Is the saying “There is too much money chasing too few deals” an Urban Legend?
It’s been repeated so frequently through the past few years that the concept is almost universally accepted as truth in the residential development industry. Many private equity funds, hedge funds, etc have raised money to invest into housing development. However, in recent years, it’s not the amount of money raised that’s been problematic, but the type of money available unfit for projects needing financing in today’s relatively stable housing market.
Before the housing bubble and subsequent bust, private home builders typically utilized bank debt and pension fund capital to build subdivisions and master-planned communities. The debt component was readily available, attractively structured and pension fund capital had relatively long investment horizons with reasonable return expectations when compared to opportunity fund money which was typically used for entitlement projects and other, more risky ventures. It wasn’t unusual to have decent sized private builders in California build and sell several hundred homes a year or more. With a couple of notable exceptions, they were not going to compete with public home builders when it came to the cost of funds. However, they were still substantial players in the market and were able to build at decent levels of production while often delivering higher quality homes than their public competitors. This all changed when the housing market crashed. Banks reduced exposure to the home building and development space by a substantial amount, as did pension funds. Some left the space entirely.
At the same time, pension funds and banks were pulling back, opportunity funds ramped up their fund raising in order to capitalize on the carnage that the Great Recession wrought on land values. They offered their prospective investors high-octane returns that would be realized when they bought trophy properties at bargain-basement prices in a distressed environment, to develop or sell as the market began to recover. This capital was and is well suited for opportunistic investments brought on by a market crash – thus the label opportunity fund. But isn’t a great fit for investment in home builder and land development deals in a stable market. In reality, the window to buy distressed assets wasn’t quite as long as many had anticipated and the doldrums of 2010-2011 quickly gave way to a run-up in transactions and land values in late 2012 into early 2014. All of which brings us to where we are today: a stable market with tight inventories where there is a ton of capital that has been raised – but very little of that capital has a return profile that fits where it is needed most: lot manufacturing and production home building. There are several reasons that this is happening:
1- Unrealistic Investor Returns in a Stable Market
As stated above, much of the capital that has been raised to deploy for home building and land development in the market today is much better suited for a distressed market than a stable one. However, there is something bigger at play: equity funds are targeting the same mid-20% IRR returns with the 10-year Treasury yielding 1.75% that they were when the 10-year was yielding 5%. All returns are relative, meaning that, in real terms, today’s targeted returns are actually substantially richer than they were when the 10-year was substantially higher. This has more to do with fund raising and marketing than anything else. Funds are reluctant to pitch investors at the returns they are likely to achieve (mid to high teens) since their competitors will still promise mid-20%s, meaning that they won’t be able to raise capital, even if the underwriting that they are using to get to those returns is nonsense.
2- Private Builders Get Squeezed Leading to Less Competition
In order to offer high returns to investors in a lower return environment, funds need to grab a bigger piece of a smaller pie, leaving less for builders and developers. Typically, this means putting steep minimum multiple hurdles in their waterfalls. Ironically, minimum equity multiples are incredibly short sighted as it encourages builders to push prices rather than absorption since the multiple hurdles are almost always substantially higher than the IRR hurdle, leading to longer sell out periods. In addition, the few bank lenders left in the space are typically quite conservative and require a full persona guarantee. So builders now have to put up 10% of the equity or more in order to get a deal done and put their balance sheet on the line to finance it and are getting a smaller piece of the returns. So what’s the point? This is a huge reason why very few decent sized private builders are left – in many cases the reward simply isn’t worth the risk.
3- Lack of Debt Capital Resulting in Broken Deal Structures
Many land deals purchased during the aforementioned 2012-2014 run-up were bought under the assumption that either debt would be available to improve lots or public builders would purchase paper lots. Fast forward to 2016 and the public builders still don’t have much appetite for paper lots nor is there debt readily available for horizontal development. Therefore the owner will need to sell for a substantially lower number than featured in their proforma (sometimes even a loss) or improve the lots themselves by raising additional equity. Thus many of the sites bought in 2013 with a business plan to entitle and flip are effectively underwater. Mind you that home prices have almost universally INCREASED during this time frame but a lack of reasonably-priced development debt or public home builders with an appetite for paper lots has caused a stealth land correction of sorts that has been playing out for months.
4- No Investor Appetite for Long Duration Deals
Many opportunity funds are of the mindset that we are getting late in the cycle since prices have risen so substantially from the bottom despite the fact that housing starts in key production markets haven’t picked up much and inventory is still bumping along near record lows. Many funds have been looking to trim project duration in an effort to ensure that they are out when the cycle inevitably turns. As a result, there are some incredible opportunities out there that require capital to execute a 5-7 year business plan that no one will touch due to duration. This short-term mentality has left a large hole in the market for anything but bite-sized infill deals.
If this actually were a market with the aforementioned “too much capital for too few deals” we would expect to be seeing increasing transaction volume and increasing land prices as the supply of capital led to a seller’s market. However, neither of these are occurring in all but a select few markets (at least on the west coast). Instead, we are seeing light (at best) land transaction volume. In order for the land market to turn the corner, either the public builders need to regain their appetite for buying paper lots and developing them or we need more sources of capital that are properly aligned with the projects that they are financing under normal market conditions.
Home building and land development can both provide great returns in a healthy market. However, trying to finance these ventures with little-to-no debt and opportunistic capital raised to buy distressed assets is like trying to fit a square peg in a round hole. Does this sound like a market with too much capital to you?