Today, I want to talk about one of the unacknowledged factors driving up the cost of housing in LA: The fire code.
Now, it’s obvious why we need the Fire Department to weigh in on the design of new buildings. The department is going to have to rescue the inhabitants in the event of a fire and it obviously has a strong interest in keeping risk to the inhabitants and the fire-fighters to a minimum.
But there are obviously trade-offs. Here’s an example: Say you’re building a two story building with an open walkway serving the units on the second floor. Say further that you have one staircase and you’d like to avoid building another, because doing so would force you to lose a parking space, and therefore a unit.
The first code absolutely mandates that second staircase, because the fire code is concerned with minimizing injury and death in the event of a fire and having a second exit certainly does that.
But a rational person looking at that situation might say: The building is sprinklered and built of modern, fire retardant materials. Yes, we need a second exit. But we can live with a fire-escape instead of a full-scale staircase, because the chance that this actually ends up mattering is extremely low and the value to the city of an additional safe, legal apartment is high.
Let’s be clear: I’m not at all opposed to having the Fire Department have a say in development. I just think that we, as a city, need to have a full and frank discussion about the trade-offs involved.
Recently, I’ve been doing a lot of thinking about where we are in the cycle, debt, risk and asset allocation.
You see, many of my contemporaries have been doing fairly high-leverage development deals and doing very well with them.
We at Adaptive have shied away from those sorts of deals, for two, related reasons:
- You to pay income tax on the profits of for sale development deals, instantly chopping your profit roughly in half; and
- Because of the tax treatment, the only way to make these deals make sense on a post-tax basis is to use construction loans, which are always recourse
For better or worse, we are risk averse. We are trying to avoid losing money on any deal. And we certainly don’t take recourse on construction loans, because we’re trying to go through our careers without having to give back properties or declare bankruptcy (both of which happen to many developers who use a lot of debt).
So, we avoid for sale development, at least in this part of the cycle. Objectively, this is the strategy that makes sense for us.
And yet, every time I see one of these development deals do well, I’m totally green with envy. After all, when you hit one of these things, the returns are pretty amazing.
I have to keep reminding myself that a dice roll where a few of the outcomes are incredibly bad is not one I’m willing to make, even if the others are pretty good.
Here’s a question we wrestle with all the time: When should lease-up begin?
You’d think this would have an easy answer: When construction is done. But you’d be wrong.
Usually, buildings are “showable” (eg look pretty close to complete) 2-4 weeks before the construction is actually done.
And, after carrying the building with no cashflow for nine months, you’re desperate to begin signing leases and getting revenue in the door.
So, you typically begin the lease up before construction is totally done.
But that leads to other complications, like “What happens when you find a tenant who wants to move in immediately?” and “What if the city inspector needs you to make material changes to the building after a tenant has signed a lease?” and “What if there are construction defects that affect the tenant after she moves in?”.
Each of these kinds of issues can be solved with patience, savvy and diplomacy (and sometimes a bit of cash to grease the wheels). So that’s what our management company has learned to do.
We’re closing today on what will become either our second or third ground-up project (depending on how you want to count this one).
In going through the design / permitting process, I’ve already learned a pretty valuable lesson, which I’ll share here.
I always wondered why investors wanted to see a higher pro forma yield on a ground-up deal than they need on a rehab. After all, it’s all just construction, right?
The reason you want to see a higher yield on the pro forma for a ground-up deal is that, to paraphrase von Moltke, no building plan ever survives contact with the city.
One way or another, some obscure, arbitrary, ridiculous rule from one of the myriad city desks which need to sign off on any new project will result in you having to build something that is not quite the optimal building you envisioned.
So, your project better have enough margin to survive being ground-down by the bureaucracy.
Had an interesting tour yesterday of a building we probably won’t buy.
The reason it was interesting is that we were reminded, yet again, of how differently we look at acquisition targets.
The broker began to give us a whole spiel about how many of the units had been renovated, what the rents were, how those could be raised, etc.
We politely cut him off. Why?
Because we don’t look at properties as going businesses; instead, we look at them as raw material to be transformed.
So, we spent the vast majority of the tour carefully inspecting the common areas, measuring the units, and trying to distinguish between cosmetic and load-bearing walls, all in an effort to figure out what we really do care about: What the property can become.