The 4 Variables in Development
In this blog, I’m going to provide a breakdown of the four big variables in a development deal and why it's relatively difficult these days to make them pencil. To be clear, this isn't a perspective that I've come to on my own. I'm borrowing this idea from a very successful developer who I had the pleasure of sitting with for an hour. He has over $2 billion under management. So . . . he's fairly credible.
The four variables: Acquisition price, Debt, Construction, Revenue. The best possible deal has low acquisition, low debt, low construction & high revenue. These four variables are always shifting individually, but impacting one another. It's important to realize though that the impacts take some time to travel from one variable to the next. So, with that said, why is it difficult to find a good deal right now? Let's look at the variables . . .
Acquisition Prices: High
Debt Cost: High
Construction Prices: High
Revenue: Falling (highly variable between markets and asset classes)
As you can see, literally each and every variable is the exact opposite of where we'd ideally have it for our 'best possible' deal. This is what I mean when I say 'The math isn't mathing'
**Aside -- The reason for my disclaimer with revenue is that in different markets, the prices for single family homes are high. I'm primarily speaking to multifamily projects, which are our bread and butter. ** The next logical question becomes…
"How do these variables impact one another? When will that start?"
That's a great question! Unfortunately the answer isn't as clear. To start to answer the first part:
The all impact one another, if acquisition prices fall, then people start buying property and the increase in supply would cause revenue to dip. If revenue dips and people stop building as much then you can expect construction prices to fall with contractors reducing their margins in order to get a larger portion of a smaller pie. With less activity happening overall, our financial overlords may drop interest rates (cost of debt) in order to spark economic activity. With cheaper debt, developers may start paying a bit more for land causing acquisition prices to rise. On and on and on it goes, ad infinitum.
This is a concept that you may have heard of called 'The Invisible Hand' by Adam Smith. Clearly, you can see there's an almost infinite combination of cause and effect relationships at play here. And unfortunately [to answer the second part of our original question] it all takes a good amount of time to play out. This means that we'll constantly find ourselves in various situations where the current reality of today as it pertains to investing is really really good, really really bad, or somewhere in the middle. Today just happens to be really really bad (for multifam new development).
"What do you do during the bad times?"
Another great question. We iterate and find what works. For us, during this time, that's a service based General Contracting business to generate cash flow and build a construction infrastructure. This serves two purposes for us.
1. Build out our construction company so that we can handle all of our eventual development deals when the math starts mathing again.
2. Generate a store of dry powder for the afore mentioned time of opportunity.
This is your friendly reminder to hit us up for any construction jobs! Our books are open and we're hoping to add one more job for a mid summer start.
Health and Wealth!