July 26, 2018

JF1423: Debate 02: Value Add Syndication Vs. Affordable Housing Tax Credit Development with Evan Holladay and Theo Hicks

Best Ever Listeners, I hope you enjoy this episode! This is my first time on the podcast, usually I’m a behind the scenes guy but I’ll be the moderator of some of these debates. Evan and Theo are both experts in their field, we’ll hear the pros and cons of what they do, and why they ultimately chose their strategy. You can let us know which strategy you prefer at bestevercommunity.com. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

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Joe Fairless: All you experienced Best Ever listeners who are looking at value-add multifamily syndication – well, we’re going to open up your eyes to a different type of approach, and that is affordable housing tax credit development. Evan Holladay is gonna be debating Theo Hicks on which strategy is best for you, and they’re ranking it based on four factors: barrier of entry, risk/returns and maintainable in a downturn.

Enjoy this debate with Theo Hicks representing value-add multifamily syndication, Evan Holladay representing affordable housing tax credit development, and when you identify which one is right for you, go to BestEverCommunity.com and let us know which one you’re gonna be doing, or which one you’re gonna be learning more about.


Grant Rothenburger: Hello, everyone. Thank you for tuning in to our second Best Ever Debate. We are filming live on Facebook right now, but you may also be listening on our podcast, the best real estate investing advice ever show… And I am joined by Theo Hicks and Evan Holladay. Theo, how are you doing today?

Theo Hicks: I’m doing great, Grant. How are you doing?

Grant Rothenburger: I’m doing great. Like I mentioned, I’m a little nervous to have my voice on a podcast for the first time ever.

Theo Hicks: [laughs] You’re gonna do great, Grant.

Grant Rothenburger: Thanks. Evan, how’s it going today?

Evan Holladay: I’m doing well, thank you for having me on.

Grant Rothenburger: Absolutely. Thanks for joining us. Today Theo and Evan will be debating value-add apartment syndication – that’s Theo’s side – versus affordable housing tax credit development, which is Evan’s side. A little bit about Evan – first of all, he was a Best Ever guest already on the podcast, so if you haven’t heard it, it is episode #1367, titled “Hustle leads to dream job as an affordable housing developer, with Evan Holladay.” He’s a real estate developer and investor, he is the host of Monumental Podcast, developed over 100 million in new construction multifamily at LDG Development, and they use tax credits to create affordable and mixed income communities. Based in Louisville. Say hi to him at EvanHolladay.com.

A little bit about Theo – he’s a creative project manager and investor, part of a team that has syndicated over 300 million in value-add apartments, co-author of two books – The Best Real Estate Investing Advice Ever, vol. 1 and vol. 2. Based in Tampa, Florida, and say hi to him on Facebook.

With that, guys… We’ll start with Evan – do you wanna tell us a little bit more about yourself?

Evan Holladay: Yeah. I think that you covered a lot of it, Grant, but just to add on to that a little bit… I’ve been with LDG about five years, been in real estate I guess coming on ten years. I really got started in college, got obsessed with development, started a development company in college, and took that out and got into affordable housing, new construction, multifamily development; we mainly do 200+ unit developments, and work a lot in Nashville, New Orleans, Tennessee and Louisiana. Those are my main markets… But I absolutely love it, I love real estate, and I’m glad to be here today.

Grant Rothenburger: Awesome. Theo, I think the Best Ever listeners probably know about your background, but do you wanna give us a little bit more about yourself?

Theo Hicks: Yeah, sure. So I started in real estate in February of 2015, I believe, by house-hacking a duplex. Then I kind of took a little break after that property for about a year, and then in the process of getting back into real estate I hooked up with Joe, and I’ve been working with him for the past – over two years now, approaching three years… So I’ve learned a ton about apartment syndications by just working with him and helping him out with his business.

I’ve just made this move to Tampa; I was in Cincinnati before. I planned on starting my own syndication business there, but instead, I’m starting it down here in Tampa. I’m in the process of learning the market, and I’ve met some property managers, some brokers, and now we’re just looking for a deal.

Grant Rothenburger: Awesome. I know we’ll be hearing more about that on future Follow Along Friday episodes, so I’m looking forward to that.

Alright, into the debate… So we have five categories that you guys are gonna rank 1 to 5, 1 being easy, 5 being hard, or in the case of returns and others, 1 being low and 5 being high.

The five categories are barrier of entry, risk, returns, maintainable in a downturn. That’s only four.

Theo Hicks: So four.

Grant Rothenburger: Four categories. So let’s go ahead – we’ll take turns and we’ll let Evan go first on barrier of entry. What have you got for us?

Evan Holladay: Okay, so you want us to rate each one individually, not as a whole, right?

Grant Rothenburger: Correct.

Evan Holladay: So for barrier to entry, I think the biggest things to take into account with new construction and tax credit development – they both have a high barrier to entry, and that is a good thing and a bad thing. The barriers to entry come from a lot of different things. I’m gonna go through some of the things that may not be good to get into multifamily, but it also helps you (if you’re getting into multifamily) protect against others that are trying to get into that industry of new construction or tax credit developments.

So if you’re doing new construction, you have to really work with communities and try to figure out exactly what they want. You have to make sure they’re on board, you have to make sure the city council members are on board, you have to make sure the mayor is on board, and really anybody along that process as far as the political side, or even the planning side, has a lot to say with how your development turns out, or can say yay or nay on the support of your project, and that can potentially kill your development. So that’s a big barrier to entry for new construction, but if you’re able to work with communities – our company, LDG, has done very well in working those relationships and being able to get through that zoning process, the permitting process, the design/development process… That is going to enable you to create those long-term relationships with cities that enable you to do not just one deal, but many deals with a community if you do it right.

So I think that’s a high barrier to entry, but I think that also adds a lot of value if you’re getting into it; it means that first deal is gonna be a whole heck of a lot tougher, but once you get that first deal done and you’ve done a good job and you put your all into that first deal, then that makes the next two through ten deals that much easier, because you have those relationships and you have that track record.

The other side of it is with new construction there’s also that unprovenness of the market; you’re building something that’s brand new, it has no track record… But that is a barrier to entry because it makes it harder, but it also is a good thing, because you’re building something that is brand new and is gonna add a lot more value to your investors, and it’s harder to build, but that also is good because then you don’t have as many competitors coming right behind you and just copy-pasting and doing exactly what you’re doing. It makes it harder for others to get into that neighborhood or that city and do exactly what you’re doing. So that helps protect your investment. I think that covers it on the barrier to entry.

Grant Rothenburger: Yeah, definitely. That was great. Thank you for that great explanation. What would you rate it 1 to 5 (5 being hard)?

Evan Holladay: Probably like a 4,5. It’s pretty high up there.

Grant Rothenburger: Fair enough. Alright… Theo, barrier to entry for value-add apartment syndications?

Theo Hicks: I would say I think it’s definitely lower than development, but it’s not a 1 or a 2. I’d probably give it around a 3. There’s a couple of factors for value-add that just take a couple of years… For example, experience; you need to have some sort of real estate experience prior to becoming an apartment syndicator. It can be something as simple as doing your own deals yourself, but ideally you’ve been involved in apartments in some form or fashion, whether it be as a broker or working for a property management company or working for a syndicator… So having some involvement and experience and experience in apartment syndication that you can leverage when having conversations with your team members.

This isn’t necessarily a requirement in the sense that you won’t be able to literally do an apartment syndication if you don’t have this, but you’re not gonna be able to do it successfully if you don’t have this, which is education. You need to know what you’re talking about, you need to know the terms and the terminology… I’m sure this is the same for development, but you need to know what you’re talking about, so when you’re having conversations with your team members – this includes your investors – you come across as a credible person. And of course, you need to have the education and experience to actually prove that you’re able to execute on the deal.

You also need to find private money… So depending on where you’re at in your life, depending on what job you do, the relations you have, it can be as easy as picking up the phone and calling up your friends, or it could sometimes require a more proactive effort, in the sense that you have to start to form relationships with other people and go to places where there are high net worth individuals.

Now, of course, for all of these things – you can offset them by partnering with someone, but you’ll have to have one of these things. You’ll have to have either access to private money, or the experience. If you have the experience, you can partner with someone who has access to private money but maybe doesn’t have as much experience, which is what I’m doing… Or if you have access to a bunch of private money but don’t know what you’re doing, you can find an operator that does know what they’re doing. So you can kind of offset the barrier of entry there, which is why I rank it a little bit lower, by partnering up.

I think experience and education are what you need to be a value-add apartment syndicator, and depending on where you’re at in your real estate career, you may or may not have that. So the barrier to entry – I would give it an average of 3. If you have those things, it’s gonna be a lot easier, but if you don’t, it’s gonna be more difficult, or at least take more time to get those things.

Grant Rothenburger: Right. Both strategies are pretty similar on the barrier of entry. It’s not something for a newbie investor. You at least need a good amount of education or a great team in place that has experience… So clearly, they’re pretty similar there. And Theo, we’ll go back to you now with risks. How much risk is involved with value-add apartment syndication?

Theo Hicks: I think the rest of these are pretty variable, because it depends on how you buy it, what your business plan is… Based off of our strategy, I’d give the risk a 2, because I think 1 is unrealistic… And here’s why. And I know we’ve recently recorded a video on this on YouTube, talking about these three immutable laws of real estate investing… Those are “Don’t buy for appreciation, buy for cashflow”, “Put long-term debt in place” and “Have adequate cash reserves.” As long as we have those three things, you are mitigating your risk as much as you possibly can.

When I think of risk, I think of capital preservation… So when I’m ranking this, I’m ranking it how at risk is the investors’ capital; not what they’re gonna make, but just the actual capital they gave me – how at risk is that if they were to invest in a value-add apartment deal?

I can go into more details on those three, but as long as you have those three in place, you’re mitigating the risk. For example, if you buy for cashflow and not appreciation – and by appreciation I mean natural appreciation of the market just going up… Not forced appreciation, which is kind of the key to value-add, which is making some sort of improvement to the physical or the operations of the property in order to increase revenue or decrease expenses, which in turn increases the value of the property… That is different than the appreciation I’m talking about; I’m talking about buying a property thinking that “Oh, for the past 10 years rents have gone up 10% every single year” or “For the last 10 years values have gone up 10%. That’s gonna happen for the next 10 years. After 10 years, my property will be worth this much more.” You don’t wanna do that, because again, if the market does not continue to go up, you’re gonna be in trouble.

For long-term debt – very similar. If you have a business plan that’s five years, you wanna make sure that the debt is set up for seven years. That might involve doing a refinance after a few years, but always making sure that you aren’t forced to refinance, aren’t forced to sell your property… Because if you’re forced to do anything, it’s most likely not for a beneficial reason.

And then adequate cash reserves is pretty self-explanatory. If something comes up and you don’t have the money, then you’re gonna lose the property.

Grant Rothenburger: Alright. And Evan, before you tell us the risk level with your strategy, would you give us — and Best Ever listeners, again, he was on the podcast already, talking about his strategy on episode #1367… But Evan, would you give us a quick breakdown of what your strategy is? Because it’s not just apartment community development, it’s a little bit more evolved.

Evan Holladay: Right, good point. So at LDG what we do is we do new construction and we use tax credits from the Federal Government that help cover some of the costs for building affordable housing, and then in return we’re kind of capping our rents based on whatever the average person is making in that metro area, and we’re taking that below the average to help provide a reasonable rent for people, so they’re paying no more than like 30% of their check or their monthly income on rent… So that gives them a safe, stable, quality place to call home and raise a family, and it helps provide housing for all the people that are working in the economy, that provide all of the services that we use on a day-to-day basis, but they are not reasonably being taken care of on the housing side…

Especially nowadays, you’re seeing more and more developers, or even rehab of existing, and the rents just keep skyrocketing… So these people keep getting pushed further and further out of town, and further and further away from their jobs, and that’s becoming a real issue. It always has been an issue, but now even more so… It’s also because more people are renting, so it’s just inevitably just driving up rents.

So that’s the value we add – we provide affordable housing, but yet the same quality as the market rate housing that’s just down the street, but we can provide it at a reasonable rent and help provide a good foundation for families.

Grant Rothenburger: Perfect.

Theo Hicks: Before you go any further, I’ve just got two quick follow-up questions pretty fast… Do these tax credits cover the entire cost to build? And then do you guys sell these afterwards, or do you hold on to them?

Evan Holladay: There’s two different types of tax credits. There’s one that covers 70% of the construction cost; that’s very competitive, you have to fit into a tiny little hole to score well to get those credits. We do not go after those credits, we go after the less competitive credits, the credits that are more readily available, but they don’t cover nearly as much; they cover only about 30%-40%… So you have to fill that last 60% with debt, so we leverage up to 50%-60% of the cost, and then we also fill in the last 10% with either putting in our own fee toward the deal, our own equity, or we get a tax abatement from a city that we can in turn borrow more money against, or we ask for a soft loan, payable out of cashflow type thing from the city or the state.

Theo Hicks: Okay, cool.

Evan Holladay: And then as far as owning, we develop and own all of our properties; tax credit compliance is 15 years, but our company has made it our strategy to build and hold, so we haven’t disposed of any of our properties.

Grant Rothenburger: That aligns with the wanting to provide housing for the —

Evan Holladay: Right, right, and that way we can keep it affordable long-term.

Grant Rothenburger: That makes sense. Cool. I thought that was necessary, so that we could have some context with direct categories.

Evan Holladay: Yeah, definitely.

Grant Rothenburger: So knowing that now, what would you say the risk level is for your strategy?

Evan Holladay: So for risk, with both tax credit and new construction – and I guess this applies to all real estate – you are at the whim of the financial market, you are at the whim of the total economy. So whatever you’re deciding today, by the time you’re ready to close, it may not be the case as far as interest rates or demand, or investor demand, but I think that is really amplified with new construction and tax credit development.

New construction – you’re just dealing with a longer lead time. The quickest deal I’ve ever closed – it took me a year from finding the land to getting the permits to getting the financing to starting construction; it took me  a year. That was the quickest I’ve ever closed a deal. Rehab – you can close much quicker than that, but new construction, you’re dealing with longer timeframes. I’ve closed a deal that took me three years to get across the finish line. So that is a big risk. I put that at 4, because there is a lot of inherent front-end risk with new construction development. You’re dealing with timing… In three years a lot can change, so that’s a big variable that you have to be aware of and be able to mitigate, and one of the ways to mitigate that is by having deal flow, having that pipeline of working on ten deals at once to close 2-4 deals a year type thing.

So that front-end risk – you’re putting money on the line; you’re putting money on the line for design/development, for permitting, for reports… So that’s all big risk that you’re putting up front. But on the back-end, what I would say is, especially with affordable housing development and new construction affordable housing, the risk just drops off precipitously.

Once you get to construction, construction is also a big risk, because you have to make sure you’re managing it well, you have to make sure you have a good GC… But once you’ve successfully built it, you’ve leased it up, that is when the risk just — for the most part, as long as you have a good economy in that area, you are almost… I don’t wanna say risk-free, but you’ve very much lowered your risk, because we’re dealing with affordable housing – our rents are capped, like I said a little earlier, and because of that, always our investors look for at least a 10% rent cushion basically below market rate rents…

And sometimes in cities where rents are skyrocketing, market rate rents are just out of control, Nashville being one of them, we have like a 50% to 100% rent cushion. So you can imagine when somebody needs affordable place to live and they see our place, that looks just as good as a market rate place down the street, but costs half as much, it makes their choice a lot easier, and financially it makes their choice a  lot easier. So that’s the cushion that provides much less risk on the back-side, because we’re always — at least right now, the last five years, we’ve been close to 100% on all our properties, with waitlists… So it’s that demand for affordable housing that’s kept it just being able to cash-flow the property and create good long-term real estate assets.

Grant Rothenburger: So you’re double-sided there… You’re really high on risk until it’s built, and then the risk kind of drops down considerably.

Evan Holladay: Right.

Theo Hicks: I don’t imagine that anyone could move into these buildings, right? For example, if you’re saying that in Nashville your rents are 50% to 100% lower than the regular rents, everyone that’s renting in those places that look the exact same and are paying way more – they can’t just come to your place, right? Only a certain type of person can move–

Evan Holladay: Right, right. They’re income-limited, basically. You have to make an income that is low enough that you need that type of housing. So it’s not just open to anybody, it’s open to people that are policemen, firemen, entry-level jobs, some sort of support role, paralegal, whatnot… People that are working, but are coming in at that entry-level job that need housing, but don’t have the ability to pay $1,800-$2,000/month.

Grant Rothenburger: And don’t need all the car wash, and…

Evan Holladay: Yeah, exactly, don’t need the amenities.

Grant Rothenburger: Alright. Theo, what have you got for us? You already did risk… Let’s go back to Evan now. Evan, how are the returns with the mixed-income, affordable housing tax credit developments?

Evan Holladay: The returns just in general — I would say it’s vastly different the way we look at returns for a development. We don’t have a sharing of cashflow with our investors. It’s very different. I’ll give my number first – I’d say returns, I’d probably put it at about probably a 4. It seems to be my number today.

So the returns for affordable housing development, at least the way that we’re doing it now at LDG – we’ve been able to build out our own units, so we act as our own GC… So for the returns side, we’re able to make that general contractor profit. We take that risk, but we make that profit and over the years we’ve been able to repeat, repeat, repeat, so we know what we’re doing by now.

So the returns are great, because we can not only make that profit on the construction side, but we can also go in and we get a developer fee as an incentive to do affordable housing. Each state allows a certain percentage… So we get paid that developer fee, or we can put part of that into the deal as our equity… But we can get paid part of that as early as closing, or through stabilization, and then after that we can get paid that out of cashflow. And we get paid that first, because there’s an incentive [00:22:39].16] tax credit development put an incentive in there to make sure that’s paid off by year 15. So our investors – they’re positively motivated to push us to make sure we get that paid in time, or else we have to pay that back ourselves. That’s a big tax event, it’s not a good thing.

So we get paid first cashflow, and then really the investors just want 1) the tax credits which we get from the Federal Government who gives it to the states… So they just want the tax credits. We get the cashflow, and on the back-end, at year 15, we’ll buy the investor out for a much smaller fee than you would a typical market rate development. So we’ll buy them out and then we can have that asset just producing regular cashflow… And we get the cashflow of the 15 years because of the developer fee.

So we look at it differently where we’re getting the majority of the cashflow. The cashflow typically won’t be as high as a market rate development, but we’re able to get that front-end construction, and then we also are able to get the developer fee and the cashflow and not really have to share that as much as you would on a typical market rate development.

Grant Rothenburger: Right. And when you get most of the cashflow, it’s okay if the cashflow is a little lower; you’re getting a bigger chunk of it.

Evan Holladay: Exactly.

Grant Rothenburger: Theo, let’s go to you. First, do you have any questions for Evan on the returns?

Theo Hicks: I don’t think so. He did a really good job explaining the returns. It’s hard to say like an actual number, as a percentage, because you’re not really putting your money in there, so it’s technically infinite. But now, I figured that in apartment syndication there’s an acquisition fee you get paid at closing, so it sounds like it’s kind of what that developer’s fee is…

Evan Holladay: Right.

Theo Hicks: And then I think the biggest advantage for you is that after 15 years the whole thing is yours. You have all of it.

Evan Holladay: Right. We pay some smaller fee, but it’s much easier to take full ownership of the development in affordable.

Theo Hicks: So for my end for returns – 5 is high returns, 1 is low… I put it at 3, right below the developer; I wouldn’t say that the returns are higher, assuming that you’re actually completing the deal.

I think it’s interesting that it takes a lot longer to do a development deal, and as you said, there’s more risk during that time period… Usually, for an apartment syndication if you close within 60 to 90 days after you’ve put a deal under contract — yeah, sure, things could potentially go wrong during that time period, but not as likely…

Something that’s different between the business model that you implement and the value-add business model is that yours is literally like a long-term hold; you’re holding on to these suckers for at least 15 years.

Evan Holladay: Right.

Theo Hicks: Whereas our business plans are five-year holds, as we usually project… So the drawback, you could say, would be that you’re not necessarily having that consistent cashflow; you have to continually do deals, but it’s a positive because you could scale it way faster. Joe has exploded in the past three years because of how quickly you can do these deals once you start having access to private capital.

So from a return perspective, why I say a 3 and not a 4 is because, as Evan said, he gets access to all that cashflow, whereas on our end we have to give the majority of that cashflow to the passive investors.

From an actual return perspective for passive investors it’s great, because they’re just giving us the money and then each month they get a preferred return, and then at the end of a year, any cashflow above that return will get distributed. Then of course there’s the forced appreciation that we do… So what’s good is that if you buy the deal right, you can cashflow from day one; you don’t have to wait to pay your investors until all your renovations are completed.

So I think that’s a huge plus, that from day one, once you identify a deal, 90 days later the deal closes, and then within the first two months, generally, they’ll get their first check. There’s also the potential for a refinance, so they can get a portion of their equity back within the first couple of years, because again, since we’re forcing appreciation, we’re gaining all that equity that we have, and that’s something that you can pull out and refinance into a new loan, especially kind of in combination with that law number two with the long-term debt – if you’ve got a five-year business plan and you’re going with a five-year loan, you’re probably gonna wanna do some sort of refinance year two or three, so that that new five-year loan pushes you out to eight years; that way, if the market is not where it needs to be at five years, you’re not forced to sell it; you’ll refinance at that point.

And of course, since we are actually selling the property, that’s when the passive investors and the apartment syndicator makes the most money, because again, you bought it at 10 million dollars, you have forced appreciation of 7 million dollars, and so take away some fees and taxes, you’re making 7 million dollars that get split between you and your investors…

And of course, returns also vary depending on how you structure your syndication. The most common is an 8% preferred return, and some sort of split afterwards, like a 70/30 split. But then sometimes they might cap that – they might cap the investor returns at a certain IRR, like a 16% IRR or something. Then once that gets hit, which is not gonna happen until sale, then that split will be reduced and the syndicator themselves will make even more money.

So again, I’ll give it a 3. I don’t 100% understand the development, but just from my understanding, the returns are definitely higher, because you’ve got a much higher risk, of course, so that’s what offsets the risk, is the benefits at the end.

I wanna say that it is really interesting, for your specific business model, and the risk – there’s all that risk up front, but once you get past there, it’s like “Phew! Alright, we’re here.”

Evan Holladay: Yeah. “We made it!”

Theo Hicks: Then it just like drops below everything else, because as you said, you’re gonna have access to — the supply of renters that you have are always going to be really high.

Evan Holladay: I just wanted to say that I’m very envious of anybody that can close in 60-90 days.

Theo Hicks: Yeah, one year being your shortest… [laughter]

Grant Rothenburger: Yeah, and it’s nice that you guys actually own the whole thing after the 15 years. With the value-add syndication, at least if you’re doing an equity raise, a syndicator never really owns the whole property if the investors stay in it. Of course, you can do a debt raise, but I think the equity raise is the more popular, for obvious reasons.

Evan Holladay: Right. I wanted to ask Theo if — you said you’re mainly targeting like a five-year hold, add-value, and then after year five you either refinance or flip… Are you guys looking at holding onto or buying out any of your investors on any of your deals?

Theo Hicks: No. The investors stay in the entire time. That’s one of the selling points for them, is that they’re in the whole time. That’s kind of what Grant was saying – there’s the equity versus debt. With equity, you’re raising money and then you’re paying them a  preferred return, like a bank. In that case, if you refinance, you can give them all their money back and maybe like a 12% profit on top of that… And then yeah, you own the entire deal.

Some syndicators do that, but we do the equity, which means that the investors stay in the whole time.

The only time a buyout would maybe happen is if the investor needs to get out, for some reason… But it wouldn’t be something that we would come to them and offer it or force him to do it, or something.

Evan Holladay: Right. Yeah, I think the five-year model seems to be the point of very good returns, but it can definitely add more — you’re constantly having to go out and find the next deal…

Theo Hicks: Exactly.

Evan Holladay: …which is the same in any real estate, it’s the same in new construction. We’re constantly having to fill our pipeline, so we can start with ten to close two… But yeah, it was just interesting to hear the other side of it.

Theo Hicks: My personal strategy is to syndicate until I have enough money where I can passive invest in syndications, that way I’m kind of reducing my time commitment. I still have to analyze deals and I still have to actually do some work, but it’s obviously gonna be drastically reduced.

Evan Holladay: Right.

Grant Rothenburger: Cool. So let’s move on to how maintainable it is in a downturn, and we are back to Theo again. So 1 being very maintainable in a downturn, 5 being not very maintainable in a  downturn – what have you got?

Theo Hicks: So I got ahead of myself and I addressed this when I was talking about those three laws… And again, this is one of those things that’s highly dependent on your business plan. It’s highly dependent on how you buy the property and how you set up your business plan.

I said the three laws are buy for cashflow, long-term debt, have adequate reserves. If you ignore those when you buy the property, then it’s not gonna be maintainable at all during a downturn. If you buy for appreciation – of course, the downturn is the reverse of that, so you’re not gonna get your depreciation… So if you’re not cash-flowing when you buy it, then how are you gonna make money on the deal?

If you don’t have long-term debt, if you’ve put some sort of short-term two-year bridge loan that doesn’t have the option to buy another year or two, and then the market takes a dip at year 1.5, then you’re in trouble, because you either have to sell teh property at a loss… I don’t think you’ll even be able to refinance at that point, so you’re gonna be in trouble.

So the reason why I give it a 2 is because for our strategy, we take all those things into account and we wanna make sure that we’re able to preserve our investors’ capital in the event of a downturn. And how we actually do that is when we’re actually underwriting a deal, we run a lot of sensitivity analysis. So we say “Okay, so what would happen…?” For example, let’s say we put a loan on a property that is a floating rate. So what we’ll do is we’ll buy a cap to that, so it can’t go any higher than that cap, and then we’ll run a sensitivity analysis like “Alright, so what happens if it stays at the same rate for all five years? Okay, what happens if it goes up 0.5%, or 1%, or 1.5%?” That way we can see, alright, worst-case scenario, if it hits the cap, will we still be able to cash-flow?

We also do sensitivity analysis for the rent premiums. So if the market rates have been increasing by 10%, we do the rental comps, we find out that we can raise the rents by $100, but what happens if we can only raise it by $50? What happens if we can only raise it by $25? What if we can’t raise the rents at all for a couple of years? Will it still actually cash-flow?

So those are the types of things that we actually do to — because you can just say “These are the three laws”, but what we actually do to make sure that it’s gonna be maintainable in the downturn is on that front-end making sure that we’re underwriting the deal properly, and that we have the proper debt in place… And then the cash reserves is kind of self-explanatory. It’s making sure that you’re raising additional money or getting additional money from a loan to cover any unexpected maintenance issues, like ten boilers going out at once. If you don’t have an operating fund, what are you gonna do at that point? What happens if that happens and then the market goes down? So you’ve got the cashflow to cover it, but then the market goes down and you lose that cashflow – what are you gonna do?

So it’s making sure that you kind of think of all these worst-case scenarios and underwrite — don’t base your entire underwriting model on that, but make sure you’re at least looking at that, so you know that “Hey, if something happens, I’m not gonna be -20% cashflow”, or something.

So to summarize, as long as you’re following those three laws, then — again, you can’t completely eliminate risk, because you never know how big the downturn would actually be, but as long as you do that, then you’re at least mitigating those risk areas of not cash-flowing, having to give the property back to the bank, and all of those horror stories from ’08.

Grant Rothenburger: Yeah, and I’m obviously working on the same team as you – I obviously agree with all three of those points. I know how maintainable in a downturn Evan’s is gonna be… Let’s hear from you. Do you have any questions for Theo, first?

Evan Holladay: I don’t think so. The only think I would add is the adequate reserves – I 100% agree. I think that’s very important. And then we’ve seen our investors since 2008 have made us put very significant reserves in. The interesting thing is with new construction we typically don’t need them as much, at least from a capital improvements or capital maintaining the property, because we build long-term… But sometimes there is that occasional — like you say, you aren’t getting the rents that you need, and having that reserve has helped us cover certain gaps… But we’ve seen a requirement of those reserves from a lot of our investors.

But as far as maintainable in a downturn, I would say like a 1… It’s not easy for new construction, in general. Financing dries up, investors dry up… Our investors buy the tax credits and they’re usually motivated for — they get a community reinvestment act; it’s kind of like a grade that is given to them (I think) each year by the Federal Government. So the Federal Government says “Okay, are you investing in all parts of the neighborhood that you’re wanting to go into and do banking in?”, basically to combat redlining.

So we have this pool of required bank investors that need our tax credits to get a good score, but even with that need for that score, they still sometimes are like “No, we’re good. We don’t want any tax credits right now. We can barely keep our doors open…”, or whatever it is, they’re trying to just maintain their own liquidity and they’re not so much worried about buying tax credits when there’s a downturn in the economy.

So that’s a huge negative, and the other side is just new construction in general – nobody wants to finance it and take that risk. So that’s the downside.

The other downside is affordable housing, as much as we have that inherent, skyrocketing demand, you also have to look at people’s income levels. When there’s a downturn in the economy, usually the people that get hit the hardest – and it’s unfortunate, but they’re typically families that aren’t making as much money to begin with.

So our rent base – yeah, it’s there, but you have to look at how much money they’re making to be able to afford the rent. So if they’ve gone from being able to pay our rent previously to losing a job or going down to part-time and now they’re below what we can qualify as a qualified resident, because they’re making too little income and they can’t pay the full rent. So it’s a double-edged sword where you would think there’s always demand for affordable housing, which is completely true, but it’s just what rent levels, what income levels are you targeting?

So there’s always that inherent demand for affordable housing, and that’s where you can get — in those downturns, if you can get the cities or the states to financially step up and say “This issue is a big enough problem for our city, and even with the downturn in the economy, we’re gonna help fill the gap that was taken away from your investors not putting in as much money, or your construction lending not putting in as much money. We’ll help fill that gap.”

So I’d say it’s infinitely harder, but it can be done though… But it’s just that much harder.

Grant Rothenburger: And just to clarify – you said a 1…

Theo Hicks: I think it’s a 5.

Grant Rothenburger: I think we just might have been backwards on the scales…

Evan Holladay: A 5, definitely.

Theo Hicks: There’s something, I guess, that could mitigate risk slightly, and that’s by what you’re doing, which is investing in those markets that have that huge 50%-100% cushion… Because I imagine what would happen is that you’ve got your cap in affordable housing here, and if your competition is only 10% higher and the rents drop by 10%, then you’re in big trouble. But if their rents are 100% higher and it drops 50%, then the demand is gonna be still a little bit stronger… But I do understand what you mean by the fact that when there is a downturn, your property would see the reduction, or be affected most by the downturn.

Evan Holladay: Right.

Theo Hicks: Something else I wanted to quickly mention about mine that I don’t think I said – because I didn’t say specifically what you do…

Grant Rothenburger: That’s how Theo wins debates…

Theo Hicks: [laughs] No, it’s just something I forgot… If a downturn happens and you’re doing a value-add deal, as long as you follow those three rules you just keep the property; you don’t do anything. You just keep the property, you’re gonna cash-flow… You don’t have to refinance, you don’t have to sell.

The reason I brought this up is I’d imagine for you, for the deals that you actually have that are already finished, the risk is a lot lower for the deals that you’re actually working on at the moment, where you’re in the middle of construction, or in the middle of that up front, front-end due diligence aspect.

Evan Holladay: Yeah, I would agree to an extent, but I think you kind of hit it on the head – if there’s not enough cushion between us and market rate, and the market rate drops low enough… In 2008 we’ve had to lower our rents because we were having to compete directly with market rate product, and we typically can’t win against directly with market rates… So we have to inevitably lower our rents.

Grant Rothenburger: Alright, cool. I actually have a surprise question… We’ll start with Evan. If you could take one aspect of Theo’s strategy and put it in your development strategy, what would it be?

Evan Holladay: Closing in 60-90 days. [laughter] No, honestly, that’s a big part of it – I think doing affordable housing new construction has taught me a valuable lesson, and that is patience. But the flipside of it is I want to do more deals, I wanna be involved in more development, but it gets harder to get that in new construction… So that’s one thing I would want – an ability to close more quickly and create a bigger, more actionable development pipeline.

Grant Rothenburger: Okay. Theo, what about you? What would you steal from the development aspect?

Theo Hicks: I’d probably say Evan’s ability to own the property outright. Again, there’s ways to do it in apartment syndication, but it’s inherent in your strategy that you own it outright, and then you have all the cashflow, too.

Evan Holladay: The grass is always greener on the other side… [laughter]

Grant Rothenburger: Some aspects anyway…

Theo Hicks: I’d totally be interested in doing a development in the future, at some point. It’d be cool just to do it, to see what it’s like… But not now.

Evan Holladay: You know, another thing I didn’t touch on is just the — I guess you could call it the ego side of it. It’s really cool to [00:39:46].00] something out of the ground where nothing existed before. That’s really cool. That’s what got me into it. There was a development going on on my campus in college, and I was like, “I need to be a part of that. I need to go learn from that guy, I need to figure out how he’s doing that. That’s so cool, just building something out of nothing, and having that permanent value to that community, wherever it is, for the next 50 to 100 years.”

Grant Rothenburger: That would be really cool to be a part of, for sure.

Theo Hicks: That would be the fifth category, Cool Factor. [laughter]

Grant Rothenburger: Development definitely has [00:40:16].24] So I added up everyone’s numbers and I made up a little scale just now… My made-up scale. Let’s see… Evan was a total of 17.5 out of a possible 20.

Evan Holladay: Seventeen… And a half!

Grant Rothenburger: Yeah… [laughs] Because you threw in that half [00:40:33].09] But the returns factor into that nets high as well, so let’s take that out… Now we’re down to 12.5, which on my made-up scale, you need some experience or education or a team mate that has a lot of that. You probably shouldn’t be a newbie trying to get into development deals, but you don’t have to be super-experienced and flipped 100 houses or own 100 multifamily units already. If you’re resourceful enough, you could definitely find that and get things done.

And same thing with Theo’s – if you take out returns, three, then he’s a 7, which on my made-up scale… I don’t like my made-up scale anymore, because that means that a novice could do it, and I think you should be more like — same with the development, you should be definitely more than a novice to be doing syndications.

So with that, I’m gonna go ahead and wrap this up, unless you guys have anything to add. Or we’re gonna do rebuttals – Theo, what do you have for Evan on the rebuttal aspect?

Theo Hicks: I think for both of us we got that in when we were going over each of the categories.

Grant Rothenburger: I thought so, too. Alright, so for me personally – and I’m a little biased, but after hearing you guys’ arguments, I’d go with the syndication side, mostly because of the risk of the front-end… But that risk drops off after it’s built, so it’s kind of double-sided there. And I do really like that you guys will own it outright, without having to share in the profits of your investors forever; that’s really nice.

But obviously, I’m biased, so listeners and viewers, go to the BestEverShowCommunity.com and give us your opinion, and tell us which one you would prefer, or which one you do prefer.

With that, guys, Evan – thank you for joining us today. Theo, I’ll probably talk to you later today… [laughter] Everyone, have a best ever day!

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