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.

The most important variable

In a recent email to investors in Adaptive Realty Fund 4, I wrote:

“In our business, there are three types of variables (of varying degrees of magnitude):
  1. Things we can’t control…
  2. Things we can control…
  3. Things over which we have some, but not total, control…”

Spent the rest of the letter discussing the most important “type 3” variable.

Today, I want to talk about the most important “type 2” variable: price.


Repositioning buildings is inherently complicated. Lots of things can go wrong and some of them are totally beyond your control (see above).

But you can control the price you pay for a building.

Pay too much, and pretty much everything has to go right.

Give yourself a nice margin of safety, and you can survive some bad breaks and/or bad execution.

The trick is to be willing to keep your bat on your shoulder, watching pitch after pitch go by, until you find one you can really drive.

How rising construction costs impact affordability

Everyone knows LA is in a housing crisis and everyone is talking about up-zoning as a potential fix.

But, recently, a big part of the problem is that construction costs are skyrocketing… and that’s what I want to discuss today.

What’s going on?

  1. The wipeout of 2007-9 crushed a lot of subcontractors (plumbers, framers, roofers, etc.). Many of them left the business and have not come back.
  2. Many subs and GCs are baby-boomers who have reached retirement age… some are leaving the business every day.
  3. All of the major economies on earth are growing right now, dramatically increasing demand for, and therefore price of, commodities – things like wood, steel, etc. that you need to build
  4. Our national government has decided that now is the right time to start a trade-war, which is driving up the price of some imports (including Canadian lumber)
  5. Our our national government has also decided to try to chase undocumented immigrants, many of whom are in the construction trades, out of the country, leading to massive labor shortages
  6. Our state government continues to add complexity to the building code, increasing the energy efficiency and life-safety of buildings, but also the construction cost
  7. Our city government has decided to add a $12 / sq ft “linkage fee” to all new apartment construction (this is so painfully stupid, I have no words)

And, most important of all:

8. There is a TON of construction going on in LA, so those GCs and subs who remain have their pick of projects.

Why do increasing construction costs matter? Well, they have a huge impact on affordability.

Imagine I gave you the land for a 4,000 sq ft 4plex apartment building for free. But also imagine that construction costs (including design, permits, fees, etc.) are $300 / sq ft.

That means you need to spend $300 x 4,000 = $1.2MM to build your building, or $300,000 / unit.

Let’s say that, to get a satisfactory return, you’re willing to build into an 11x GRM (in other words, you’re willing to spend 11x the annual rent roll to build the building). $300k / 11 grm / 12 months = $2,272 / month.

In other words, even if I gave you the land FOR FREE, you would still have to charge rents which are unaffordable to most working people in LA.

So, while up-zoning (which is intended to reduce the land costs) is part of the solution, it’s not going to come close to getting us all the way out of the crisis.

How increasing replacement costs imply a widening investment moat

Experienced real estate investors know to keep an eye on replacement cost when considering rehab deals.

The idea is to try to ensure your property will have a cost advantage vs. its neighbors.

The thought process is pretty simple: When considering doing a project, you want to look at what it would cost a competitor to buy a lot nearby and build a building from scratch to compete with you. You want to try to ensure that your all-in cost, on a per square foot basis, will be lower than your competitor.

Here’s an example of the calculation:

  1. Assume you’re looking at a 10,000 sq ft, 10 unit building you want to buy and rehab
  2. Say you’ll be all in for $3,500,000, which equates to $350 / sq ft
  3. Assume further that the lot next door is zoned for, say, five units, and similar lots have sold for $1,000,000 (eg $200,000 / unit of land)
  4. Assume that building a 5,000 sq ft, 5 unit building ground up on that lot would cost $300 / sq ft, or $1,500,000

To come in and compete with you, someone would need to spend $2,500,000 ($1,000,000 for the lot, then $1,500,000 to build). So, for his 5,000 sq ft building, he would be all-in for $2,500,000 / 5,000 = $500 / sq ft.

To carry the calculation to its conclusion:

  1. Assume you can each get $3,000 / month for your units ($36,000 / unit / year) and that expenses will equal $10,000 / unit / year, implying net operating income per unit of $36,000-$10,000 = $26,000
  2. On your 10 unit building, you have invested $3,500,000 to get $26,000 x 10 = $260,000 of net operating income, or a yield of $260,000 / $3,500,000 = 7.4% (awesome!)
  3. Your competitor would be looking at investing $2,500,000 to get $26,000 x 5 = $130,000, or a yield of 5.2% (a terrible outcome)


Obviously, the higher the cost to compete with you goes, the lower the yield a competitor can expect. And the lower the yield he can expect, the less likely he is to come in and compete with you.  Less supply means more pricing power for existing suppliers, implying higher rents and, therefore, net operating income and free cashflow.

What we have here is a naturally-occurring investment moat (for more on the concept, you go read Warren Buffett), one which works to protect and enhance your return over time.

Want to end by sharing a few implications of the above:

  1. If the city wants the market to supply more apartments, it desperately needs to reduce the cost of doing so. Most of the conversation in this area lately has been about up-zoning, which in theory ought to reduce the per unit cost of land. Much more attention needs to be paid to construction costs, which, after all, make up a much large portion of the total cost of building ground up.
  2. As construction costs have gone through the roof over the past few years, the moat protecting existing owners has widened.

Some love for Scott Weiner

As a housing supplier, it is in my financial interest for the government to continue to block development of new housing at a scale commensurate with demand.

However, as an American who loves cities, in general, and Los Angeles, in particular, I am strongly in favor of loosening restrictions on development. More housing equals lower rents, which means more people can afford to live in cities, where their hours will be spend more productively, etc.

So it was with great pleasure that I read about Scott Weiner’s proposed state legislation to forbid municipalities from restricting development around mass transit.

This is the kind of revolutionary change required to address CA’s housing crisis. And it won’t cost the state anything.