What Do Developers Do When There's No Development?

Thom, what inspired you to title this month's PCBC panel "How does a development company stay alive when there is no development?"

Thomas Cox: The original premise for this panel was that multi-family housing is going to lead us out of this recession, and we thought it was going to happen pretty rapidly. We had to do a little side-step here and change our approach. Multi-family housing is going to lead us out of the recession-maybe not tomorrow or even a year from now; it is going to take some time. We refocused ourselves around what we should do in the mean time, as a development team, a finance team, or even an architectural team, to keep ourselves viable over the next year or two.

With credit and financing the mother's milk of development, what do those like yourselves in the multi-family market do until credit flows again?

Gregory Vilkin: Multi-family housing is always viable for either investment or development at different parts of the cycle. Today is in an investment part of the cycle: you can buy below replacement costs. For a multi-family investor and an operator of property, it is a good time. Rents are trending down and will trend down as jobs continue to get shed. Jobs and housing are linked-without one you cannot have the other. Until jobs start to come back we will continue to shed housing occupants. Then it will have to wait awhile until everything that is already built has been absorbed. Once it is absorbed and there is no new product being built, which is happening now, there will be upward pressure. That upward pressure will cause rents to rise. Once rents rise, there will be enough value created where it will make sense to build because it will be cheaper to build new than to buy existing. That cycle depends on how long it takes, but it always repeats. Right now, as a multi-family investor, you want to buy older product to reposition and rehab. You don't want to do new construction.

Jeff, once you conclude that it is cheaper to buy built product than it is to build new, what becomes your business strategy?

Jeff Allen: What we have done, from a strategic point of view, is mothball the development business. We are still looking at properties for future development, but we are not acquiring anything right now. The development sites we currently own have been put on the shelf for the time being. We have shifted our team's focus from development to value-added acquisitions. We are out in the marketplace making offers on existing properties. We just successfully concluded our first transaction with a new fund we put together. We bought 204 units in Sunnyvale, California, a market we think is going to, over the long-term, generate the kind of value increases to support job growth that Greg was just talking about. It is a value-added deal but the value-added proposition today is very stressed.

We found that in most markets we can't get the necessary return on the incremental dollars needed to be spent on the value-added component in order to justify initiating that value-added strategy. In our Sunnyvale property, about two-thirds of the units could be rehabbed to bring them up a notch in terms of interior quality, fit, and finish. But we can't generate the rent to justify that investment today. Our tenants would much rather have a lower whole-dollar rent than new cabinets, appliances, and granite countertops.

The benefit to us in today's market is that we can buy that project and projects like it at a very attractive cap rate. Since Fannie Mae and Freddie Mac are still active lenders at attractive rates to the apartment investment community, we can get positive investment leverage on our acquisitions. Although we are expecting rents to decline over the next 18 months to two years, we are still looking at a nice, leveraged return on our investment dollars without taking the risk of development.

What impact are current federal efforts to unfreeze credit markets, i.e. housing tax credits, having on reviving the multi-family housing marketplace?

Vilkin: Since the state of California has not adopted their regulations as to how the re-credit purchase is going to work, we haven't seen any impact yet. One of our portfolio companies, McFarlane Costa Housing Partners, owns 27,000 units of affordable housing. We have not been able to syndicate a tax-credit project in nine months. What we are hoping is that, in very short order, California will adopt the policies that will allow them to start repurchasing credits at 80 cents on the dollar. The federal government has allowed states to do that but it hasn't really filtered its way through yet. I haven't seen any direct impact.

Is the stimulus funding trickling down or impacting your markets?

Allen: I am trying to figure out exactly where those stimulus dollars have been spent. In our markets, which are primarily the Southern California and coastal markets, we are seeing continued job deterioration rather than job creation. Granted, the rate of decline has moderated quite a bit, but we are not projecting any kind of job growth scenario for the next 18 months.

Are there specific housing markets in the U.S. that offer opportunity for each of you?

Allen: We are looking at markets that have the kind of characteristics that are ultimately going to produce increased rental revenue. That means looking at high-barrier-to-entry markets where there is a constraint on supply over the long-term, and markets where, historically, there has been a good capacity to increase jobs. That means the coastal California markets. At some point we will probably look at Seattle, Phoenix, and Las Vegas. But right now Phoenix and Las Vegas are going through a lot of repositioning and stress. Those markets don't have the high-barrier-to-entry component that we like. They do have a long-term history of strong job creation. We are not venturing too far beyond those markets.

Vilkin: We are still seeing things go down in value. We have $350 million in dry powder, but we haven't made an investment in probably nine months. We are still waiting for the right opportunities to come. Our thresholds have gone up dramatically, however. We aren't seeing risk-stratification in the marketplace. This is part of the danger to the administration's aggressive approach to financing and bankruptcy. For example, if you wake up as a Chrysler debt holder and you think you have a secure position so can you take a lower return, and the next day you find out that you were wiped out in favor of the unions-that has a big impact on whether you stratify your risk by lowering the risk curve and taking a first lien position when you could just as easily be wiped out as in an equity position. That has everybody in the institutional markets pretty nervous right now.

It is very difficult to get any financing today in anything other than equity rates. That makes it very difficult for projects to work. A project in a stabilized, rented apartment building is not a lot different than a busted condominium building with no tenants, saying that I'm going to put money into it and want to make a mid-20s return, regardless of the risk factor. So we are not seeing a lot of deals come to market. We are seeing owners of apartments say, "Hey, I am willing to sell today at a 5.5 or 6." We are seeing buyers say, "I want to buy today at a 7.5 or an 8." We are seeing a real gap in the market.

There are some deals trading on a sort of circa-80s and 90s apartments that are a little bit older getting traded at nominal cap rates in the sixes, with rents trending down and that make it more the equivalent of a seven cap rate. Those are starting to clear the marketplace today. If you can buy an apartment building today and finance with Fannie Mae at a sub-6 percent fixed rate, and buy at a 7 percent, you are locking in a hundred basis points of spread, you will make a 9 or 10 percent return on that investment right out of the blocks. That is about the only thing we see happening, where you can get a Fanny or Freddy loan. Those loans are down into the 60 percent loan-to-value range. Other than that, we aren't seeing many pockets of real opportunity. We haven't seen the banks start to cough up the bad loans yet. They are holding onto them, hoping things will get better. We are seeing a very big spread on most product types.

Where is the pony for architects in the current market environment?

Cox: One of the key points for us is what we do now during the middle of all of this. Education and innovation is where we come into play. Architects typically are going to start working probably six months to a year before projects get approved, financed, and back into the market. We need to do our plans, designs, yield studies, and permit process quite a bit ahead of the curve. That could be as much as a year and a half.

Right now we are investing our time primarily in innovation. The products we have been rolling out for years-the podium products, the urban-infill products, the wrap products, which get densities up to 50 to 130 units per acre-haven't been financially viable for a long time, so we are reinventing wood-frame, on-grade product type that will get us 35 to 40 units per acre at a cost point that is like a suburban product but acts like an urban product. We are trying to get ahead of the curve on that and trying to get our clients educated about what the next big move will be in terms of multi-family housing. We are doing a pretty big rollout on that idea with all of our clients.

How are municipalities balancing their needs for more revenues with their new housing development goals? Are new congestion mitigation fees and processing fees being adopted? Are local development processes being streamlined or are they now more cumbersome?

Allen: As an example, we mothballed two sites, one in Corona, CA, and the other in Pasadena, CA. I am in very close contact with the leaders of those cities. They are really struggling right now with a balancing act between trying to maintain a revenue stream typically generated from development fees while motivating new development through the use of incentives to developers. I don't know that any of the municipalities we have dealt with have come up with an answer that suits everyone. It is a give-and-take proposition. Developers need financial support today in order to move forward with projects, but the communities are very reluctant to give significant financial incentives because they need the money. I was at the opening for a project in Palos Verdes, called Terranea, a project that Lowe Enterprises has spent the last 12 years developing. Just recently, in order to motivate Lowe to complete the project and open it, the city agreed to provide an $8 million incentive. The city clearly would prefer to keep that money in their coffers. At the same time, they knew that to make that development successful they had to provide help to get the project open. In order to get it opened, Lowe needed the subsidy, so the city gave them the subsidy. I'm sure that it was a very contentious issue at the city council meetings.

For those of who will miss the PCBC panel discussion in San Francisco, share what's not yet been addressed by this discussion.

Cox: It's not all gloom and doom. There are some bright spots on the horizon. It's more of a function of timing. The consensus in this group is that we are probably talking somewhere on the order of 2012 or 2013 as a turn around in the multi-family market. For me, as the architect, that means that about 2010 or late 2011 I start getting busy. The actual rise in value for apartment properties and projects is more like 2012 or 2013. People I have talked to and our group here pretty much agree that when the market does take off it is going to take off with a burst of energy, an explosion if you will. For at least for the short-term, maybe for two to five years, there will be a very robust market in the multi-family sector.

Vilkin: Those of us who are a little bit longer in the tooth remember the 1986 crash in multi-family. I had a portfolio of properties in Texas. Everybody said, "There will never be another job in Houston; it will take 100 years to fill up the product." I had units that we were boarding up because we couldn't rent them to cover the expenses, let alone any debt. Those projects all got absorbed, and new product got built. It took a few years, but the "100 years to absorb all of the space in Houston" actually took about seven. Just like it is never as good as it seems-as we were saying in 2006-2007, "it can't last"-it is never as bad as it seems. Growth will resume. You have to make sure that you can survive for when the market does come back. When it comes back-and it always does-it comes back much faster than anybody projected.