Over the past few years, it seems development yields have decreased substantially. My company delivered some highly profitable projects in 2014-2017 (10%+ ROC for Class A multifamily urban infill deals). Now, we're in acquisition mode and can barely get deals to pencil. The only deal that pencils is our riskiest project with a 7 year timeline, it it barely pencils!
Got me thinking on a broader scale of the long term risks facing the profitability of development:
-Rising construction costs: I know the lumber bubble recently popped, but prices will still be higher than before and will likely continue to increase overtime
-Cost of land: this is increasing because there's less of it and more buyers. "Off market" deals aren't necessarily off market.
-Competition: As real estate has become more institutionalized, there's more development companies in general. And a lot of companies competing on a national scale. Seems like there's even a lot of competition in tertiary markets.
-Oversupply- With a lot of development companies in existence, a lot of product is being built. Since there are limited areas that have upside where land is cheaper, developers all only flock to these areas and the neighborhood gets overbuilt.
-Interest rates: This is always a wild card, but you would think rates would increase at some point. It's rumored 2023.
-Community opposition growing: The community believes developers are overbuilding (could be true). For multifamily, A lot of developers are on the hook for not providing affordable housing in Class A product. Affordability laws are being put in place in gateway markets, probably soon to follow in secondary markets. Even with 5-10% affordability, your returns are significantly impacted.
The above risks have always been present, but now it seems they are on a much bigger scale.
Is the risk/reward balance worth it anymore? I see development becoming more of a fee driven business, looking at a total return of ROC + fees.
You were riding a wave in the multi family from 2009-2018 that had significant momentum and outperformance. Yes it will be harder to make as much money right now as you were then.
Sectors go through waves that can drive great performance if you are there at the right time. The 80’s was a great time for big office towers. Power centers did great in the 90s. Industrial is doing great now. Maybe single family rentals will be all the rage in 5 years.
I know my post mostly talks about multifamily, but a lot of this applies to all sectors across real estate.
Hotels could be next. Time will tell
So your concern is that it isn't easy to make as much money in a lower interest rate and higher competition environment? Welcome to every other business, ever. People pile in, yields drop. If you want to make generational money, go innovate. If you want to do what everyone else is doing because it's safe and proven, expect a race to the bottom on yields and fees. This isn't rocket science, it happens in every industry.
Agreed that innovation is necessary to perform well. At the end of the day, construction costs, land acquisition, and rents are what drive value. If you innovate, you could argue that your can drive high rents. If you get lucky, you can find an off market land deal at a reasonable price. I guess construction costs are the hardest component to solve. Going pre fab and using timber maybe? And getting around the city's distaste for outsourcing more labor and using less of the local labor pool.
Respectfully, I could not possibly disagree with this opinion any more strenuously, and I think it's indicative of exactly the point I'm making about innovation and the inability of people to understand that making huge amounts of money isn't simple in this business.
You say value is driven by "construction costs, land acquisition, and rents". This is true as far as it goes, but again displays a remarkably blinkered and narrow vision towards development. Do you know why Stephen Ross is a billionaire? It's not because he bought the land at Hudson Yards cheaply and hit hit rents. It's because he bought and built tax credit projects in the 80s and 90s. In other words, the basis of Related's profitability is based not on acquiring properties on the cheap, or on building for less than competitors - it's because they're involved in a different business line in which your three drivers of value or effectively irrelevant. They innovated. Or rather, they found an asset class in which the metric for success wasn't yield driven, but protected by the high knowledge barrier you need to enter.
If you know something someone else doesn't, or have a skill they don't, then you don't need to worry about the value drivers you mentioned. Self storage has been around for decades, but it's only in the last ten years that anyone really decided to go out and aggregate these things and professionalize their management; the folks who did that made a killing, because they understood that the risk factors traditionally associated with self-storage (especially concerns originating with lenders) might actually be a result of mom and pop management that couldn't drive down expenses or effectively raise pricing, and not necessarily anything intrinsic to the asset class. But they could have been wrong! Or they might not have wanted to hustle, and go to these rural-ish areas and negotiate 150 unit deals 30 times a year to start to get some scale and operational efficiencies.
I'm not sitting here claiming that I know the next value driver that someone will come up with - if I did, i'd be out hustling to make it work. But frankly, it pisses me off a little bit to hear the whining about how the industry is so competitive and that there isn't opportunity to compete with institutional money. That's horseshit. As I said, it's the attitude of someone who wants an easy and uncluttered path to creating generational wealth. The person who wants the no risk, high reward model. That doesn't and never has existed. It's easy to look back and think "wow, that was so easy!" In thirty years, people will be talking about the 2020s like that, just for a different thing.
Developers need to take on more risk by building in non-Tier 1 cities. If you are basing your investment decisions off of widespread knowledge, you probably are not alone (eg. migration numbers, job creation, etc.).
Yields are still there big time in non-Tier 1 cities.
Aside from that, you're not entirely wrong that in the current environment development becomes more of a fee-based business (FYI - it's ALWAYS a fee-based business, why do I care if a deal only pencils to a 15% IRR if I have an institutional partner who wants in that will give me good GP economics that bumps my equity multiple from barely 2.0X to 5X+ before deducting overhead?). There's tons of institutional capital out there that will still bite at lower returns than what we've seen in the last decade, so developers can still make their bread.
It's harder for scrappy small-time developers right now though, for sure. If your investors consist of HNW individuals looking for traditional heavily outsized returns, you're going to have a hard time finding deals that you can raise capital for.
Why don't you just lower your exit by 25 bps
this is actually the real answer. and the simplest!
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I feel like you could post this any year based on what ever the circumstances of the day are. Ever talk to someone in real estate before 1986? The tax reform law pretty much killed the business. I started a few years before the 08' crisis, development wasn't supposed to restart for 10 years if you listened to the press. Or imagine the investors who left real estate, declaring everything too risky/overprice because..... cap rate fell below 10%!
This is just a tough, competitive business and that is always been the case. I mean, if suburban mall developers can change, adapt, and survive there is hope for all of us.
Will all firms and developers survive? Nope.... that is the truth. But so long as there is growth and demand, there will be active developers.
great post, love the bit about the mall developers!
This is important to remember. Survivorship bias is a huge thing; no one remembers that alongside all the firms that started in the 80s and have been successful, there are as many or (more likely) more who couldn't hack it and fell out of the industry.
Of course it looks "easy" when you see that everyone from that era was successful. By definition that will always be true, because the unsuccessful or unlucky ones aren't around to be counted.
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