Don’t be an ostrich

In our business, shit happens.

That’s just the way it is. Tenants try to short you on rent. Contractors try to extort money through bogus change-orders. City inspectors call you out for things you know are fine. Buyers try to chip price. Sellers lie about their rent rolls. And on and on and on.

When one of these problems arises, there is a natural tendency to avoid picking up the phone when we call you to discuss it. You’re hoping that, if you just avoid answering, someone else will figure out a way to resolve the issue.

I have never, in my life, been an ostrich. Neither has Jon, my partner. When shit happens, we get MORE interested in the project, spend more time on it, and don’t stop until we have some kind of resolution.

There’s never any kind of guarantee in our business, except this: If you try to avoid problems and hope they go away, your deals will get screwed up.

(Can you tell we’re dealing with someone on a project right now who doesn’t like to pick up his phone?) 

Avoiding a pretty painful “oops”

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.

To sell or not to sell

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?

How a good contractor handles inspectors

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:

  1. Good quality work (obviously); and
  2. Confidence.

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!).

What we want in a contractor

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…