Today Jason Hartman continues a conversation from the previous episode with investment counselor Doug. They talk about PE ratios and real estate. Then they go into why it is important to analyze rent to value ratios to see whether a bubble is forming. On the other side of that, they discuss why it would be danger to solely use RV ratios to predict bubbles.

Investor 0:00
Once we did encounter some challenges because we were part of your network and because I have an investment counselor, I always felt like I had somewhere to go for an answer. I always felt like I had somebody with more experienced than me that I could lean on and Sarah didn’t know the answer, she got the answer.

Announcer 0:16
Welcome to the creating wealth show with Jason Hartman. You’re about to learn a new slant on investing some exciting techniques and fresh new approaches to the world’s most historically proven asset class that will enable you to create more wealth and freedom than you ever thought possible. Jason is a genuine self made multi millionaire who’s actually been there and done it. He’s a successful investor, lender, developer and entrepreneur who’s owned properties in 11 states had hundreds of tenants and been involved in thousands of real estate transactions. This program will help you follow in Jason’s footsteps on the road to your financial independence day. You really can do it. And now here’s your host, Jason Hartman with the complete solution for real estate investors.

Jason Hartman 1:06
Welcome to Episode 1259 1259. Today we’ll be covering part two of future pricing and real estate PE ratios with our investment counselor Doug. Now Doug has been working with us for about 10 years or so now, and he has been on the show many times, so I hope you’re enjoying this episode. He approaches things from a very analytical perspective. Before we dive in, go to Jason Hartman comm slash cruise and check out our upcoming cruise in October it is getting close folks so we hope to see you there with super high speed medallion class internet. I know a lot of people get on a cruise ship and they’re afraid Will I be able to connect will it be expensive Can I do it from anywhere on the ship. It is cheap and it is high speed and it is all over the ship. So medallion class internet on this cruise, Jason Hartman calm right on the front page of our website or directly Jason slash cruise. Here we go with part two future pricing and P ratios. Let’s talk about the investment markets. Let’s talk about commercial real estate and cap rates residential market. And you know, you can also apply a cap rate to it, obviously, but I think the rent to value ratio is more simple, obviously. And then the stock market and the P ratio and how future expectations influence all of those

Doug 2:39
the way to think about a cap rate or a capitalization rate. It’s to say that if you purchased a property for cash, and then you had the you had the rental income and then the operating expenses, and you looked at what you’re left with relative to what you paid, what is that as a percentage return and the way that the pricing dynamics work is that for a given property as the price starts going up, the capitalization rate will start going down. This is actually very similar to a yield on a bond. So if you see that the yield on bonds are going down, what that means is that the price you have to pay for that stream of income payments is going up.

Jason Hartman 3:15
Right, by the way, little note on that. That’s why when you hear someone talk about the bond market, it influences mortgage rates or interest rates in general, because when bonds rally, interest rates decline, and when bonds decline, interest rates go up,

Doug 3:33
right? Okay. And bonds actually have another real important element, which is that government bonds or you know, there’s a bunch of different types of government bonds when people say government bonds or treasuries, they use those terms synonymously. But the government bond interest rate is what finance people call it the risk free rate of returns. So in other words, if I go buy a 10 year government bond, the chance of default is zero. Now I have inflation risk, but basically I can get rate of return from government bonds for zero risk.

Jason Hartman 4:03
And in reality, it’s not really zero risk. But at least Historically, the only default on that has been inflation, which is a default, in a sense. But

Doug 4:12
let’s say for for a zero repayment risk, as I do, and I, sometimes when I get more concerned on the return of my capital than return on my capital for

Jason Hartman 4:23
the wealth well set. So

Doug 4:25
yes, you have zero risk of return of your capital for bonds, you will get your money back and you will get a little bit more. And so what happens is sometimes you’ll have things like the capitalization rate for commercial properties start getting close to the yield rate for government bonds. Well, when that happens, that’s stupid. Because if you purchase the property, you have risk, you have huge downside risk. And if you’re getting no more return than the risk free rate of return, right, you don’t have risk free return, you have returned free risk, right. You know, you’re taking risk that you’re not getting paid for. Okay. Okay, I

Jason Hartman 5:02
think I think you got to slow down and just suss that out a little more there. Sure thing. So, okay, why is it a huge risk to buy a property? And will you just explain that a little more elaborate on that one?

Doug 5:13
Sure. So for example, let’s say that we you buy a property that’s it’s a it’s a strip mall, right? has about, say, two anchor stores, and about 20 other stores. Right,

Jason Hartman 5:22
right. During the retail Apocalypse, don’t do it. Yes. Okay.

Doug 5:27
Yeah, well, exactly. So what can happen is right, you could have a major tenant who says, All right, your major tenant goes bankrupt because most anchor tenants at most strip malls or grocery stores, having a grocery store is an extremely low margin business and consolidation has been going in that industry for a really long time. So you could lose a major tenant now all of a sudden your cash flow takes a hit. You could lose some minor tenants. Now your cash flow

Jason Hartman 5:49
as the strip mall owner. Yeah,

Doug 5:51
yeah, exactly. You could get a new regulation that comes through the local municipality, all of a sudden your compliance costs went up. But all of your tenants are locked into leases. And so what that means is your margins just took a hit, there could be a really bad crime or really bad accident, you could get a lawsuit. There’s all kinds of ways you can lose money. When you have an active asset like commercial property, what typically happens is that when you have additional risk with an investment or an asset, that it should earn a higher rate of return. And the thing that you’re looking for as an investor is I want to look for a rate of return that is high relative to the amount of risk Right, right.

Jason Hartman 6:30
So that’s known as the risk premium. Exactly. Okay. Yeah, you as an investor, you are entitled to a risk premium, because the investment is more risky. So obviously, you should expect more

Doug 6:43
or if you don’t get a risk premium, you’re stupid. Okay?

Jason Hartman 6:47
Don’t be so harsh. Doug, you know, someone, some someone is out there listening, and they’re thinking, I’m stupid. Oh, and then they’re gonna write me a bad review on the show. Don’t

Doug 6:58
let them write to me because I I’ve done plenty of stupidity in my own life and the way that you improve is to figure out what you’ve done that stupid and stop doing.

Jason Hartman 7:06
Okay? All right. All right. Sorry folks. Doug’s a little harsh. Okay, he, I’ll tell you one of the reasons he’s like that he drinks like six cups of coffee every day and it’s just too much. It’s too much. I’ve got a product limited to three but go ahead

Doug 7:19
it down from eight so

Jason Hartman 7:20
Oh, very progress now.

Doug 7:23
Progress CC, you just stopped doing things that are stupid. I didn’t stop entirely, but at least I got back.

Jason Hartman 7:29
You’re only a little stupid. Okay, go and

Doug 7:30
get little stupid. Exactly. But what happens is right, typically, as an investor, if you are going to take risk, you should be compensated for it. And I don’t want to make it seem like I’m trying to talk down or belittle people. There are a lot of people who, myself included who have overpaid for stuff in the past, because you get emotional about things. But you know, rationally speaking, anything that carries risk should have a risk premium. And the thing that you want to understand as an investor is what is the reasonable amount of risk that I’m taking and then What’s the premium that I’m earning for that? And is that greater or less than the real amount of risk? Because if you consistently invest in situations where the amount you’re earning exceeds the amount of risk you’re taking, you will do very well over the long run. You know, that’s fundamentally what Warren Buffett does, is because his what he does is he says, hey, look, you know, if you give it a long enough amount of time, anything that I buy is eventually going to regress toward its fundamental value. So it doesn’t have to be a great deal. Let me just interject there. So during my creating wealth conferences, I talk about that a lot. The concept of how income property, you just always win, as long as you can stay in the game. It’s a game of staying power, and to be able to stay to buy the right to have staying power. You need to have sustainable investments, which means you follow commandment number five, the property must make sense the day you buy it. You don’t buy it. Go ahead. And exactly just kind of pinning on that a little bit. So, you know, for example, you don’t, let’s say you have a property that generates cash flow. And let’s say that the market for whatever reason just doesn’t do that, well, worst worst worst case, you’re amortizing that thing down, and in 30 years, you’re gonna own it out, right? And so, you know, say, you know, even if the price compresses by like 10, or 15%, you know, let’s say you have a value out flight, you’ve still been generating cash flow, or even maybe the cash flow compressed at the very least, you’re still amortizing out that loan. And I think the benefit of real estate that a lot of people don’t really get or don’t really understand is that there is a lot of embedded risk protection or there’s a lot of embedded risk containment, in a cash flowing property with a self amortizing loan. And so that’s one of the reasons why I say that. So

Jason Hartman 9:54
let’s let’s call that what I like to call it self liquidating. Self liquidating. Yeah,

Doug 9:59
yeah, self liquidating. Get right.

Jason Hartman 10:00
And what that means is that the debt basically is it’s paid off by the tenant itself liquidates. Normally you have to liquidate your own debt. If you borrow money to buy a car or you have student loan, that’s that you’ve got to liquidate, you’ve got to pay it off, you’ve got to pay it back. But with income property, it’s so beautiful, we can delegate the repayment to the tenants.

Doug 10:21
Correct. So what ends up happening is, you know, when when you’re able to buy at a decent rent to value ratio to your cash performance is going to offset your loan costs, offset your maintenance costs, hopefully even generate some additional cash flow. Right now you have a lot of embedded risk protection, the amount of ways that the deal can go sideways is pretty limited. You know, anything can go sideways, if enough weird stuff happens. But if you have a portfolio of these things together, the chance of something weird happened forever happening for every property in a portfolio of properties is really low. On the other hand, you know, let’s say you go for the townhome in San Francisco. That you paid 3 million bucks, all your eggs are in one bad basket, all your eggs are in one basket and you’re getting paid no risk premium, because you’re taking on a lot of risk. And your returns are entirely speculative. And you know, when the bottom Oh,

Jason Hartman 11:14
you know, no, not not entirely. I mean, look, you’ll probably get for your $3 million condo in San Francisco, you’ll probably get let’s think about it for a minute. 10,000 bucks a month if it’s not rent controlled. Okay, but you shouldn’t be getting $30,000 a month if you had a 1% Rv ratio. Yeah,

Doug 11:34
go ahead. Yeah, exactly. But the thing is, right, 10,000 a month isn’t going to be anywhere near enough to pay for just cover the mortgage payment, taxes, you probably cover taxes, you might get insurance, and you might cover, I don’t know, like maybe a few months of mortgage payment or something like that. But so much of the return profile is speculative, that you’re taking an enormous downside risk that’s so big that you’ll effectively be wiped out Before you get to the point where where you can say Yo, where the price is at the point where you can say, Okay, I can read this out,

Jason Hartman 12:06
right? And then you’ll be saying things or you’ll be crying about things like, well, the markets going to go up the markets going to go up, it has internal value. Everybody wants to live here because it’s such a desirable place and all these crazy rationalizations, and then you will remember Warren Buffett’s quote, or maybe it wasn’t Buffett originally, you know, what is it? That market can be irrational longer than you can remain solvent? selfing.

Doug 12:30
Exactly, exactly.

Jason Hartman 12:32
Okay, so what else do you want to say about this? Let’s apply it. So RV ratios. Let’s be specific about rent to value ratios here for a moment, okay. The rent to value ratio, the RV ratio and I coined the way I do it about 15 years ago. Now, other people have used that term rent to value ratio, but they had like funky ways of calculating it that I thought were just silly. You know, my my way is simple, okay, it’s just a percentage of value every month, right? And so we like to get a 1% rent to value every month. If we can, that has definitely become a lot more challenging in recent years, because why? Well, the market has gone up just like bond prices going up, pushes yield down, right? Because you have to pay more for the property, the bond and the rental incomes about the same on the bond, the interest rate is the same, right? But the value of the bond went up. So same exact concept. Now, that 1% rent to value ratio, just to give you some comparison, because I’m always saying compared to what is the magic question for almost everything in life compared to what and if you look at during the Great Recession, when people were very scared to buy properties, you could get yields on rent to value ratios of up to and we had properties like this, and many of our clients bought them but not enough, including yours truly, I didn’t buy enough of 1.8% per month. So hundred thousand dollar property 1800 dollars a month. Wow, incredible, incredible. And lots of them at one point for $100,000 property for 1400 a month. Go ahead.

Doug 14:24
Yeah, and one of the things that I was thinking about too, with the Great Recession, because a lot of people like okay, you know, I’m just going to wait until the next great recession because it was such good deals, but there was really a perfect storm that probably won’t repeat. And the perfect storm that you had in the great recession was you had giant price compression because everybody was afraid and you had low interest rates. And the reason for that is because the recession was driven by the housing market, that chances are the next recession will not be driven by the housing market. It’s going to be driven in some kind Yo, it’ll basically be a credit cycle recession, which is where you’re going to have a number of businesses and people that are over leveraged, and they’re going to start defaulting and and that’s what’s going to drive recession. And they if he asked me You look to consumer debt credit card student loans and auto auto loan. Yeah, exactly, exactly. But what that means is that the things that’s really going to drive the price of the houses down isn’t going to be massive waves and mortgage default, it’s going to be higher interest rates. So as an investor, if you’re buying at a lower RV ratio today, you’ll be buying at a good interest rate. If you wait for a higher RV ratio in the future, that may happen. But you’re almost certainly going to be paying a higher interest rate, you may or may not have better net cash performance.

Jason Hartman 15:41
And I’m glad you you brought that up, because RV ratio is just the quick rule of thumb metric. Of course, we look at overall return on investment as a much more reliable thing. As you all know, I don’t love cap rate, I think it misses a couple very important factors, but we don’t need to go into Right now, okay, so future expectations but here here’s the real magic question in this whole discussion. This is what if you’re not thinking, this is the thing you want to know? Then let me tell you this is the thing you want to know. And what you want to know is when do we know if it’s a bubble? When do we know if it’s a bubble? bursts? Well, that’s true. Sure. The only

Doug 16:27
way you know it’s a bubble. It’s after the prices have already started going down. It is too late just

Jason Hartman 16:32
just like saying just like saying how do you know how much your property is worth? Well put it on the free market, expose it to lots of buyers and have someone buy it from you and then you’ll that’s the ultimate appraisal. Okay. Now, every other appraisals just someone’s opinion. I think we do have some real clues to a bubble whether there’s a bubble or not. And we can look at in the stock market, the price to earnings ratio, the P ratio in the real estate market, we can look to the RV ratio, the rent to value ratio. And I think we can make a good educated guess on whether or not we’re in bubble territory whether or not this investment makes sense and follow commandment number five. So I say that the ideal number is 1% per month rent to value ratio, hundred thousand dollar property thousand dollars a month. You’re doing great. You can go down to that caveat that a little bit

Doug 17:33
sure go. I would say the ideal is 1% on a rehab turnkey if you’re doing a new construction 1% is very unlikely it’s probably going to be close to about a point seven.

Jason Hartman 17:44
Well that’s so funny. You mentioned point seven because that’s exactly the number I was about to say. I think a point seven is an acceptable rental value ratio. In other words, hundred thousand dollar property $700 a month as an example that’s just a ratio but You’re not going to get new construction for 100,000. That’s for sure. So say it’s 200,000. And it rents for 1400 a month, same example. But here’s the thing. You’ve also got to take into account, as you just alluded to Doug, the class of the property. So if it’s a in this is what a lot of shady promoters are out there doing. They’re promoting C and D class properties. And the rent to value ratios will be great. But it doesn’t.

Doug 18:28
Yeah, on paper, because collecting that rent, exactly.

Jason Hartman 18:30
Try to collect the rent. So you want to buy quality properties for the best rent to value ratios you can get in quality areas, right? That’s certainly the answer. And you want to be able to sustain those properties long enough to earn your return. The Warren Buffett philosophy, you don’t agonize over whether the deal is good or not too much. You just buy quality and you sustain your weight funding. Just a little aside. Here quickly, one of the things I always said, well, other entrepreneurs I know and to myself, because self talk is probably the most important conversation you’ll ever have is that the key to success in business is staying in business long enough for something good to happen. Because every day in business, bad things happen. No one can disagree with that businesses really complicated. There’s so many moving parts. So bad things are always happening. But you gotta stay in business long enough for something good to happen. I know it sounds kind of trite, but it’s really quite true. Because amazing, just fortuitous. things do happen to businesses all the time. But a lot of them aren’t around anymore to take advantage of those. Earl Nightingale said, luck is what happens when preparedness meets opportunity. And to some extent the same is true with your real estate portfolio. Right? Exactly. I mean, and to me, I really think of it as coming back to Making sure that you’re earning a risk premium and or paying reasonable prices for the performance. Because I think the thing you’re talking about with the shady promoters that will take the C and D class properties and basically write to compare them against B class properties and write them up from Pro forms, the assumptions that are appropriate class property, and they like they never have any vacancy and gonna have any repairs and everything’s gonna be perfect. Oh, yeah. Good luck.

Doug 20:26
Yeah, exactly. Yeah, we have a, you know, a two bed one bath house that was built in 1910. And Detroit, and we think it’s going to rent for $800 a month with no vacancy and no repairs. Yeah. But yeah, I think, you know, a lot of it really comes down to appropriately understanding, right, you know, what’s the risk that you’re taking and what’s the offsetting return? And is the ratio between the two of those reasonable because you know, if you consistently keep that in mind, and consistently make certain that you’re, you know, that you’re investing at a reasonable risk return trade off over the long term, you’re, you’re going to be fine. You will not run into problems.

Jason Hartman 21:07
Yeah, absolutely true. Okay, so when is it a bubble? When the rent to value ratios get 2.5 or below that? It’s a bubble, you know that that’s when a bubble is coming. Of course, it’s an estimate. But now that I’ve been doing the investor only business for 15 years, and I’ve been through the Great Recession, okay. I would say when you’re point five or below in rent to value ratio, you better be careful. And some areas, the cyclical market areas of the country, they never get above point five in most property types. You know, if you’re in Los Angeles, or Orange County, California, where I’m from, you’ll see a point three, rent to value ratio is the norm. In other words, a $600,000 property that rents for 2000 In a month, give or take, I mean, it’s a rough thing. But if you’re in a point three or a point four, you got a problem. That’s just a property that will never make sense. It will never be sustainable. And the likelihood is there’s going to be a correction.

Doug 22:15
Yeah, I think point five for RVs is probably right about there. The way that I would think of it is that I try to think, what’s the level of rent performance that you would need to offset the costs for essentially zero or reasonable cost for zero cash flow if you purchase property at the market value, because that level that’s going to say, okay, you know, what, I can be sustainable here, I can purchase the property, I can carry it, and I can not have to drain money into it every month. That to me is that kind of breakeven point, the further you get away from that and the price appreciation category, then essentially what you’re doing is you know, you’ve just gotten to the point where you’re not earning any risk premium and all of you return your returns getting more and more and more speculative, and so saying Actually, when we’re at a bubble, you can’t do it. But you know, can you say Are we in bubble territory? Absolutely. You’re in bubble territory in stocks, bubble territory, bonds, bubble territory, real estate. You know, we are much

Jason Hartman 23:12
cyclical market real estate. True. Yes.

Doug 23:14
cyclical market real estate. Oh, sorry.

Doug 23:17
I just have MySpace Schiller had on Yeah. Jason, there’s only one real estate market in America.

Doug 23:25
It’s not a composition of like 100 and some essays.

Jason Hartman 23:28
Well, no 400 essays. Yeah. And the Case Shiller index with I mean, the primary Case Shiller index. I know they got another index, but the one that everybody’s quoting, has 20 markets, and 15 of them are cyclical. They’re totally weighted 75% of that index is weighted into cyclical markets, only 25 and hybrid and linear. It’s so stupid and absurd, but show me someone in the news media that understands that and you know, I’ll Buy them a cup of coffee because or give them a hug. Okay? Because because they just don’t get it. They just don’t get it. And it’s amazing that you’ve got a Nobel laureate Robert Shiller who just doesn’t even mention that.

Doug 24:13
Yeah, seriously, this is what passes for economic predictions and prognostications and statistics and, you know, translates into investing advice. It’s terrible. It’s terrible. It’s shameful, although, I would say, dear listeners, be thankful for the collective idiocy of all the prognosticators because if they articulated things accurately, then you wouldn’t be able to get properties for as good prices as you can get it all get bid up just like everything in the stock market. And the cyclical markets. Yeah, the shortsightedness of the people of the talking heads on TV is the reason why there are still deals out there. Yeah,

Jason Hartman 24:50
see, embrace the stupidity and the fragmentation, both things because that’s where opportunity is for all of us. Doug, wrap it up with a closing Thought basic closing

Doug 25:00
thought is that just learn how to be reasonable and what isn’t looks reasonable. And don’t let yourself get tricked into chasing after speculative returns. And it’ll be really hard for you to screw up using that philosophy.

Jason Hartman 25:16
Good point. Good point. Until the next episode, which is probably tomorrow, depending on this one actually runs. We’re now running six days a week, folks, you’ve heard our really cool guided visualizations that come out every Saturday now. So we’ve got the normal shows five days a week, then we’ve got that six show now, which is a guided visualization on Saturdays every Saturday, Doug, thanks for joining me and everybody. Happy investing, go check out the website Jason Hartman calm and we’ll talk to you on the next episode. Thank you so much for listening. Please be sure to subscribe so that you don’t miss any episodes. Be sure to check out the show’s specific website and our general website heart and Mediacom for appropriate disclaimers and Terms of Service. Remember that guest opinions are their own. And if you require specific legal or tax advice or advice and any other specialized area, please consult an appropriate professional. And we also very much appreciate you reviewing the show. Please go to iTunes or Stitcher Radio or whatever platform you’re using and write a review for the show we would very much appreciate that. And be sure to make it official and subscribe so you do not miss any episodes. We look forward to seeing you on the next episode.