Bucking the traditional real estate private equity model

The traditional real estate private equity model is broken.

Here is how it works now:

  1. Sponsor finds deal
  2. Sponsor raises equity from investors, then uses as much debt as possible (to enhance the returns to investors)
  3. Sponsor adds value to deal (renovating, building ground-up, whatever)
  4. Sponsor sells deal as quickly as possible, pays off the loans, returns capital to investors, takes her cut (the promote)

The model above is designed to maximize pre-tax IRR (internal rate of return), which you do by using as little equity as possible and returning as much capital as possible (by selling), as quickly as possible.

Sounds good, right? What could be bad about maximizing IRR?

Well, there are some issues:

  1. Lots of leverage – To maximize IRR, you want to minimize the amount of equity capital used in your capital stack. So, you absolutely max out on debt, including really high interest mezzanine debt (the stuff that is junior to the senior debt, but senior to the equity – basically, risky loans that cost a lot). Regular readers know that leverage magnifies outcomes, good ones but also bad ones. Structures that load up on debt are EXTREMELY vulnerable to collapse in the event anything goes wrong (construction cost over-runs, construction delays, leasing delays, etc.). This is a recipe for foreclosure, which means total, permanent loss of equity capital invested. Ouch.
  2. Requires an exit – The churn-and-burn business model usually means adding a little value, quickly (the old lipstick-on-a-pig routine), and then flipping the property to the next buyer. But what happens if there is no next buyer, or rather, if prices have come down in the interim such that the next guy isn’t willing to pay what you’d hoped? In that case, you’re stuck either selling at a loss (permanent capital impairment) or else owning the deal as the lipstick wears off, and dealing with the rent stagnation/declines and opex increases that inevitably entails. Meanwhile, your investors, who were promised a quick turn, have their dough stuck in a deal they don’t really like.
  3. Maximizes transaction costs – Any time you buy or sell real estate, there are transaction costs, including broker fees, escrow fees, title fees, legal fees, transfer taxes, etc. In LA, those costs can easily add up to 6-8% of the gross sale price… and that’s before the sponsor takes her fees! On a good flip deal, where the unlevered, gross ROI might be 30%, a full 10 percentage points (a third of the total profit!) might be eaten up by transaction costs.
  4. Maximizes taxation – The private equity model was presumably designed with the needs of non-tax-paying, institutional limited partners (pension funds, endowments, foundations, etc.) in mind. Since they don’t pay tax, they don’t worry about the huge chunks state income tax and federal capital gains tax take out of each flip deal. But, for an “ordinary” high net worth investor or family office, paying out 25-40% of the profit on a deal to the government is ruinous to the after-tax return (which, after all, is what those investors should care about).
  5. Requires re-deployment of capital – When an individual buyer invests in income producing real estate, he’s making a simple deal (whether he knows it or not): Exchanging a certain amount of cash today (the downpayment) for an income stream going into the future. Contrast that to an investor in a churn-and-burn deal: He does all this work to vet the deal (if he’s smart!), then, like 18-36 months later, gets back his money, plus a heavily-taxed profit. And then he has to put the dough back out again… with the risk that this next deal doesn’t go as well. Or, if he likes the sponsor, maybe they go do a 1031 exchange to defer the taxation… which means having to buy a replacement property with a ticking clock, which makes it very tough to make a good deal.

So, if churn and burn deals aren’t great for standard, tax-paying investors, why do sponsors keep pushing them? Simple: Because they’re GREAT for sponsors, who get to:

  1. Notch a “win” on their track record – After all, everyone likes to see 25% IRRs in pitch-books, and damn the tax consequences
  2. Charge fees coming and going – Acquisition and disposition fees are a standard part of the set-up
  3. Crystalize their promotes (usually 20-30% of the profits) quickly – Since they didn’t have to put up the dough for that share of the profits (that’s the whole point of the promote), they don’t care about the taxation… it’s all income, anyway.

Bottom line: At Adaptive, we regard capital as precious and hate the idea of vaporizing it with taxes and transaction fees. So, we’re long term holders. And, if that means we need to buck the traditional real estate private equity business model, that’s what we’re going to (continue) to do.

We keep evolving

Have been spending a lot of time over the past few weeks speaking with capital partners, both existing and prospective.

Yesterday, a guy who has backed us for a lot of years said something that really stuck with me.

He said something like: “The way you describe your business has really changed over the past few years.”

And it’s not just words – our business has changed in some important ways.

But, critically, those changes weren’t random.

Our north star on every deal is trying to maximize unlevered yield while minimizing all-in price per square foot.

As the environment in which we operate (asset pricing, construction pricing, zoning, rents, etc.) has changed, we have made changes to our business model in order to continue to head in the direction of our north star.

When an organism undergoes changes in order to thrive in a changed environment, we describe those changes as “adaptive”.

Why we no longer announce acquisitions

Was browsing the LinkedIn newsfeed yesterday and came across a video a guy had posted of his latest acquisition, which included the name of the neighborhood in which it is located.

The video had a ton of likes and comments (mostly from brokers) and I admit to feeling a bit jealous. (Side note: If you think me getting jealous about a real estate acquisition gives you a window into my personality… you’re right).

So, if letting everyone know about your latest deal gets you a lot of attention, the question is: Why don’t I do it anymore?

The answer is, when we find an area or a building type that works for our peculiar business model, we don’t just want to buy one of those buildings. We want to buy all of them.

And alerting our competitors to what we find interesting is stupid, because it drives up competition for deals.

So, I will (sadly) forgo the ego boost that comes from telling you about what, exactly, we’re buying, in order to give us the time and space to put out as much capital into these interesting opportunities as we can.

Why construction costs are so high

Was at a panel discussion on development recently and rising construction costs came up.

Everyone wants to know why it costs like 30% more to build a building than it did two years ago.

There are lots of theories, including:

  • All the sub-contractors retired in 2008
  • Lots of laborers went back to their home countries (often in Latin America) as a result of our insane immigration policies
  • The tariffs are pushing up materials costs
  • Workers comp insurance is too expensive
  • Millennials don’t want to get their hands dirty in physical jobs

And lots more.

One of the panelists at our discussion was a contractor, and he had a different perspective. He said something like: “For a while there, in 2008, 2009, 2010, 2011 and 2012, you guys were sticking it to us. Now the shoe’s on the other foot.”

In other words, part of what’s going on is that contractors know there’s a ton of demand for construction services and not a lot of supply, so they’re taking the opportunity to increase their margins. And it’s a free country, so who can blame them?

That said, while we certainly aren’t immune from rising costs, we have suffered less than most, and here’s why: Our contractor relationships are LONG term. We kept those guys working in 2009, 2010, 2011, etc., when no one else was doing anything. And they know we’ll be buying lots of buildings when things get bad again. So they don’t feel like they have to kill us on price now… in a long term relationship, everyone knows what goes around comes around, eventually.

SROs: A new, old idea

I read a TON about business, in general, and real estate, in particular. So it’s fairly rare for me to come across an idea that’s genuinely new to me. But I came across one last night, during a conversation with a much more experienced owner-operator, that I’d like to share.

We were discussing the housing affordability crisis currently affecting cities across the country, and particularly on the West Coast.

The usual suspects came up: Zoning, construction pricing, stricter building codes, etc.

But he had another take: That cities ought to be allowing the construction of SROs (single-resident occupancy hotels).

SROs are cheap to build, because the residents share communal kitchens and bathrooms, and generally don’t get parking. Because they cram a lot of people into a relatively cheap structure, they can generate a good yield, even with very low rents.

SROs flourished in LA and other cities during most of the 19th and early 20th Centuries. Young, unmarried men, in particular, used to congregate in SROs while they worked to find their footings in adult life.

However, during the 20th Century, cities adopted more stringent zoning codes aimed at increasing property values and banned construction of SROs, either explicitly or through things like minimum dwelling size restrictions, parking requirements, etc.

In doing so, city governments wiped out a whole stratum of cheap housing that was ideal for single people, thereby forcing those people to double- and triple-up in conventional apartments, pushing the price of those units up as well. From a housing affordability perspective, this wasn’t so smart.

Now, you could argue that the birth and growth of the co-living model is sort of a rebirth of SROs. However, it seems to me that the co-living companies target the more affluent end of the single-renter demographic, by bundling in expensive services and space (like group dinners, communal living rooms, etc.), which drive up the monthly rent.

Perhaps what is needed, as my fellow owner / operator pointed out, are new SROs, or co-living facilities stripped way down to allow for the lowest possible monthly rent.