Real estate lacks network effects, and I’m ok with it

Am reading a biography of Lew Wasserman, one of the most powerful people in the history of Hollywood, and it’s giving me plenty to think about.

Lew took over MCA, the first real powerhouse talent agency, from Jules Stein, its founder. Stein started MCA representing bands that played at dancehalls (this is way back, in the 1920s and 1930s).

Stein discovered a really powerful network effect that he used to grow MCA from nothing into the most powerful player in its market.

It worked like this: The more bands he represented (particularly popular ones), the more power he had over dancehall bookers. The more power he had over dancehall bookers, the more attractive he was to bands. Over time, he leveraged this network effect into exclusive relationships with talent and dancehalls, and from there into radio and them, with Wasserman’s help, into movies and TV.

Network effects are among the most powerful forces in business. When you harness them, you get rapid growth and, eventually, really strong margins for the dominant platform. Think of eBay: The more sellers, the more buyers, the more buyers, the more sellers. Or Uber: The more drivers, the more riders, the more riders, the more drivers. Or AirBnB: The more rentals, the more renters, the more renters, the more rentals. And so on.

I’ve always lamented the lack of network effects in real estate. It’s just not the case that it gets easier to rent apartments, the more apartments you manage. Nor does it get materially easier to buy deals as you buy more.

But this morning, as I was feeling down about the fact that our business can be a real slog, it hit me: The lack of network effects in real estate is the reason the business is so fragmented, which is what has allowed a newcomer like Adaptive to find and grow a niche.

You can’t be the 8th largest rideshare business and thrive. Or the 785th largest online market for secondhand goods. But you can generate very strong returns for your investors, and a great living for yourself, being the 2,016th largest multifamily owner.

Teaching an old(er) dog a new trick

We just agreed to buy a new property, with the intent of executing a business model which is different from what we have done before.

It’s not too far afield from what we have done before, so we have pretty much all of the relevant skills, relationships, etc. in house.

But underwriting the opportunity has been really interesting, because it feels a lot like it felt to underwrite our original apartment repositioning deals:

  1. Am forced to make assumptions based on other peoples’ deals, instead of just using our internal data;
  2. Because of the increased uncertainty and, therefore, likelihood we’ll screw up a bit, have had to look for deals that REALLY look like they have a ton of margin in them, so that we have a wider-than-usual margin of safety
  3. Amazingly, because we’re looking at deals through this new, far-less-common lens, we’ve found this deal (and hopefully will find others) with pro forma returns that seem almost too good to be true

When you’re young and inexperienced, and you haven’t seen a million things go wrong, it’s easy to dive into a deal that looks promising, because you don’t know enough to be worried.

When you’re more experienced, you’ve got used to doing things a certain way for a very long time, and it’s worked, it can be hard to wrap your mind around doing something new.

But you also have to trust yourself and your experience. Every once in a while, you really do just come across a good deal sitting right there to be done.

An annoying new trend in apartment building listings

Apologies for the slow posting – have a lot going on right now.

Wanted to highlight a ridiculous trend I’ve noticed recently in listings for apartment buildings. (Don’t want to offend anyone, so not going to name anyone in particular.)

The trend is that brokers try to convince me to buy a property by noting that other people are building a lot of units nearby.

This is irksome for a few reasons. First, if I’m going to be a supplier of housing in a neighborhood, then I should not want more supply in that neighborhood… I should want less!

Look, I support any changes to the Los Angeles zoning code which would result in more housing construction, because I believe increasing supply is critical to the long-term health of the city and the people who live here. But I do so knowing that more supply runs directly counter to my selfish interests as an existing supplier.

Given that it’s pretty obvious that a generic existing supplier should rationally OPPOSE new housing construction in her / his neighborhood for economic reasons, why are these brokers trying to use additional supply as a selling point?

It’s all about social proof. Implicitly, what they’re saying is that I should choose to be a supplier in that neighborhood because others are doing so. It makes sense, right? Humans are social creatures, and seeing others do something provides us with validation that that is a worthwhile thing to do.

Except I’m not like other people. Without meaning to sound obnoxious, in evaluating a potential choice, I give little or no weight to whether others are making the same choice. In fact, as an in-my-bones contrarian, my default setting when I see lots of other people doing anything is to want to do it less, not more.

So, this trend is like a double whammy: 1. Wrong on the merits; and 2. An implicit indictment of my decision-making process.

Where to find opportunities to cut construction costs

Have been spending some time reading about buying companies. One piece of advice is to buy suppliers that supply customers with a product or service which represents a small piece of the customers’ own business, but for which quality is crucial.

For example, find a pipe-threading company that cuts pipe threads for oil and gas exploration companies. Pipe-threading is a very minor part of cost of drilling and operating an oil well, but a mistake in pipe-threading that holds up a profitable well for even a few days can be extremely painful to the well operator.

The reason these kinds of companies are interesting targets is that they can frequently raise prices without their customers caring much. A 10% increase in price on a service which represents 5% of the total cost of a project results in a 0.5% increase in total project cost… in other words, a rounding error which the customer probably won’t care about.

The ability to raise prices over time without much push-back from customers is likely to result in pretty high margins. That’s why you want to buy those companies.

Why do I bring all this up, on a blog focused on buying and renovating apartment buildings?

When you are thinking about how to get your construction pricing down, it is natural to look to the big ticket items first.

But it’s worth looking also at your smaller cost lines, the ones where you’ve kind of been ignoring price increases, because they didn’t feel significant to the overall project. It’s in those areas where there may be surplus margin you can negotiate away.

What to do if you get a Notice of General Manager’s Hearing and Notice of Acceptance into the Rent Escrow Account Program

Late last week, a new property management client sent over a Notice of General Manager’s Hearing and Notice of Acceptance into the Rent Escrow Account Program (REAP) from the Housing and Community Investment Department of Los Angeles (HCIDLA).

That’s one of the worst letters you can receive as an owner of apartment buildings in Los Angeles. If your property is accepted into REAP after the GM’s hearing, the city starts taking some of your tenants’ rent payments and you’re blocked from refinancing the property or selling it to someone using a loan. And, once it’s in, it can be pretty tough to get your building removed from the program. So you can imagine the owner was upset.

(The backstory, I think, is that his previous manager never resolved a Notice to Comply which he received from HCIDLA. Once you fail to resolve issues identified by the city by the deadline, a General Manager’s hearing is scheduled automatically.)

The good news is that this is a solvable problem, if you are willing to move quickly. Here’s what to do when you receive a Notice of GM’s hearing:

  1. Make arrangements to resolve the outstanding issues (usually, this involves bringing in handymen or, for more complicated problems, contractors)
  2. Contact the city inspector assigned to the case to explain that you are working on getting the issues resolved
  3. Actually start doing the work to resolve the issues
  4. 7-10 days prior to the hearing date, call out the inspector to have him/her check off those issues which are resolved and show him that you are working on any others which remain unresolved at that time

Hopefully, you have resolved all of the issues, the inspector checks them off, you go to the hearing, and the hearing officer closes the file. But what happens if you can’t resolve the issues identified by the date of the hearing?

Then, your goal at the hearing is to get the hearing officer to grant you an extension of the deadline for resolution and thereby avoid getting your property put into REAP.

The key to getting the extension is to be able to demonstrate that you are making a good faith effort to get into compliance. That means:

  1. Show that you have resolved the straight-forward issues (that’s why you have the inspector come out prior to the hearing to check off whichever issues you have already resolved)
  2. Demonstrating your path to resolving the unresolved issues – for example, being able to show a contract with the relevant contractor/subcontractor which calls for her to resolve the issues, showing payments to that contractor, showing permits opened by the contractor for the work necessary to resolve the issues, being able to provide upcoming inspection dates, etc.

Obviously, you’re at the mercy of the hearing officer, who can be more or less understanding. However, in my experience, if you demonstrate good faith by doing what I outlined above, the hearing officer grants you an extension instead of placing your property into REAP.

Final note: If you are in a jam like this and need help, feel free to get in touch by emailing me at moses@adaptiverealty [dot] com. Sometimes, it makes sense for us to take over management of the building. Or, if you’d prefer to avoid the hassle entirely, we might be willing to buy the building from you, as-is.