Why we focus on unlevered yield

Had someone write in and ask me why we focus on unlevered yield when we look at deals.

To be clear, unlevered yield is calculated by dividing the forecast annual net operating income from a property by the cost total cost of buying and renovating it… in other words, treating the project like it will be done all-cash, with no debt.

It’s a good question, because a lot of other people in the business look at levered yields (in other words, they assume there will be a mortgage on the property).

We have two main reasons for ignoring debt when we’re under-writing a project:

  1. Using lots of leverage can make a so-so project look ok or even great, particularly if you forecast rent growth in the future and/or an exit (sale) at an aggressive cap rate. We don’t forecast rent growth, we don’t forecast exits, and we don’t want to do so-so deals.
  2. Using leverage to make your deal work puts you at the mercy of the debt markets, and we try to avoid putting ourselves and our investors at the mercy of forces we can not control.

To expand on point 2 above: When we completed the repositioning of our first batch of deals via our old company, Better Dwellings, in 2011-12, we knew that we have created a TON of value. We thought for sure that we would be able to get banks to underwrite our stabilized rent rolls and then cash us out on refinances with cheap debt.

They refused. Banks were extremely gun-shy after the crash, and, despite all of the numbers showing that the buildings could easily handle the leverage, they simply refused to make the loans.

This had a HUGE impact on my thinking. Once you see that banks can/will behave irrationally, you realize that you don’t want to base your business model on them behaving rationally.

How do you avoid leaning on the banks? Well, you make sure that you do deals where the unlevered yield is sufficiently high that you and your investors would be ok with just holding the deals all cash. That way, if the banks want to loan on terms that make sense, great. If not, you’re still ok.

Walking away from a potential homerun

Just walked away from a really nice deal and I’m still in mourning.

Last week, we were offered the opportunity to buy a group of smaller buildings in a single portfolio, off market, through a broker with whom we’ve done business before.

The numbers looked good and even got a little better after inspection.

I was excited, because I was planning to use this portfolio as the cornerstone investment for the fund we’re going to start raising shortly.

However, during our diligence, we discovered an obscure issue which I feared might make it extremely difficult to refinance or sell one of the three properties.

This is an issue that not many people know to even look for (including, presumably, the seller). So, I think many in our position would have been tempted to move forward with the deal, rolling the dice that the issue would never emerge.

In fact, I was tempted. But, the more I spoke to experts and considered the issues, the more certain I became that this was a show-stopper for us. So, we walked away from what looked on the surface to be an opportunity to put out about $7MM at around a 7% unlevered yield… which is a homerun in LA in this part of the cycle.

And today, while I’m sad not to be doing the deal, I’m 100% at peace with the decision. Before everything else, our obligation is to look out for the best interests of the people who trust us with their precious capital.

A great capital partner

Yesterday, a long-time capital partner and I finalized the operating agreement for the entity for a new deal we’re doing and, because the process unfolded in precisely the way I like to do business, I want to highlight it here:

  • We brought the deal to this partner about a month ago, after we had inspected the building but prior to getting it under contract… our proposal included reasonable deal terms
  • He indicated interest in the project, drove the neighborhood, then confirmed he wanted to explore the deal with us – all within a day or so
  • We gave him all of the relevant numbers and then worked together to determine our bid price
  • We won the auction, then kept our partner in the loop as we went through the diligence process… when issues emerged, we discussed them and agreed reasonable solutions
  • Prior to removing contingencies, we produced a deal memo setting out our final plan and forecasts, plus identifying the key risk factors as we collectively understood them
  • After reviewing the memo, he agreed to our proposal to remove contingencies without asking for any price reduction (this is a major point for me… we never try to renegotiate deals in escrow, so we can’t work with investors who expect that we will)
  • Then, during the period between contingency removal and closing, I marked up an operating agreement we had used previously to reflect the deal terms for this new project
  • He requested one reasonable change to the terms (one which did not hurt us at all), then we finalized the agreement

Take a look at the steps above again. Did we spend time beating each other up over economic terms? Did he start calling contractors to check our construction numbers to see if we’re telling the truth? Did I have to worry about whether he actually has the capital? Did he call rental agents to check if our rent estimates were legit? Did he question our proposed layouts for the units? Did either of us employ lawyers to try to screw over the other guy?

No, because we have done business with this partner for six years and everything he ever promised to do, he did, and everything I ever promised to do, I did.

It’s not that every deal has gone perfectly. Among other issues (most of which I can’t disclose here), a building we were renovating for him once had a major fire during the renovations. But, every time we’ve run into a problem, we’ve worked together to solve it, and the deals have all come out (REALLY) well.

And, because we’ve built up so much trust, we can work together in a close-to-frictionless manner. He gets good returns on his capital. And we get to make money, doing the thing we’re best at.

Once you’ve had a taste of doing business with partners like this, it’s extremely difficult to imagine doing business any other way.

My biggest management problem

Heard a really interesting interview with Brent Beshore recently that crystalized a big problem we have in our business.

Brent was talking about how he loves the HVAC service business, because, as long as people live in variable climates, they will need machines to maintain comfortable air temperature, and someone is going to get paid to service those machines. That’s a recipe for a stable, non-cyclical business… the type private equity investors love.

Interestingly, though, Brent has never invested in an HVAC maintenance company. The reason is that he has never found an organization that is 100% focused on service. And the reason for that is that the owners of HVAC companies can make a lot more money during economic up-turns by focusing on installation of new machines in new developments. So, their service businesses are always treated as after-thoughts and starved for resources, talent and management attention.

Why are the problems with HVAC businesses relevant to Adaptive?

We are similar to HVAC companies, in the sense that we are really two businesses wrapped together:

  • A development company that is well-compensated by investors for generating well-above-market returns in multifamily real estate in Los Angeles; and
  • A property management company that gets paid at standard market rates to manage buildings on behalf of our investment entities and also third parties owners

The development business is considerably more exciting and profitable than the property management business. It’s creative, the projects are (relatively speaking) over quickly, and the compensation is healthy.

Property management, on the other¬† hand, is both less exciting and less profitable. Since we and our clients intend to hold our buildings forever, there is no end… every month is a repetition of the month before… collecting rents, helping tenants move in and out, paying bills, taking care of buildings, keeping good records, etc. And, while it’s nice to have recurring revenue, the fees we get for managing buildings are not going to get anyone really excited.

Can you see what the challenge is, from a management perspective? It’s so tempting to devote all of our time and attention to development and ignore our property management business. And yet the management business is the foundation of everything, because, without it, the rent money would stop coming in, the buildings would empty out and fall apart, and we would not be allowed by our investors to continue doing development deals.

So, we, as an organization, are consciously devoting resources and attention to improving property management. Because, even though can be a little boring and is definitely not that lucrative, it’s kind of the foundation of everything else we do.

Having a little fun with the team

On Friday, we closed up shop to take the whole in-office team wine tasting in Malibu.

While I am truly proud of our business, we are not exactly curing cancer. So, Jon and I have realized, if we are going to get very high-quality people to work with us, we need to make Adaptive a great place to work.

That means hiring smart, honest people, paying them reasonably well, empowering them to do their jobs, avoiding micromanaging them, and holding everyone accountable, including, most importantly, ourselves.

And, every once in a while, it means showing everyone a good time.

Here’s (most of) the team: