ADDAZERO Creed
As I look for new projects I try to use the lessons learned from previous transactions to guide me. How could I have generated higher returns for my investors without adding unreasonable risk? What would I do differently going forward? I try to make each mistake only once. Below I’ve put together some principles, guidelines, and lessons for future investment in real estate. Call it the AddAZero creed:
Low leverage is better
While it’s truism in real estate that leverage is what drives returns, it also puts great pressure on short-term results and dramatically increases volatility when the market turns. I believe debt for income properties should be maintained at or below 70% of value whenever possible with perhaps the exception of construction debt on vacant rehab or ground-up projects with the aim of stabilized debt at or below 70% of value.
Hold long term and rarely sell
In 2015 I sold an asset that we bought in 2008 on Centinela Avenue. When we bought it, the area was a mix of middle and lower middle-income homes with C-class retail along Centinela. The last several years has seen enormous development in Mar Vista, Playa Vista (the New Silicon Beach now housing Google, Yahoo, Microsoft, YouTube, DirectTV, among many others). Washington Boulevard has sprouted many hip restaurants and continues to develop as a destination. It’s only a matter of time before Centinela Avenue sees similar development as it becomes the main artery between Playa Vista, Mar Vista, and the West Side.
I am a long-term buyer in LA as the 2nd most populous city in the wealthiest country on the planet and as a continuing demographic magnet. My job for investors is to seek out value on acquisitions (make the profit on the buy) wherever possible, seeking areas where my experience and relationships can uncover undervalued assets and let the city do as much of the work of value creation for me as possible.
Briefly, manage the money more and the asset less. Which brings me to . . .
Renovate or build to hold, not to sell
If you know you’re holding long-term it becomes clearer when it’s right to undergo the expense and brain damage associated with major renovations and when you’re just looking for trouble.
There is often a lot of waste (of capital, time, and energy) in the pursuit of short-term gains. It can certainly be worth it, but there has to be great accretion in revenues to justify the large expense of renovating assets, especially if your aim is to hold long-term and your general expectation is for rent growth to do some of your work for you.
I don’t at all dismiss a value-add approach to real estate investing. I’ve spent years renovating apartment buildings to great success. But I do recognize that the money spent on renovations and the subsequent increase in cost basis, lost revenue during renovations, fees for construction financing, and additional debt service to achieve higher revenues may ultimately achieve no more net profit than the passage of time at much less expenditure of money and energy.
New construction requires lots predevelopment and construction expense when no money is coming in. Plus you’ve got to find the right site and buy it well. However, hopefully you end up with a brand new asset without many of the maintenance issues that vintage multi-family typically comes with, high demand for your beautiful new units, and an ability to command top of the market rents. In an era of low to near zero interest rates, you may be able to pull out nearly all your equity after construction is complete and you’ve leased up. Why would you want to sell after all that work and risk? It can be very tempting because buyers will pay a real premium for those assets. You can also console yourself with the knowledge that you’ve likely captured all the upside in rents upon lease-up and are giving up an asset with little room for rapid rental growth. It’s a nice problem to have, but I would rather hold the asset, put on stabilized debt, leave enough money in the deal to keep my leverage sustainable in a downturn, and bet on interest rate and rental growth to provide returns that will typically outpace whatever yield I trade into.
Generate more revenue and less gain
It’s a good thing to sell now and then, or even to take an income property and raze it to build another income property if the situation calls for it, but with income property, the aim should be on generating revenue, not capital gain. Buy more revenue with revenue, meaning make regular distributions to investors, but re-invest revenue to acquire more assets to create more revenue. Let the assets do the work that you might spend on capital intensive improvements, timing sales right, finding exchange properties to defer gain, and all the fees that go along with that. Instead, spend that time and energy on properly managing the existing assets, maintaining clean balance sheets, and avoiding large debt.
The IRR for this last investment I mention on Centinela was not particularly high (6.71%), though the overall return was decent (43%). For the length of time it was held and particularly when it was purchased, I think we did well to safeguard that capital and grow it over time. The property was purchased Feb 28, 2008. We refinanced the property on Sep 30, 2008 and returned 29.14% of the initial investment at that time. To give some context, Lehman Brothers declared bankruptcy just two weeks earlier on Sep 15, 2008, precipitating the beginning of the banking crisis and of the crash in real estate and equities values.
The IRR for an investment in the S&P over the same period would have been nearly identical. However, had we done less renovation and simply focused on cash flow and making modest distributions, the IRR would have been much higher. We likely would have sold the property for less, but spent much less on fixing it up and the profit would have been about the same. I intend to focus on this much more in the future.
All this long-term, low-leverage stuff is safer and ultimately is likely to outstrip returns over the long-term over the more harried value-add approach. This is especially true when you consider that there is always another correction coming and the next bust can wipe out all your short-term profits from the last deal. You can hedge against the next bust by always taking some profits off the table (take some gain and pay some taxes - there are worse things) from any short-term gain and by very rarely re-investing all your capital in the next project. It may sound like I’m ruling out short-term gains here, but I’m not. In fact . . .
Short term gains are great, but seek them in Single-Family development
There can be very attractive outsized returns available in single-family development. These projects are much riskier, more volatile, short-term (2 years and under), and should therefore provide a big return (+25% IRR). I’ve spent the last several years building an expertise in developing luxury single-family homes. Timing is critical and unforgiving, as the last housing bust demonstrated. These deals are typically highly leveraged to increase returns. I plan to continue to grow this business as the cycle permits and will offer these projects to investors alongside the more staid income-property investments.
Goal - The AddAZero Fund
I. This fund will be organized around the principals and guidelines I’ve mentioned above:
a. Lower leverage is better
b. Hold long term and rarely sell
c. Renovate and build to hold, not to sell - mostly
d. Generate more revenue and less gain
e. Make regular distributions, but buy more revenue with revenue
f. Short term gains are good, but seek them in Single-Family development
II. I will offer investors the ability to acquire interest in a portfolio of income property (focused on multi-family with some mixed-use commercial and office) to be acquired over an indefinite period that will be held long-term and that aims to throw off regular distributions that will grow over time. Returns will be further enhanced by opportunistic single-family developments located around our income portfolio and in prime areas of Los Angeles.
III. The fund will be focused in areas in which I have demonstrable expertise and edge – Los Angeles and the surrounding areas - always looking to uncover undervalued areas and properties that are likely to see improvement or in prime areas where we have the opportunity to purchase at or below market.
IV. I will seek to offer redemptions every few years by refinancing assets, by the re-sale of interest, and the occasional sale of assets so that the investments are not completely illiquid. But for the most part, these investments will be for those with patience and a long horizon. Over time the distributions will become very substantial, providing regular income.
Sincerely,
Sebastian Rein
AddAZero Corp