead by what we will call the “investor demand” cycle. Likewise, the investor demand cycle is also not fed by the real economy, but instead fueled primarily by what investors are reading or hearing from the media. This information shapes their decisions.

It is through the investor demand cycle that money flows, in the form of financing, into the real estate industry. These investors, both institutions and individuals, are the savings and loans, banks, insurance companies, as well as, pension plans, public and private syndications, and wealthy individuals.

The reason the real estate cycle lags behind the economic cycle is that the media can only report data and statistics concerning the economic cycle after they have been accumulated. In addition, their true job is to report what they feel we are most interested in hearing. If they miss the public’s interests too consistently, they are not going to grow.

By looking at our original economic example and tracking what the media are reporting and how the investors are reacting to it, we can see how these two cycles interact.

Using the chart above, starting at the bottom of the economic cycle, we are at the pit of the recession. During this period, the media would be reporting what I will call “Bad Press.” Top stories, because it has been so bad for so long, would probably be exploring the more tragic, human side of problems caused by the bad economy. Unemployment and the pain of failed, small businesses, etc. are the primary economic news.

Since the news has been bad for some time before this bottom actually occurs, the investor and his funds have long since fled this marketplace. Because of the investor’s alarm, he will have sought new places or areas for his capital to be invested. The real economic recession, therefore, will become paralleled with a subsequent, complete halt of development in the real estate industry.

As the true economy starts to climb out of the recession, a real demand/growth cycle will be in effect for 6-12 months before any new improved statistics can become available and subsequently reported. During this economic startup period, since no new positive statistics are yet available, the news from the media will be flat. Since flat news is uninteresting, the local media will choose to report on non-economic issues. The national media will be diverting investor awareness to areas of the economy and country that are currently booming, such as maybe the stock market or what is happening in China, etc. Since investor awareness is diverted to where the “Good Press” is, no new construction money will be available to this real estate market from investors.

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Because such little money is available, very little new construction is contemplated. As the current supply of realty inventory is absorbed, the newly developed projects of the inside investor will gradually start to appear. As this occurs, some members of the media will see the turnaround more quickly than others and release some brief, positive stories. However, once scared away, the investors will require overwhelming proof that the market is strong and very safe before they will choose to re-enter it.

During the oncoming, stronger economic upswing, the press will start to give more and more positive signals. The first substantial proof of the recovery, in the form of statistical data, will now finally become available and be published.

The press, because of these confirming statistics, now will swing into a full “Good Press” mode. Reading the repetitive “Good Press,” investors finally start to appear. Unfortunately, however, because of the lack of development activity, real shortages are already present and are now getting worse. The reality of the two-year time lag from project contemplation to project completion will over-exaggerate this shortage problem, causing even higher increases in rent and sales prices. Total consumption of the available material and labor force will drive the prices upward and thus creates the long awaited boom period for the real estate industry. The “Good Press” keeps getting better and stronger, and the money that had just previously started to trickle into the market now comes flooding in.

The institutional investor, finally feeling safe because it can no longer be criticized, opens its money gates. As new businesses are formed and economic expansion continues, everyone and his brother begin to enter the real estate industry to capitalize on the boom.

The problem, at this point is that the real economy has just begun to peak and start its normal slowdown. However, it will be a year before the statistics finally confirm this slowdown, during which the period the “Good Press” will still run at full steam. Meanwhile, every small investor in the country is now aware of the “Good Times” in real estate and wants a piece of the action. Billions of dollars demanding placement through the private syndicators will become available. The financial institutions, having a difficult time competing, will become even more aggressive in lending.

By this point, when the building should have stopped, it just now shifts into high gear. Two years of oversupply is built-in approximately a six-month period. In addition, as we discussed in my last column, builders will build as long as they can get money, and the investors, following the positive press, are only too happy to comply.

Then, unfortunately, the historical bad statistics finally become available and confirm the reality of a recession, which has now really been underway for the last 6-12 months, and the “Bad Press” begins. The non-sophisticated investor remains for a while longer, but the institutional investors, coming face to face with reality on the front page of their newspapers, slam on the brakes. People, who thought they had strong banking relationships find out that they have no banking relationship. Many businesses that could have survived with a prudent working banking relationship will now go bankrupt, furthering the economic collapse.

Within a short period, the reporting becomes “Very Bad Press.” All remaining investors flee the market, which is just prior to the bottom of the real economy’s recession cycle.

For the next period, “Very Bad Press” becomes the word for the day, and big headlines appear regularly. The slide into total recession occurs almost immediately as soon as the money vanishes. Only projects that have been pre-funded will start during the period that follows. Soon, we are at the point, which this example started.

In my next column, we will explore a method I developed to predict where we are in the real estate cycle and what will happen next.

Read more about Jody Tallal, a pioneer in the financial-advice industry, in the WND story announcing his column.

How the economic and real estate cycles interact

Exclusive: Jody Tallal explains relational peaks and valleys of markets

In my last column, we starting a discussion about economic cycles and the importance of being able to both understand and predict them. That column concluded by pointing out the fact that in reality there is not one but two cycles running concurrently, but out of sync. These two cycles feed on each other. The first cycle is the economic cycle; the second is the real estate cycle.

A good model of cycles looks like a mountain-like graph, which shows the roller coaster effects of the cycle. Below is an example of two complete cycles of both the economic and real estate cycle and how they interact with one another. In the chart below, the economic cycle is depicted by the black line and the real estate cycle by the blue line. As noted above, these two cycles run together but slightly out of sync.

First, let us examine the causes and effects of the true economic cycle through an elementary discussion of basic economics.

If we look where the mountain peaks and starts back down (show by the red arrows), this is the beginning of a recession. Recessions are a contraction period due to a reduced demand for products, which is a result of a previously weakened economy.

Because of this weakening, corporations will steadily reduce inventories and employment. An increasingly high unemployment further reduces the need for new products. This process feeds on itself until the supply and demand have finally stabilized. During this period, new corporate expansion has long since come to a halt.

If we look at the real estate industry during this economic down turn, we will see this translates into low absorption of new office space due to the corporate inactivity. Additionally, there is an oversupply of residential housing due to unemployment, which creates a buyer’s market in residential housing; and likewise, there is a high vacancy factor in multi-family projects. Since real growth is recessed, these markets will also feed on themselves until their supply and demand ultimately stabilize.

Now leaving the real estate sector and going back to the economic side of this example, as we come through the bottom of the recession in the economic cycle, we start up into a demand/growth period.

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After all supply has finally been absorbed and inventories depleted, the demand naturally starts to exceed the supply. Industry, still very cautious, wants serious confirmation prior to unbundling itself. These time lags usually create even greater shortages.

As the demand continues to escalate, the wheels of progress slowly start to turn, thus creating new jobs. New employment continues to spur on the recovery as new incomes create new product demands. Then new corporate expansions start which furthers this process.

Translating this back in the real estate world, office space will become scarce. This is a result of the two-year time lag, from project inception to project completion. The reason there is a two-year time lag is because it takes two years to conceive, finance and build any new project.

In addition, more employment means new worker salaries and therefore new money for new home purchases – which produces a need for even more product. Apartment vacancies diminish, creating additional demand for more multi-family development. As a result, more and more jobs are created, which spurs on the economy.

This is the growth/expansion cycle personified. Money from the investment industry for new expansion becomes more and more available. Because of the availability of money and the apparent historical strength of the economy, more and more entrepreneurs appear in all industries.

Still more product becomes available until they ultimately catch up with the bulging demand, and then finally exceed it. If we could slow the stream of new product supply at this time, to stay constant with the demand, a period of steady growth might exist for some time until it is finally upset by some monumental crisis.

However, due to the opportunities that continue to be apparent, our entrepreneurial spirit and the continuing expansion of more and more new investment capital demanding placement, an oversupply of product is ultimately created.

Unfortunately, all good things must end, and such is true with the expanding growth economy. This is the peak in our roller coaster ride. Once again, in real estate this would mean additional office space under construction when there is already a two-year supply and record new apartments and housing starts when they too are already over built.

At this point, it is important to note that builders will build as long as money is available, regardless of need for their product. You cannot blame them; that is the way they make a living. If the investor is driving the builder by giving him money, then the investor has the ultimate responsibility for what is happening in the marketplace.

As the oversupply hits the marketplace, strong competition begins. This unfortunately leads to reduced profits in business.

As more and more product is produced, with the demand staying constant, profit yields become less and less, creating a slide down the backside of our roller coaster. As the realization of the oversupply sinks in and the conservative, contractionary philosophy begins, jobs are lost. This causes an additional softening in product demand, which further weakens the economy.

This loss of purchasing power works dramatically against the oversupply. Once again, the process begins to feed on itself and we enter a full recession, bringing the economy cycle back to where this illustration began.

Obviously, this is an over simplification of the way our economy runs, but it is very accurate. In my next column, we will further explore the interaction between the economic and real estate cycles and show the relationship between investment capital and the press.

PREDICTING ECONOMIC CYCLES: IS IT POSSIBLE?

Exclusive: Jody Tallal calls media-reported data less than helpful to real estate investors

Over the last several columns, we have been discussing investing in pre-development land and a special real estate acquisition matrix I developed. In the next couple of columns, we want to shift our focus to understand economics cycles that affect real estate, and in later columns how to predict when they will occur and what will happen next.

As referenced in a previous column, time is the biggest factor in the real estate investment-yield equation. The longer you have to hold something the more it has to sell for just to keep the yield the same. If you can buy at the end of a recession and sell into a booming market, obviously that would be much better than buying at the top of the market, only to watch a recession occur and values plummet.

For this reason, I am a strict contrarian when it comes to my real estate investment philosophy. That means buying at the end of a down cycle when everyone is selling and almost no one is buyer, and selling into an up cycle when everyone is buying. While this makes sense, being a contrarian investor is hard. This is because you are going against the natural flow of what everyone else is doing. Therefore, it becomes imperative, if you are truly going to be a contrarian investor, to learn how to read economic cycles.

I am from Dallas, Texas, and we have the same types of economic cycles as everywhere else. However, for some reason Dallas seems to rise higher in its booms and fall deeper in its recessions than just about anywhere else in the country. As a result, the market dynamics and relating factors appear to be a little more defined in Dallas than in other markets. This made it the perfect place for me to study real estate economic cycles.

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I am a student of history and like to learn as much as I can from mistakes made, both mine and other peoples’. Back at the end of the 1980s, this mindset led me into an intense research project in an attempt to try and identify common denominators or elements present in the marketplace prior to a market cycle transition. I have always felt that if you had a crystal ball that allowed you to know in advance when a recession was going to occur (or when a boom period was going to begin), you could cut out the biggest risk there is in land investing: marketing timing. Therefore, what I am going to try to explain now and over the next several columns is what causes boom cycles and recessions, and more important, how to more accurately predict when they will occur.

marketing timing. Therefore, what I am going to try to explain now and over the next several columns is what causes boom cycles and recessions, and more important, how to more accurately predict when they will occur.

My personal clients know I do not particularly like to make multi-million dollar investments decisions based purely on what a staff writer for a particular newspaper or magazines might think is right. However, it is a fact that what is written does have a major effect on others investors’ perceptions and subsequent actions.

As a result, I am going to try to explore the true effect and relationship between the real economy, the real estate industry, the investor’s attitude and the tenor of the current press. What I hope to demonstrate is that the investors’ perceptions of the real economic cycles are distorted because what the press reports are data that are historical and statistical in nature.

This historical data can only become available after the completion of a prescribed period (quarterly, semiannually or annually). Since these data are historical, and we have to wait for that period to end, it is therefore non-current and already out of date from the true market. As a result, waiting on such data to be reported makes us operate with out-of-date, non-current information.

In reality, there is not one but two cycles running concurrently, but out of sync. These two cycles feed on each other. The first cycle is the economic cycle; the second is the real estate cycle. We will explore these two cycles and there relations to one another in greater depth in my next column.

 

With real estate buys, stay away from the bank

Exclusive: Jody Tallal on how to structure investment acquisition for maximum yield

In my past columns, we have been discussing my multi-pronged real estate acquisition matrix. The next element in the matrix is obtaining favorable terms. This is one of the main elements in real estate acquisitions were you have the ability, through negotiations, to cut major risks.

Land investments bought for cash normally do not produce major returns. If a property doubles in value in just three years, which means you made a good selection, if you paid cash for it, after deducting commissions, closing costs, property taxes, etc., you will be lucky to make 20 percent per year on your money, before the impact of taxes and inflation. If it takes a couple of year longer, this investment’s return is no longer as attractive.

Fully leveraging any type of investments is not wise for several reasons. For example, in income-producing real estate, the prime purpose of an investment is to produce net cash flow. Major appreciation is normally a distant factor. If you fully leverage income-producing real estate, you severely eat into to the primary reason you bought it.

However, with land, appreciation is all you are looking for, and income or net cash flow is non-existent. The way to maximize yield on an appreciating investment is full leverage – 100 percent if possible. The less money you take out of your pocket to control an investment tract, the more profit you will make when it appreciates.

However, everyone knows if you fully leverage your investments you greatly increase your risks – right? In other words, leverage is a double-edged sword. If the investment grows, you make multiples of its true growth. However, if it fails, you lose multiples of what you put up in cash. Leveraging all of your investments can bankrupt any investor if everything turns sour all at once; or can it?

Is the risk of leverage failure of the investment or loss of value? The answer is No!

The real risk of leverage is the debt instrument you sign; it’s the promissory note that collateralizes not only the investment itself, but all of your other assets if that investment fails. The language in the loan document you sign is what creates the risk. If your investment fails, this document can create a type of triple collateralization, which encompasses all of your other assets.

What would happen if you could negotiate away this total financial liability language and remove all references to the collateralization of your other assets and/or future incomes? In other words, let the only collateral on the loan be the investment asset itself for which you are borrowing the money in the first place. What I am saying is that you take no personal liability.

How do you get a bank to let you borrow on land with no personal liability? You can’t. Today, they are all federally regulated and have personal liability language built in their notes.

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As you can see, the problem with leverage is definitely the liability language in the note, not the possibility of a project failure. So what is the solution? Do not leverage any land investment at your bank or any other regulated financial institutions for that matter. No matter how well you structured your investment; no matter how perfect your research your project; no matter what other major players are in your immediate area; something could go wrong that you did not expect. One mistake can start a whole domino process and wipe out all of your other investments.

Therefore, the real question becomes, where can you finance your land investments without using a bank? The land investment industry is one of the only industries with the capability of self-financing without institutionally regulated funds.

In many markets, many owners of undeveloped land are willing to finance their own property sales, since bank financing of it is so difficult to obtain. Since these individuals are not federal or state regulated institutions, the terms and the language in these loan instruments becomes negotiable. In other words, you can negotiate no personal liability language with the investment standing as the only collateral.

Using this method can create fully leveraged investments with the same risk of cash investments. In other words, with no personal liability, you still receive all the benefits of leverage; with none of the associated risks.

The next element in my matrix is directly contradictory to many land investment products being marketed today. I do not like to buy a property that is not zoned and has no utilities currently available. Many syndicators sell the concept of buying land cheap and waiting for utilities and taking the property through the zoning process.

While this does increase returns, it also can greatly increase risk. Nothing is more unpredictable than a planning and zoning committee or a city council. I have seen some of the industry giants spend tens of thousands of dollars and without getting anything close to the zoning they needed to make a project work.

To me, buying unzoned land is a big “if.” “If” I succeed, I create a major increase in value, but “if” I fail, I may have actually paid more for the land in anticipation of success that will ever be worth it. Many cities today, across the United States are afraid of an over built marketplace scenario and as a result, are acting out their concerns by randomly denying zoning to reduce the demand on them to provide new infrastructure. This leave too big an “if” for me to feel comfortable. In addition, if utilities are not available to this property, then all of the land is good for is farming; no utilities and no zoning equals no current use.

One of the final elements in the matrix is to evaluate to whom you plan to sell your property and negotiate your acquisition to conform to their needs. This means putting on the shoes of your prospective purchaser and thinking like them. What size tract will they use? What will the market support? Are there any underlying title problems that will prevent them from wanting the property? Is the immediate market area already over built in this zoning classification? If you read your buyer’s needs well, you will greatly enhance your ability to sell at the maximum profit in the shortest time.

In my next series of columns, we will discuss economic cycles, and I will share with you a system I developed that will show you how to accurately predict Booms & Busts. This way you will learn how to know when to get out of the market before the next real estate recession begins.

NOT ALL INVESTMENT RETURNS ARE EQUAL

Exclusive: Jody Tallal on why he prefers to be a land banker vs. land developer

In previous columns, we have been discussing investing in pre-development land, and I have explained the different category of land investors. As I continued my research on investing, I realized that not all returns on investment are equal. Making, say, 20 percent a year on an investment was just part of the true yield equation.

Let me explain. If I make 20 percent a year on a stock portfolio and it takes me four hours a day to plot, follow and trade my portfolio, that is not the same return as if I made 20 percent a year in rental houses and spent only four hours a week managing them. In addition, that would not be the same as if I owned warehouses that only required four hours a month to manage and made the same 20 percent.

With pre-development land, it requires only a few hours of my time a year to manage. I could do a rain dance on the property several hours every day, but that is not going to help its value.

If I acquired my investment property properly, it is going to do whatever it is going to do because of the influence of major market dynamics around it that are outside my control. Therefore, it requires very little of my time to manage, and I am available to acquire and manage much more of it and/or do other things with my time.

If I were to shift my role from land banker to land developer, that means I now have to incur a substantial amount of development debt with personal liability. It additionally means I have to become responsible for day-to-day operational commitments of real estate development.

Because my objectives are that of a pure investor, this extra bit of profits of continuing on from land banker to developer just does not justify or parallel my goals. Please do not interpret this to mean I feel being a developer is inappropriate; it is just that I feel each person needs to determine to what investment camp they wish to belong, and then try to stick to it.

After you have decided on your objectives and strategies, the next step in my real estate acquisition matrix is to identify specific investment criteria. In other words, what kind of land, price, location and terms are you looking for?

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There is an old adage in real estate that says, “The three most important factors in selecting the best property are:

1. Location;

2. Location; and

3. Location.

Nothing has ever been truer when it comes to making a profit in land. “Location” is foremost in importance. Therefore, it is a very important element of our matrix. In my opinion, it is much better to have the primary future corner at a major intersection in a hot market and pay 150 percent of fair market price today than to have a back parcel, irregularly shaped, down the way and only pay 75 percent of the market. The prime corner will make more money every time.

Since land is non-income productive, your only yield comes from appreciation. Since investment return is a product of holding cost, holding period and gross profits, time is one of the key elements.

If a property doubles in value in one year, you make 100 percent growth; if it takes two years to double, you make 50 percent a year; 3 years, 33 1/3 percent per year; etc. The primary corner will usually be the first to develop. Usually, it takes at least another year for the second-best corner to develop. Additionally, it is not uncommon to see the worst of the four corners sit idle for 3-7 years past the development of the first. Therefore, can you see how important being the first to develop is?

The timing of your future sale is a product of your property’s location. Therefore, I try to select the best property with the fewest development flaws.

The next element in the matrix we have already briefly covered. It is the need to be surrounded by major developers and big league investors. I call these people major players. Major players can make an entire market area happen.

As an example, back in 1977, I saw a section of land in far west Plano (north of Dallas, Texas) at the intersection of Preston Road and FM 544. It was more than 20 years away in the Plano development guide back then before the city intended to bring sewer lines to this area. Subsequently, all the property in this area was selling for $5,000 an acre, because it was merely farmland.

The Hunts owned one corner, Sears Roebuck the 110 acres across the street, and several other major players were also in the immediate area. These landowners got together, put up approximately $350 an acre each for the property they owned in the area, ran sewer lines from the plant to service each of their properties – and then donated it all to the city of Plano. Bingo. In one move, property in this area went from $5,000 an acre farmland, 20 years away from development, to $40,000 an acre prime development property. If a group of disjointed Joe speculators owned the majority of the land in this area, they would have had to wait 20 years for something to happen.

In my next column, we will discuss negotiating the best terms to produce the highest yield on your investment.

The real estate philosophy that worked for me

Exclusive: Jody Tallal explains power of snatching up the ‘going home’ corner

In my last column, we began discussing a special real estate acquisition matrix I developed. Part of this matrix’s purpose is to determine which type of real estate investment philosophy best applies to you. In the last column, we covered the first type of three categories of real estate land investors: the real estate speculator.

The second type of real estate land investor is where I found my investment home. It is the camp I call “Predevelopment Land Bankers.”

When I first analyzed land investing in the early 1970s, I realized almost all land investors were playing as speculators. Once I disqualified land speculation for myself, I was somewhat disillusioned. I had already determined the land was what made my wealthiest client wealthy, but my first preview revealed only these speculative opportunities. Then I found a second group of players who made big profits virtually every time they bought. In the Dallas real estate market where I lived, back then these people were Ross Perot, the Hunt brothers, Bob Folsom, Trammell Crow, etc.

This group was not speculating; instead, they bought large tracts of land that if left alone would remain undeveloped for many years. Then, because of their influence, money, political contacts and organizations, they physically enhanced the land. They might pay for and build sewer plants that were not in the city’s plans for the next 20 years and then donate them to the city in exchange for zoning; or they may build important infrastructure, roads, etc.

In other words, they bought the property as raw farmland and through their efforts changed it to development property and made all the profits for doing so. Quite often, they then also made the final profits by physically building the actual structures on the property.

I felt that this was great; they hit a home run every time. There was just one small problem, however. I did not have Ross Perot’s money or Trammell Crow’s contacts.

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Then it dawned on me: If I put my boat in their harbor, when their activities raised the tide, my boat would rise right alongside theirs. My plan ultimately became quite simple. Find two or three major developers who have already started their developments, wait for them to finish zoning and the development of the infrastructure and then actually kick off their projects. If I found one major development over here that was underway with 10 percent of the rooftops (homes) in place, and another over there with 15 percent of its Phase 1 in a 4-phase project completed, if I then followed the traffic patterns from those subdivisions to the workplace, I would always come to a major underdeveloped intersection. It was undeveloped because you cannot develop retail space until you have enough rooftops to support it. In fact, this intersection was still usually three to five years away from having the demographics needed for development.

I then determine what is called the “going home” corner (the corner people passed on the way home from work) and would try to buy that one. The reason for buying the going home corner is that is where people will want to stop on the way home to pick up what they need. Therefore, that corner should also be the first to develop.

Granted, because of the new major activity and publicity in the area, the speculation had already occurred a long time ago on that corner. Therefore, its price was no longer 5, 10 or $20,000 an acre, but instead 40, 80 or $120,000 an acre. In addition, all of the true real estate speculators were now three hilltops over the next horizon looking for the next hot area.

Now remember, it is still 3-5 years before the demographics in this area could justify retail development. It has been these types of tracts I bought because I knew in just 3-5 years, what I bought for $2-3 per foot would be worth $6-8 per square foot or more. Additionally, taking a piece of land from $3-8 per foot in a 3-5-year period can produce some very handsome returns. If we got lucky, it all happened quicker.

With this system, I knew when the first subdivision was finished in three years and the other in four years that the demographics from these would create the demand for my property to be developed. Therefore, I let the big boys make my properties usable by their developments, and it worked repeatedly.

The final camp or type of real estate investor is that of the land developer. They are the ones who are the real user of the land. They turn it from dirt to a finished product, which can generate income.

The land developers’ profits are the smallest of the three groups, but the most predictable. This is because they are more in control of their own fate.

I have often been tempted to continue from pre-development land banker to land developer, but in the final analysis have decided against it. The reason is not that it is not a profitable area, but that it does not meet my personal investment goals. Being a land developer is a hands-on business that requires full-time work staying on top of the development. On the other hand, as a pre-development land banker, I have managed a $150,000,000 portfolio of land investments, part-time, with the help of a real estate broker and property manager.

In my next column, we will explore why all returns on investment are not equal.

MY REAL ESTATE ACQUISITION MATRIX

Exclusive: Jody Tallal discusses ‘checklist’ that must be completed to move forward

In the next several columns, I am going to explain a Real Estate Acquisition Matrix I have developed over the years. It is the criteria and requirements my years of study, research and experience have shown me should exist in every transaction.

I treat this matrix like a checklist, and I will not buy a piece of property unless every item on this list is checked off. I feel about my checklist like a pilot should feel about the pre-flight checklist provided by the aircraft manufacturer for his plane. Every time he gets to the beginning of the runway, he is supposed to carefully run through this checklist.

Obviously, if not everything in this checklist is working properly; he should abort his takeoff and return his plane to the hanger for repair. If he ignores the problem and takes off anyway, he is courting disaster. This does not necessarily mean he will crash if he takes off; it just means his odds of having a problem have been substantially increased. I treat my real estate acquisition checklist with the same respect. If 90 percent of it is there and some items better than normal, but I cannot get that last 10 percent negotiated; I pass on the investment.

My averages of acquisitions to attempted negotiations are approximately 1 out of 50. Granted, I spend a lot of time to produce nothing, but since it is my economic life with which I am gambling, it has to be 100 percent to pass.

One of the biggest mistakes I have seen people make when trying to buy land is becoming emotionally involved with the tract. Maybe they want it because they used to pass it as a child, or their rival competition is bidding against them. Whatever the reason, it is a kiss of death to become emotionally involved with a piece of land. I can truly say that as an investor, I have never seen a piece of land I simply had to have.

If you stay completely objective, you will never have to worry about the trap of rationalization. When a tract does not fit your checklist, simply drop it and move on.

When negotiating to buy or sell a property I have a little practice that operates on the “It’s my Football Theory.” Remember the child when you were a kid who, if he did not get his way, took his football and went home. I am very much this way when it comes to negotiations. When I am buying, if I do not get my price, terms, etc., it is my money, and I can go look elsewhere until I find somebody else who wants to play by my rules. Likewise, if I am a seller, if I do not get what I want, nobody can twist my arm and make me sell.

In other words, once you truly understand this theory, you realize “Nobody has anything you have to have.” If it is not absolutely right, move on until you find something that is.

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If you arm yourself with this philosophy, you will have already significantly increased your odds of success and reduced you chance for failure. Therefore, when negotiating an acquisition determine your bottom line before you make your first offer.

The next step in the matrix is to determine you land-acquisition philosophy. I like to look at this in terms of “What do I want to be when I grow up?”

I break land buyers into three distinct camps. All are quite different and have their own points of merit, and each investor needs to decide which is best for him or her.

First comes the land speculators. They are the risk takers, but also make the most money in the real estate game when they are successful.

A land speculator plays hunches. He or she tries to determine the next area where the big real estate developers are moving before they themselves know. If the speculators call it correctly, they get very rich; sometimes seeing land values jump from $5,000 to $40,000, or even $60,000 an acre in just a few years. However, if they miss, no bigger headache exists in the investment world, because it takes years and lots of holding expenses to figure out you were wrong. I have always had a lot of trouble with being in this camp personally.

I feel that one would have to be very egotistical to try and out guess the likes of a Ross Perot, Trammel Crow or Jerry Jones. They are truly experts and have incredible research staffs that spend tremendous amounts of time determining where they are going next. In addition, as you probably have guessed, they do not broadcast that fact prior to their acquisitions, which are usually done in the most secretive manner to prevent rapid price increases during their accumulations phases.

No, unfortunately, I do not feel qualified to compete with these experts, their money and research. Therefore, I disqualified land speculation for my own account, even though the profit potential is quite attractive.

In my next column, we will discuss the other two types of land investing philosophies with the hopes of giving you enough information to choose which type of philosophy is best for you.

Investing 101: Impact of rent on land values

Exclusive: Jody Tallal reveals how to determine whether property investment is worthwhile

In the past couple of columns, we’ve discussed the benefits of investing in raw, predeveloped land and how to determine the true value of a tract of land. Now, let’s look at the impact all of this has on commercial undeveloped land values. Land values are a floating variable within the fixed development equation.

Let me state that again because it is very important: Land values are a floating variable within the fixed development equation.

For example, if a developer wants to earn a 10 percent total return on his investment, he would simply take the projected net operating income, or NOI, from the proposed project and divide it by his desired yield to determine the project’s maximum projected development costs. This process allows us to determine exactly what the land is worth as part of that project.

Let me demonstrate. Assume that the net operating income for a new proposed development is projected at $500,000 when this project is 95 percent occupied. If we divide the $500,000 net operating income by the desired 10 percent return, the developer then determines that he can justify spending up to $5 million building this project. Therefore, he knows his maximum budget for everything must be less than $5 million.

Total development costs for any project can be broken down into three different categories. First, there are the soft costs such as architectural fees, loan brokerage points, building permit fees, interim financing costs, etc.

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Next, there are the hard costs of the development, such as, concrete, steel, lumber, electrical, plumbing, windows, doors, labor, etc. Finally, there is the cost of the land.

Since the hard and soft costs are relatively fixed, based on a competitive market, the variable in this equation becomes what we can justify in paying for the land. In other words, if the hard costs of this project are projected to be $3 million and the soft costs to be $1 million, then the land’s value is the remaining $1 million of the $5 million development costs.

Now let’s see what happens when rental rates dramatically increase in a short period, say from $12 to $18 per square foot for office rent. This type of dramatic increase is what occurs at the beginning of most real-estate booms because during the bust, as things stagnated, rent likewise declined as well.

What’s the direct impact a 50 percent increase in rents will have on land values? Will the value of land rise an equal 50 percent? Let’s use our little formula to see.

If our net operating income in the above illustration was based on rents of $12 per square foot, which then subsequently increased to $18 per square foot (over a two-year period), then the net operating income would grow from $500,000 to $750,000.

Now, if we take the exact same project but use $750,000 as the projected net operating income, let’s see what happens:

The $750,000 NOI is divided by the same 10 percent desired investment yield, which now produces a new total development cost of $7.5 million. In other words, the developer under these new income projections will now see this project as capable of supporting a $7.5 million development price tag. However, since neither the hard nor the soft costs should have escalated very much, the remaining variable in this equation is land value.

So using the same factors as before, we can determine the effect that a 50 percent increase in NOI will have on undeveloped land values. If we take a $7.5 million project and spend $3 million in hard costs and $1 million in soft costs, that means the true value of the land is the remaining $3.5 million. Like I said earlier, land values are a floating variable within the fixed development equation.

The land value in this example, therefore, has increased from $1 million to $3.5 million (a 350 percent increase) due to an increase in NOI of only 50 percent.

Now understanding this concept, let us assume we want to buy a tract of pre-development land as an investment that’s three to five years away from being ready for development. We can then project its future value based on today as explained above and then discount that price backward based on our projected holding time, plus what we would like to earn on our money in this investment. This will establish a purchase price that we can pay, hold the property for the anticipated time and still meet our desired investment yield.

Now, what if you find a tract that meets your goals, but the seller of that tract wants a higher price than you can pay? What if all the comparable recent land sales prices in that area are higher than your established price? What if other speculative investors have already raised the value of all land in this area past your desired comfort level? Then I go back to my philosophy that dirt is basically worthless until it can generate income, and it is safer to pass on this opportunity.

If the development market has determined a maximum purchase price for the land based on the above illustration and I cannot buy a piece of property at the discounted determined price, hold it for the necessary time and still generate my expected return, I’ll pass on this investment opportunity.

Quite often, investors develop a fury of land speculation that heats up land prices well in excess of today’s true value. This is called the greater fool theory: “I am going to pay more than I know it is worth because this market is so hot I can find a bigger fool to sell it to and make a profit.” When this happens, these inflated prices don’t raise the real value of the land. That usually means that sometime in the near future, someone is going to get burned.

This is where the contrarian philosophy will serve you well because it will allow you to enter the market when it is ending a bust and all the other investors are still too scared to participate and then sell into the boom that follows as everyone is trying to get into the game. In later columns, I’ll explain more about how to read cycles so you can do this.

Determining the true value of that raw land

Exclusive: Jody Tallal explains how to evaluate potential future income streams

In my last column, we started a discussion about investing in real estate and how raw pre-development land was in my opinion the best option. I also promised that in this column we would discuss how to understand the true value of land.

One prime method the majority of land investors use to establish the value of a tract of land (or any real estate for that matter) is by comparing other comparable sales. I personally have found this method an easy trap in which to get snared when used as the exclusive method of valuation.

Granted, I do look at other comparable land transactions in making my analysis, but it is not my principal tool. If you are going to use comparable sales, allow me to share a few observations. First, do not compare asking prices of other tracts around you. They are usually inflated because of the pride of ownership. What everyone is asking is not near as important as what has sold and to whom.

Sales of comparables can be useful in negotiations if you fully research your comparable: who was the buyer; what were the terms; and what is the zoning for the tract. If the buyer is McDonalds, Home Depot, or Ross Perot, its sale is probably a good indication of true market value. Such buyers do extensive research prior to making an acquisition. On the other hand, if the buyer is Joe Blow syndications and his merry group of investors, take it with a grain of salt. Many investor groups buy stories, concepts and pretty illustrations that sometimes have nothing to do with real future value.

The best method I have found to determine value is to determine the future best use of the land. You can best determine the future ultimate value of land once you first understand that land is worthless until you can put something on it that generates an income stream. The capitalization of that income stream denotes its ultimate true value.

If a tract is farmland and will not have usable utilities for at least 20 more years according to the nearest city’s plan, I do not care how many speculators like its location or freeway frontage, or whatever – to me this land is farmland for a long time to come. Since time is a very important part of the investment-return equation, you have to factor into this process how long it will be before a tract of land can produce revenue.

In the above example, farmland’s value can be determined by its potential productivity. If it can generate $200 an acre, if you want a 10 percent return, then its worth is $2,000 an acre.

If, however, the farmland becomes surrounded by development, utilities arrive and you can divide that acre into 4 lots and sell them for $50,000 each, then you can calculate your development costs and build in your profits to determine the land’s true future value.

In the above example, farmland’s value can be determined by its potential productivity. If it can generate $200 an acre, if you want a 10 percent return, then its worth is $2,000 an acre.

If, however, the farmland becomes surrounded by development, utilities arrive and you can divide that acre into 4 lots and sell them for $50,000 each, then you can calculate your development costs and build in your profits to determine the land’s true future value.

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Once land becomes scarcer and the population density increases around it to the point it can be zoned and justifies multi-family development, then the value for the same acre of dirt magnifies again. This is because you can now rent that foot of ground monthly and create a continuous stream of income. That income stream when capitalized at the desired rate of return determines its value.

If the acre happens to later end up as a corner intersection with a high traffic count and the acre can be zoned retail, its value changes once again. The reason is because now instead of a one-time rent per month like apartments, you can sell products from that same square foot of land, over and over again several times each day, generating higher profits.

Finally, once you have land in an area that is so densely populated, you can justify building on the same square foot into the air over and over again, you have reached land’s ultimate value: a high rise development. Its value again will be determined on the amount of net revenue that can be generated from rents, so that will be greatly determined by how many stories high can be successfully developed.

Let us go back to our original premise that dirt is worthless. If a piece of land is ultimately going to be developed as a shopping center, then you can gauge its ultimate value by determining what major developers have just paid for shopping center land they are currently developing. Once you determine this, you can work backwards to determine a fair value today. Simply anticipate the projected period for this tract to fully mature to prime development status, and then calculate your desired return. Using this approach, you can arrive at what you are willing to pay today.

In my next column we will look at the impact that all of this has on commercial undeveloped land values.

 

THE BEST INVESTMENT VEHICLE I’VE FOUND

Exclusive: Jody Tallal explains significance of knowing ‘science’ of risk vs. return

In my next several columns, I am going to be discussing real estate as a potential investment vehicle. More specifically, how to invest in raw land.

Back in the early 1970s, I began analyzing my clients’ investment portfolios, and it readily became apparent to me that no matter what size income a particular client might have, or where they choose to invest it, prior to my assistance, most of the time they ended up losing a significant amount of what they invested. It did not seem to matter much whether they invested in stocks, gold, oil, cattle, or genetic research in Brazil – they all seemed to fail the vast majority of the time over the long haul.

Occasionally, however, I would see a client whose investments were worth several millions of dollars. It was not until after several years of additional research I realized that all of those clients had one thing in common. Each of these clients had made principally all of their money in real estate investments – more specifically, Raw Predevelopment Land.

Many times, it seemed to occur quite by accident. I remember one case where a client had bought a couple hundred acres of farmland north of town to get away on the weekends. Then several years later, a country club bought the land adjoining his. His land immediately jumped from $1,000 an acre to $25,000 an acre, and he was an instant multi-millionaire. In other cases, it was apparent my clients had a predetermined plan to buy property in the line of future growth. Regardless, I felt it more than coincidental that this pattern was present.

It was at this point I decided to start studying different actual land investments, in an attempt to differentiate the good transactions from the bad. It was my objective to identify potential areas of risks and try to develop methods to remove those risks, without affecting the industry-wide chance for return.

I began my own investments in real estate in 1973. My first couple of investments did not work out as well I had thought they would; but I studied them and learn what I did wrong. By 1975, things were working out much better. In fact, by 1985, I had produced 46 programs for me and my clients. By 1985, 33 of these properties had sold. The average rate of return received by my clients was 63.8 percent per year, and this was net of my fees. These properties were acquired for $25 million and were held an average of 3.5 years. They were later sold in excess of $50,000,000, and all 33 of the programs were profitable.

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One thing I learned in the process of successfully investing in land was that to maximize profits you need to adopt a contrarian philosophy. The reason is because real estate runs in well-defined cycles of booms to busts to booms again. The difference in real estate cycles when compared to, say, stock market cycles is that they are elongated and take years to develop. I will cover more real estate cycles and how to read them in later columns.

What I want to demonstrate in this series of columns is a strategy that proves that land investing is a science and by understanding that science, you can substantially reduce the risk while maintaining extremely high returns. This is done primarily through using a negotiation matrix I developed which will be share throughout this series.

Experience gives the 20/20 hindsight needed to see the irrational, invisible side of the investment world; or to put it another way, experience allows us to ask the irrational question that are invisible to the purely intellectual mind.

Real knowledge is the key that makes the wealthy land investors wealthier and over the long run keeps transferring the assets of the average novice investor to them. I found this lesson very important to recognize as I entered the land-investment maze.

I learned that there is one important thing that must always be done first before the negotiations start. That is to set out your bottom-line criteria in advance of your first offer. Now, most people feel that their bottom-line investment criteria are simply to make as much money as possible. Maybe that is right and maybe not.

What are your true objectives? How much risk are you willing to take? Are you a speculator, land banker, or developer? What is the bottom-line value you are willing to assign to the dirt, and what is the probable upside potential?

These questions have to be answered before you should make you first offer. I learned after my first real estate crash, which was in 1975, that dirt was basically worthless. You could not eat it, build out of it, or create anything else in value from it; and, in an illiquid depressed market, you cannot sell it.

Therefore, how do you determine its future value? We will cover that in my next column.