Leadership failure

One of the worst things about running a small company is having to let people go.

When you hire someone, you’re entering into an exchange, where he gives you his best effort during the most productive hours of his day, for an indefinite period, and you give him money to support himself.

It’s awful for everyone if, after making that bargain, you realize the bargain isn’t working for your company.

Now, I don’t mean it’s equally awful for everyone involved. I’ve been fired before, and I viscerally recall the sense of desperation I felt. At the time, I did not have any savings, nor a strong network upon which I could fall back (I was living in the U.K., far from my family, etc.). It was horrible.

So I’m 100% aware that, when an employer lets an employee go, it’s the employee who gets the worst of it.

That said, it’s not great for the employer, and not just because it’s emotionally very difficult to inflict pain on another person (though, of course, that’s a huge part of it).

For me, a major, additional source of the pain is the realization that, as an employer, I have failed in one or both of the following tasks:

  1. After a search to which I devoted my time, skills, money, etc., and in spite of the fact that it’s my company about which I know more than anyone else, I chose the wrong person for the job; and/or
  2. After choosing the person I thought was the best fit for the position, I failed to bring that person successfully into his role in my organization (via training, etc.)

I do a lot of things at Adaptive: I find the capital and the deals, oversee the financials, oversee management, etc. But, as we have grown, I have learned that our organization is way stronger when we bring in and train highly energetic, smart, honest people, show them what we’re trying to accomplish, and then let them get on with making things happen.

In other words, probably the most important things I do here are hiring and training our team.

So, when we we realize we need to let someone go, it’s fair to say that I have failed, utterly, at one or both of the most important tasks in front of me.

Ouch.

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.

Why are there vacant buildings for sale?

Lately, have seen a bunch of vacant apartment buildings come on the market for sale.

Normal investors don’t buy vacant buildings, because banks generally won’t lend on them.

So, these vacant buildings are being marketed to cash buyers who would presumably renovate and re-tenant them.

Since a sale strategy that dramatically limits the pool of prospective buyers is, on the face of it, likely to produce a sub-optimal outcome, you need to ask why these guys are selling.

I suspect the reason is that the current owners entered into the projects without fully comprehending the cost of renovating to modern standards in LA. Upon getting construction bids, they realized they’d rather bail out now with a profit, rather than push through to completion with a lower-than-expected yield.

So far, we’ve passed on these deals, for two reasons:

  1. Price – Every one of these owners paid a lot of money on the way in. Then, they spent a lot of money to vacate the building. Now, they’re looking for a big return, which means selling at a high price. Unfortunately for me, the prices they’re asking don’t leave anywhere near enough meat on the bone to renovate and re-tenant and get a reasonable yield.
  2. Legal issues relating to previous tenancies – The city has strict rules about vacating rent stabilized apartment buildings. While I have no particular information about any vacant property on the market, I worry that the present owners are unlikely to have followed those rules, creating risk for a new owner.

Eventually, I expect these deals to sell at prices low enough to tempt rehabbers to come in. Maybe we’ll buy some.

But I am hopeful the prices will be low enough to dissuade the original owners from repeating the process, thereby clearing the field of some of our competitors. (A guy can dream, right?)

Let’s behave ourselves

Have been stewing over the behavior of a few of our competitors, who skirt city law in order to drive up the returns they earn on deals.

All businesses are subject to some level of government regulation. For a variety of reasons, including the fact that the assets are immovable, the ownership of rental housing is probably the most heavily regulated of all.

Many owners and developers hate and fear this regulation. And they’re not crazy. Anyone who has spent time winding her way through the Kafkaesque maze of rules where LAHCID and LADBS overlap can be forgiven for getting emotional.

But we need to remember that our business exists at the sufferance of the public and their elected representatives. The regulatory environment can always get worse, particularly if bad actors cut corners and take advantage of people.

So, we need to conduct our business in a fair and above-board manner and comply with the existing regulations, while patiently making our case to the relevant decision-makers.

Cities will always need clean, safe, well-maintained rental housing. So, as long as the suppliers conduct ourselves in a reasonable manner, cities will continue to have an interest in allowing us to make a reasonable return on our investments.

Long term holds

Why do real estate private equity investors sell assets?

After all, most private owners of real estate generating really nice cashflow hold forever.

And selling forces you to either re-place the capital via a 1031 exchange under duress (eg with a short window) or to pay huge tax bills.

So, again, why do the smartest guys in the business sell?

It all comes down to the incentive structure built into the pref / promote model.

Sponsors (developers) are penalized for holding by rapidly accumulating preferred returns (eg the longer they hold the asset, the smaller their share of the eventual profit is). And their promotes (their share of the profits) are calculated based on pre-tax returns to investors, so they don’t care about the post-tax, “real” returns.

This incentive structure works well for the kind of institutional investors who back Blackstone, etc., because many of them are foundations or endowments and thus pay no taxes.

But, for an individual investor or family office, investing with a sponsor who intends to sell doesn’t make much sense.

When you have a good asset in an improving area, you put on sensible debt, and you hold it forever.