Another obstacle to in-fill development

Want to give you some insight into why, exactly, its so hard for LA to add more housing.

Here’s a perfect example:

We own a big, R3 lot in an improving area, bordered by two alleys.

This ought to be a super easy lot to develop and, indeed, we are in the process of obtaining permits for a new building.

The pr0blem we have is a utility pole whose guy wire (basically, a cable holding the pole up) blocks access to our lot in a way that complicates the parking layout.

There are two solutions:

  1. Re-design the parking and the building to avoid the wire, resulting in a worse design and higher construction costs (because we need to use parking lifts); or
  2. Move the pole

Now, moving a pole ought to be pretty simple. It’s basically a few guys and a truck working for a few days. We’ve heard estimates that this ought to cost in the range of $30-50k. Really expensive, but not fatal to the deal.

The problem? Timing.

Because DWP is a state-owned monopoly with ZERO incentive to do much of anything, there is literally no way to know, with any certainty, whether moving the pole is feasible, how much it would cost, and how long it would take.

In case you haven’t figured it out from reading my blog, the one thing I absolutely can’t stand, it’s uncertainty… because I can’t sell “I don’t know” or “maybe” to my investors.

Bottom line: We may end up just the existing structures on the lot. It’s way less hassle… but the city loses a bunch of units it could have had.

Growth and land-use

Love this article in today’s NY Times.

For the lazy: The article makes the case that America doesn’t have boomtowns anymore, because the cities with the most economic opportunity have put in place land0use restrictions that keep housing prices very high, blocking new workers from coming in.

Now, as a developer with a growing property portfolio, I’m obviously benefitting from these growth restrictions.

But, as an American who would love to see the economy return to the days of 3-4% / year growth instead of 1-2%, I would welcome anything that would make it easier to add housing to LA and other highly productive metro areas.

To me, the big opportunity to do so is the impending arrival of autonomous cars, which have the potential to free all of us from the tyranny of minimum parking requirements.

Simply by waiving parking requirements, LA could easily add tens of thousands of new units, which would have an amazingly positive impact on the city (each new resident is a new potential employee, consumer of goods and services, and new tax-payer).

Let’s hope our politicians are brave enough to seize this opportunity.

Small-scale, in-fill development blues

Everyone should read this article in today’s NY Times, which goes into great depth about the problems associated with in-fill development in coastal CA.

My experience with the ground-up deal we just completed was similar. No lawsuits, but it did take nearly a year to get permits to add four units to an existing duplex, by right, with no discretionary approvals.

This mess hurts housing-starved cities in at least two ways:

  1. The uncertainty involved means that investors are not inclined to provide capital to build marginal deals, meaning fewer projects get the green-light; and
  2. The extended permitting process adds to carrying costs (interest expenses, property tax, insurance, security, etc.), increasing the total cost of the project and thereby making fewer projects pencil out

What you want is a transparent, rapid, predictable entitlement / permitting process.

What we have is the opposite.

The math behind what we do

At this point in the cycle, when we consider a new deal, we spend a lot of time thinking about leverage.

Mainly, we’re looking at how our pro forma unlevered yield (eg the cap rate we’re trying to hit post renovation) compares to the projected interest rate on the refinance we’ll do at that point.

I know this is a little boring, but stay with me!

Let’s look at three scenarios, all $5MM all-in deals.

Scenario 1: 7% unlevered yield

  • Invest $5MM
  • Hit 7% unlevered, so $350k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $7.8MM (divide $350k by 4.5%)
  • Borrow 65% LTV at 4.5%
  • That’s a $5.1MM loan, with annual debt service of $309k
  • So, we’ve got all the money invested back out of the deal and we’re earning $350k-309k = $41k / year
  • Levered yield of $41k / $0 = Infinity!

Scenario 2: 6.25% unlevered yield

  • Invest $5MM
  • Hit 6.25% unlevered, so $313k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $7.0MM (divide $313k by 4.5%)
  • Try to borrow 65% LTV at 4.5%, but can’t, because the NOI won’t exceed the debt service by enough to make the banks (or us!) comfortable
  • Instead, borrow $4.3MM (61% LTV), with debt service of $260k
  • Leave $5MM-$4.3MM = $700k in the deal
  • Receive free cashflow 0f $313k-260k = $53k
  • Levered yield of $53k / $700k = 7.6%

Scenario 3: 5.75% unlevered yield

  • Invest $5MM
  • Limp into a 5.75% unlevered, so $288k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $6.4MM
  • Borrow $3.95MM (ouch), with debt service of $239k
  • Leave $5MM-$3.95MM = $1.05MM in the deal
  • Receive free cashflow 0f $288k-239k = $49k
  • Levered yield of $49k / $1.05MM = 4.7%

As you can see, in Scenarios 1 & 2, the more you borrow, the better the deal gets. That’s because the unlevered yield exceeds the cost of the debt (which is the total debt service divided by the loan amount). In Scenario 3, because the cost of the debt exceeds the unlevered yield, the more you borrow, the worse the deal gets.

The above is, in a nutshell, why our business exists. We get paid to deliver unlevered yields that are in excess of the cost of the debt, allowing investors to benefit from leverage, rather than get killed by it.

Here we go again

Just started interior demo on a new, large project in an area we absolutely love.

Despite the market being hot, because we bought well, this project is going to end up being a really good one.

But, before we get to the fun part where we release beautiful new homes for people to enjoy for decades, we have to slog through construction.

And here’s how that starts… with a 100% complete gut job: