Who cares if the tenants find out the building is for sale?

Pretty often, owners want to try to prevent their tenants from knowing the building is for sale.

I get why this is a concern with market-rate tenants. They are paying full-whack and you want to keep them happy.

But, with under-market tenants, this is just insane.

What, exactly, are they worried about? That the tenants are going to move out? That would make the building MORE attractive to the buyer.

Anyway, the net result is that the Adaptive inspection team, which often comprises 10 people, is often described as “insurance inspectors”.

But I don’t think anyone is fooled.

The problem with portfolio sales

As the market heats up, am seeing more and more portfolio sales. That’s when an owner decides he’s ready to exit the market and offers up all of his properties for sale together, rather than individually.

There are at least three reasons for an owner to do this:

  1. He’s not interested in selling part of the portfolio. It’s either get out entirely or nothing;
  2. He knows that some of his properties are better than others and wants to entice buyers to take the bad ones by tying them to the good ones; and
  3. He believes that, by offering everything together in one big deal, he can access a pool of (presumably institutional) buyers who want/need to deploy their cheaper capital in very large chunks.

Despite the above, I think most portfolio sales in LA do a very poor job of maximizing value, for the following reasons:

  1. Most of the properties involved are not institutional quality (because they’re small, subject to rent control, and usually have deferred maintenance), so the cheap money usually doesn’t flow;
  2. Most portfolios available contain a mix of value-add and cashflow deals… which interest very different kinds of buyers;
  3. Most portfolios available contain a mix of locations, again interesting different buyer pools; and
  4. Because the portfolios contain different property types / locations which naturally attract different buyer pools, it’s very unlikely that one broker will be the best person to sell all the properties, and yet that is what is required in a portfolio sale.

So, when does a portfolio sale make sense? Two scenarios:

  1. Where the properties are very similar in type, condition and locations; or
  2. Where the seller wants to exit quickly and is willing to sell the whole package at a discount to the combined value of the underlying properties

Unless your portfolio falls into one or both of the categories above, you’re far, far better off breaking the properties up and hiring absolutely the best broker to sell each property.

That’s how you maximize value.

Uh-oh… they’re baaaa-aaaccckkkk

We’ve now reached the point in the cycle where brokers describe their over-priced apartment deals as “condo conversion opportunities”.

Why would a broker do this? Well, if your client demands a price so high that no buyer could actually achieve any kind of yield on their investment, you don’t really have many options.

But, in all seriousness, what does the re-emergence of “condo conversion” as a strategy tell us about the current state of the market?

To answer this question, you first need to think about where we’ve been since 2008 or so. With interest rates at zero, capital has been chasing yields. Apartment buildings are reliable income generators, so capital has flowed into apartment buildings, raising prices and reducing returns.

But two factors are converging to change this state of affairs:

1. There’s only so high prices for cashflowing assets can go. Once you hit the point where the price is so high that the yield is negative, it’s pretty hard to convince even the stupidest buyer that he should go forward with an acquisition.

2. There is no limit to the insanity of single family home buyers in LA. Residential real estate in LA is totally, 100% detached from any fundamentals. No one thinks about what kind of rental yield they could get by renting the house or condo out. No one considers what it would cost to build the same house or condo across the street. Instead, they just convince themselves to pay a bit more than whatever the last sucker paid for a comparable house.

Given the above, it’s no wonder we’re seeing the re-emergence of the condo conversion as a marketing plan: If the price for your apartment building can’t go any higher, just transmute it into residential real estate and float away from the dreary world of actual returns into the beautiful fairy-tale of wanna-be stars living the dream.

Why I’m no longer a seller

Back when we started, Jon and I needed to sell renovated buildings.

The reason was pretty simple: We needed the dough.

When you’re in the money management business, you generally don’t see much in the way of money yourself until you make your partners money. They don’t take it on faith; they want cold hard cash in their bank accounts.

So, for us to unlock our own profits, we needed to sell the buildings and pay out the investors.

Now, things are a bit different. We aren’t as hard up for cash anymore. This means we’re more content to hold real estate.

This fits with my long-term view of the market anyway: I think we’re in the middle of a generation-long trend away from suburban living and towards denser, urban living.

Owning newly-renovated apartment buildings in improving neighborhoods in Los Angeles is exactly where you want to be if you believe in that trend: They’re not making any more land in LA and it’s really hard to build, so rents should continue to grow faster than inflation.

Since we no longer need to sell, our strong bias is against doing so. Instead, our aim is to refinance, return (tax-free!) cash to our investors, and then ride what should be a very good stream of cash-on-cash returns.

(Of course, if someone wants to make us a ridiculous offer, we’ll listen.)

A well-run sale process

We’re currently participating in an interesting sale process, so thought I’d share the details.

The seller and listing broker have chosen to run their process differently than most and will, I think, achieve better than average results.

To understand what they’re doing differently, you first need to understand how a normal process works. In a normal process, the broker puts the property on the MLS, Loopnet, etc. at the highest price he thinks a buyer might possibly pay. Offers trickle in, the seller counters, eventually a deal is struck and then the buyer begins his diligence (inspections, etc.).

The downside to a normal process is this: If the buyer decides, for whatever reason, to walk away after inspections, the listing broker is left having to go back to the other potential buyers (if any) and try to rekindle their interest in the property.

The process in which we are participating is very different. Here’s how it’s being run:

  1. Property was marketed at a very reasonable price
  2. All serious buyers who submitted offers were invited to inspect the building thoroughly on the same day
  3. After inspections, buyers still interested are required to remove the physical inspection contingencies from their offers
  4. Those buyers receive access to a data-room with all of the relevant documentation, including leases, estoppels, etc.
  5. Buyers who remain interested are then required to submit their best and final offer on a totally non-contingent basis (eg with no way to back out)

Obviously, the downside of this new process is that buyers are required to invest considerable time and energy in the deal prior to learning whether they will actually get it, meaning that some buyers will be less likely to participate at all.

On the other hand, the seller is able to maintain competitive tension all the way through the inspections and documentation review. And, the seller knows that the winning bid is firm (eg that the buyer can’t easily want away).

Of course, there’s no way to know whether this process will result in a better outcome for the seller than a normal process would have (because we don’t get to run experiments in real life). But my guess is that it will, and I think more sellers ought to consider running processes like this one.