The gestation of an idea

I spend a lot of my time kind of aimlessly drifting.

It’s pretty weird that I do this; I think most business people are much more focused than I am on a day-to-day basis.

What I do is read a whole bunch of stuff and talk to people.

I’m not necessarily specifically looking for an investment thesis or idea. I’m just trying to think about what the world will look like years from now and how one might allocate capital now in order to be positioned to take advantage of these trends before they come fully to fruition.

And then, every once in a while, an idea comes to me.

Mostly, these ideas are too small to be interesting. But, sometimes, they’re big.

What do I mean by big? Well, the ideas need to be big enough to put $5-10MM in capital to work. Otherwise, it’s not really worth the headache to figure out of how to implement them.

Just in the last few days, I’ve had another one of those ideas.

Now, lots of people have big ideas.

What separates me from other dreamers is that, when I get a big idea, I know how to make it happen.

And that’s what I’m going to do with this one.

Stay tuned.

The problems with retail

I have spent years thinking about trying to apply our design sensibility to the retail asset class.

After all, we’re very good at maximizing the value of small spaces. It ought to be possible to do this with stores, too.

So, why haven’t we jumped in?

Two reasons:

1. The macro-trend towards online shopping. My family buys almost everything online (almost all from Amazon, but that’s a different story). I assume that, as people get more and more comfortable with online shopping, this trend will continue, making it very, very hard for traditional retailers to compete.

2. The conflict between our design sensibilities, tenants’ credit and what the banks want to finance.

Given where we do business and the kind of deals we do, I’m sure you can guess that Jon and I are not exactly in love with large chain retail. I’m not any kind of a psycho on this issue, but, given the choice, I prefer interesting one-off shops over chains. And, obviously, if we were going to start doing retail deals, my impulse would be to design projects to appeal to / enhance the businesses of independent retailers.

The problem is that independent retailers are terrible credit risks. They go out of business all the time and they tend to do so all at once when the economy goes bad.

Now, if your tenants are big chains, a recession isn’t so bad. As long as the company avoid bankruptcy, you know the rent is getting paid. But, with independent tenants, there’s not really much you can do, unless you have secured personal guarantees and you’re really excited to try to take peoples’ houses away.

Banks know this and so they are very hesitant to lend against retail properties with so-called non-credit tenants. So, on top of the business model issue, there is also a financing issue, in that the leverage you want / need is both harder to get and more expensive than it is in multifamily.

Bottom line: The type of project we’d love to do, with well-chosen, independent shops, is risky and difficult to finance. So, unless the land is an absolute steal, we’re going to stick with multifamily for the time being.

The kind of regulation that drives me crazy

Hat tip to Adrian over at Curbed for noticing a new, irritating piece of regulation from LA’s city council.

Here’s the regulation, in a nut-shell:

“The LA City Council … preliminarily pass[ed] an ordinance that will make it illegal to covertly demolish buildings more than 45 years old… The ordinance requires property owners to notify neighbors and their Council District Office, and to post notice on the property, for 30 days before they can get a demolition permit for an old building. It also introduces a $60 fee for anyone looking to tear down an old building, to cover costs.”

It’s only 30 days, right? Not a big deal, you might think. Wrong. Why?

45 years ago, LA was basically a bunch of inter-connected suburbs. A ton of residential structures were not built as densely as the zoning allowed. And much of the commercial space reflected the times in which it was built (for example, strip centers with awful parking lots abutting sidewalks and making neighborhoods feel terrible).

Developers big and small are now making money by buying these obsolete buildings, ripping them down, and building better structures in their place. Am not arguing that all development is sensitive / good… there’s plenty of junk being built. But, by and large, I’d prefer to bet on the profit motive forcing developers to build densely, which is the most important thing for making our city more affordable / walkable.

So, you might ask, why does a 30 day delay matter?

The answer is that it introduces additional uncertainty into the development business. Now, instead of closing on a property, getting plans approved, and ripping the existing structure down, you’re going to need to run this 30 day gauntlet with your fingers crossed, hoping that some wacko isn’t going to start a campaign to save it.

When you add uncertainty to development projects, you force the developer to demand more profit in order to run the risk of building. The main ways to build in more profit are to buy the land for less (hurting the existing owner) or else sell / rent the resulting new structure for more (driving up housing / business costs).

Now, I’m not arguing against the idea of historical preservation. There are clearly some exceptional buildings that we’d like to keep around in our city. And, if the city is doing its job, then those buildings should be on historical preservation lists where you can’t pull any demo permits, ever.

But it’s patently absurd to make delay ALL development so that we can avoid maybe losing some marginal structures that aren’t actually important enough to be designated as landmarks. Not very smart.

(For what it’s worth, here’s my prediction: Developers will start asking sellers to post notices and then pull demo permits prior to removing contingencies on acquisitions of properties with “historical” structures. This way, it will become the seller’s problem, rather than the buyer’s.)

Ballpark returns

Had an interesting conversation today with a guy looking at building condos / small lot.

One of the questions he had was what kind of returns a developer can expect.

I’m far from an expert on ground up, but I’ve run the numbers on a lot of projects.

Right now, here’s where I think you end up for smaller projects (say, 5-20 units):

  • As a rental: If you know what you’re doing, think you can build into a 6.5-7.5% unlevered yield. That means you buy the land all cash and build all cash and, when it’s done, you get roughly 6.5-7.5% on your money annually. You can improve this number by using a construction loan to build and/or refinancing post stabilization.
  • For sale: I have seen several 20% ROI deals. Again, this assumes building all cash. Remember, too, that building for sale projects is more of a 24 month project (since the entitlements take longer to secure than those for rental housing)

Just to clarify, it’s not like deals like this are falling off trees. You have to hunt them, know what you’re looking for, and know how to execute. And, of course, there are all kinds of risks with ground-up construction… the scariest of which is the market moving against you during the project.

Still, if I had a ton of my own money, I think I’d be buying pretty high quality land, building rentals on it, and holding them. Long term, owning high quality, non-rent controlled assets in good parts of LA is probably a winner, even with the relatively high cost of land at the moment.

(Note: This post is not a solicitation for investment nor a guarantee of any kind of performance on any particular deal.)

Apologies for the lack of posts

Didn’t write Friday or Monday because I’ve been slammed.

We were finishing up diligence on the first deal for Adaptive Realty Fund 3, our latest investment vehicle.

Late last night, we removed contingencies, with closing to come early next week.

On top of that, my very capable assistant has been out sick, so I’m doing more of the grunt work than I usually do on one of these deals.

Anyway, we’re super-excited about this latest building and will provide details when its prudent to do so (eg not for a while).