Developers Are Ditching This State as Regulations Rise

Henry:
When I first started investing in real estate, I had tunnel vision and I only thought about buying rental properties, but I’ve gotten so much more strategic with my investing by looking at other exit strategies and asset types. So today we’re discussing trends from three different areas of real estate and why they matter even if you’re not investing in those areas. Hello everybody. I am Henry Washington, one of your hosts today while Dave Meyer is out. And welcome to On the Market. I’ve got Kathy Fettke and James Dainard with me. What’s up guys?

Kathy:
Good morning. Morning guys. Today we’ve pulled some of your most intriguing observations and trends from the BiggerPockets forums. We’re going to look at them from all sides so that we can make more informed investing decisions, how California regulations are shifting the market landscape, whether we agree with the folks throwing in the towel on commercial real estate and how to juggle rising construction costs and unpredictable ARVs. That’s after repair value.

Henry:
But before we jump in, let’s give a quick shout out for the BiggerPockets forums. The trends we’re talking about today are all observations by BiggerPockets community members just like you. So head on over to biggerpockets.com/forums to join the conversation. So our first forum post comes from Reese Schulman and it says that real estate developers are removing their operations from California. Two contributing factors are high construction costs and regulations that make obtaining construction permits difficult. California already has a large housing shortage, and if developers do not build additional housing units, it is likely we will see rents increase on much older and likely inferior housing compared to what developers would have built. So we got to point the finger at Kathy. Kathy, what’s the deal with the building regulations in California?

Kathy:
It’s pretty tough to build anything. We were building subdivisions probably 10 years ago, and at that point I think we compared just the cost to get permits. Let’s just take school fees. The school fees in California were tens of thousands of dollars more than just over the border in Nevada. So I think just trying to get into the ground, the difference was $120,000 costs versus maybe 20,000 to go to Reno. So we shifted our operations to Reno at that time and we’re in Bozeman and Oregon and other places. But California’s tough. On the other hand, I literally just talked to a real estate investor who said, this is good news for me. I have less competition when we bring something online. There’s a lot of obviously interest in it because housing is so desperately needed. So depending on how you read this, there’s an opportunity for somebody who can come in and fix the problem and some people are, but for those of us who just don’t want to deal with it, absolutely not. Here’s an example, just a line from this article. It says, the entire state of California with 40 million people will produce less rental housing than Dallas-Fort Worth with 8 million people in 2024. So places like Texas, it’s a lot easier to get permits and to get something up and running and built. That’s why we’re doing a build to rank community in Texas because we can get it up and running in a couple of years. I don’t know how long it would take in California, but I’m not willing to take that risk.

Henry:
It seems to me like first of all, I mean this only makes sense, right? If it’s challenging for someone to be able to make a profit building new construction, they’re obviously going to look at places where they can make a profit and move that infrastructure from a business standpoint. That makes sense. But also you’re right, it’s almost like any industry. There are areas where it is challenging to make money and areas where it’s not, but the people who do really well are the ones who can navigate the more challenging areas effectively because of the limit on competition. But I think it really is going to boil down to people who have some sort of edge. Your edge has to be, you can get labor more inexpensively than other people or you can buy the land more inexpensively than other people. You’ve got to make up the cost somewhere. And so I think people who kind of have those superpowers within their business will do great in California, but other people who don’t, they’re going to have to look other places.

James:
So one thing to note about this article is this is a developer that builds rental units not for resale. That’s the issue with the west coast right now. I mean the west coast is actually, it’s not a bad place to build homes. If you’re going to sell ’em for resale, you can purchase the properties. You get high appreciation, you get bigger margins at that point. I mean, I look at these guys that build single family homes in SoCal or where I just moved from, they would pay two and a half million for a lot. They’d spend two and a half to build and they’d sell it for seven. That’s a huge profit. And the developers that are building to resale, I think they’re still doing okay in California because the money is there. The issue being is in the west coast there is way too much regulation and the costs have gotten too high to deal with that.
Your dirt costs, your borrowing costs, your bill costs, they are through the roof. And not only that, that process takes forever to get these permits. In the city of Seattle, we just purchased a property 12 months ago where the developer had owned it for three years and was permitting over a 200 unit. Ew, an apartment building where they were bringing 200 units to market. The issue being is the city took forever. It took ’em three to four years to get this permit. During that times rates shot up, building costs shot up, and they could not make this deal pencil anymore. They would’ve had to write a massive check just to get this thing to break even. So we ended up purchasing this property off that developer scrapped their whole plan that they waited three years for. We’re keeping the apartment building, we’re building about 20 townhomes next door.
And that’s how the deal makes sense. It’s not just about being on the west coast and can you make money. It’s more of the timelines and the costs just don’t make sense. And with all this regulation coming down the west coast on rent control and what you can do to your rental properties, it’s not worth the pain. I would never build an apartment building in the west coast. We do all sorts of different things. We build town homes, single families. I’m not building apartments, I’d rather rent or them. It is a complete waste of time and a nightmare for developers and that’s why they’re leaving and they have to fix this if they want more units on the west coast.

Kathy:
Yeah, I want to add one thing that there’s a lot more than just finding some land and building a house or a property. You’ve got to do traffic studies. You’ve got to make sure there’s enough utilities for all of those new people. And that’s a huge issue, especially in California when just a couple of years ago, we’re out of it right now, but a couple of years ago we were in a pretty major drought and we had pretty severe water shortages. We couldn’t water our lawns and don’t feel sorry for us. I mean, poor us, we all had these lovely houses with brown yards, but that’s just how do you bring on a lot more supply and spread that water out when you just don’t have it. So again, there’s a lot more to it and that’s why areas that don’t have those issues, that don’t have the water issues that’ve got plenty of water and they don’t have the traffic issues that we have in California, which are kind of hard to fix when it’s an area already built. How do you bring in more roads into la? It’s like it’s a big mess already unless you have more public transit. So those are things you have to look at too, and that makes it tough.

Henry:
That was really going to be my next question is it’s easy to say California is difficult to deal with because of the amount of regulation, but is the regulation necessary? And I think that that’s not something we always have a clear picture of.

James:
It’s not, I’m sorry, some of the regulation is not necessary because here is the issue with that. The dirt’s too expensive, the bill costs are too expensive, your debt’s too expensive. That means you have to build an expensive product that is the cards that are being dealt to these developers. They cannot do anything different than what they have an opportunity for.

Kathy:
Yeah, that’s right.

James:
That’s not product that’s for affordable housing. That’s brand new, more luxurious product that has to come to market. And there is that demand too over the low income and the more affordable housing. And so it’s like they’re putting this regulation on and all it is doing is affecting the working class that are actually bringing in tax dollars and that’s why they’re getting drained with big deficits every year. What are they 50 million in the hole right now? Or 50 billion? Excuse me. It’s a bad plan. You cannot, you’re overregulating an asset class that doesn’t even fit in there. It makes zero sense

Henry:
And then you build it and you can’t insure it in California. So it’s super tough.

James:
Yes, I mean my insurance got canceled four times in California. I was like, I’m out. This is crazy.

Henry:
We brag on California, but every state has some sort of regulation and I think if you’re going to be a successful investor or builder, you have to understand what the states or aren’t looking for in your area. You have to understand how to work with those officials. It doesn’t matter. I have a project right now that I’m going to have to go to the city and you always want to go to the city and go in a place where you’re able to say, look, how can we partner together to solve a problem that the city needs? And I think that you have to be a good operator no matter where you are. But in places with high regulation, you really, really have to have a superpower in terms of working with the cities

James:
And also look for the gaps of where you are. The west coast doesn’t make sense to build multifamily a lot of times nowadays it used to. Now it doesn’t because the cards that are there, but you can rent ’em. You can go buy apartments and rent them and do very well in California and the west coast. You can build homes for resale. I mean there is a gap somewhere. You just got to adapt your plan. Maybe you don’t build the rent but you rent out to rent. That math works pretty good for us in Seattle, work down in LA County as well.

Henry:
Alright, we have to take a quick break, but don’t go anywhere. We’re discussing more of your forum questions when we come back. Welcome back to on the Market. Let’s jump back into the forums

James:
And this leads into our next post. So this post comes from Eli Cantor and it’s about commercial real estate. What’s going to happen with all these buildings that are starting to not be occupied and landlords are starting to give up and give the keys over to get out of the deals? The question says in today’s markets, many office landlords would much rather walk away from their properties and take a loss than fight to attract tenants and avoid foreclosure for these owners. The future of office space looks so grim that the best option is to simply give up. What do you think lies ahead for building and their owners? I thought this was a very interesting question because I think this person might’ve read too many headlines. I think we were all predicting that they’re going to be walking away, but the foreclosures just aren’t that much in commercial real estate.
Our landlords across the nation struggling with new costs, lack of rent growth, yes, that’s what’s going on, but it’s also obviously in office. It has slowed down. The pandemic has changed things, but it is not as crazy as what they make it out to. In 2020, commercial foreclosures were at an all time low hitting 141. Now today, 2024, it has risen 117% to 6 25. That seems like a big number, but when you look at the total commercial buildings in America are over 5.5 million properties or estimated to be, that’s a very small splash in the bucket for what’s actually going on. So I don’t think that commercial real estate owners are just handed the keys over. I think if it really mathematically doesn’t make sense and it’s by a larger hedge fund or a bigger bank or someone that is investing for the long term and they see as a bad investment, they are handing those keys over because they’re just making a decision.
But I don’t know any commercial landlords right now that are just handing over their properties and I don’t see that coming as of right now. If we hit some sort of major mix up in the economy, we saw an unemployment been jumping the last couple months, if that continues, then we might start seeing a little bit more pain in the commercial space. But right now the economy’s still moving. Commercial real estate isn’t this huge collapse that we’ve seen so far. And I think owners, if they are handing over their properties, it’s just a bad investment and sometimes that’s the best thing you can do. If you don’t have a personal guarantee and you can deed that property back to the bank because you were hemorrhaging money and you do not see the upside over a five-year period, that could be the right business decision too. But I just don’t see a lot of that going on. Kathy, in your space, you work on a lot of big projects, I know you do more residential. Have you seen this as you guys have about looking for new investments across the nation? I know we haven’t seen this many. I mean, have you guys seen the opportunities come your way? Well,

Kathy:
We don’t invest in office. We have one suburban office building that we actually have on the market right now. And Suburban seems to be doing better than downtown office if we are going to partition what kind of real estate we’re talking about. I was interviewing for someone to manage our syndication department at Real Wealth and I had this Wall Street guy, he wanted a $500,000 salary. We’re like, yeah, that’s not in the ballpark, but he goes, well, real estate is so simple, it is just math. I’ve been doing this for years. I said, great, let me see your portfolio. I’d like to see the performance of the deals that were so simple because I don’t agree. That is simple. Sure enough, it’s like he had this whole section of office that was basically going under and then he’s like, well, yeah, but that’s cycles. Yes, it is cycles, but you clearly paid too much for these office buildings When interest rates were low prices, asset values went up, and especially on Wall Street, these are big numbers, lots of zeros, and it can sometimes just feel like, oh, it’s just math until the math gets screwed up because of some outside force, which is, oh, I didn’t realize rates would go up from 2%.
Of course they were going to go up. So I think there are a lot of, I mean you just see it in the REITs, right? There is a drop in value. Just recently this news came out, I think it was from Biznow, but it says Data from MSCI shows that 20 billion worth of commercial real estate was seized in the second quarter. That includes not just office states but multifamily and other commercial assets. It also says that more than 94 billion in commercial real estate was distressed in June and another 200 billion at risk. So it’s not over, it’s just people have been saying survive till 25. That’s been the same. We just survive till 2025 and we’re almost there, right? Rates are coming down and some of these loans that are due might be in a better position because they’re on adjustable rates and as rates go down, they might be able to get themselves out of this, but there are companies that won’t survive till 2025.

Henry:
So I have a couple of thoughts here because I own a commercial asset and we have one vacancy in this asset in particular that we’ve been struggling to get filled that we didn’t struggle to fill vacancies a year ago. And so we’re seeing a little bit of the impacts of what we’re talking about in this article. And I just notice every time I’m driving by office buildings in my market, I mean they are vacant, they are empty, and I’m talking legit office, not retail. There are businesses who must have a brick and mortar and they’re going to continue to fill up retail spaces, but the pure office complexes, I just see lots of vacancies and for rent signs. Now I am not seeing a lot of foreclosures in this space, but how long does that last? And even if rates come down to a point where these people can refinance and continue to hold onto the assets a little longer, that doesn’t solve the problem of being able to fill vacant spaces with office tenants who don’t need office anymore.
And so I do think that some of these owners are going to have to get creative on how they fill these spaces or how they monetize their buildings because even if you can lower your mortgage payment, you still can’t pay it if you’re not getting rent. And so I think creativity is going to have to come into place here. Maybe you can shift the use of some of your office building to some other sort of commercial asset where somebody will pay you rent, maybe you take some office and use it as event spaces. Maybe you take some office and convert it to affordable housing. I do think that whoever figures out the office, vacant office to affordable housing problem, whoever solves that problem is going to make a ton of money. We need affordable housing. We’ve got a bunch of vacant office. That seems like a huge opportunity, but there is a lot that will need to happen for that to actually become a reality. But I think that there’s a huge opportunity there.

James:
And what Henry just touched on about being creative in the demand where when you have a bunch of open buildings, where is the demand? The demand is affordable housing, like Henry just said, there’s not as much demand in the office world and there will be a trend where someone’s going to figure that out or figure out how to cut these things up to go where their demand is because you have to do it when you’re dealing with these size of properties. In 2009, we bought, it was a 10,000 square foot medical office and we thought we got the deal of a lifetime. We paid a hundred bucks a foot for this thing. That’s like 20% of what you can build it for. It was 50% below appraisal and we’re like, we’re going to be rich on this property was up for rent for a year.
And then what we found out is it doesn’t matter what you buy it for, if no one wants to rent it, it’s worth nothing. And what we had to do to get that thing filled was get creative. We ended up moving our office down, which was 40 minutes out of where we wanted to be. We occupied the building, we pumped some life into the building by having someone there. And then we started basically WeWork down there in 2009 where we cut up and did offices at 150 bucks to 250 bucks, small little offices. And that filled the space. And as we filled the space, more people came in and eventually we sold that building down the road. It was not a win. I mean we wrote a check to sell that building eight years later, but that building would’ve sunk us unless we got creative. And to Henry’s point, these buildings that are just sitting there abandoned, they better start figuring that out because there could be issues. If the dollars aren’t coming in and your insurance and taxes are going up, you’re going to start writing checks every month that you do not want to write. And that’s where we could see some more foreclosures going on.

Henry:
So I think the moral of the story is you need to be monitoring your commercial asset to figure out a, can you keep it and hold it long enough to sustain yourself and can you get creative enough to actually generate income and keep the asset as this market continues to change and develop. Alright, we have one more of your questions to tackle right after this ad break. Welcome back investors. Let’s jump back in the conversation

Kathy:
Onto our last forum post. It’s about a trend one user’s noticing with renovation projects. Henry Lazar, Lowe’s post reads. I have noticed an interesting trend that’s been more and more common since about 2018 buildings selling for more than their after repair value merits. For example, a building that needs $150,000 of work will sell for $300,000, but the after repair value is only $420,000. And so you look at that would be a $30,000 loss. Maybe people are buying and not fixing who just wants a multifamily unit at a lower price point. So yeah, that sounds like bad math basically. Exactly. I’m guessing if this is a trend, maybe it’s a house hack where it’s like, Hey, I can live with this not being fixed for a while and fix it over time. I don’t know, James, what are your thoughts? Have you seen this trend?

James:
I think this is bad math and you’re just looking at the wrong deals. We buy all sorts of different properties and they’re heavy fixtures and people think they should be torn down and we are able to implement a plan on an increase the value. And if you think it’s 150 in the Matt’s not working out, they are figuring out one way, shape, or form. The first thing is you’re either missing hidden value in the property. Can you cut up that lot? Is there zoning upside? There might be a different purpose that you’re maybe not underwriting for. The second is you might need to audit your construction costs because if I’m at a hundred thousand and you’re at one 50, that’s a huge difference. If I can get my cost down 35% lower than you, that means I can execute on it and actually turn a profit. And so if the math’s not making sense, I would rather look at my internal processes rather than look at the deals and go, these deals don’t make sense because if other people are buying them, you need to switch some things up. I know Henry is constantly buying deals and it’s about implementing the plan, not just buying the deal.

Henry:
Dude, this is if you just reword what this guy is saying, he’s saying something we have always said, which is like when you put in an offer on a property and you put it in at a price point that makes sense and somebody comes in and scoops it up for like a hundred thousand dollars more. We’ve all asked that like, man, how are these people making money on these deals? And then I just move on because it’s not my strategy. My strategy is to buy deals where the numbers work, right? Like I’m buying value add, I’m buying under market value, I’m adding value and I’m monetizing at the higher value. And you will rack your brain trying to figure out why somebody is willing to pay more than you in a situation. And there’s a lot of reasons why people may be willing to pay more than you.
Not everybody is looking to take that asset and make income on it the way that you need to make income on it. Some people are literally parking money to avoid taxes and they don’t care if the property cash flows. Somebody could sell an asset in California or New York and need to plant that money somewhere so that they can not have to pay so much taxes and they’ll go and they’ll buy something that is not going to cashflow but benefits them in some other way. You’ll rack your brain trying to figure out why other people do math differently than you do. It happens all the time.

Kathy:
Oh, Henry, that is such a good point because I remember back in 2012 when the hedge funds started to come in and buy single family, that’s after Warren Buffet came out and said, oh, if I could buy a few hundred thousand homes, I would if I knew how to manage them, wall Street listened. That’s when they came in and they were paying way more than any investor would even consider and we’re all just scratching our heads. What are they doing? Well look at them now. 10, 12 years later. I think they did all right. They were looking at different math. We were looking at how do we make this cashflow? And they were looking at, these are cheap. We’re buying stuff for so cheap, they’re going to go up over time. So that is so true, Henry, I’ve done it. I’ve paid too much for stuff and I’m sure other people were scratching their heads, so either people are going to make money or lose money. Time will tell.

Henry:
Look, I brought two new construction houses this year that make me almost no cashflow per month. They just barely pay for themselves, but I bought them so that I could cost save them and it’s going to save me a bunch of money on taxes. So did I pay more than somebody else will probably pay? Absolutely. But I had a whole different reason for buying it than other investors were looking for. That’s just it’s real estate guys. That’s how it works.

James:
Well, yeah, and an on market deal, if you’re paying the most, you’re paying the most. We buy tons of on market product. We are paying the highest in the market. Does that mean we’re buying a bad deal? No, it doesn’t. It means we’re buying a deal that works for us. If you’re getting out-priced and you can’t figure out the bath, go look at what other people are doing. If Henry outbids me on a project and I’m going, I can’t understand how this math works. You know what I’m going to do? I’m going to get my car and I’m going to start driving by Henry’s house and see what he’s got going on there. I’m going to see who he has working there. I’m going to see what he’s doing and I might need to borrow his contractor. And that way I get in the game, do whatever it takes to get yourself in the game. And if it means stocking the investors that are out bidding, you go do that and go get the resources because yours aren’t working.

Henry:
So at the end of the day, look, your real estate math is your real estate math. You need to stick to your numbers that work for your exit strategy and don’t kill yourself trying to figure out how all these other people are making money on numbers that don’t work for you. You just have to keep to your numbers and understand your business and then use it as information like James said, to go learn what they’re doing and maybe get a little bit better if that strategy fits your financial goals as well.

Kathy:
Let’s touch on the AR v though, because we were talking about costs, but we weren’t talking about that after repair value. And so you can kind of control what you think the costs will be to repair the house and obviously to purchase the house and the holding costs and so forth. But how do you really know you’re on the mark with that rv?

Henry:
Yeah, it depends if it’s commercial or residential. I mean, if it’s commercial, that asset’s valued on the income it’s producing, so you can do things to increase your A RV by either increasing your revenue or decreasing your expenses. That can help you get that a RV up. And you can essentially force appreciation with commercial, which is pretty cool with residential, you are reliant on that appraiser. Maybe some people are in there sweet talking these appraisers and making them believe they did more than they actually did when they bought those properties because we are literally at the hands of the appraiser when it comes to that. And so sometimes these plans backfire because people estimate or underwrite their A RV, assuming that the value that they add is going to get them a certain a RV number, and then that appraiser comes in and says, nah. And so now you’re upside down based in that appraisal. There’s just less control there.

James:
And if you don’t want to be off on your A RV, and that is something that is really important for buy and hold investors or even flippers because if you’re off on that exit number, you have to either write a check to get out of your flip, you’re going to lose money now selling for less, or if you’re going for your first bur, your money’s going to be trapped there as the value comes in. If it comes in low and your basis is too high, you have to cover that as the investor. The banks are only going to leverage you so much, 70 and 75%. Typically, how you ensure that your A RV comes in at value is really a detailed scope of work. What value are you trying to achieve that you put on it during your underwriting, what upgrades were done? Do not spend more on that property just because you feel like it or your gut says it’s a little bit nicer. Use logic and use math. Appraisers. Don’t care if you upgraded your countertops to the slabs that are double. If you spent 10 times more on your tile, it looks like tile to the appraiser, spend your money wisely. That’s how you control your cost by controlling your cost. That’s how you stay within your refinancing guidelines and making profit on a flip.

Henry:
Well, thanks everybody. That’s our show. If you have opinions on these topics, chime in at biggerpockets.com/forums. Maybe your question will end up on another show just like this, and we will see everybody on the next episode of On the Market.

Dave:
On The Market was created by me, Dave Meyer and Kaylin Bennett. The show is produced by Kaylin Bennett, with editing by Exodus Media. Copywriting is by Calico content, and we want to extend a big thank you to everyone at BiggerPockets for making this show possible.