Archive for the ‘Development’ Category
A reader wrote in to ask me a question about yesterday’s piece, which argued for refinancing and holding, rather than selling, completed repositioning projects.
The question: “Only thing I don’t understand is why not refi on a LTV more than 60% to get back all of your original 2million dollars.”
It’s a reasonable question. After all, with a property value after stabilization of $3.2MM, you might be able to get a bank to loan you as much as 75% LTV, or $2.4MM.
Remember that we invested $2MM in the hypothetical property, so a $2.4MM loan would allow you to get all of your money out and then some. That seems like a pretty great deal, right?
The reason I stuck to a 60% LTV loan in the example is simple: Risk avoidance.
When you have a fully-renovated property with very high rents, you need to be conscious of the fact that rents can fall in the event of a recession. For example, in 2008-9, rents at our 16 unit building on Reno fell roughly 20%.
Recall our example property, which has net operating income (“NOI”) of $160k. Let’s assume that equates to rents of $220k / year (if you think a 72% operating margin is unusually high, you’re right – our unusually high rents make our properties’ margins unusually high). Now imagine the economy tanks and rents fall by 20% to $176k.
In recessions, expenses don’t fall by nearly as much as rents… the tenants are still going to use as much water / sewer as they did during the good times, right? Let’s say expenses decline by 10%, from $60k / year to $54k / year. What happens to your NOI, the money available to service the debt? Well, it falls to $176-54 = $122k.
Recall that at 60% LTV, our annual debt service was $116k. So, even with the 20% decrease in rents, our NOI still exceeds our debt service and we can still pay our loan and even have cashflow (albeit microscopic).
What would have happened if we had borrowed to a 75% LTV? Our debt service on that $2.4MM loan would have been $146k, which would would have serviced with our NOI of $122k… Ooops.
We at Adaptive get paid a lot of money to avoid “oops” moments. So that’s why we wouldn’t ever lever up as high as 75% on a property with maxed-out rents.
One of the problems a beginning money manager has is deciding whether to sell or hold completed projects.
To understand dilemma, you first need to understand what we’re generally left with when a project is completed:
- Fully renovated building with all new plumbing, electric, etc.
- High quality tenants on modern leases with good security deposits
- An un-levered yield on cash invested in the deal of 7-9%
Implicit in the final bullet point above is a bunch of value creation and, therefore, unrealized capital gain.
To understand why, consider a hypothetical deal into which we invested $2MM and which is now generating an 8% unlevered yield… so NOI of $160k.
We’re theoretically in a 5% cap market (though, for maxed-out properties, probably more like 5.5-6%), so that property is potentially worth $3.2MM. Assuming 7% cost of sale, that’s a net value of $3MM and an unrealized gain of $1MM or 50% on the $2MM investment.
The incentives for selling ASAP are clear: Return capital and realize profit.
The above sounds pretty compelling, right? After all, the whole point is to make a lot of money quickly.
But the downside of the above is the requirement of paying taxes.
To keep things simple, assume the manager is entitled to 20% of the gain and the investors the rest. That means the investors are taking $800k of the profits… a 40% ROI.
But the problem is that they are going to pay taxes. In CA, depending on your income, you’re looking at paying 25-30% in taxes. Assuming 25%, the investors are looking at $600k net.
And guess what? They’re left with the problem of where to invest both the original $2MM AND the $600k profit. If they just buy plain old 5% cap properties, they’re looking at generating NOI of $130k… worse than holding the original property (even accounting for the manager’s take)!
What’s the better solution?
Refi at 60% LTV on the new valuation. Pull out $1.9MM in cash. Assuming a 4.5% interest rate on the $1.9MM loan, that means annual debt service of $116k and free cashflow of $160k-116k= $44k. That’s a 44% return on the $100k in equity remaining in the deal.
And the $1.9MM in loan proceeds that the investors get back? That’s tax free money.
Much better solution, right?
By now, we’ve had a LOT of experience dealing with city inspections.
And we’ve seen how many different contractors handle them.
And here’s what separates the contractors who get their permits signed off from the ones who get endless streams of corrections:
- Good quality work (obviously); and
The nature of renovating old buildings is that things are not always going to get built exactly to plan.
You and your contractor are going to have to improvise in order to create the best possible space within the constraints under which you are forced to operate.
The hard part is when the inspector comes in and sees that what has been done deviates from the plans.
Now, if what you have done violates the building codes, there’s not much anyone can do… you’re not going to get away with it.
However, if the work is to code, then you might. If your contractor has a history of doing good work and projects confidence in his own knowledge of the building code, the inspector is likely to allow some deviations without requiring you to go back to plan-check (which can impose weeks or months of delays).
If, on the other hand, your contractor does low quality work and/or lacks confidence in his own knowledge of the building codes, the inspector is likely going to run roughshod over him, which means multiples rounds of additional inspections and / or trips back to plan-check.
With isolated exceptions, we have found city inspectors to be pretty reasonable people. If they think you know what you’re doing, they let you proceed. If they think you’re an amateur, then they force you through the wringer (which, by the way, is how you go from being an amateur to being a pro… trust me!).
The construction part of our business is inherently messy.
This isn’t new construction, where you start with a nice, flat lot and build exactly what your architect drew on the plans.
Our raw material is old buildings with weird framing where the foundation has probably settled unevenly over the years. That means that what is on the plans and what gets built are not always the same thing.
Sometimes the surprises are bad: It turns out you’re missing a crucial two inches to fit a shower you need to get the rents, the framing doesn’t allow you to open up the kitchen, etc.
Sometimes the surprises are good: You find concrete under the carpet that you can polish, the roof framing is sufficiently strong to allow you to raise the ceilings, etc.
In order to mitigate the negative surprises and take advantage of the positive ones, you need a contractor who who finds a way to say “yes”.
Most contractors aren’t like that. They want to stick exactly to the plans and, if you ask them to deviate, try to kill you with expensive “change orders” (additional charges over and above the agreed contract price). Because of the inherent unpredictability of our raw material, this forces us either to spend way, way too much money and time planning the project, to live with results which are very suboptimal, or to spend more than we budgeted. None of these is an acceptable outcome.
The contractors we want to work with know going in that changes are likely. They price the job accordingly, so that if we throw them a curve-ball, they can accommodate us (within reason; obviously massive changes necessitate additional payments).
The way they think about it is this: On any given job, they may make more or less money (more when we don’t change anything, less when we do). But, over time, they end up far better off, because we keep them working all the time, so they don’t have any down-time.
Amazing that more contractors don’t think like this…
There are some deals right now that:
- Aren’t right for our current fund (because the near-term returns aren’t high enough), but
- I want to buy (because I think they have a lot of potential down the road)
One obvious solution to this problem would be to buy the deals with non-fund money, either my own or from a JV-partner.
The problem is that doing so might come pretty close to the line from a fiduciary perspective, because I’ve committed to my fund investors that I will give the fund my best ideas.
If I go buy these deals with separate money, the investors in my fund might get the idea that I haven’t lived up to my moral and legal obligations. And that’s not something I’m willing to let happen.
So, I’m going to let these pitches go by. How annoying.
Am looking at an interesting deal, but it’s in an HPOZ (Historic Preservation Overlay Zone).
Because the structure was built during the time-period the HPOZ is intended to protect, it is categorized as a “contributing structure”.
It is extremely hard to do anything to a contributing structure.We would need prior approval for any work on the exterior and that approval will not be granted for anything that changes the original design.
That means we can’t, among other things, move or enlarge the windows, insert sliding glass doors, build our standard fencing, etc.
Because we can’t use most of our normal tricks, we need to project lower rents for the completed units than we would if we were not constrained.
Because we are projecting lower rents, the deal goes from being a marginal “yes” at the list price to a strong “no”.
On my numbers, the reduction in building value due solely to the HPOZ designation is something like $100,000, or 10-15%.
It’s not unfair to wonder what, exactly, the city is getting in exchange for that diminution of the property value.
Saw that someone arrived on the blog yesterday using the following search term “convert duplex into single family home”.
Here’s my advice: Don’t do it. Or, at least, don’t do it with permits.
Regular readers know I’m strongly in favor of using permits for every single construction project. It’s a bit more expensive, but you want to be able to sleep at night knowing that the work was done properly and is in compliance with relevant city codes.
So, why am I advocating doing any conversion of a duplex into a single family without permits?
This is one piece of work that can cause severe, permanent value destruction.
Why? Many older buildings have grandfathered units. For example: You might have a 4plex on a lot which is now zoned only for duplexes.
If you go to the city and ask for a permit to remove a unit in the aforementioned building and turn it into a triplex, they will happily give it to you. But later, when you want to re-convert the triplex into a 4plex, you will not be able to.
Why does this matter? After all, it’s not like, in converting from a 4plex to a triplex, you’re losing square footage.
But, as we’ve discussed previously, generally the smaller the unit, the higher the rent per square foot. Given the choice, you’d always rather have more units rather than fewer in any given square footage.
So, it’s insane to remove a unit, because you will impair the achievable rents and, therefore, the value. And the change is likely to be irreversible.
…who didn’t also renovate tons of apartment buildings, I would:
- Run rent surveys across all relevant neighborhoods, all the time
- Constantly poll my clients about construction costs for different finish levels and unit sizes
- Constantly poll my clients about eviction / tenant relocation costs
Why would I do all these things?
Because, without the above information, I would:
- Ignore some deals which I absolutely should push my clients to buy; and
- Push my clients to buy some deals they absolutely should not buy.
Both of the above mistakes would cost my clients money (either in bad deals or missed opportunities) and therefore cost me credibility.
Fortunately for me and for our clients, Adaptive does so many renovation projects in the relevant neighborhoods that we know better than anyone what the above numbers actually look like. That doesn’t mean we don’t make mistakes, but it does mean those mistakes are rarer and less costly than they would otherwise be.
In case you’ve been under a rock: The stock market has been in free-fall since the beginning of October. Here’s a handy chart:
The thinking among investors is that the world economy is slowing due to weakness in Europe and China.
Usually, when investors get spooked by stocks, they sell stocks and buy relatively safer government bonds. And, indeed, you can see the result in US Treasury bond yields:
Yields were around 2.50% and then fell very rapidly down to 2.15% (as of noon today).
What does all of this mean for real estate? Well, mortgage rates tend to be pegged to the yield on t-bills. So, as investors get spooked and flee equities in favor of government debt, they are driving down the rate at which you can borrow on homes / apartment buildings / etc. Here’s the relevant graph:
It’s a bit hard to see, but rates, which were as high as 4.4% in January, are down to 4% as of today.
In real estate, all else being equal, prices rise and fall in an inverse relationship with interest rates (the cheaper the debt, the higher the price someone can pay for the asset and get an acceptable yield, and vice versa). So, if we’re entering another period of low interest rate loans, you can expect prices to stay the same or rise, all else being equal.
For a long time, as young professionals aged into their late 20s / early 30s, they would move out of LA to suburbs in search of a big single family home with a yard, etc.
Demand for apartments in LA, particularly in the areas east / north of Hollywood, was therefore mostly constrained to professionals in their 20s and working people who did not have the income or assets to move out to the suburbs. (That’s not to say there weren’t / aren’t exceptions… we’re speaking in broad strokes here.)
It’s not clear what caused professionals to stop moving to the ‘burbs. The trend really began in earnest around the beginning of the Great Recession in 2007-8. So it may have been that professionals didn’t have the money to move or couldn’t get the loans.
Another explanation was that 2007 was when the first of the Millennials (the massive generation born roughly 1979-2000) hit the age when previous generations would have started to consider moving to the suburbs… but the Millennials basically said “nope” to the high consumption, high debt suburban lifestyle.
Whatever the reason, LA finds itself with a major problem / opportunity: The Millennials are staying in the city and competing with more traditional renters (the young and the working class) for housing, driving rents through the roof. So either the city is going to find some way to allow developers to massively increase supply, or we’re looking at rapid rent increases for the foreseeable future.