A New Development Model and Preparing for a Recession

Fundamentally, we’ve always been a developer, although we have a lot of crossover and overlap of value-add investors and we invest in our own projects, we are not purely an investor per se. So we are a developer, which means that we just look at from the standpoint of our job to create new projects and new assets. We like the differentiator between value-add and development in this part of the market cycle, I think that’s a very common theme that everybody who is in the value-add space would love to have deals that I always put that criteria. Except that in this part of the market cycle, which would be when the market cycle is climbing, meaning going up and positive growing in order to have peak, then value-add existing assets start to become very expensive, which I think everybody in any major urban metro has this as an issue. Returns are being eroded, because they have to pay high prices. That's the opposite model which I call the above replacement cost value or above replacement cost model, which is the development model. I’ll give you an example, so in a downturn, at the drop, if you could buy a project that was 80,000 a door and it costs 100,000 to replace, below replacement cost, then you would say generally that's good value, right? In a rising or upward trending market, those values for those assets will start to rise, then eventually, they’ll flip over, so the value is now above replacement cost. So our motto is build it for 100K a door, and its value when we sell it is 120K. We’re the opposite of below replacement cost, and that will always be true. That is just vigilant preparing, raising capital differently, we’ll know that the development model will basically be less preferred when replacement cost can be or projects can be bought below replacement cost. So that market cycle does influence what deals work best, so we just look at it from the standpoint that we know when that happens.

Now, in a long-run basis, we know that a recession will come, and what we’re anticipating and one of the reasons we like this workforce housing model is because our tenant base is very sticky is the way we describe it. The social networks that I described before are very strong, that that means in a recessionary environment, people will stick around. In other words, their families are local, their kids are in school, their church is close by, so they're not necessarily going to pick up and move to Austin tomorrow. My internal joke is when you build millennial housing, and this is nothing wrong with the choice that they make, it’s just they don’t have that stickiness. There’s nothing tying them to that market, so they can leave, they got a job in Austin, and they can go, and they’ll leave your apartment if you happen to run into that specific profile. So we see workforce housing as a defensive model, meaning we have a stable sticky tenant base. We know in recession that values will decline, but if incomes stay stable, rents stay stable, and then life stays stable. Then we think we have a defensive strategy but still able to be real estate developers.

So our preparation is predominantly revising the financial structure of how we raise equity. So typically, when the market is rising and in good shape, and we’re looking for recession maybe two to four years out, we would complete a project, lease it up, and sell it, so build it around itself. That’s merchant build model is what I call that. How we change now is that we’re anticipating the recession somewhere between 18 to 36 months out if you look at the various data points. We don't know that for sure, but we’re on the longest expansion that we’ve had in recent history. So we just know to be careful and anticipate. So what the houses do is raise equity that is on a 7 to 10-year hold with the idea that we would ride through the recession with our investors with us and then our engagement together, having a defensible, stable tenant base. They are the working families who want to stay close to their job locations and their family that as long as the income stays stable and we don’t have to have a capital event during the recession, meaning investor wants to get out, we got to sell the property, and then we’re out of luck because a sale is forced. We want to avoid any sort of forced events, because we’re under recession, so as long as we underwrite our permanent debt appropriately, so we would be the defensive there, meaning, assume push in in the underwriting of permanent loan. We can’t, of course, guarantee that that will be perfectly bulletproof in a downturn. But compared to most other new development apartments that I’m speaking about. Specifically, if you’re in the millennial market and you have major job losses in the local market that would fit, say, the technology sector, you can anticipate that a lot of those folks who were in your profile would leave, they would go home, they’d get roommates, they’d usually have to go and get another job. Nothing wrong that, because they’re all perfectly appropriate for their life stage or part of their life cycle. We just say we prefer to be in a different demographic that’s more defensible.

Listen to full episode: https://lifebridgecapital.com/2019/10/ws351-a-new-development-model-and-preparing-for-a-recession-with-scott-choppin/