Brick and Mortar Real Estate Developer - Still a viable industry?
Hello people, hope to have some advice on what is happening to traditional real estate developers, and any alternative career choice i could take.
I graduated few years back and joined a reputable local real estate developer that focuses on building apartments and office buildings. Currently working as an investment analyst.
My problem is that with asset prices at all time high and rental income not picking up proportionally, my company's holding co. sees real estate development as high risk business and correspondingly set a very high return requirement which the market simply wouldn't give. So work is really terrible for me as i have to run the same spreadsheet over and over again, reaching the same conclusion of no deal.
A while back, I chanced up one of Prof. Damodaran's books and in a chapter on real estate, he mentioned that since traditional developers are not diversified and have high return requirements, more and more real estate will ultimately be held through funds and trusts. This book was published back in 2002 and looking at it today, it feels sooo true.
Could anyone working in traditional real estate development company share how are you/your company adapting to this trend? And if I want to move into a real estate fund, what kind of knowledge should I start to build up?
Thank you so much.
Part of it may be that institutional investors have lower return requirements, but I bet it’s also that they essentially have to deploy capital continuously. (These are somewhat but not entirely distinct from each other.) Pension funds have to invest their members’ contributions, which flow in constantly. And big investment funds have a major incentive to maximize AUM, which in turn leads them to invest in marginal deals. If “traditional” developers have more flexibility about when or whether to invest, it stands to reason that they would be least active late in the cycle.
Thanks for sharing on the funds.
If you are familiar with the "traditional" developers, could you share how are the most of them coping with the current market? Are they just staying on the sideline?
Thank you.
I understand the OP reference to “traditional developers” to mean those who rely on LP capital via JVs or funds, and contribute relatively little of the equity themselves. They sponsor the deals and earn most of their money in the promote structure.
As far as I can tell, a lot of these developers are struggling to find deals right now. Their problem is that the high asset pricing and corresponding decline in yields hits them very disproportionately. If a huge REIT or some other major institutional investor develops something, the project-level levered IRR is essentially their own IRR. So if project level IRR goes down 200 bps, so does their own. Not great, but not the end of the world either.
The 200 bps decline is potentially much worse for the traditional developer, because it may be the difference between them hitting their promote or not. So the project level IRR decline produces a developer IRR decline a number of multiples larger. In other words, their business model simply doesn’t work anymore.
In my (major, coastal, very active) market, I’ve seen developers who used to stay in the core look at deals in inner suburbs. The inner suburban developers in turn look to secondary and tertiary submarkets well outside the city, where the institutional people aren’t active. Prices in these submarkets were stagnant for a long time after the ’08 crash, but more recently they’ve seen a lot of growth.
The players who are doing core deals now have to have some special advantage: low cost of capital, or possibly sitting on land that they bought when it was a lot cheaper than it would be now.
In some markets, including mine, an influx of foreign capital has been a significant factor as well. I recently talked with a guy who’s running local acquisitions for a HNW foreign investor. The investor is willing to buy at low cap rates because he wants to preserve his wealth in core US real estate. So this acquisitions guy has been doing deals left and right.
One additional thing on the tertiary (read: crappy) peripheral cities. As I mentioned, recent price increases there are being driven by acquisitions activity and resulting cap rate compression. But they’re also being driven by NOI growth. A lot of these places had a ton of unemployment in the last recession, and although the overall economy has been booming for a while, it’s only more recently that there’s been a tighter labor market and real wage growth at the lower end. A friend of mine who’s a big landlord in one of these cities told me that his evictions and late rent payments are way down in the last couple of years. Everyone who wants to be is employed now.
I would expect these places to cycle pretty hard when there’s a downturn, though.
Thanks BeaconStreet, The company I work for is similar to the institutional investor that you described in paragraph 2. We inject equity equity to acquire land and construct, while using substantial leverage to improve IRR.
From your post, it sounds like other than seeking out higher-yielding (read higher risk) deals in non prime areas, there seems to be no other creative business models that produce better returns? Thanks a lot again.
I think higher risk is inevitable.
One other thing my company has done is to buy land without entitlements, which they never used to do. It has worked out so far, but there's a substantial risk factor there.
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