The market feels different

Regular readers know that I often complain about the lack of deals in the market. I’ve been doing it for years and I’m sure I’ll never stop. (I can hear Mr. Lyons, my old faculty advisor at the Phillipian, repeating his joke about the whiny Kagan brothers…)

But, right now, the LA multifamily market feels different than it has since I really began following it religiously approximately 10 years ago.

For the past decade or so, if you put a gun to my head and told me to buy the best deal I knew of, I could do something tolerable. Not great, necessarily, but tolerable.

Right now, with the exception of an opportunity zone deal or two (where investors ought to be willing to tolerate worse numbers to get the tax benefits), I am unable to point to a single thing that comes close to making sense.

That’s not to say that the market has seized-up. Far from it. People are still buying, even at today’s prices.

But, because I intimately know the numbers behind these deals, I am categorically certain that the juice on these babies will not be worth the squeeze, so to speak.

Fortunately for us, between the deals we already have in our pipeline and our existing management business, I can now say, for the first time since I got into this business, that I don’t really care if we do another deal this year.

Would I prefer to? Of course. Would my investors prefer I do one? Of course. But the deals Mr. Market is offering make no sense right now, so I’m going to sit on my hands.

Classic bad advice at a broker conference

Spent most of the day yesterday at the annual Marcus & Millichap LA apartment conference.

As part of an on-stage interview, one broker (I won’t say which one) was asked what he sees happening over the next year. He went into a whole rap about how “it’s a good time to sell, there is capital moving around from asset class to asset class, blah blah blah.”

I obviously started snickering and people were staring at me.

It’s hard to imagine a clearer example of a guy talking his own book than a broker, who only gets paid when investors transact, suggesting that it’s a great time to sell.

For the record: Every time to you sell a property, an enormous amount of value is destroyed… you pay brokerage commissions, escrow fees, title insurance, loan brokerage fees, city and county transfer taxes. And, valuable Prop 13 property tax basis is destroyed (in other words, the property is literally worth more to you than to the buyer, because his property taxes will be higher than yours are).

You know when is a good time to sell? Ideally never, and certainly as rarely as possible.

Are we headed into a buying opportunity?

In light of the news coming out of the bond market recently, I have been thinking about how the numbers behind our deals will change in the event of a recession.

Obviously, the ideal scenario for us would be:

  • Interest rates decrease;
  • Rents stay the same or continue to rise; and
  • Prices for assets decrease.

In that scenario, our models would show both higher unlevered yields AND the ability to get more / better leverage post stabilization, and therefore higher levered yields. That would be awesome for us and our capital partners.

Of course, that’s extremely unlikely to happen, because, if rates decrease and operating performance stays the same or improves, the appeal of owning the assets increases, and therefore prices are likely to increase.

So, what will happen in a recession? Most likely, as already seems to be happening, interest rates will decrease. And then employment growth will slow, then reverse, leading to weakening demand for apartments and, therefore, rent decreases.

The question is, will rents go down enough to counter-act the effect of reduced interest rates and make buildings less appealing, leading to asset price decreases and, therefore, a buying opportunity?

I have no idea.

An obvious way to quickly add lots of housing to LA

Los Angeles is in the midst of an un-precedented housing shortage.

All over the city, there are vacant, obsolete commercial buildings.

City law prevents these buildings from being easily re-purposed for residential use, due mostly to parking and set-back requirements.

Yet the city waived these requirements for re-purposing of obsolete commercial buildings in specific Adaptive Reuse zones beginning in the mid-1990s. The result has been the creation of thousands of desperately residential units in, for example, downtown.

So… why aren’t we rolling the Adaptive Reuse zones out across the entire city?

Learning, some more, from Buffett

Am in the process of going through Carol Loomis’ Tap Dancing to Work: Warren Buffett on Practically Everything 1966-2013, which is spectacular.

Have taken away two nuggets which are relevant to our business, one great and one not-so-great.

The first comes in the form of a comment Buffett made to a bunch of MBA students, (I think) in the 1980s. To paraphrase: The government does not tax unrealized capital gains, which means you can compound the value of your investments by holding long term.

Obviously, I have placed a major, career-defining bet on the power of long-term holding to create net worth for myself and my investors. But it can be hard sometimes to stay the course, when so many of our competitors are making “easy” money flipping deals. So it’s nice to be reminded that Buffett made the same bet (and did pretty well with it).

The second, not-so-great insight (from our perspective) concerns the use of retained earnings. With the help of Charley Munger, Buffett realized (sometime in the 1970s, I think) that, so long as you have a good management team, it’s actually a good thing when businesses retain earnings, instead of distributing them out to shareholders in the form of dividends.

Why? Because retained earnings are a signal that management has found opportunities to re-invest in growing the business. So long as those investments actually do drive real, profitable growth, shareholders should be thrilled.

Why is this bad for us? Real estate doesn’t really offer the same opportunity to reinvest to drive growth. After the initial, value-add strategy is executed, real earnings growth is fundamentally determined by the rental market you’re in, not by anything you can do.

Luckily, Los Angeles rents and values have grown faster than inflation for a very long time, and look set to continue to do so. So I feel good about what we own now. But it sure would be nice to have a lever to use to accelerate earnings growth in the existing portfolio faster than whatever our market can provide.