Over the years, cities, states and the federal government have created incentive programs that were designed to stimulate investment in disadvantaged, or economically challenged areas. Some incentive programs were structured as tax credits, some were low interest rate loans, while others were direct cash incentives or grants. Regardless of the structure, the ultimate goal was to help stimulate direct investment to create jobs, stimulate the economy and enhance the overall quality of life for an area. One of the most recent and successful programs designed to accomplish this stimulus goal in the Opportunity Zone.
The Opportunity Zone legislation was championed by U.S. Senator Tim Scott (R-SC), and strongly supported by President Trump. And, according to Senator Scott, there is no time like the present to accelerate and grow these Opportunity Zones. “As we work to recover from the economic effects of COVID-19, we cannot allow the patterns that emerged following the 2008 financial crisis to occur again,” Scott said. “The Opportunity Zones initiative has proven to be a powerful tool, and with these necessary adjustments, it will be a leader in helping our most vulnerable communities get back on their feet. Every American deserves the opportunity to succeed, a reality made even more imperative following COVID-19.”
The Creation of the Opportunity Zones
On December 22, 2017, Congress enacted H.R. 1, also known as the “Tax Cuts and Jobs Act” (the “TCJA”). Among many other provisions, the TCJA established a new tax regime for investments in vehicles established for the purpose of acquiring “qualified opportunity zone property.” These vehicles are referred to as “qualified opportunity funds” or “QOFs.” The tax regime is referred to as the “QOF Program.”
In order to qualify as a QOF, an investment fund will need to hold at least 90% of its assets in qualified opportunity zone property in each of its taxable years, determined by calculating the average of the percentage of qualified opportunity zone property held by such investment fund (i) on the last day of the first six-month period of the taxable year of such investment fund, and (ii) on the last day of each taxable year of such investment fund. Qualified opportunity zone property generally includes direct and certain indirect interests in businesses or property located in a population census tract that is (i) a low-income community (or contiguous with a low- income community) located in a state or possession of the United States and (ii) designated as a qualified opportunity zone by the applicable state or possession and approved by the U.S. government.
In addition to the potential tax benefits to investors described below, investing in qualified opportunity zones can benefit these underserved areas, as substantial real estate investment in qualified opportunity zones can assist in creating the infrastructure and economic growth necessary for attracting new business and investments to these areas, thereby, creating a cycle of economic growth.
Qualified Opportunity Zones
Under the provisions of Subchapter Z of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), as enacted by the TCJA, individual U.S. states and possessions have nominated certain census tracts to be designated as opportunity zones (“Opportunity Zones”). Such nominated census tracts have been certified by the Secretary of the Treasury. An Opportunity Zone generally must be a population census tract within a U.S. state or possession that qualifies as a “low income community” as defined under Section 45D(e) of the Code (or, in certain cases, is contiguous to a low-income community). A low-income community is a population census tract with either a poverty rate of no less than 20 percent, or a median family income that does not exceed 80 percent of either the statewide or metropolitan area income, depending on the tract’s location. The number of Opportunity Zones designated in each U.S. state or possession cannot exceed 25 percent of the number of population census tracts in such U.S. state or possession that qualify as low income communities, provided that if a U.S. state or possession has fewer than 100 low income communities, it may designate up to 25 of such low income communities as Opportunity Zones.
As of June 2018, all 50 states, the District of Columbia, and five U.S. possessions had areas designated as qualified opportunity zones; a total population of nearly 35 million Americans live in these approximately 8,700 designated communities.
Qualified Opportunity Fund Program Need
Since the 2008 financial crisis, and excluding the recent effects of COVID-19, the U.S. economy had enjoyed a strong recovery, but the recovery has not been distributed evenly across the United States. Based on data from the 2011-2015 American Community Survey, qualified opportunity zone-eligible census tracts had an average poverty rate of over 32%; the poverty rate for the average U.S. census tract is 17%. During that same timeframe, qualified opportunity zone-eligible census tracts have lost an average of 6% of jobs while the United States on average experienced job growth. The QOF Program was created in order to spur economic investment and development for these historically underserved areas in order to rebalance the uneven post-crisis economic recovery.
Potential Tax Benefits
The QOF Program is intended to provide investors in QOFs four types of potential tax benefits:
(1) Temporary Deferral:
There are two kinds of deferral that occur:
(a) If a taxpayer realizes eligible capital gain from the sale or exchange of any property to or with an unrelated person, the taxpayer, generally, has 180 days from the sale or exchange to elect to defer all or part of the eligible capital gain from the sale or exchange by investing the gain in a QOF. Eligible capital gain does not include (i) certain gains from “section 1256 contracts,” i.e., any regulated futures contracts, foreign currency contracts, non-equity options, dealer equity options, dealer security futures contracts, and (ii) any capital gain from a position that is or has been part of an “offsetting- positions transaction.” The 180-day period for investing eligible capital gains from section 1231 property in a QOF begins on the last day of the taxable year (i.e., after the amount of long-term capital gains from such property can be determined). The amount of the eligible capital gain that has been invested in a QOF by the taxpayer is referred to as the “Deferred Gain Amount.” The taxpayer’s equity interest in a QOF that is attributable to the Deferred Gain Amount and invested in the QOF is referred to as the “QOF investment” and such Capital Gain may be deferred. The taxpayer is required to include the Deferred Gain Amount (subject to certain adjustments described below) in its taxable income on the earlier of (i) the date the taxpayer sells or exchanges QOF investment, with some exceptions (explained below), and (ii) December 31, 2026 (the applicable date, the “Inclusion Date”).
(b) Because of the deferral of the Deferred Gain Amount, the taxpayer also gets to defer payment of the 3.8% net investment income tax that applies to certain high earners until the Inclusion Date – as stated above.
(2) Step-up in Basis:
The initial tax basis of the QOF investment will be zero.
If the taxpayer holds the QOF investment for at least five years and the Inclusion Date has not yet occurred by such 5th anniversary, the tax basis of the QOF investment will be increased by an amount that equals 10% of the Deferred Gain Amount.
If the taxpayer holds the QOF investment for an additional two years (or seven years in total) and the Inclusion Date has not yet occurred by such 7th anniversary, the tax basis of the QOF investment will be increased by an additional amount that equals 5% of the Deferred Gain Amount (or 15% in total).
Upon the Inclusion Date, the taxpayer will be required to include as capital gain on its tax return an amount equal to the excess of (i) the lesser of (x) the Deferred Gain Amount or (y) the fair market value of the QOF investment, in each case as of the Inclusion Date, over (ii) the taxpayer’s basis in the QOF investment as of the Inclusion Date; immediately upon this tax event, the tax basis of the taxpayer’s QOF investment will be increased by the amount of gain so included. The deferred gain that is included by the taxpayer on the Inclusion Date will have the same tax character as such gain would have had if it had not been invested in a QOF.
(3) Permanent Exclusion:
If the taxpayer holds the QOF investment for at least 10 years, the taxpayer can make an election whereby the taxpayer’s basis in the QOF investment will be made equal to the fair market value of the QOF investment on the day the QOF investment is sold or exchanged. Generally speaking, this means that no U.S. federal income tax will be owed with respect to appreciation in the value of a QOF investment (i.e., a qualifying equity interest in the QOF) that is held for at least 10 years.
Placement or other similar fees paid by the investor are not expected to be treated as Deferred Gain Amounts invested in the QOF for these purposes.
The following illustrates the benefits that a taxpayer could receive by investing in a QOF if the taxpayer were to (i) sell stock in 2020 for $150,000 in cash, which was originally purchased for $50,000; (ii) contribute $100,000 in cash to a QOF in exchange for an interest in the QOF in 2020 and within 180 days of such sale; and (iii) sell such interest in the QOF for $200,000 in 2030 (after holding the interest for more than 10 years). This example addresses only U.S. federal income tax consequences and does not address state, local or other tax consequences.
THIS SUMMARY IS NECESSARILY GENERAL AND IS QUALIFIED IN ITS ENTIRETY BY THE STATEMENT THAT THIS DOCUMENT SHOULD NOT BE CONSTRUED AS TAX OR OTHER INVESTMENT ADVICE. ANY SUCH ADVICE SHOULD BE RECEIVED BY A LAWYER OR TAX ADVISOR.
With the hopes of COVID-19 restrictions beginning to ease across Texas and nationwide, many real estate developers and real estate investors are looking for opportunities in the hopes of an economic recovery to the devastation caused by the virus, namely opportunities that provide immediate cash flow. The covered land play (“CLP”) redevelopment strategy just might be able to fill that investment need to a T … as long as you have patience.
In real estate development, a CLP comes in various forms, shapes and sizes, but at its core, is when a real estate developer purchases property that is already producing income, yet the developer has a motivation to redevelop the property into something that can generate more operating income, the land can be repurposed into the highest and best use and, in the long term, can convert the property into an alternative use which serves a greater benefit to the community at large.
The Alternative Option – The Growth Strategy
Urban Sprawl has created countless opportunities where many developers acquire a tract of land along the outskirts of town, provided the land was in the anticipated growth corridor of the city. Why not … land was cheap, and the developer had a view that within the next five to ten years, the city or county would develop streets, sewer, water, drainage and other required infrastructure, and the acquired tract of land would soon be enveloped by development, commerce and activity. This development strategy is used quite often in all real estate investment classes … be it single-family lot development, multifamily, retail, office, mixed-use, etc.
However, what happens if there is a downturn in the economy or a slow-down in the real estate market? The real estate developer quickly morphs into a land speculator, hoping and praying that a “greater fool” will come along and purchase the land for a profit before they run out of money. Numerous real estate cycles witnessed over the past 40-years can illustrate that this identical situation plays out more times than you would care to guess. The cost of carry for raw land is extremely expensive. Between taxes, insurance, interest, maintenance, cost of capital, engineering, architectural design, land planning, city entitlements, etc., pretty soon the developer runs out of money … or at least investor fatigue sets in … and the developer and investors are overheard saying … “forget the cheese, just let me out of the trap!” So, they sell the land at a discount to live another day and to fight another battle.
The Alternative Option – The Covered Land Play Strategy
Now, take for example, the same developer is looking to develop the exact same mixed-use development. But instead of acquiring cheap, raw land and sitting on it in anticipation of the coming growth, they pay a little more and acquire an existing mobile home park on the outskirts of town. Not a sexy investment, yet the revenues from the month-to-month or quarter-to-quarter tenants, is sufficient to pay the property taxes, debt service, etc. until they are ready to start their mixed-use development efforts. This is a very simple example of a CLP. However, what if there was an in-fill site, near or adjacent to the central business district (CBD), as opposed to the outskirts of town. Does this strategy work there as well? The simple answer is … YES
A lot of planning goes into whether or not a piece of land (with an existing cash flow) is a prudent investment. It does not happen overnight as the developer is truly performing simultaneous due diligence and planning on two separate real estate projects. The first is the existing property analysis, based on the current use. The second is, of course, the long term, highest and best use of the property.
An Existing Case Study
One recent example of the in-fill, CLP is referred to as “Project Catalyst,” which is located near the CBD of Austin, Texas. Due east of Austin, between the CBD and Bergstrom Airport, is a stretch of road called East Riverside Drive. During the building boom of the early 1980s, many multifamily developers over-built student housing on both sides of Riverside Drive. It quickly became “the place to be” for the thousands of new students coming to the University of Texas. However, with the advent of the “new and improved” on-campus student housing in the 90’s, and the new Public-Private-Partnership strategy to building new amenities and resort style social life and living environment, new, closer-to-campus developments started to attract students away from East Riverside. So, along came higher vacancies, deferred maintenance, an increase in crime and all of the atrophy that one would expect in a declining and dilapidated area.
However, with all of this new development came a shortage of inexpensive land, and areas close to the CBD for new development. Furthermore, gentrification in near-east Austin (east of I35) has started to occur, and new development has replaced older, run-down single-family homes. Rents, acquisition and operating costs started to skyrocket and sitting here today, the CBD has living and office space costs that rival New York City.
In an effort to benefit from the CLP along East Riverside, the Austin-based development firm of The Presidium Group started to buy up thousands of units of these 1980-vintage multifamily properties. With a systematic approach, purchasing one at a time, they have amassed during the past 10-years over 3,000 multifamily units with an average occupancy of 96%, which aggregates to over 200-acres of contiguous land. As a result of their relatively low investment basis, the highest and best use is no longer student housing, as they now own a footprint that rivals the area of the entire CBD. More importantly, they have time on their side as the properties currently cash flow, and as a CLP, the holding cost of their larger scale, mixed-use development is minimized. This Project Catalyst development, and the overall redevelopment plan, is taking seven million square feet of land in the East Riverside Corridor of Austin, and the developer is proposing to convert it into various purposes. Class A multi-family housing, office spaces, retail, entertainment, arts and culture and hospitality are all part of the overall development plan, while there still will be a large student housing population generating income on the land as the development proceeds.
Benefits to the City
From an economic development standpoint, the city of Austin simply loves the overall strategy. Why not, a private developer is taking a crime ridden, run-down area of the city that contains a high population of homelessness, and creating a new vision which can help drive the economy, increase the quality of life and start producing exponential growth in tax revenues to fund the city’s ever-growing budget.
Now that the vision has been published in local media, others are starting to jump in. The Austin Chamber of Commerce recently was successful at winning the competitive bidding process to secure the relocation of the World Headquarters for the new Oracle Campus. Bringing over 11,000 new, high paying jobs, was a great win for the city of Austin. The location for these new jobs, is along East Riverside. Because of the vision of Presidium, without even starting an investing in its redevelopment plans, the vision has taken hold and the land values have started to grow exponentially.
PPP – The Capital Investment from the Public Sector
The leadership in each major city in America understands the benefits of economic development. If they can grow their tax revenues by adding jobs, attracting new retail sales tax, adding new property tax revenues to their coffers, etc. it enables the city to reduce their property tax rate to the citizens. As this tax rate comes down, and the citizens are able to put more money in their pocket, and as they spend the savings, it creates an exponential impact to drive the local economy. This is Supply-Side Economics at its core.
However, cities understand that economic development is competitive, and they need to fight to secure and incentivize companies, like Oracle, to bring these high paying jobs, new office space, new commerce, etc. to their area. Consequently, the economic development departments are constantly bidding on these packages and providing incentives for their relocation. In other words, if the city is willing to invest $10 million in new roads, sidewalks, greenspace, sewer, water, etc., and it benefits the target company as well as the current citizens, yet it also brings $50 million in new tax revenues, then that is a solid return on investment for the city’s capital.
There are many moving parts throughout the entire incentive process of a CLP, and the purpose of this document is not to go into how a PPP works or the myriad of tools available, but merely an illustration to provide clarity and reference. In Texas, many CLP’s have been executed successfully with the incentives provided by a Tax Increment Reinvestment Zone (“TIRZ”). A TIRZ is a special district that is created by the public sector with hopes of attracting new investment and assessed property values to areas that are in need of redevelopment. In short, as the property owners within the TIRZ boundaries pay their property taxes, a portion of these taxes are redirected by the public sector to be used to fund capital, or pay off bonds, used to help in the overall new development within the TIRZ boundaries. The property owners are paying the same tax as other areas of the city, yet the public sector has agreed to redirect and use such payments for a specific cause.
Being that there are over 200 different TIRZ districts in the state of Texas now, it is apparent that this has become a popular method to spark interest in redeveloping an area. The main goal of a TIRZ, besides simply raising interest in revitalizing the area, is to examine the potential value the land holds. Various members of local government (city, county, etc.) have different TIRZ districts under their jurisdiction, so communication with the local government is beneficial in the execution of one of these types of deals. Many times the local government wants to incentivize investment / redevelopment of certain areas that the city cannot do on its own, which is why TIRZ exists in the first place. Through finding an attractive piece of land within an existing TIRZ, or articulating the need to elected officials and communicating the development plans to the local government in hopes of their buy-in for the creation of a TIRZ, these efforts can be very helpful in causing a good development, to become a great development.
So … What is the Next Step of This Process?
Patience … Patience … Patience!
Simply put, this is a long-term strategy. Executing on the CLP strategy, is not something that you can jump into overnight, as it requires a well-thought-out short-term and long-term strategic plan. Again, the investor needs to perform due diligence on the properties being acquired, as the property owners need to look at the investment as a stand-alone investment. The investor needs to continuously ask the question of “if this is the only asset I am successful in acquiring as part of this strategy, is it a good, stand-alone investment?”
Secondly, this development strategy requires that the developer “walk softly and carry a big stick. As the CLP strategy plays out, the last ting that any developer wants if for the “cat to get out of the bag” too early. Once the acquisition process gets started, the developer must use pseudonyms or unrelated entity names, lawyers, title companies, etc. In other words, keep your mouth shut on the fact that the buyer is slowly aggregating property, and this news will start to leak out and will result in higher purchase prices for the overall development, It truly could be the difference between whether or not the economics of the large scale, mixed use development will work.
Third, the developer must have a better understanding of the goals and objectives of the city, county or other quasi-governmental entities. Ys, the redevelopment plans must be driven by the developer, but it cannot be a developer’s plan, or a mayor’s plan or a city managers’ plan, yet it must be the plan for and by the community citizens. You must have community buy-in, otherwise you will meet up with opposition in some of the most unusual places.
Fourth, you must understand the public sector’s willingness to provide incentives, and determine if there are any Capital Improvement Plans (“CIP”) budgeted over the next 5 to 10-years by your public sector partner. If there is a willingness, and if there are CIP items such as a library, school, park or open space, amphitheater, stadium, convention center, convention center hotel, etc., etc., then this can help with your overall land plan and design. If the public sector intends to floats bonds or allocate resources into one of these public sector projects, then perhaps it can be relocated and serve as a public-funded asset and anchor for the ultimate development.
Finally, you must have patience! Patience to prepare your strategic development plan … Patience to slowly and quietly acquire your multiple properties … Patience to negotiate with the public sector … Patience to diplomatically engage with the community and gain community support for the overall development.
You may have heard the term “value-add investment” before when referring to real estate, but what exactly is this concept? How does it work? What are some of the tools you need to be successful?
Value-add investments are an innovative process that combines the different elements of arts and science. In simple terms, value-add investments are properties that require improvements in order to increase its overall value. These plans typically target properties that have in-place cash flow, but over time seek to increase that cash flow by making improvements to reposition the property, thereby increasing revenues or reducing operating expenses. In order to maximize this opportunity, a plan to raise rents or reduce expenses must be in play to make up for capital investment in the property itself.
There are many properties that are in distressed or rundown conditions because many owners don’t have enough capital to make these improvements or have reached a point of obsolescence to where they don’t care to improve the quality of their properties. Much of the success behind value-add investing requires a vision along with creativity in order to truly uncover and understand the potential an asset could contain. The investor must also have a strong plan and discipline to successfully carry out their investment goals which maximizes results. Although this “value-add” concept has been around for a very long time, value-add investments have been dominating the multifamily markets as it is clear that there is a huge trend reflecting the idea that residents are willing to pay higher rents in order to improve their personal living experiences.
Many times, the capital improvement made to the property is of a size and amount that the owners would choose to capitalize the improvement from an accounting standpoint. However, it is not uncommon for the owner to actually expense the improvement in an effort to secure the tax write off in the current period. In the event the property owner elects to expense the improvements, they will generally see a reduction in net operating income for the short-run, yet will see a material increase once the improvement are completed. The following is a visual example of such an expense treatment:
These charts are supposed to show how NOI may expectedly drop, but then recovers into a state of stability and smooth growth. This leads us to believe that this goes hand in hand with the unit renovation schedule.
Value-Add Categories of Opportunity
While there is a plethora of opportunities that “add value” to multifamily properties, each strategy being dependent on the market or property, they are usually focused in one of three different categories: operational enhancements, capital improvements and total repositioning.
The first category, operational enhancements, are usually the most common in under-managed properties. Oftentimes, they also require little or nominal capital investment. Enhancements to property management can drive some of the quickest improvements in net operating income. Some examples of operational enhancements include reducing expenses, raising rents to meet market level, and enforcing fee income policies, such as pet fees or late fees.
Capital improvements can be extremely crucial as they increase the attractiveness image, curb-appeal and overall desirability of the property. Although this potential revenue source can take place in many shapes or forms, the most impactful and measurable are properties that undergo interior improvements. An example of a capital improvement can be kitchen or bathroom upgrades that can increase the appeal … and rental rates … of an older or vintage apartment property.
The final category is total repositioning. This strategy evolves around the idea of transforming a community’s marketability to appeal to more affluent residents. This category is especially unique as it combines aspects of the other two categories, operational enhancements and capital improvements. To give an example of total repositioning, you can utilize the expiration of a Land Use Restriction Agreements (LURA). When a LURA related to an affordable housing property expires, rent restrictions usually fade away or altogether are eliminated, thereby allowing the property owner to increase the rents to standard market levels. This can trigger resident turnover, which ultimately leads to higher-income clientele, elevated property valuations and overall enhanced identity of the property.
Finding Success in Value-Add Properties
When looking to be successful with a value-add investment, it is important to choose renovation opportunities that potentially have the most embedded upside profit potential. Properties that are viewed as older, uglier, in disrepair, mismanaged and generally unsightly have the potential to be more profitable. In other words, you have a greater incremental increase in value when taking a D- property to a C, that a C to a C+ property.
It is important to find a property that may not be the most aesthetically pleasing, but has no structural issues. Then, you must rehab it and reposition it within the micro-location and market in which it serves. If the specific property is substantially more unattractive than other properties in the market, and there is significant room to raise the rents once the property is renovated, then that is worth investigating further. In simple terms, this strategy can best be defined as “ugly with good bones.”
Instead of taking the rent roll of the entire property and forecasting how much each individual unit will require in terms of renovations to predict the available rent premium, there is a smarter and more efficient way to execute this process. The whole idea is that a property owner has a bunch of apartment units that produce an aggregate cash flow. Based on this approach, this bundle of units can be viewed on a hypothetical average basis, that commands a certain average rent. Because all the units in an apartment start from a similar level and end up at the same state, it makes more sense to utilize an average renovation budget per unit, along with an average monthly rent premium, when determining the cost-benefit analysis.
Embrace the Change and Become an Early Adopter
Abraham Lincoln once said, “The best way to predict the future is to create it.” And there is no industry where that is truer than in the real estate industry. After all, you can control the location, the asset class, the architect, the general contractor, the target market, the capital decisions, the tenant mix. You control everything … right? Or do you?
When one thinks of a “disruption” in an industry, they generally think of a new technology or a new “start-up” as the disrupter. Therefore, something as mature and stable of an industry as real estate, one would think, should be immune from shockwaves caused by these disruptions and “new ideas.” However, in the current and uncertain times in which we live, nothing could be further from the truth.
Predicting the future, when it comes to real estate, is essential to success in the field. Although there is no crystal ball when it comes to real estate, it is important to sit back, analyze, and think outside the box when it comes to a list of predictions of the major things that the industry should focus on in the coming years. These items range from impacts caused by demographic, psychographic, pandemic, economics, geopolitical and many other trends and impacts caused by the “new normal.”
The Corona Effect
Yes, we have to talk about it… As we have all learned this year, life can be very unpredictable. Normal life has been flipped on its head and has tested everyone. One of the effects on real estate has been the movement out of office space, ostensibly for social distancing purposes, but what does this mean for the future of office buildings … and their tenants. Yes, technology has advanced to enable everyone to be connected, whether they are sitting at their desk in an office or sitting at their kitchen table. Plus, many folks are seeing the benefits and efficiency of zero commute time, a more efficient workforce, lower facility cost, etc.
While right now it seems like a short-term reaction to the pandemic, this is a trend that will, most likely, not die soon. Many major companies have already started to permanently get rid of their office space and move to remote working arrangements. British Petroleum, for example, is in the process of permanently shifting almost 50,000 employees towards remote working and flexible workplace layouts over the next 24-months. So, it seems like office space is getting ready for a shock as existing tenant leases come up for renewal. The prognosis is that office vacancies will grow, and rental rates will be stagnant or decline.
As for retail, the International Council of Shopping Centers (ICSC) has historically cautioned retailers that digital technology will have an affect on the brick and mortar sales, but, what the ICSC did not see coming, was the large amount of tenant defaults, bankruptcies and downsizings that were as a result of the government-mandated closure of many retailers. So, what this means is that many retailers that once never thought a certain center or location was in their price range, now have the ability to negotiate from a position of strength with these desperate landlords that are now looking to fill vacated space. The prognosis is that retail vacancies will grow, and rental rates will be stagnant.
But not to fear, there is still need for other forms of traditional real estate, in particular commercial and multifamily real estate. There will still be some demand for office flex space, along with increased demand for industrial spaces as constraints are put on the supply chain. Furthermore, there will be increased demand for assets such as fulfillment centers, cold storage and dry storage for online ordering, and additional factories as popularity of onshoring sweeps the nation. The prognosis is that demand for the industrial, storage and fulfillment facilities will grow, and rental rates will escalate.
With respect to multifamily, the current economic forces have had an impact on the incomes, livelihood, and savings of many citizens. As a result of this, and in particular for middle class America, it appears that many of these folks will continue to stay in a rental pool for the foreseeable future. The prognosis is that the demand for multifamily will remain high, and due to the effects of Covid-19, rental rates will remain flat, until clarity is reached for future employment outlooks.
A note about Covid-19 when it comes to the residential sector is that people have learned that their home (whether multifamily or single family) matters … a lot. Months on end stuck in the house has led people to question their current living conditions. And to go along with the shift away from offices, private designated workspaces in homes or apartments will be more important. People will be spending more time at home and as a result, spending more time inside the home. For these reasons, people are now be looking for larger residential units with private office space and as much yard as they can get.
Another underlying impact of Covid-19 is that people have also learned to appreciate public outdoor spaces a lot more. Parks and other outdoor areas have become a very important commodity. Access to outdoor amenities will feature more prominently in the future of real estate, whether we are talking about private communities, commercial spaces, or urban planning. While Covid-19 is temporary, its effect on the world, and impact on real estate, will be felt for decades to come.
International urbanization is the name of the game. Cities have been, and will continue to be, welling across the fast-growing countries in Asia, Africa, Middle East, and Latin America. Along with that, developed western nations will continue to urbanize. By 2050, urban populations are projected to increase by 75% to 6.4 billion, from 3.6 billion back in 2010. China will be leading the way by moving 70% of their population, about 900 million people, into cities by 2025. Asia will be the fasted growing region, with sub-Saharan Africa right behind.
Populations are rising and the United Nations has stated that by 2050 the world population will be 9.8 billion, up from 7.8 billion in 2020. The need for living space will be highly in demand for both the emerging markets we have already looked at, but also already established markets in the west such as cities like London, who’s population is forecasted to rise to 10 million by 2023, from 8.9 million today. Along with the growth in population, the middle class will rise by about 180% from 2010 to 2040. Global construction output is expected to almost double to $15 trillion USD by 2025. Also, by 2025, emerging markets will host 60% of global construction activity. China, United States, Indonesia, Russia, Canada, and Mexico will account for 72% of expected construction activity.
Public Private Partnership
The economic implications of Covid-19, and the ability for cities to maintain consistent sales and property taxes, will ultimately have an impact on the revenues and capital budgets of municipalities. Consequently, these municipalities will be searching for additional ways to advance economic development efforts and encourage development in their respective cities. Going into this new age of real estate development, working in partnerships with government bodies, will be very important. Not only will the investment community need in-depth knowledge of local economies, but also, they will need to navigate opaque planning laws, access to governmental incentives and to work in partnership with the government and to make sure their strategy is aligned with the private sector. Governments are going to want construction and economic development in their cities and will be looking to collaborate with private developers.
The advent of the “sharing economy” has made an impact on several industries ranging from Ridesharing, to co-working to vacation rentals. But what about a “co-living” trend? While it might seem like something like a commune or a kibbutz, co-living has become one of millennials favorite ways to live. The idea of co-living is to create a cost-effective environment for likeminded people to live and work.
People rent individual rooms, but share common areas such as a kitchen, living room, recreation area and outdoor space. This allows for the individuals rental cost to be lower as common areas are a shared expense, and the stress of setting up a new home is eliminated. Another desirable aspect of the “co-living” space is the social opportunity of meeting and living with others with similar interests. For whatever reason they choose, co-living is a growing lifestyle for the younger generation. While it has started to take off in the United States, other areas such as Asia and China have already fully embraced the idea.
A great example of an early-adopter is Ziroom. Ziroom is a co-living style apartment building that has properties in nine of China’s major cities that total over 1 million bedrooms. Ziroom already has over 1.2 million residents that have embrace the concept. The rooms that they offer range from around 100 to 300 square feet and come with the many shared spaces including coffee shops, bars, gyms, libraries and relaxing spaces such as rooftop greenspaces. Ziroom has already seen much success and has made the idea of co-living “cool and desirable.” The trend of co-living seems like it will continue to spread through Asia, while it becomes a mainstay in living in the west.
Technology in Real Estate
Blockchain is here and it is not going away. If you are not yet familiar with blockchain, here is a short explanation: at its most basic level, blockchain is literally just a chain of blocks. Blocks store information about transactions like the date, time, and dollar amount of transactions. In simple terms, it is a way to store transaction information in a decentralized data base. Real estate transactions are, for the most part, conducted in offline engagements and transactions. Blockchain has opened up a way to change this in the future.
The introduction of smart contracts in blockchain platforms now allow assets like real estate to be virtually “tokenized” and be traded like “cryptocurrencies.” Because of this, blockchain could remove the need for Brokers, Lawyers and Banks. Blockchain can assume functions such as listings, payments, and legal documentation on a real-time basis. Cutting out these intermediaries will result in buyers and sellers getting more out of their money, as they save on commissions and fees charged by third parties, and also makes waiting periods caused by human delays and interactions non-existent. All of this could lead to a more inexpensive and efficient way to buy and sell property without dealing with banks or other slow processes.
A future with A.I. We have all heard of Artificial Intelligence and have seen it implemented in many different parts of our life such as smart cities, big data mining, Siri, Tesla, Alexa, etc. The future of A.I. is very bright and its limits are endless. As of now humans have just scratched the surface of Artificial Intelligences uses. As for real estate, there are already opportunities to use A.I.
Machine learning can help with property management by detecting suspicious spikes in energy use by analyzing weather data to give managers ways to save money. As for selling homes, A.I. can find homes that clients would like, much faster and easier than any human. With an input of data, it can use algorithms to determine every listing that falls into predetermined categories. It can learn more about the client and use A.I. to determine brick colors, appliance, layout designs, size, yard, etc. In the future, home selection, commercial site selection, etc. will be a far more accurate and quick process with the use of A.I. Those who use this technology will be able to anticipate rent, expense, and sale price fluctuations, or identify the perfect timing for selling property to optimize returns. Real estate, as a whole, is normally late to innovations. Being a first adopter to these new technologies will give you a true advantage.
Embrace the Change – Be an Early Adopter
In the coming years, the real estate space will be seeing some major changes. Yes, there will be some difficulties, but by and large, many great new opportunities will exist. The key for the coming decades will be to embrace and be a first adopter to change. With these advances happening so rapidly, what would have been months behind in the past, will now be equivalent to years behind in the future. New innovations will happen at an even faster rate, and if you do not adjust fast enough, you will be left in the dust. So, go out there and create a better future for yourself!
The concept of privatizing public services has the ability to create skepticism and controversy among the laymen. However, public-private partnerships (PPP) have been part of the fabric of American history since its inception. Simply put, a public-private partnership occurs when the public sector (the government) and the private sector (business or private entity) enter into a partnership in order to achieve a goal – either providing a service or engaging in a project. There have been countless examples of such partnership dating back to the Age of Exploration when new routes were discovered by daring explorers, to recent times when waste management, water, and other public services are provided for by private companies. This type of partnership is what has allowed humans to continue making progress, as it relies on the expertise of a private organization to get specialized work accomplished while the governing bodies can ensure their constituents will be entitled to the benefits.
Public vs. Private Good
“Public Goods” are defined by two characteristics – “non-excludability” and “non-rivalrous” consumption. This means that it is a good or service that generally is not performed for a profit, can be used by a number of people at the same time, and is not hinged upon payment consideration. An example of this would be the number of public services including national defense, police, fire, public safety, national parks, etc. On the other hand, “Private Goods” are the exact opposite. This means that a profit motivation can be realized, and that the good or service is based on expected payment. An example of a private good would be any consumer goods for purchase such as a sandwich or a candy. Of course, like most things in life, the line between private goods and public goods is not always clear. In fact, the following graphic provides a strong analogy for how things are often more complicated than initially perceived. Just as the colors commingle, there are opportunities that arise for privatization and public-private partnerships to add value to all parties involved.
The most basic type of public-private partnership occurs when a government agency outsources a specific function – whether operations, management or maintenance – to a third party provider. Outsourcing in this way allows the public to benefit from a particular private company’s expertise, competitive bidding, economies of scale, etc. in a given area, without necessitating that the representative government become an expert in that same area. In general, this allows government entities to maximize utility and efficiency for each taxpayer dollar spent.
Many progressive cities are now reviewing the list of services and determining if they can reduce overhead, while ensuring that services are performed for constituents. In the past, many cities would take the position that the public sector was there to perform the services that the private sector would not or could not perform. This might be correct for services such as police or fire. However, other services once viewed as solely public sector are being looked at in a different light now that the private sector has created a public-private industry.
In this regard, most citizens turn on the water and assume that the city is responsible for its taste, clarity, and odor – especially since they typically receive a water bill from the city. Likewise, since a wastewater charge is included in the city’s water bill, citizens assume that the city is providing that service as well. However, just like with solid waste management, these services are undertaken by a private company that the city enters into a contract to collect the solid waste, manage water, treat the wastewater, etc. The city does not sell any assets, and they generally maintain the ownership of the pipes in the ground as well as the wastewater treatment facility. Additionally, they still own the water or other groundwater rights within the city.
Simply put, municipalities have proactively been seeking partners to help provide basic services in order to free up resources and concentrate on expanding their municipalities. They are no longer simply in the business of providing the services of water, wastewater, tax collection, etc., although they maintain responsibility and control through outsourcing. This means that instead of the city manager or mayor worrying about compliance with EPA or state environmental quality issues for the water, they can now devote this time to unifying a community over controversial issues, driving economic development, enhancing public safety, or outlining a plan for the city’s future.
PPP Financing Mechanisms
For a developer, the advantage of entering into a partnership with a public entity is that it decreases the developer’s risk by filling in financing that would otherwise need to be covered by a developer’s own investment in a project. Therefore, a developer can minimize the firm’s exposure and maximize the internal rate of return through this type of partnership. While not all partnerships are equal, working together to forge a public- private partnership could lead to a win-win scenario for both the public and private entities.
Most importantly, by creating this partnership, the private entity then gains access to additional public finance resources that can help to cover different aspects of a project’s costs. Combining several of these sources can add up to a substantial sum. The keys to this method are (1) creating the partnership; (2) well-defined project perspective, objectives and goals; (3) detailed agreement between the public and private entities; (4) creative thinking in matching up existing public funding with the needs and qualities of the proposed project; and (5) willingness of each partner to help meet the other partner’s needs. Though there are various financing mechanism available, the following list highlights the several major types utilized for real estate-specific assets:
Tax Increment Financing (TIF): The most frequently utilized mechanisms in PPP earmarks estimated increases in property and sales taxes in a designated geographic area (a “District”) to underwrite public improvements related to development in the area. This can be done by creating a quasi-governmental body which manages the TIF by issuing bonds to pay for the public improvement. These TIF Bonds may then be issued and repaid with the incremental increase in taxes to be realized and captured within the TIF District. Often, the area designated as the District is considered to be unimproved, blighted or underdeveloped.
Payment in lieu of tax (PILOT): In a PILOT program, the developer shifts ownership of real property to a tax-exempt entity, such as an industrial development board. The developer then agrees to make a payment to the tax-exempt entity in an amount that the developer would have been required to pay were the real property not tax-exempt. The tax-exempt entity then uses the PILOT payment to fund the construction of public improvements within the development. As with TIFs, a PILOT can also involve a bond issuance.
Public Improvement Districts (PID): Also known as Community Improvement District (CID), or a Municipal Management District (MMD), a PID/CID/MMD is a taxing entity which can finance, construct and maintain public improvements. A PID may be formed to address any type of public improvement or service. It has authority to issue debt and impose a mill levy against real and personal property within the district. PIDs are typically empowered to finance infrastructure such as sidewalks, streets, water & wastewater lines, bridges, and drainage improvements.
Community Development Block Grants (CDBG): Designed by HUD to provide communities with resources to address a wide range of development needs, the CDBG program provides annual grants on a formula basis to local governments and states.
Tax Exempt Financing: Due to a number of legislative initiatives over the past decade, several areas across the country have been designated for tax incentives, including tax- exempt financing, as part of redevelopment. These zones allow for tax-exempt bonds to be issued in support of redevelopment projects. The most recent examples are the Opportunity Zones that have been established by the Trump Administration.
Tax Credits: Tax credits exist on local, state and federal levels, and can be combined to increase the equity in any real estate development project, as well as to reduce the exposure of a developer in a given project. They take many forms, and are targeted to achieve different policy objectives, such as economic development of low income areas, brownfield rehabilitation, or energy efficiency.
Environmental Grants/Underwriting: An area of underwriting that exists to assist developers in creating environmentally friendly projects. Including green space in a development and maintaining wildlife habitat can potentially qualify a project for federal funding that is administered by state wildlife agencies. Some programs that could potentially qualify for funding include reclaiming waterways, protecting woodlands, preserving natural habitat, creating energy efficiency and coastal preservation.
Case Study: Sugar Land Town Center
An example will illustrate the economic benefits of a Public-Private Partnership, giving particular attention to the general economics of these successful developments, by comparing “traditional” economic structures with only private equity to those that include a public sector capital contribution as a result of a public-private partnership.
Sugar Land, Texas utilized a public-private partnership to develop its mixed-use Town Center, contained on 32-acres of land, and summarized as follows:
Below is an analysis of what the Sugar Land Town Center development would have looked like without public incentives. This structure will be called “traditional” as it is compared to a public private partnership.
Based on current revenue, expense, and market valuation techniques, the following is the anticipated value and internal rate of return on the (traditional) equity, assuming that the assets were sold roughly four-years after the start of construction:
Following the repayment of the traditional debt (70 percent loan-to-cost) the net cash flow from the sale of this development would yield roughly $89 million. Based on the initial (traditional) equity investment of $56 million, this return, over the four year investment horizon, equates to approximately a 17 percent internal rate of return. For a traditional real estate investment, particularly one that requires $56 million in equity, that is not that attractive of a return, after adjusting the investment for risk.
For many real estate equity investment funds, a minimum threshold for internal rate of return should be 30 percent – far above the 17 percent in the above “traditional” equity structure. Consequently, since there may not be any room for cost or expense reductions, or even revenue enhancements, the only way to increase the internal rate of return would be through leverage.
This leverage was found through a partnership with the city of Sugar Land, as the city had a desire to see the development succeed for a variety of visionary reasons. Indeed, the plan met the public sector’s desires to shape its future and achieve a particular vision of what life should look like for its citizens.
Thus, the financial structure of the development under the public-private partnership was as follows:
For the developer, the city’s contributions made a significant positive impact on its internal rate of return. The capital structure, including the impact of these incentives was:
As a result of the city’s incentives, the developer’s equity investment was reduced from $56 million, to $34 million.
Following the repayment of the traditional debt (70 percent loan-to-cost) the net cash flow from the sale of this development would yield roughly $89 million. With the developer’s equity investment of $34 million, over the four year investment horizon, this finance structure results in approximately a 37 percent internal rate of return.
Due to the city’s incentive package, the developer was able to increase the internal rate of return from 17 percent to 37 percent. Consequently, the finance structure under the public-private partnership for the Sugar Land Town Square development made the project economically feasible solely as a result of the incentive package offered by the city.
What does all this mean? Municipalities are beginning to craft their own visions of what they want their futures to look like – from small towns to large cities. Often times, these vision statements are paired with development incentives or economic development funds that aim at facilitating the realization of this vision. This rings to be even more true when the typical cash resources become limited during questionable economic times. Public entities will look to lean into more PPP’s, to help continue development and growth in the communities. For the private organizations that participate, benefits will be apparent as the Public contributions usually come in form of a grant which doesn’t need to be paid back or cause dilution in ownership. Both of these benefits shave a direct impact on the return developers can produce for their investors. However, these project’s success is usually heavily relied upon the strong relationship forged over years of working together between both private and public sectors. Organizations with these relationships will not only get the opportunity to thrive even in concerning economic climates, but also enable both sides of the table to utilize their strengths to move the needle on human progress.
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Will COVID-19 Create a Real Estate Crash…. Mitigating Risk Through Multifamily Development During A Down Cycle
With Covid-19 redefining our idea of the word “normal” and affecting all areas of life in terms of elbow bumps instead of handshakes and questioning our economic recovery, we are playing the long game. Just like the pandemic, the nature of real estate is intrinsically a long-term investment. Aggressive allocation of funds for a “quick return on investment” is not how real estate experts play the game. Therefore, we can investigate what it is that will keep you safe investing in real estate during this interesting time, and how the pandemic may actually be a source of opportunity.
Many people’s jobs are being shuffled around, and some are left unemployed, some are furloughed, and the sources of income have been reduced. This has encouraged many people to turn towards renting multi-family housing, rather than making their desired home purchase. Despite these volatile and unforeseen circumstances, people will always need a place to live and this is why we have seen a surge in demand for multi-family housing during Covid-19 times.
I would like to strongly preface this by acknowledging the fact that we are uncertain as to what the future will hold as a result of COVID 19 or any other natural disasters. We have already seen the impact that the last several months has had on people’s income, equities, world stock markets, fixed income asset values, alternative investments, etc. However, I would remind you of the white paper that was prepared on the benefits of investing in fixed assets such as real estate during these “inherently risky times.” I stand behind the proposition that now is a good time to invest in real estate for the reasons stated therein.
With the foregoing caveat, there are no predictions right now that a real estate crash is on the horizon. In fact, in a recent article from Forbes Magazine they discussed the Darwinian effects of the COVID pandemic on real estate.
According to the Forbes article, “Every economic crisis is intrinsically Darwinian, producing winners and losers while shifting the natural balance of power.” It continues with “There are no simple answers. Opinions and models run rampant on how fast the economy will re-boot. Few economists believe that we’re in for the brutal elongated “U” that America experienced through the Great Recession. Most predict a more rapid corona “V”, especially for manufacturing and retail, pointing to the speed with which businesses and factories have re-opened in China and South Korea.
Buying a house, however, isn’t the same as turning the Frappuccino machines back on, or pulling the trigger on a bigger flat-screen TV in case we’re locked down again. Housing is an emotional, big ticket game, inextricably linked to macro-level downwind pressures on employment, wages, job mobility, the stock market, and ultimately, consumer confidence—whose quick resuscitations are still far from certain.”
There will be losers (single family residential real estate, hospitality, retail strip centers, malls, shopping centers, office, etc.) For the reasons outlined below, the multi-family, residential class, will be a winner. People will always need a place to live and if they cannot afford to buy a new home due to reduced income and wealth, then they will need to rent.
According to Bisnow, “The National Multifamily Housing Council’s rent payment tracker showed that 94.6% of rent was partially or fully paid in April, 95.1% in May and 95.9% in June, as reported by more than 11 million professionally managed market-rate apartment units.” The CEO of Nitya Capital, Swapnil Agarwal, spoke about how “people are starting to see how recession-resilient multifamily assets are, and what that’s going to do is really increase the demand for multifamily assets going forward… [He expects] in the next two to three months, the debt market will become very active, and as soon as that happens, there is a lot of equity being raised and just sitting on the sidelines.”
Not to mention the normalization of working from home to follow “stay at home” orders and to practice social distancing; people are in need of homes, multi-family complexes standing at the forefront. The real estate market currently makes up about 6.2% of the U.S GDP. This statistic highlights the reign of the real estate industry and showcases how, regardless of any external factors, real estate always returns to a happy equilibrium.
I am not underestimating the implications that come along with real estate at this time, such as project timelines being pushed back due to safety precautions and the hesitancy of potential investors. The psychology behind potential investors has shifted entirely, creating a sense of additional speculation before they would think of investing at this time. However, what many people don’t consider is how this introduction to a new world could be framed to work for you, as long as you take the steps necessary to carefully invest in properties that mitigate investment risk. These are things that, pandemic or no pandemic, real estate experts are prepared for in this industry, and I would recommend that you implement the following to mitigate risk during a down cycle and protect investor capital:
(1) Investing in properties with cash flow in mind – Do not be a speculators. Your investments should have plenty of cash flow being generated from the property. For any buy-and-hold investor, it’s all about this steady income, and not so much about rapid, forced appreciation and a quick payout. While that’s certainly an effective strategy for quick wealth-building, it’s not the best choice when the focus is on investments designed to last during a market crash. To insulate against such a crash, I want an investment that performs for the long-haul, month after month.
(2) Don’t buy properties that rent too high – I do not want to have the highest rental rates in the market. One of the things that past crashes have taught me is that people just don’t have money to spend on high rent during these times. Part of every paycheck will need to go toward housing, of course, but they’re not going to put more of that money toward it than they need to. Times are too tough for that during COVID 19, an economic crash, etc.! So this is when it pays to have a property that rents are at or below the median, rather than above. Those high dollar units are going to be the first to be vacated during a crash, so we target properties with median rental rates.
(3) Handling mortgages correctly and reduce debt – Do not over-leverage your properties, but use this economic downturn to capture some of the lowest interest rates in history. Having too much debt can spell disaster in a crash climate, so make sure you are securing amortizing debt and paying it down as quickly as possible. I realize that some people don’t share this philosophy, as financed real estate can be used as leverage to purchase more properties. However, I don’t think massive amounts of debt is ever a good idea, especially if the economy is struggling.
(4) Avoid properties that require major remodeling unless they are part of a specific value-add, redevelopment strategy. Unless a company has a tried and true value-add strategy to boost investments, searching for properties that are in need of a makeover is not the ideal path to travel down right now. Thankfully, the value-add strategy is designed to secure an exponential growth in value based on smart, strategic renovations. Additionally, this is the same method I would have recommended pre-Covid. I don’t acquire properties with significant deferred maintenance, but if I can invest $1, and by increasing rents, reducing expenses, and other strategies, I can get a $3 or $4 increase in value making it is a wise investment. Generally, properties in need of work on deferred maintenance fall below market value, which is the exact opposite of what you want during a crash situation. Unless you’re an investor who’s experienced with renovation and value-add work, it’s safer to buy properties in good condition that don’t have a lot of deferred maintenance.
(5) Diversification of assets. I cannot stress diversification of assets enough. Even if the strategy is narrowly focused on multifamily assets, the diversity within this class could range from independent living, age-restricted senior housing, market-rate traditional assets, attainable housing, value-add existing assets, differing geographic markets, differing product type (wrap-product, garden style walk-up, etc.), etc. One of the best ways to be protected in the event of a real estate crash is to make sure that our investments are diversified. Having investments with a variety of market backgrounds and types of properties is essential to mitigating risk.
(6) Analyzing “Macro-Location” Market Data. Only invest in cities that have a growing population, specifically from people migrating from other cities. These cities are typically a safe investment since jobs are increasing, and demand is likely to remain consistent. Generally, I am looking for a steady increase in the level of median household income. Typically, the formula is a 3 % increase in median household income for every 2% growth in population. This data point supports the growth in population and reiterates a sound economic foundation for your investment. Of course we focus on other “micro-location” factors such as vacancy rates, competitive set details, crime statistics, new construction, etc., but I always focus where a “rising tide of population will lift all boats.”
I am informing you of this because things are looking pretty attractive for multifamily real estate investors, contrary to popular belief. I have been studying the issue of potential economic downturn, continuously examining our situation to make sure that from a fiduciary standpoint, you should be always prepared for a crash.
We all remember what happened in 2008, and while I don’t foresee a burst housing bubble event recurring (namely because banks and other lenders have changed a lot of their lending policies since then), there are other ways an economic downturn can affect us. I don’t know when and what will precipitate it, but history has shown that we are doomed to repeat crashes, which are a normal part of the economic cycle.
Rather than praying such events do not occur, the competitive advantage includes being extremely selective with where you should invest through the 6-Step Model on how to Mitigate Risk. I believe that this approach, combined with this investment strategy, can help to mitigate risks during a down cycle.
Remember, just like the pandemic, the nature of real estate is intrinsically a long-term investment. Use this investment strategy to keep you safe in real estate and to recognize that multifamily truly will represent the “survival of the fittest.”
To read more from David G. Wallace see the rest of the blogs on the website.
COVID-19, or coronavirus, is an epidemic that has put the entire world under lockdown; shaking the foundations of the global economy and bringing down with it, people’s livelihoods. However, what the virus also brought was a tsunami of change. While this pandemic is something to be feared in terms of a health, economics and society, this change also brings an inherent, albeit unexpected, opportunity for those who are daring to ride the new waves.
As a consultant working with real estate developers whose focus is to build on the attainable housing model in the state of Texas, I am recommending that folks lean into the COVID Storm by adapting to the new environment and taking advantage of any unforeseen opportunities. While some see nothing but headwinds from the storm, I see these winds as a potential lift into the future and beyond.
The Attainable Housing Model
In its simplest form, the “Attainable Housing” model is the use of econometric data that analyzes over 30 open-source data sets in which to determine the exact census tract for a multifamily product. Through lower land prices, prefabricated construction methods, the temporary reduction in producer price index components and the near-record low interest rates, a developer can construct a high-end, Class-A multi-family product, yet places its product in a middle-class America Census tract, and can therefore thrive and profit on middle-class rental rates due to its reduced overall costs.
Infamous bank robber Willie Sutton was once asked by a reporter “why do you rob banks?” His reply, of course, was “that is where the money is.” In a similar fashion, the attainable housing model places its high end, lower rental rate model into the census tract that has the precise average household income, educational attainment, employment rate, growth trends, demographics, etc., and to place the product in the largest universe of renters possible … middle-class America. Some economists suggest that middle-class America, based on average household income and other data points, represents nearly 60% of all Americans. And, as a result of the current economic issues associated with COVID-19, there is little doubt that middle-class America just got a little bit larger.
Home Buying Impact
The largest single asset purchase that most Americans will ever make, is their home. However, due to the recent stock market decline of roughly 30% due to COVID -19, the average 401k value has dropped by 19%, causing heavy financial damage to people’s retirement as well as a potential source of equity for their home purchase. Although there has been a bit of a rebound in May and June, the consumer confidence has been shaken and many people have decided to sit on the sidelines instead of going out and making that large investment in buying or building a new home.
Furthermore, the headlines are riddled with the announcement of company closures, bankruptcies, jobs being furloughed, people being laid off and, in short, people losing their ability to qualify and pay for a new mortgage. It is hopeful that this growth in unemployment is merely a temporary situation, yet all of this has shaken the consumer confidence and the ability for people to invest in and purchase their new home.
According to the president of Cleveland-based TSL Consulting, Tom Malfa says that he forecasts that “home prices will drop 20% to 30% over the course of this calendar year.” It is uncertain as to whether or not that drop in home prices will actually occur, however, the demand curve will obviously be blunted due to the lack of liquidity brought on by the stock market drop, combined with the chilling effect of the drop in the Consumer Confidence.
“Already, experts are seeing slowdowns in home showings — which are now largely done virtually — and expect that permits for new construction might also drop.” Quotes similar to these are being written every day in dozens of articles nationwide … this one attributed to The Texas Tribune. Unemployment is high in every part of the globe. The massive loss of employers leads to the closure of many businesses. Another example, the Innovation Map, explains, “The analysis, published April 2nd, indicates business closures in Harris County — which represents two-thirds of the region’s population — have caused a 27 percent drop in the county’s daily economic output.” The senior vice president of research at the Greater Houston Partnership Patrick Jankowski, “anticipates the Houston area tallying job losses of at least 200,000.”
However, this does not mean that people are unable to work, as most essential retailers such as Walmart are still hiring and offering jobs to middle-class America. Walmart recently committed to hiring more than 150,000 new associates by the end of May. Since then, Walmart has had over 1 million applicants, hiring an average of 5,000 people per day. In addition, according to industry relationships and friends, they have seen little to no decrease in work demand and pricing in licensed professionals (architects, engineers, surveyors, etc.) in the past quarter, and hardly any drop for Skilled Trade Workers (electrical, plumbing, HVAC, etc.).
Although the most recent macro data is encouraging in that it shows that supported by lower interest rates, mortgage applications for house purchases have surged and are now running above their pre-virus rate and up by 2.7% year-over-year in May, it does, however, reflect that those home purchases are concentrated among older, wealthier individuals, who are less likely to have been laid off in recent weeks and who are more likely to have accumulated a pot of savings during the lockdowns. Consequently, such a “V” shaped recovery is unlikely to be replicated across the entire economy.
And with physical distancing likely to be required for the foreseeable future, there are still some industries that will simply not recover providing credibility to the idea that the residential housing market will stage only a partial recovery this year.
The Perfect Storm
The universe and size of the ‘renter pool’ is growing due to the void in home purchases, lack of liquidity, unemployment trends and the consumer confidence has chilled the enthusiasm of people wanting to rush out and make an investment in a home. Consequently, the psychographic impact of the current environment is forcing people to continue to rent.
The Pew Research Center defines middle–class or middle–income households as those with incomes that are two-thirds to double the 2018 U.S. median household income of $63,179 (per the Federal reserve of St. Louis). According to this formula, Pew would determine that middle–class Americans have median household incomes ranging from approximately $41,698 to $126,358. As a result of the lower average household income, due primarily to an increase in unemployment and first-time recipients of federal assistance, “middle class” America just got a little bit larger due to COVID-19.
However, in terms of construction, the largest single two line-items of a real estate development generally are the “Hard” Construction Costs and Interest Expense. Looking around, it is apparent that goods such as gasoline, cars, entertainment, hotels, cruises and airline tickets have become cheaper. This is also true for material goods, or “hard” construction costs. According to the Markets Insider, there are visible drops in prices for wood, metals, and oil and natural gas.
What this means for those in construction and manufacturing, the cost of raw materials is significantly cheaper, thereby resulting in a better opportunity for those who wish to develop and build assets like multifamily housing. According to an article from PNC Insights, “Overall, the cost of materials used to build multifamily housing had been expected to rise somewhat more than the rate of inflation overall in 2020, after rising just 0.7% in 2019, according to the ACG’s analysis of the Producer Price Indexes kept by the Bureau of the Labor Statistics. That’s a slight rise compared to the 4.2% increase in 2018, as investors and contractors worried about a series of ongoing disputes between the United States and its largest trading partners.” However, this rise has not materialized.
From an interest rate standpoint, COVID-19 brought an extraordinary amount of uncertainty and considerable risk to the economy, according to the minutes of the Federal Open Market Committee (FOMC). Interest rates will be kept near zero until a recovery is firmly in place and the Federal Reserve is committed to using a full range of tools to support the US economy. Fed officials also noted on April 29th that a second wave of the coronavirus outbreak with another round of strict restrictions could drag the US economy deeper into recession prompting a jump in unemployment and renewed downward pressure on inflation. Consequently, the Fed left the target range for its federal funds’ rate unchanged at 0-0.25 per cent on April 29th.
So, what does all of this mean?
At a point in time when many people are sitting on the sidelines and wondering what to do, my recommendation is to take a contrarian view and lean into this storm. I believe that renter demand for attainable housing has and will continue to grow for the foreseeable future. Additionally, if you use an econometric model to make data-driven decisions as to precisely where we look to place the rental supply, god things can happen. These micro and macro data points are more important now than ever because without even knowing it, they have helped protect us against unforeseen volatilities in the economy, such the black swan event we witnessed in Covid-19.”
As a result of the producer price index reductions in the ‘hard construction costs,’ the general contractor community is expecting a 2% to 5% savings if you lock in your prices now. Furthermore, my financial advisors such as Jones Lang LaSalle (JLL) are encouraging people to take advantage of the bulging capital markets that are in need of placing debt capital at highly attractive rates.
Yes, each and every one of us has witnessed an overall change in how people live, work and even socialize as a result of COVID-19. The decrease in employment, captivity resulting from a forced “shelter-in-place” mandates, a downward pressure in the stock market and reduced wealth have all had an adverse impact on consumer confidence. But I see this present situation as a buying … no, a “building” opportunity.
In short, you should use these headwinds as lift to rise above the issues and drop its shoulder and push through with its strategic plan for growth. And if ever asked in the future why you chose a specific location in which to develop a multifamily development, you can respond by saying … “that is where the tenants are.”
To read more from David Wallace (Former Mayor of Sugar Land), see out blog section.
Banks’ New Policy: No to American Family Homeownership?
This article was originally written in 2011 for the Houston Business Journal.
Attempting to fix the problems in the mortgage market, Congress and the Administration need to use market forces and successful state policies as their guide, while protecting market fundamentals from over-reaction.
To protect their interests from further exposure, banks changed lending practices in the real estate markets, reducing real estate loan portfolios — even selling performing loans at a discount. By intentionally eliminating commercial and residential real estate from their portfolios, banks are ensuring a future shortage in single-family lots that will drive up home prices and hamper any recovery. If not addressed in new policy, this over-correction will reverse the greatest wealth producing mechanism for American families: home ownership.
Most homebuilders want to deploy their capital in constructing and selling homes. Before this can happen, another developer must buy the land and invest capital in the streets, sewer, water and other infrastructure required for a single-family lot development.
Initial bank responses to the mortgage crisis were aimed at ensuring that mortgage customers were qualified: increasing the minimum threshold for credit scores and income levels, and requiring additional escrow funds by existing mortgage holders, as security against default.
Developers altered their plans to meet consumer demand, scaling back the number of developed lots and creating home designs with fewer rooms and amenities – adjusting to the new economic reality. Nevertheless, lenders exited the single-family home development market.
The question now becomes: have banks unilaterally determined that the era of homeownership for American families is over?
States that instituted parameters for loan-to-equity ratios did not experience the collapse in home and mortgage markets like states allowing homeowners to take out 100 percent or more of the appreciated value in their homes. Guidelines must be instituted as an industry standard to allow for rational borrowing and more secure lending for home purchase.
Likewise, speculative home development unconnected to market demand fueled the crisis. With the nationwide mortgage crisis of 2008, national housing starts declined sharply. Banks stopped lending to residential real estate developers – even to those whose plans for new single-family homes were directly connected to market demand.
As banks collapsed and were re-structured by the FDIC, the initial banks’ obligations hung in limbo. Even if developers acted in good faith, and were on-schedule with profitable projects, developers were left without the funding they had secured in loan agreements with the initial bank. Successor banks did not assume the initial bank’s liabilities in real estate construction or there was the request from the lender to “move” the loan to another bank – a daunting task in an industry reducing real estate exposure. Unlike banks, developers did not get a bailout.
Implications for future mortgages, developments and contracts due to the retreat from real estate markets are far-reaching and destabilizing. What developer would seek funding if the threat of unilateral cancellation were implicit in the loan agreement? What developer would fund a project in its entirety to avoid partnering with an unreliable lender? Two unintended consequences will result: developers will halt activity in the single-family home market, and new, higher cost lending entities will develop outside of the current regulatory system. Both possibilities will destabilize the economy, retard recovery, increase overall construction costs and sow the seeds of the next financial crisis.
Still, banks and regulators do not have to follow this path. Market forces already are impacting the scope and quantity of the developments. Developers can make the case for a given project, but they need willing financial partners. Lenders can establish market-based criteria and can work together with qualified developers on specific projects to avoid this future predicament.
Rationality must be returned to the marketplace – a guiding principle that fuels sustained growth and discourages speculation and panic. Government entities should set limits on the loan-to-value ratio and not force banks to make loans to unqualified applicants for non-economic reasons. Congress should impose a regulatory regime on non-bank lenders who fueled the crisis by granting loans at twice the bank rate to applicants that could not repay them to purchase over-priced houses.
While some areas the single-family home market is over-stocked, this is a market-specific phenomenon. In fact, there are municipalities that have viable economic development plans based upon sound research and vision. Banks should invest in new single-family developments in these markets –facilitating continued economic growth of an area.
In other words, one size does not fit all. Fear need not determine our reaction to a crisis. It’s time for banks and regulators to stop over-reacting and bring rationality back into the conversation. We have the opportunity to minimize the negative impact of over-reaction and support recovery by allowing developers to prepare the sites that will someday become single-family homes. Without willing and reliable financial partners, however, our economy will continue to be stuck.
Public-Private Partnerships - Breaking the Status Quo
I have had experienced Public-Private Partnerships (PPPs) from both the public and private side. From my work as a real estate developer, I knew a great many qualified developers doing good projects all around the country. As I listened to these developers speak about their projects, I noted that the vast majority were only tangentially tied to a public entity. At the same time, while working and traveling as Mayor of the City of Sugar Land, Texas, I met a great many energetic and talented local leaders, each with a vision for their particular community. These visions included clear sets of goals and specific projects, yet for some reason, these goals were not always being achieved. It became obvious that opportunities were being missed due to a lack of understanding, on both the public and private sides, of the respective needs, values and opportunities that each could offer. I realized that part of the reason for this void in understanding lay in the difference in approach to questions, as well as needs, roles and responsibilities, not to mention the differences in background, experience and skill sets that each brought to the table.
As I reflected upon the projects I had worked on as a developer with cities, as well as city projects I had facilitated as a Mayor, I asked what had worked and why? Also what didn’t work and why? Where there were failures? Where there were successes? I asked myself, was there any common thread to failures and successes? How could I take a fresh look at things to provide focus on the opportunity for a PPP for the benefit of both developers and communities?
Having been on both the public and private sector sides of the development equation, I knew from experience that a PPP does not make a bad project good, rather it can make a good project possible … especially in the tumultuous economic climate in which we presently operate.
PPP does not make a bad project good, rather it can make a good project possible …
I also knew that there are well-intentioned people on both sides of the discussion, but that there was a better way to approach the question of development. It requires a commitment to the final outcome, recognition of the differences in both parties, an openness to communication, some innovative thinking, an openness in approach and a good deal of listening. In short, getting to that “win-win” situation requires a commitment to building relationships and a focus on the end game. I wanted to demonstrate how the public and private sectors can work together to create new developments which achieve the mutual and respective goals, increase economic activity in a specific area, attain a required internal rate of return for developers, and in the end, deliver a better life for all residents of the area.
In order to accomplish this, however, we must break the status quo and broaden the universe of our partners. In expanding our list of partners, I am not necessarily referring to the classical sense of investment equity partners, but let’s look to bring other public-sector partners to the table such as the Municipality, County, Public Improvement District, Management District, etc.
Municipalities are beginning to craft their own visions of what they want their futures to look like – from small towns to large cities. These vision statements, or “comprehensive plans” can be used to direct development projects and funds, encourage economic investment by targeted companies, or identify areas of the city that need new development or redevelopment. Often times, these vision statements, which very easily could include a student housing component in a larger master-planned development, are paired with development incentives or economic development funds that aim at facilitating the realization of this vision – resulting in additional benefits for developers that seek to meet the vision. These statements are created after a process of community input, professional evaluation of the applicable economic factors, and a review of the area’s existing resources and benefits. For developers, these documents present opportunities to create partnerships with the relevant public entities and fulfill the residents’ collective vision while creating economic opportunities for citizens and a higher return on investment for the developer.
When partnering with a university on a student housing development, the PPP discussions generally evolve around pricing, investment returns, resident life programs, Freshman-on-campus programs, master-leases, marketing characteristics, etc. The discussion does not center around how many jobs am I creating, or what is the incremental increase in Hotel / Motel Tax, Sales Tax, Ad Valorem Tax, etc. However, by broadening the list of public sector partners, a developer is able to add to this “discussion list” a few additional items, such as economic development tools, incentives, grants, tax abatements, etc. In short, additional contributions that can be added to the developer’s capital structure, without the incidence of ownership dilution.
Several of these mixed-use projects can include student housing, and be part of a larger mixed-use facility that can combine retail, hotel, convention center, parking, sporting and entertainment venues, office space or other features. Of course, the student housing developer can stay focused on their industry segment, and a master developer can secure other “industry specific” partners to focus on the other development components. Yet collectively, all of the individual developers win by the shared infrastructure, incentives and reduced cost structure. The common thread that runs through all of these PPP projects is that the public sector’s support is leveraged to facilitate increased economic activity that can be a catalyst for positive impact of job creation, increased property values in the surrounding area, greater ad valorem taxes collected from sales and property taxes, higher average income, and more school taxes collected. These benefits justify the risk that the public sector will take.
For a developer, the advantage of entering into a partnership with various public entities is that it decreases the developer’s risk by filling in financing that would otherwise need to be covered by a developer’s own investment in a project. Therefore, a developer can minimize their exposure and maximize the internal rate of return through this type of partnership. Most importantly, by creating this partnership, the developer then gains access to additional political support, as well as additional public finance resources that can help to cover different aspects of a project’s costs.