3:15 – Jason wants to talk to his audience today about construction costs.
7:10 – Jason breaks down the cost per square foot in the various regions in the United States.
11:00 – Jason tells you how you can figure out the land value.
15:20 – Older homes may be built with a little more care, but newer homes are built with more technology.
18:15 – If you go to JasonHartman.com you can see some lucky deals you can get on houses.
19:30 – Jason explains why it’s important to know the land value and the improvement costs.
23:15 – You can find more information on this subject on Jason’s YouTube channel.
“The prudent income property investor is the one who invests based on cash-flow.”
“I have never met or known or anybody, any guru, any economist who can accurately predict appreciation and depreciation.”
“Older homes were maybe built with a little more care and quality, but newer homes are built with more technology.”
Mentioned In This Episode:
I want to talk to you about construction cost and when we’re investing. As you know, my very unique risk evaluator model relies very extensively on construction cost and land cost as a way to determine how to minimize risk when investing in real estate and it took me 19 years to discover that. So far as I know, it is completely original thought and my insurance broker at the time helped me discover that on one of my first nationwide property purchases. Before that I had pretty much been confined to investing in California and I did not realize there was a whole new wonderful, beautiful world of investing out there and great opportunities, and I didn’t have to rely on the speculative rollercoaster of the California cycle to invest in properties, and it’s been a great, great ride since then.
What I want to talk about today is different construction costs, and this was inspired by an article that just came out, which is by the NAHB – National Association of Home Builders – and they, of course, discuss economics and housing policy. They did an article and it is about construction costs per square foot: what it costs to build properties in these various areas, and they look at contract price per square foot of new contractor-built single family houses, starting in 2013, and this is very very enlightening. Before, I’ve talked about what I call – and this is one of my trademark terms (I’m trying to add to the language of real estate investing here), and it is called regression to replacement cost. These examples that I give you have a lot to do with it, so we know that the riskiest markets are high land-value markets because they are cyclical in nature, they have big highs and really ugly lows, and people lose fortunes in those markets if they don’t time it just right.
We also know, and I’ve talked about this previously, that over time, the linear markets tend to do just as well as the cyclical markets, or even better in many cases. I’ve given the example of Kansas City, Missouri, compared to Orange County, California. You would think that high-flying Orange County, my former home town, would be the one that would win because they have such extreme upsides in the market. Over the course of 18 years, Kansas City actually outperformed Orange County, in the example I gave where Orange City average depreciation – I’m just doing this from memory here, folks – I think it was 5.2% average and Kansas City was 5.8% average, and remember, the devastating things about these cyclical markets is that you give so much back when there’s a downtime. In these downtimes, which are very hard to predict, as you know, I have never met or known or anybody, any guru, any economist who can accurately predict appreciation and depreciation.
The prudent income property investor is the one who invests based on cash-flow. If the appreciation comes, it’s icing on the cake and it’s wonderful, but let’s not count on it. Let’s just have that be a pleasant surprise. When you look around the country, according to this NAHB and their survey, you see that in the Pacific region that includes California, Oregon, Washington and Alaska, the median (there is a different between median and average, statistically, and sometimes I prefer to use the average, but that’s a whole other discussion for statisticians, but I don’t know if I can lead that because I’m not an expert. I never took statistics class in College – I should have though, I would like to be able to understand that stuff better) price per square foot is $145. In the mountain region, which includes Nevada, Arizona, Colorado – the four corner states – the median price per square foot of a single family home is $107, versus Pacific at $145. Occasionally, you can have actual cost of construction that makes this happen, but the thing you’ve mostly got with these variants in prices is a regulatory environment which makes it more difficult to build, which drives the price up, but you also have higher price markets.
When you have a higher cost of living where you’re hiring contractors and sub-contractors to build a house, of course you have to pay them more because they have to be able to afford to live in the place in which they work – so that does drive up prices a lot too. In the mountain region $107 per square foot, Pacific region $145. The West North Central region, it’s called, which is the area that includes Illinois and that area about Texas is $103 per square foot on the median price to build a single family home. In the West South Central region, and that includes Texas and all the states around there, it’s only $85 per square foot. Just $85. And then the East South Central, which is a little bit east of Texas is $84 per square foot, not much of a difference there and those are both regions in which we like to invest.
Then they pulled out another region which they call the South Atlantic Region (Florida, Georgia, the Carolinas) which is $88 per square foot, and mid-Atlantic, which is a little bit above that as we get close to the expensive areas is $103. The New England states way back up, just like the West coast and Pacific region go to $143 per square foot. You have the East North Central region near the great lakes, which is $90 per square foot. So you see how these prices vary pretty significantly around the country. What does this mean to us?
Before I get to that I want to tell you that the median for the entire country is $93 per square foot and none of these numbers include land value. They all exclude the value of the improved lot on which the house is sitting. What do they mean by ‘improved lot’? They mean a ‘finished lot’ that is ready to build a house on: it’s graded, it’s compacted, it has utilities pulled to the curb and so a contractor can go and build a house there. So $93 per square foot is the US median price, so what does this mean? It’s pretty darn exciting. As you know, next month, November 22nd and 23rd is our Birmingham property tour, so I want to talk to you about a property that’s available right now in Birmingham and to compare it to some of these numbers, which you’ll find to be rather interesting.
Here, I’ve got a great property in Birmingham which is for sale right now. You can go to www.JasonHartman.com, click on ‘Properties’ and you can find this exact property. It is 1104 square feet and it’s priced at $70,900 so that comes out to $64 per square foot which you can see right on the proforma. Now, let’s take the land value out of it. I’m going to just take a very rough guess here, not knowing what the land value is, and there are 3 ways that you could know the land value. 1: The property tax assessor has their own opinion of land value, which varies because nobody exactly knows. They’re an estimate but they give you an idea. They separate the improvement, the house or the apartment building sitting on the land from the value of the land itself. That’s one way you could have a clue of the land value versus the improvement. It’s very important to dissect this and look at both parts of the value equation. 2: Get an insurance quote, and the insurance company doesn’t insure the land because even if the house burns down, the land won’t.
If the house burns down, they will have to pay at least some portion to rebuild that house after you haggle with them and possibly have to hire a lawyer to haggle or even to sue them to pay the claim. You know how this can go sometimes and that’s why I always say the best insurance is a high loan balance. Let your lender haggle with them. Let them work with your insurance company to protect your collateral. I’m going to estimate the land value very roughly at $25,000 and the third way you can find that out is an appraisal. An appraiser will make an attempt to dissect the land value versus the improvement value. Three sources that I’m aware of: tax collector or assessor for property taxes, an insurance broker – an insurance company selling you a policy based on the property, and an appraiser. So let’s say for argument’s sake that this land is worth $25,000. Let’s look at the land cost per square foot – not per square foot of the land, per square foot of the house. I want you to see how much of this equation is potentially land cost.
We know we can purchase this property for $64 per square foot, but if you take $25,000 and divide it not by the square footage of the land, but by the square footage of the house sitting on the land, we’re going to divide it by 1104, which is the square footage. That means our land value integrated with the house value is $22.64 per square foot. Now let’s look at this. Let’s take the purchase price of $70,900, subtract $25,000, leaving us with $45,900, so we took the price of both (land + house), subtract out the potential land value, with my estimate of $25,000. Let’s look at $45,900 as the value of the structure or the house sitting on the land – the value of the improvement. Let’s divide that by the square footage of 1104, and that means the house cost is $41.58 per square foot.
Well, I hope you’re getting excited, because I am. Remember I’ve talked on prior episodes about my trademark term: regression to replacement cost, and the beautiful thing is that you can still fetch a few properties out there – these are drying up and there aren’t that many so there is real urgency to be investing because prices have definitely been going up and they continue to go up, and business is very very strong, so you’re going to constantly see a lack of inventory. Here you’re at $41.58 per square foot as our potential for the calculation that we made. In this region, according to the National Association of Home Builders, it costs $85 per square foot to build a house. This house isn’t brand new but it was renovated this year, so it’s brand newly renovated. Of course there is a different between old and new houses, and some people really like older homes better. There are benefits of older homes, they just tent to have more generous spaces and they obviously have a very different style. Some like newer, but it just depends. Many would argue that older homes are built better than newer homes. I think older homes were maybe built with a little more care and quality, but newer homes are built with more technology. We could have that debate for a long time, but let’s not bother.
To rebuild this house, if it burnt down, an insurance company would probably spend about $85 per square foot, according to the NAHB. They have lots of members that build homes, so they should know. If we take $85 per square foot, their number for construction, and we multiply it times the square footage of 1104, we can see that it would cost $93,840 to build this home today. Well, you can buy it for $70,900, so right there you’ve got about $23,000 of potential gain already. Oh, you say, but wait a second because we didn’t include the land value. That’s just the improvement, it’s just the house sitting on the land.
What about the cost of the land? Let’s add back in $25,000 – our potential lot value estimate – and then we add those two together. $93,840 to build the house, plus $25,000 for the land and we get a grand total here of $118,840, so we’ll just call it $119,000. That means when all of those construction materials are worth what they actually cost, and I know that’s kind of a funny thing to say. It’s like the concept of – and I’ve said it before – when a piece of wood is worth what a piece of wood costs (I used to say that during the downmarket to illustrate my regression to replacement cost concept). When it regresses toward the actual replacement cost, you have a potential gain in this property, and this is not really the same thing as appreciation. Regression to replacement cost, I would argue, is homeostasis. It’s equilibrium and it’s what it should be worth, intrinsically. You have a gain potentially here, of $47,940. That’s pretty great! You can see examples there aren稚 as many as there used to be, but if you go to www.JasonHartman.com and you click on Properties and you start browsing through all of the property proformas, you will see several examples – not as many as you used to because prices have gone up and they continue to rise, but you will see examples of some lucky deals that you can still get where properties are priced below replacement cost. This is a good example of that.
If you want to see more properties like this, join us next month in late November (the weekend before Thanksgiving) as we look at properties in Birmingham, Alabama just like this property. You池e buying below the cost of construction, you致e got regression to replacement cost opportunity built into the equation. One of the things I do is I will not allow our local market specialist to represent their properties as being below market value, even though in my opinion, many of them are below market value. I will not allow them to represent the properties that way, so when you look at the proformas at www.JasonHartman.com, you’ll see one number for initial market value, and another number for purchase price, and those numbers should always be the same, unless they snuck one by us and we didn’t catch it. When you understand the math of the two components of an income property investment (the land component and the improvement or the structure sitting on the land: house, apartment building, or an office, retail or industrial building) the point is there are two value drivers in any real estate equation. One is the land, the other is the improvement sitting on the land, and you’re really got to dissect those and understand them. One reason, also, is because you only depreciate the improvement on your tax return, not the land. The land will always be there so the IRS doesn’t allow you to have this awesome depreciation opportunity.
I should say, for those of you who are the gamblers and the speculators out there who like to invest in expensive markets (I値l call them overpriced markets, whether they be California, the New England states or whatever, maybe Miami they池e expensive markets). Remember, you don稚 get nearly as much tax benefit in those markets because your land cost is so high, and your improvement is so low as a ratio to land cost. You only get to depreciate the improvement cost. The example I give when I talk about the risk evaluator and how to really reduce risk if you want to hear more about this, go to www.JasonHartman.com and there’s a little search bar on the website. Just go ahead and search ‘Hartman risk evaluator’ and you’ll find prior podcasts where I’ve talked about the extensively, as well as some blog posts that explain it. You really increase your risk when you invest in high land value markets, but you also massively decrease your tax benefits and of course your cash flow, and of course we are prudent cash flow investors. We’re not the gamblers, we’re not the speculators, we’re on the conservative side.
On this property that we’ve been talking about, the projected return on investment overall on this property is 38% annually – cash on cash return projection is 15% and cap-rate or capitalization rate is 9.7%. Get this, your debt coverage ratio with 25% down is 2. That means your property could go badly half the time, and you’ll still cover your debt service on this property because you’ve got a debt coverage ratio of 2.00. A lot of our properties had debt coverage ratios of 1.4, 1.6, 1.8, something like that. I’ve actually been looking for one for you that is a 2 and we’ve found it. What a champ. This property has a projected cash flow of a little over $3400 annually, and that’s with your maintenance, your property management, your vacancy, all imputed into that equation, so make sure you really know how to analyse these deals, folks.
Another thing I just want to recommend is that several episodes ago I did a podcast on how to read a property proforma, and the YouTube video that shows the visual and you can follow along on how to read a property proforma. Just look for that and that is a fantastic tool which will make you a better investor. It’s on YouTube so if you look for our YouTube channel at Jason Hartman Media, or you just type ‘how to read a property proforma’ you can probably find it. Add my name to it and you’ll find that. It’s just a great lesson on how to read that, but it doesn’t really talk much about this land to improvement value equation that I just shared with you.
This is for advanced investors who really are thinking about all the multi-dimensional aspects of their income property investments, and I know that’s you, because you listen to the show. You want to know more and you want to be a more prudent and more sophisticated investor, so thank you for doing that, and thank you for doing your homework and really studying this stuff. Please do, if you like the show, or even if you hate the show, go write a review for us on iTunes. We had a few reviews come in last week and I really appreciate that. I know I never ask, but it really helps us get the word out there about the show, so please take a moment and go to iTunes or Stitcher Radio. You can do it 3 minutes or less, and we really appreciate that, so thank you very much.