Landmark Links November 8th – Size Matters

funniest-urinals-around-the-world-5

Lead Story…. CIO Magazine posted a thought provoking piece last week about how first time private equity investment managers consistently outperformed established managers from 2000-2012.  Many of our investor clients are private equity funds and I worked for a commercial real estate pension fund advisor in a prior life.  Needless to say, this is a topic that fascinates me.  From CIO on how newer has been better when it comes to performance:

First-time private capital funds have consistently outperformed more experienced managers in recent vintage years, according to Preqin.

Newly launched private equity, private debt, real estate, infrastructure, and natural resources funds achieved a higher median net internal rate of return than established counterparts in every vintage year but one between 2000 and 2012, the report stated.

Private markets investors who took a chance on a brand new fund were rewarded with “strong (and in some cases, exceptional) fund performance, increased portfolio diversification, and experience with niche strategies,” said Leopold Peavy, Preqin’s head of investor products.

Overall, investors have grown more likely to invest with first-time managers, with more than half of surveyed investors saying they would at least consider committing to a brand new private capital fund, compared to 39% in 2013.

CIO didn’t give a reason for this outperformance but I have a theory as to why this happens, at least in the real estate world: Size matters.  A lot.  Most first-time funds are substantially smaller than established funds as they tend to attract less capital due mostly to a lack of investment track record.  Most managers aspire to grow their AUM because it means that they make more money.  Larger asset base = larger fees in dollar (if not percenage) terms.  However, while this growth in AUM might be a great deal for the manager, it isn’t such a great deal for their investors.  To illustrate why, lets look at the typcial life cycle of a fund:

  1. Fast Out of the Gate: In the early years, a typical real estate fund starts with a relatively small amount of capital.  Let’s say $200MM.  The young fund is running lean and can be extremely picky in choosing the deals that they enter into.  Why?  Because they don’t have a large amount of capital to place so they can do it on a highly selective basis.  This typically means off market deals and value-add opportunities that the big boys might consider too be a waste of time and difficult to scale.
  2. Asset Aggregation: By the time that our fund goes out to raise another investment vehicle they have done well.  Really well.  Their ability to be nimble and pick up smaller deals has led to outperformance of market benchmarks.  Large institutional investors take note and jump in, throwing money at the growing manager and allowing them to increase their AUM substantially.  The problem is that this comes at a price: once you take on the capital you have to place it.  This means no more small deals and less off market opportunities.  They just aren’t efficient enough to place a large amount of capital.  Our once-nimble manager now needs to target more capital intensive but often underperformign segments like class A office and large portfolios in order to get money out.  Their performance suffers accordingly and falls back to the pack.
  3. Maturity: The fund is now a steady market performer – maybe beating benchmarks by a little bit.  However, in a market where AUM begets more AUM, they are a focused fundraising machine and able to raise capital well into the billions.  Their old 2,000sf class B office space is now a full floor headquarters in a class A building and they are staffed up accordingly, running a high G&A budget.  The only way to pay for all of the extra expense is to keep the fundraising gravy train going.  However, the returns aren’t what they used to be and top performers from within begin to go out on their own, only to re-start the cycle again.

The irony here is that the very thing that a manager wants – a lot of AUM is often responsible for suppressing returns as they grow.  It’s nearly impossible to have it both ways.  You can either beat the market by being relatively small and nimble or you can become a huge AUM machine.  It’s rare to have both.  Size matters a lot when it comes to real estate investment funds and it often correlates closely with how long they’ve been in existence.  It’s a lot harder to steer the Titanic than a Boston Whaler.

Economy

All About the Benjamins: Friday’s jobs report was pretty good despite the headline number coming in a little below consensus.  The big story: wages are rising.  See Also: What we know about the 92 million Americans who aren’t in the labor force.

Counter Intuitive: Will the rising number of retirees cause more inflation rather than less?  It’s not as far-fetched an idea as you may think.  See Also: Rising bond yields are telling us that inflation is returning.

Reading the Tea Leaves: How big data mining operations are combing social media and review sites to create a more detailed picture of US earnings.

Commercial

A Different Type of Farm: How vertical farming technology could lead to higher demand for warehouse space and more efficient food production.

Residential

Easier Said Than Done: The McKinsey Global Institute thinks that they can “fix” housing in CA by targeting vacant land tracts in urban infill areas for high density development. Conor Dougherty and Karl Russell of the NY Times lay out why this is largely doomed to fail (and in some cases already has).

Rise of the Machines: This homebuilding robot being developed in Australia could lower construction costs substantially….but could eliminate some construction jobs.

Off the Grid: Tesla’s new solar roof tiles and battery packs could completely alter the way that America generates and uses home electricity.

Getting Out of Dodge: Tech workers and startups are getting out of Silicon Valley and moving to new markets with a much lower cost of living.  This isn’t going to have any impact on the Apples and Googles of the world but the next generation of small startups could come from much more diverse locations.

Profiles

Tear Jerker: Meet the Cubs fan who drove 600 miles to sit in a cemetery and listen to the Cubs win the World Series with his father at his grave, keeping a promise he made decades ago.

Skimmed: Great profile from Bloomberg on how The Skimm (the first thing that I read most mornings) became a must-read for Millennials.

Nip and Tuck: More Americans 65 and older are getting plastic surgery than ever before….and not only in Newport Beach.

Charts of the Day

WTF

Innuendo: I found something that both Hillary and Trump voters can agree on – Anti-Prop 60 (for those not from CA, that’s the one where they are trying to make condoms mandatory in pornos) ads are the best political ads ever.

Squirrels Gone Wild: A squirrel went on a rampage in a retirement community resulting in a resident calling 911. Once again, because Florida.

Seems Reasonable: A drunk Russian man murdered and dismembered a friend for insulting his accordian skills because, Russia.

A Little Wired: A man was caught driving through a family neighborhood with wires attached to his genitals because, Florida.

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com

Landmark Links November 8th – Size Matters

Landmark Links October 25th – When Will The Empire Strike Back?

darth-vader

Retraction: Before we get to today’s post, Leonardo DiCaprio’s rep announced that he doesn’t support the anti-density initiative that I spoke about on Friday, despite his name being all over it’s literature.  Maybe he is a regular Landmark Links reader and didn’t like getting called out 😉

Lead Story…. Since I began writing this blog last year, one of my main areas of focus has been how the historical relationship between primary and secondary markets has broken down in this cycle, especially in CA.  In the past, the inland production markets would heat up when prices rose along the coast.  This lead to a virtuous cycle where housing starts beget jobs which beget more employment, wage growth and ultimately more household creation and home buyers.  This cycle has been different for several reasons:

  1. Difficulty of inland builders to develop affordable homes profitably due to low FHA caps and high impact fees
  2. Growth in preference for urban living among wealthier adults
  3. Declining home ownership percentage impacts the marginal entry level buyer more than the affluent one and historically, the marginal buyer is more likely to look inland for housing.

It’s become fairly common in our industry to look to increases in FHA limits as the salvation of the secondary markets.  However, for that to occur in any substantial magnitude (all indicators point to a small increase next year),  Congress would have to revise the statutory formulas that they set back in 2008 to govern FHA limits.  As my colleague Larry Roberts wrote in OC Housing News, that is far easier said than done:

Through the lobbying efforts by the National Association of Homebuilders or the National Association of Realtors, Congress knows exactly how the conforming loan limit impacts home sales and new home development.I recently spoke with Scott Meyer and Michelle Hamecs of the NAHB. They provided me their NAHB Issues Update that detailed the FHA loan limit issue (click here for that document). It isn’t ignorance to the problems the prevents Congress from raising the limit.

The conforming loan limit demonstrates the tug-of-war between two conflicting desires of policymakers.  On one side, advocates for the housing industry and advocates for expanded housing opportunities to all Americans want to push the loan limit higher. On the other side, the more fiscally conservative lawmakers want to lower the limit to restore the prior mandate of insuring loans only for lower- and middle-income Americans. Further, they want to reduce the potential liability for the US taxpayer, who would currently cover all the losses if the market crashes again.

If the conforming loan limit were reduced, it would decrease the potential liability for taxpayers and reduce the size of the GSE operations and make it easier to someday dismantle them; however, the last time the conforming limit was dropped, Irvine, CA witnessed an 84% decline in sales volume in the price range no longer financeable with GSE loans. Ouch!

There is no doubt that increasing FHA limits would help.  There is nothing particularly healthy about having a market that is 100% reliant on government-backed loans to function but unfortunately that’s the hand that we have been dealt.  Raising FHA limits attacks the problem from the bottom of the prospective home owner pool by allowing buyers at lower price points to purchase homes with much lower down payments than what’s available using a conventional mortgage.  Today, I want to look at a different scenario that could play out in the next few years.  It’s more from the upper end of the pool where coastal renters could find themselves once again looking inland if prices continue to rise.  Today, I’m going to focus on Orange County and the Inland Empire but the demographic dynamics that I’m going to focus on could apply to many affluent coastal regions and their less-affluent inland neighbors.

On the surface, things look great in Orange County.  Economic growth is strong as is employment and home prices are now above their prior peak.  Development is humming along and occupancy levels are extremely high in commercial and multi-family projects.  In addition, OC has diversified it’s economy quite a bit as finance and tech have taken a large role as the County has become less dependent on real estate.  However, as the OC Register detailed last week, Orange County has a growing demographics problem and I think that the Inland Empire just might be the prime beneficiary.  The problem isn’t that Orange County isn’t creating jobs.  It is and we actually have the lowest unemployment rate in Southern California.  It’s that the jobs being created often don’t come with wages that would allow someone to live here.  Combine that with relatively few new housing units being built and the cost of existing units rising quicker than inflation and you have a recipe for what economists predict will be a declining population of prime workforce age population (25-64 year olds) from 2010 – 2060.  From the OC Register (emphasis mine):

“They say demographics are destiny,” Wallace Walrod, the Orange County Business Council’s Chief Economist told the conference. “It is imperative that everyone in this room understand the consequences of pending demographic shifts.”

The national trend of aging baby boomers moving into retirement, he said, is “magnified and exacerbated” in Orange County, where the over-65 population is on track to nearly double by 2060 to “a staggering 26.2 percent.”

Unlike California as a whole, every age cohort other than seniors is shrinking in Orange County, where the median age has risen from 33 to 38 since 2000.

Most worrying, the prime working-age population – 25-to 64-year-olds – is expected to dip by 1 percent by 2060, even as overall population grows by 15 percent.

By contrast, working-age groups in Riverside and San Bernardino counties are on track to grow by 61 percent and 47 percent, respectively.

“We are losing not only our 25 to 34 year-old workforce – millennials – but also losing K-12 and the college-age cohort as well,” Walrod said.

The trend, he warned, “could devastate O.C.’s pool of workers, creating talent gaps as large swaths of the workforce retires, leaving open positions that will likely go unfilled.”

The Register went of to identify the the obvious culprit: housing.  I frequently hear friends, neighbors and co-workers and neighbors who live in Orange County complain that the area is being over-developed.  The stark reality of simple math shows that view couldn’t be more wrong.  Again, from The OC Register (emphasis mine):

A severe housing shortage has turned Orange County into one of the most expensive markets in the nation, with median home prices exceeding $650,000 and average monthly rents at about $1,900. Higher-density developments that could alleviate the shortfall are often opposed by current homeowners.

Rising values are “good news for current homeowners, but bad news for those looking to afford to relocate to O.C. or to buy a house and stay here, especially millennials,” Walrod said.

As a result, he added, “domestic outmigration has been accelerating.”

The report projects that “new job creation will significantly outpace projected new housing units over the next two and half decades, resulting in a housing shortfall that will grow from a current reading of 50,000-62,000 units to a staggering 100,000 units by 2040.

Many workers are being forced into neighboring counties to find more affordable housing, increasing their commute and complicating their work-life balance.”

……

According to the report, it takes an hourly wage of $32.15 to afford a two-bedroom apartment in Orange County, putting it out of reach for minimum-wage workers in the county’s fast-growing service sector, given the current California wage floor of $10 an hour.

The story goes into much more detail about a developing skill gap and low wage job boom.  However, I want to keep the focus on housing for this post.  Note the above projections about working age populations in Riverside and San Bernardino Counties (growth of 61% and 47% respectively from today until 2060).  Those are massive numbers that will create a strong demand for housing and not all of it will be entry level.  If you take the median income required to buy and rent a median-priced home in Orange County today, it is around $100k (assuming you can put down 20%) and $70k, respectively, so there are a lot of people with well-paying jobs that fall below that amount.  Given the fierce opposition to density in the OC, it is likely that those numbers will only increase.  Also, keep in mind that the averages above are for the entire county.  The most desirable areas with the best school districts can easily be double those amounts which is incredible when you consider that median income to afford an apartment in the neighboring IE is around $55k.  At some point, something has to give.  My guess is that it’s a move towards more relatively affordable housing markets, in this case the Inland Empire.

I want to make an important caveat about what I wrote above: I haven’t a clue as to when this change will actually take place and more affluent workers will start to look inland to buy or rent.  However, one thing that I’ve learned witnessing our current market is that things change incredibly quickly once they hit a critical mass.  Just a few short years ago we were subject to an endless barrage of “renting is superior to buying” articles in the mainstream and business press.  Just this week, Bloomberg ran a piece that argued that it’s almost always better to buy.  Such an article would have never seen the light of day in 2011.  Both types of articles are virtually assured to be wrong since they argue in absolutes. In reality it’s sometimes better to buy and sometimes better to rent but that level of nuance doesn’t lead to many page views.

My comment about how quickly things change goes for regional and local trends as well.  For example, 15 years ago, pretty much no one with a college education wanted to live anywhere near downtown LA.  Within the past 10 years that has changed rapidly and an area which was once in the grips of urban decay has become one of the most desirable locations for young, affluent home owners and renters in the US.  Some of the same conditions that created the LA gentrification/urban renewal boom have caused the Inland Empire to lag: delayed household formation by Millennials, preference for urbanization among high earners and a downward trend in the percentage of Americans who own a home.  However, I have serious doubts that these are permanent trends and there are other factors at play already that could begin to create more inland demand:

  1. Addition of urban elements and amenities to existing CBD and downtown regions.  This is already happening in downtown Riverside as more density and foodie oriented retail are on their way.  There are other urban areas out in the IE that could experience the same thing over time, downtown San Bernardino for example.  It’s probably difficult to imagine right now but that’s ok.  Downtown LA as it currently exists was didn’t seem feasible back in 2001 either and I doubt that many of us foresaw luxury condos and apartments going up next to Skid Row.
  2. Self driving cars could help to ease commute stress in markets without mass transit infrastructure.  The technology is advancing rapidly and the Inland Empire will arguably be the region that will benefit the most in the US.
  3. Bank lenders are starting to compete with the FHA for low down-payment loans to entry level buyers.  Bank of America has been so successful with their 3% down program that they are doubling it.  These lending programs are still tiny by comparison but it wasn’t long ago that they didn’t exist at all.
  4. Millennials are getting older.  Many of the oldest Millennials are now entering their mid to late 30s which are the prime household creation years.  Once people start families, studies show that they are more likely to favor the stability of owning over the mobility of renting and the family-friendly single family home over an apartment.

The Inland Empire is down but I wouldn’t count it out over the long term.  The current trends that have hurt the housing market there aren’t likely to last forever and the region is adjacent to too many incredibly expensive areas to not experience some spillover as even relatively high earning families eventually get priced out of the coastal regions. Conventional wisdom is that only an increase in the FHA loan limit can revitalize the IE housing market.  In the short term, that may very well be the case but a sustainable recovery just might come from higher earners moving into the region.

Economy

The Walking Dead: How bankrupt oil companies that are continuing to pump could keep a lid on oil prices.

Stay In: It’s getting more expensive to eat out even as grocery prices are falling.

Commercial

The Spigot: Pension funds have been steadily increasing commercial real estate allocations for the past few years and that isn’t likely to change in 2017 despite signs of a maturing market.  See Also: REITS have become a more attractive target for activist investors.

High Times: A San Diego based medical marijuana landlord just filed for an IPO.

Residential

Further Afield: High prices and low yields near the coast have investors looking for rental homes in cheaper locations through management and investment services like Home Union, Investability and Roofstock.  However, a lack of local knowledge can lead to out of area investors paying the dumb tax by thinking that they are getting a good deal when they aren’t.

Profiles

Pull the Lever: How smart phones and app developers create digital addiction by mimicking slot machines.

Paradise: The Cubs paved the way for the Dodgers to come to LA by hosting their spring training on Catalina Island. See Also: For the Cubs oldest fans, this year could be their last chance. And: There are people trying to get 6 figure ticket prices for a single seat at World Series games at Wrigley Field.

Chart of the Day

WTF

Hard at Work: Meet the TV weatherman who got bored with his job after 23 years and decided to become a porn star.

Not a Detail Person: Russian oligarch has giant hideous boat built at a German port on the Baltic Sea. Ship draws too much to get out of the straits at the entrance to the Baltic. Epic FAIL ensues.

Lawsuit of the Year Nominee: A woman is suing KFC for $20MM because she felt that her bucket of chicken wasn’t full enough.

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com

Landmark Links October 25th – When Will The Empire Strike Back?

Landmark Links October 18th – On Point

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Lead Story…. A bit short on time this week so I’m going to outsource the lead story.  Joe Bosquin of Builder Magazine wrote a wonderful summary about how California priced itself out of the market for entry-level home buyers titled The Unintended Consequences of Law. Spoiler: it has everything to do with Prop 13 and CEQA.  Bosquin’s piece as good as an explanation for our absurd housing prices in the Golden State as you will find.  Yours truly gets a bit more than a quick mention and they included an article  that I had written for Builder (and Landmark Links) back in May about why our impact fees are so high compared to the rest of the country.  By the way, the non-partisan Legislative Analyst Office published a piece in September in which they confirmed my thesis about the relationship between Prop 13 and impact fees.

Here’s an excerpt from Builder but you should really check out the entire article.  It’s a quick and easy read even if you aren’t a housing and development nerd:

According to a widely referenced 2015 report from the California Legislative Analyst’s Office (LAO), the Legislature’s nonpartisan fiscal and policy analysis arm, since 1980, California has built half of the housing units it needed—about 100,000 per year—to keep up with demand. And that’s just in aggregate. In high-demand locales like the San Francisco Bay Area and Los Angeles, the housing deficit is even greater. “Most of California’s coastal counties needed to build three times as much (or more) housing as they did,” the report claims.

Stated differently, during the past 36 years, California did not build the additional 3.6 million homes that it needed to keep its skyrocketing prices in check. To put that number in perspective, it would take the collective efforts of every home builder in the country, building nonstop at 2016’s projected pace of 1.26 million housing starts, three years to put a dent in the state’s problem.

The report concludes that NIMBYism, local communities’ lack of financial incentives to approve more housing, and anti-growth proponents who go to daunting lengths to block development have contributed to the problem, as well as more inveterate challenges such as a scarcity of suitable land along the coast and an ever-increasing population.

The LAO report found that the average cost of homes in California is two-and-a-half times higher than the rest of the country, and rents are 50% higher. It also points to evidence that high housing costs were making it difficult for companies to recruit employees, even in Silicon Valley, and threatened the state’s jobs base. Other reports that came out in its wake highlighted a net migration of 625,000 people out of the state from 2007 to 2014, primarily among lower income earners, attributed to housing costs.

All of which leads to the question, how did California get to a place where it tacks $75,000 onto the cost of a new home in the midst of a housing crisis that’s eroding its jobs base and pushing the country’s most populous state into an unwinnable war of the haves and have nots?

First off, major thanks to Joe Bosquin for writing this.  Also, a big shout out to Kris Vosburgh, executive director of the Howard Jarvis Taxpayers Association for calling the rest of us who cited facts in the article “morons” after he apparently couldn’t counter the points that we had made on factual grounds.  I’ll wear that one as a badge of honor.

Economy

Glass Half Empty: The downside of our technology revolution is a lack of job creation.

Warming Up: Wage growth is now at the highest level that it’s been in a year but the stock market might not be thrilled.

Visual Representation: 27 fascinating charts that will change how you think about the American economy.

Useless: The WSJ surveyed economists and found that 59% believe that there will be a recession in the next 4 years.  For those not familiar with this sort of methodology, 4 years is an incredibly long horizon in which to forecast such things.  The incredibly-accurate Bill McBride thinks that we are in the clear for 2017 and likely 2018 as well (although he cautions that even 2 years out is too far to accurately forecast).

Commercial

Bucking the Trend: While most benchmarks have remained low this year, LIBOR has climbed substantially mostly due to new money-market rules which could lead to an uptick in financing costs for commercial real estate.

Supply Exceeds Demand: Rents in Manhattan are falling as listings surge 35%.

Residential

Selection Bias: All of the Urban revival stories that you read these days are really about the amount of money flowing into urban centers than the number of people.

Viva Mexico: A condo boom in Tijuana, coupled with easier border crossing rules for regular commuters could help ease a housing shortage in San Diego….but is not without it’s risks to American buyers.

The First Step: The Federal Reserve has now acknowledged that we have a housing affordability crisis.  Admitting that you have a problem is the first step to recovery.

Profiles

Prime Time: Nearly 60% of US households and 75% of those that make over $112k per year are now Amazon Prime members.  Let. That. Sink. In.

Screen Shot 2016 10 14 at 11.00.26 AM

Pay For Play: For-profit college Devry University has finally agreed to stop using the bullshit claim that 90% of it’s graduates seeking employment found jobs in their field within 6-months of graduation.  The action came as part of a settlement with the Department of Education over misleading advertising.  That claim would be impressive (and improbable) if it was made by Harvard, let alone a lowly for-profit school that may or may not be a diploma mill depending on who you ask.

Foot in the Door: How Uber plans to conquer the suburbs by partnering with cities to ease parking congestion.

But First, Let Me Take a Selfie: Companies are starting to use facial-recognition apps that utilize smartphone snapshots to verify identity.

Chart of the Day

Things that we want are getting cheaper.  Things that we need are getting more expensive.

WTF

Hero: Regular readers know that I’m a sucker for a great headline.  Man ‘High on LSD’ Saves Dog From Imaginary House Fire is among the best that I’ve seen.

The Softer Side: That Russia is a bizarre place is pretty much self evident.  This new Vladamir Putin calendar featuring the Russian leader cuddling with kittens won’t do anything the change that perception.

Parent of the Year: A Pennsylvania woman has been charged with child endangerment after refusing to feed her 11-month old son anything other than fruit and nuts.  I’ve said it before and will say it again: veganism is a mental disorder.

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com

Landmark Links October 18th – On Point