Moving is about as much fun as a poke in the eye with a sharp stick. Maybe more fun. We are moving out of our house this weekend so this month’s Insight will be a little shorter than normal. To answer the question many likely have, we are moving because we have lived in our home a little over two years and the tax code specifies that every two years the gains from a primary residence can be realized tax free. With the marginal tax rate being what it is for California residents, this means that on a dollar for dollar basis the gains from our primary residence are worth twice what earned or business income would be. Being in the business and having the resources to locate and reposition properties, my wife and I can benefit nicely from what the tax code provides. But of course, the downside is the moving.
Startup Bubble: I am on the screening committee for our local angel investor group (www.northbayangels.com). When a company, often not yet more than an idea, pitches to us in hopes of being chosen to present to the general membership a “pre-money” valuation is provided so that an investor can know what they are buying into. Historically we have seen pre-money valuations in the $1M – $3M dollar range. If the presenting entrepreneurs pushed the valuation the advice of the screening committee was almost always that they should dial it back if they hoped to raise investment. Over the past several months the pre-money valuations have been creeping higher. A couple of our members attended angel events in the Bay Area property and were shocked to see entrepreneurs asking for, and receiving, pre-money valuations in the $10 M – $12 M range. For clarification, these are companies that have an idea, often a proof of concept, sometimes a few customers, but little else. A $10M pre-money valuation means the investors are agreeing that this infantile start up, with little more than the unproven idea is worth $10M. To say this indicates a frothy market amongst tech angels is an understatement. While analysts of all different investment types are calling the warning for bubbles (stocks and bonds especially), this is something to keep an eye on. However, unlike in 2001 when the tech bubble was in publicly traded and venture backed companies, this bubble, at least so far, is being funded out of the pocket of angel investors, most of whom make such high risk investments with only a small part of their investment portfolio, their play money if you will. If this is truly a bubble, when it pops the investors will be hurt, but in and of itself it is unlikely to raise recessionary pressures. The true damage will be to the angel investing community, which is such a vital piece of the entrepreneurial economic framework, as they won’t have the same levels of funds to continue to invest. This will result in a reduction of support for entrepreneurs, also resulting in reduction of job formation (in most cases the angel investments weigh heavily towards human capital accumulation). This will hit areas like the Bay Area and Austin, Texas harder than most other areas of the country, though the total effect is hard to quantify.
The World’s 9th Largest Economy: As reported by the AP, a recent study by the Competitive Enterprise Institute, the cost of federal regulation on the US was $1.88 TRILLION in 2014. That places the cost of this regulation just behind Brazil and just ahead of Italy if it were compared as GDP. Assuming this study is accurate, this massive sum of money results in an average cost per US household of $14,976 PER YEAR. This is roughly 29% of the average family budget of $51,000. Most of this regulation is not a direct cost of course. It is paid through increased prices on everything from health care to transportation to food. And of course in a higher tax burden. The Federal government alone spent ~$60B in enforcing the regulations, a cost that must also be borne by tax payers.
- In line with previous topics of Altus Insight, the regulation hits small businesses the hardest, creating a cost burden of roughly $11,724 per employee for firms that employ fewer than 50 people. This is significant since small businesses provide a majority of US jobs. Keep in mind that for the first time in the history of the country, more businesses closed up shop in 2014 than opened their doors for business. For the first time we had a business death rate higher than the business birth rate, although the trend has been in that direction for the past several years.
- Optimism on the horizon? Hardly. According to the report there are 60 federal agencies, departments, and commissions that have 3,415 new regulations in the process of being finalized. In 2014 agencies issued 14 new regulations for each new law (3,554 vs 224). The EPA alone issued 539 final rules in 2014, up 12.5% in five years.
- It is a shocking event that will make all the news outlets. It is death by a thousand cuts.
GDP Numbers Disappoint: This past week revised GDP numbers were released that showed the economy shrunk by .7% in the first quarter of this year. This was a downward revision of almost 1% (roughly $371B to put it in perspective). Despite optimistic talk from people who make their money selling financial transactions the results weren’t really a surprise to anyone. What is a little surprising (at least to me) is how quickly the financial press was able to put an optimistic spin on the news. While true that the decrease was less than last year’s Q1 contraction, it was also coming off a far slower Q4 growth rate, meaning it had a lower level from which to fall. As was the case in explaining away last year’s poor Q1 results, the blame was placed on poor Q1 weather. Seeing as how Q1 consists of January and February, two of the most harsh weather months of the year, poor weather should be expected. And I have never seen anyone downplay a strong growth rate number due to good weather. It will interesting to see where the Q2 numbers shake out. If the economic slowdown is truly solely weather related, then Q2 should be a banner quarter as pent up demand and 3 months of weather forced savings enters the economy.
Feet on the Street: This past month I finagled an invite to a mastermind group that met in Orange County. One of the rules to be included was to have experienced, and made it through, two real estate cycles. My career as a principal in real estate started in 1999, so I barely made the cut off and was the youngest person in the room. The people in attendance are really smart and have made careers of making correct calls on real estate throughout the various parts of the cycle. That isn’t to say that none of them have gotten hurt by downturns but the damage inflicted was far less than most in the business and across the board they were in position to take advantage of the downturn coming out the other side. Most of the attendees spend considerable time and resources following economic indicators. All the attendees had some level of experience in flipping houses but were also heavily invested in other real estate segments. The following are some of the takeaways from meeting:
- Residential real estate in the large metro areas in Southern California have slowed drastically with some of the markets even seeing price declines. The consensus among those that work those areas is that it isn’t a lack of people wanting to buy, it is an issue with affordability.
- Across the board, with the exception of one gentlemen working the Bay Area, everyone is pulling back from flips. If they are doing them they expect larger margins, are assuming longer marketing times, and they are reducing their investment exposure within those properties.
- Everyone was asked to provide their two year outlook and their concerns for further down the road. Most felt that without a geopolitical shock the next two years should be relatively stable with little change to pricing or interest rates. Farther down the road two concerns dominated the conversation. 1. The debt and the interest rate manipulation and 2. The growing rich/poor divide.
- Due to the rich/poor divide mentioned above many are pivoting their business models to focus on one or both of those extremes. High end houses and trailer parks and/or solid “C” apartment buildings. With the high end houses several are using their expertise in construction and design to move to a service based model instead of a product based model, meaning they are no longer purchasing the properties themselves, but instead being paid for the expertise as a service provider.
- To go into further detail on #4, people have to have a place to live. Across the board there was great concern about the large economic reset due to the shrinking middle class and increasing affluencey gap. The focus on mobile home parks and “C” class apartments was with the thought of being able to provide housing to someone making minimum, or slightly over, minimum wage. Places that can offer a clean safe environment for people of that income level will stay full. I have limited knowledge of mobile home park management but we do have some apartment expertise and our long term outlook for our investing is much in line with the mobile home park premise.
- Several people in attendance lived out of state but all had lived in California at some point in the past. Those that have moved out aren’t coming back.
- Everyone in attendance was an entrepreneur and all were being hit hard by the Affordable Care Act. It had led to some downsizing their organization. No one has a solution, but all mentioned the problem.
Altus continues to stay busy. We are finalizing our investor raise for Cedar Hills Apartments in Oklahoma and have 4 complexes in contract in California, all of which fit the criteria discussed above. Please contact us for information on any of our current activities.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at email@example.com.