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.

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.

Cranking the machine back up

Acquisitions have been slow at Adaptive over the past few months.

And it’s not by choice… prices in our core neighborhoods in 2018 have generally run way out ahead of rent growth, taking our forecast unlevered yields down to levels we don’t find appealing.

However, recently, we have identified a few areas where the equation is swinging back into alignment, driven by a combination of price reductions and rent growth.

So, we’ve begun making some offers… and I’ve got a new spring in my step.

Why we’re sticking to our knitting

Regularly get asked the following questions: Are you planning to venture out to other cities? Start doing other product types (office, retail, etc.)?

The answer to both is that I would love to branch out. Aside from the intellectual stimulation that comes from learning new things, expanding the pool of potential projects would allow us to put more capital to work, which would be good for Adaptive.

But we’re pretty unlikely to expand to other cities or product types any time soon.


It comes down to “circle of competence”, the range of potential deals were our existing skills and knowledge give us an advantage over competitors.

When it comes to fixing up apartment buildings in Los Angeles, I can say, with no exaggeration, that our organization is the best. We know, with great certainty, how much we can pay, what we’ll do with a building, where the potential pit-falls lie, what kind of rents we can expect, how to finance the deals, etc.

Are we perfect? No way. This stuff is really hard and we make plenty of mistakes. But I’m confident, because we’ve fixed up ~80 buildings over the past 10 years, we know what we’re doing.

This is utterly not the case when it comes to buildings in, say, Austin. Or office buildings, even in the submarkets we know well.

Now, if we were in the midst of a down-cycle, when everything gets cheap and you can depend on subsequent rent / price increases to bail you out if you screw up, I would absolutely be looking to try new cities and/or product types.

But, since we’re in a pretty hot market, where we need to pay top dollar for assets, we’re going to stick with the type of deals we truly understand, even if it means I get a little bored of looking at hundreds of apartment buildings every day.

Finishing up another one

We’re just finishing a 6 unit deal in an area where we’ve done a ton of business, and thought you guys would like to see pics.

The ads went up this past Monday (so, seven days ago) and already 5 of the 6 units are spoken for.

Think the unlevered yield on this one is going to be ~7.5% / year… and we bought it last summer.

That’s a home run.