What is Workforce Housing and What Makes it an Outstanding Real Estate Investment?

Ed Aloe:

Welcome to the Real Estate Wealth Podcast, the show about how you can build wealth by investing in real estate. I'm your host, Ed Aloe, founder and CEO of CALCAP Advisors. I'll dive deep into multifamily investing in today's current market. I'll also help you acquire the knowledge and tools necessary to generate passive income for life through discussions with friends and experts in the industry.

Ed Aloe:

I'd like to welcome to the show this morning Josh Holman. Josh was actually employee number one of CALCAP. We hired him kind of shortly after we got started in 2009 as an analyst, an acquisitions analyst, because back then we were looking at distress deals and the market was kind of changing rapidly. We felt like, geez, if we're going to hire an employee, which we really couldn't afford to do at the time, but we did, and I'm glad we did, let's hire a smart young analyst who can really help us kind of sift through these opportunities and figure out where we should be investing the money.

Ed Aloe:

In and around 2010 I believe, Josh was nice enough, I offered him an opportunity to actually relocate temporarily to Phoenix, Arizona where we were doing our first renovation project on a 43 Unit REO property we had purchased. And I really thought it was important to have someone that we trusted out there that understood the business and could oversee kind of the day to day renovation that we needed. He became a partner with us in CALCAP Asset Management last year, which we're thrilled about. So Josh, with that, welcome to the program.

Josh Holman:

Well, thank you, Ed. That's a great introduction. I really appreciate it and it's great to be here with you.

Ed Aloe:

So would you mind, Josh, kind of just giving our listeners a little overview of your background and what you do for CALCAP?

Josh Holman:

I got started directly out of college. I worked for a company called the Myers Group, and Jeff Myers was the principal of that company. And at the Myers Group there was a lot of smart people that I still remain in contact with, and Jeff had the ideas that there was a need for information to be gathered and distributed to single family home builders, primarily. And so, he put together these books that had information on sales trends, pricing, et cetera, for all of the subdivisions that were being built in southern California. And he started that in the eighties, and in nineties he was really growing that business. So in the late nineties, I joined that company and I worked for Jeff for five years, learned a tremendous amount, and then parlayed that experience into a medium size kind of a boutique residential developer and commercial developer in Newport Beach. And from there I started working on new developments on a small team that was working on projects, getting condo developments designed in and around Orange County.

Josh Holman:

In 2007, things were really active and we were putting a lot of deals under contract working with the city of Santa Ana. And then in 2008, condo became a very negative four letter word just because there were so many deals out there and they were failing, they were not moving forward. And then residential, just in general, became very challenging in 2008. And so, I started working for that same company, but working on trying to identify distress deals. We were interested in trying to buy finished lots and put them under contract at say 10 cents on the dollar. And so, we pursued that opportunity for a while, and I think it was probably just a little bit too early in 2008 to be trying to actively buy stuff, because everyone was still concerned about how far the market was still going to go down, trying to catch a falling knife, so to speak.

Josh Holman:

And so in 2009, that's when I made the transition over to CALCAP and I saw that you guys were entrepreneurial in pursuing opportunities to pick up these broken condominium projects that I had experience with and potentially put them back together, so to speak, in terms of you buy them at a discount and then you rent them as apartments rather than trying to sell them off as condominiums. And so, that's how I got my start with CALCAP, and then it just morphed into different things and I've worn a lot of different hats, as you know, over time from there.

Ed Aloe:

One of the things that we consider early on was buying these broken condo buildings because there were a lot of them. It required a ton of capital intensity and had a skill set we really did not possess at the time. As Josh said, we morphed that strategy into buying traditional apartment buildings, which has worked out very well for us.

Ed Aloe:

Today, Josh, we're going to talk about workforce housing. A topic you and I talk about every day. I think a lot of people when they hear workforce housing, they think it's the same as LIHTC or low income housing tax credit business, but it's not. I mean, we kind of joke that we own affordable housing with a small A, not a large A. CALCAP not only invests in workforce housing, we also manage it, we lend on it. So we kind of see it from all angles.

Ed Aloe:

When I think about workforce housing and the opportunities, and why we like it and invest in it so much is it's really a demographic play. When you look at the affordability, when you look at the number of people renting and the rental demand continuing to increase, because of aging baby boomers and millennials who are moving out and renting before they become first time home buyers. And now you throw in of course, interest rates going up and the affordability of people being able to buy a first time home is now going down again, which creates more rental demand. So Josh, would you mind kind of from your perspective defining for our listeners what workforce housing is?

Josh Holman:

When I think about workforce housing, it's really at the core, it's housing that's affordable to workers and their families and it's close to their jobs. So you can look and find different definitions in terms of how much people make that qualify for workforce housing. Typically, I would say it's probably people that make 80% of the area median income, or AMI. Although I've seen kind of definitions that say somewhere between 60 to 120% of the area median income. I think the main thing is that it's housing for the essential workers: teachers, nurses, police officers, others that we rely on every day and they need to have quality housing at a relatively affordable price. So I mean, the beauty of it is it's in extremely high demand, and from investor's perspective, it's in relatively low supply. So if you can find workforce housing opportunities and you can manage them correctly and operate them and add value, it's a great space to be in. And that's mainly what we do, right? And so, we've had some good success over the years owning and operating, and renovating workforce housing.

Ed Aloe:

And I think you touched on something interesting saying the teachers or police officers or nurses who today occupy workforce housing, 30 years ago those people would've been homeowners in the community, right? But as the price of housing has gotten more and more expensive, and in markets like California as an example, it's very, very difficult for workers to afford to buy a home. And so, they have become renters. The US is becoming a renter nation as affordability gets more and more out of reach for people. So I guess just as an overall take on workforce housing, what do you first look at or what makes an investment attractive for you to pursue as an acquisition opportunity?

Josh Holman:

Yeah, that's a great question. We want to be able to provide quality housing for our residents. And so, we're looking for the right mix. I'm looking at median incomes, I'm looking at crime reports. I mean, I don't need to be in an extremely affluent area, but I don't want to be in an extremely high crime area either. We're looking for an area that has close proximity to jobs, it's not surrounded by a lot of properties that are blighted, et cetera.

Josh Holman:

And then from there, I really dive into the physical characteristics of the property. We focus on 1980 or newer assets, and we're looking for properties that have good bones, so to speak. When I say good bones, I mean just quality construction. You see some assets that you come into and you can improve the value by making renovations, but some just have a lot of functional obsolescence. They were never well built to begin with. And I would say that we're probably going to spend a lot of money just on deferred maintenance that doesn't add a lot of value to the property. I'm looking for an opportunity to enhance the property and increase the value by increasing the rents and/or lowering the expenses. And that's really what I focus on.

Ed Aloe:

We look and we try to invest in areas where we see population growth, right? So over the years it's been the southwest and now we're kind of expanding out. What we call the Smile States. We just bought a deal recently in Atlanta, so we kind of own all across the bottom sunbelt of the US, because that's where people are moving to, right? So we look at growth, and I think one of the things maybe you can touch on that your team does a really good job with is we sit down quarterly and go through a ton of different metrics looking at, okay, what markets should we be investing in? Are the markets we're currently in still the right markets? Are there markets that we're not in that we should be looking at? And there's really no magic answer. I think a lot of people look for, oh, what's the hottest market to invest in? Once a market becomes the hottest market, you probably missed a lot of the opportunity. So we kind of take a longer range plan when we look at markets. And do you want to talk about some of the metrics that we go through on a quarterly basis when we do that?

Josh Holman:

Yeah, I mean that's something we do. I'm sure that other groups do something similar, but I'd like to think that what we're doing is a little more robust and maybe a little more analytical. I mean, we're looking at and constantly talking about things that have happened in the past, so metrics in terms of job growth and population growth. We're also looking at forecasts of those same things, population growth, job growth, rent growth. And we're also looking at construction supply and comparing that to existing inventory to see how saturated a market might be in terms of new supply compared to the existing supply.

Josh Holman:

And so, what we do is we subscribe to different sources for data. And so, we'll take information that we get from our paid services and we have a system that goes through and scrubs those reports and then uploads them into our weighting mechanism that we use, and we calculate a weighting of all these markets based on that information. So we're taking a lot of data and we're combining it into one analysis and then weighting the markets based on those factors and coming up with markets that we think we should be in. And constantly looking at the markets that we're already in to see, do we still like these markets? Do we still want to be in these markets? And if so, why? Does it look like we're heading for an issue where occupancy is going down? And if so, why is that? Is there a lot of new supply that's coming on the market? What does the future pipeline look like in new supply? Are they forecasting? Has rent growth been very volatile in the past? Is it going to be volatile in the future? If we believe that it's not, why? Is that? Because the employment base has become more dynamic and they've had different industries move into the market. Doing that analysis with the team that we have on the acquisition side, looking at the data, coming up with results, and then discussing it on a quarterly basis.

Ed Aloe:

Josh, let's talk a little bit about a property itself and how we look at the project individually. We say we're kind of value add buyers, which I think is probably a term that's been a little bit overused in our industry in the last five, 10 years. But let's talk about value add, what that means, and how we look at getting the most value out of a property that we buy.

Josh Holman:

Yeah, so I mean, I do agree with you. I think it's probably something that's been overused. And I mean, you'll see people send out deals that were built two years ago and they'll call it a value add opportunity, and it's like, I don't know how many times can I repaint it? And it's just been painted two years ago. So it has been overused and that's because it's been very profitable to go down that path of value add.

Josh Holman:

When we look at projects, we're looking at, I would say probably three main things. I'm looking for management or operation upside, first and foremost. I'm looking for a property that I know based on how we operate properties, we can come in and do certain things maybe a little bit better or just differently. And this is just based on how we run our properties.

Josh Holman:

The other things that I look at on value add properties are external value add components as well as interior type value add. So on the exterior, there's something to be really said in terms of if you have a property that is looking tired, coming in and refreshing the property. I mentioned painting. I mean, that's still probably one of the biggest value ads you can do. We've found that if you come in and you have a property that hasn't been painted in 10 plus years, you put on a nice updated color scheme and you do a cleanup of the landscaping, there's a increase in rent that's available pretty much immediately, because the residents and the neighborhood sees that you're working on the project, and those are things that we'd like to do kind of right away. So exterior renovations that add value include landscaping, painting, adding some amenities like dog parks or other areas for people to gather, barbecue areas, enhancing the pool area to make it more modern and feel more like a resort style.

Josh Holman:

And then on the interior side, a lot of the 1980s and 90s assets, you go in there and you'll see that they have white or maybe even kind of that old almond colored appliance package get what can we do to refresh these interiors? Definitely come in and paint, potentially add new appliances, new flooring, if it's got a lot of carpet in there. People are moving and really the faux wood look of vinyl flooring. And so, those are the type of things that I look at in terms of adding value is management or operation improvements, exterior renovations, and then interior upgrades. We find now that most residents want washer dryers inside their homes, and so to the extent that a property has washer dryer hookups, and we can come in and purchase those appliances and add it to the monthly charges, that's pretty much a low hanging fruit that I talked about before where you can get that additional income just because it's so desirable.

Ed Aloe:

Right, and I think the other thing is some of the properties we buy have those older type kitchens that are dark. So anytime we see an opportunity to maybe remove a level of cabinets or anything we can do to open up that kitchen to the living area, that's also something that we look hard at because tenants today want spaces that are more light, bright,, and airy. And so that's another focus when we renovate.

Ed Aloe:

Another point is some properties that were built in the 80s or even 90s, there's functional obsolescence with the amenities back then. As an example, a lot of buildings we see built in the 1980s had tennis courts, where today you'll drive by and you won't see one person playing tennis. And so, we would use that opportunity and say, okay, what can we create from that space? And so, that might be a great dog park, or maybe now with pickleball rage, we might try converting some of those into pickleball courts. So you have to look at where the market is today, what amenities people find important today, and it changes. It's different than it was 30 or 40 years ago. Josh sometimes will get benefit for green pricing. Do you want to talk a little bit about how we look at that from a sustainability standpoint and some pricing benefit with the agencies?

Josh Holman:

Yeah, so with the green financing, there's typically a requirement that you would go in and reduce electricity and water consumption by a certain percentage, make improvements to the property, and reduce those utility expenses by a certain percentage and then you qualify for reduced pricing again on what's called a green loan program. So when you're underwriting a property, they'll have a consultant come in and do a report and they'll tell you, these are the things that you can potentially do, and this would have the greatest impact on utility savings and they would list everything. They would list the things that have the biggest impact are typically changing out the toilets to low flow toilets, putting in low flow shower heads and faucet aerators, and then also changing out the existing incandescent lighting throughout the property to LED lighting. And so, if that hasn't been done before, you can typically just do those things on the water side that I mentioned and then change out the common area of lighting and you can qualify for the green loan at reduced pricing.

Ed Aloe:

And along that topic, it kind of reminded me of there's also certain cities or counties where we own where you can get a benefit by saving water, by maybe removing lawns, right?

Josh Holman:

It's the water district, typically, you can get the credit from. They look at it as you have every sprinkler head is almost like an outdoor shower, and you're removing those and putting in a drip line irrigation system with desert xeriscape landscaping and saving a lot of water. So I'm a big proponent of it. I think it makes a lot of sense, and I think they actually have a mandate that they want to pursue that on most of the apartment communities. And so, they're definitely pushing for that and I think we'll see more of that in other areas as well.

Ed Aloe:

One thing we touched on, Josh, was bridge debt versus kind of agency permanent debt. And when CALCAP as users of capital are, we're very conservative by nature because we started this business out of the ashes of the great financial crisis, right? And so, we saw what being over leveraged can do to you, since those were the early REO properties that we bought, many of them. I think last year, bridge debt, bridge lending became a substantial, I want to say 70, 80% of the debt markets for workforce housing were financing these projects for buyers where we looked at that and go, wow, these guys are taking on an inordinate amount of risk. We felt, right? So we became a little less competitive as a buyer because the more leverage you put on a property, the higher return, right? It's risk reward. So these guys were putting more risk, more leverage on these properties in exchange for higher returns, which translated to, okay, they could pay a lot more than CALCAP can pay for the properties. Do you want to touch on that a little bit and how we've seen that now shift with rates going up.

Josh Holman:

With bridge debt, the lenders are willing to look at your proforma, which is basically your forward looking assumptions, your operating budget going forward. And so, they'll take into consideration, well, I'm going to value add this deal. I'm going to raise rents a hundred dollars by spending $5,000 per unit, or whatever that number is, and they'll give you some kind of credit for that in terms of sizing up the loan for you.

Josh Holman:

You had a situation when there were so many bridge lenders out in the market, so many funds that they were looking to deploy capital. And so, they would get extremely aggressive last year if they could deploy a $20 million bridge loan. We were seeing interest rates that were actually lower than agency financing. And that kind of got me scratching my head. I just did not get that. That did not make sense, and I felt that it was unsustainable.

Josh Holman:

It has proven to be something that has shifted. And so, there's fewer bridge debt lenders out in the market, whether or not some of these loans that they made last year, two years ago, that are higher leverage, higher risk, and to sponsors that have a lot of execution risk on their business plans, it remains to be seen, like next year, the year after, if they're able to exit and sell their property at a gain, especially if we're in a rising interest rate environment.

Josh Holman:

That's the interesting thing that's happened with bridge financing is that it was extremely aggressive, low interest rates, high leverage, and now I think we're seeing a shift back to kind of a more normal Fanny Freddie bank loans. And with those types of loans, the lender is looking at historical performance. They're taking the actual revenue of the property, typically we call it the T3, so what that is in whatever month you're in, trailing three months of income, and saying, this is what your actual trailing three months of income is, annualizing that, and using that as a determination to size the loan. They will look at your expenses and they'll also look at the expenses from their appraisal and they'll take that income, the actual income of the property, and the expenses that are underwritten by you, and then justify by the appraisal and come up with an amount of net operating income. And then they will use that net operating income to size up a loan that works specifically for that property.

Josh Holman:

We did a deal where we had a 57% loan to value, and we made it work and we feel felt fine about it because we were taking lower leverage and the deal still made sense, but now I'm starting to see that more groups are using agency financing and the leverage amount is around 60% of the purchase price depending on the deal. And that's kind of resulting in pricing being where it's at, where it's gone down in some markets, it's held flat in some markets, I'm not seeing prices increase because of what's happening primarily in financing.

Ed Aloe:

Yes, and so some of these investors who aggressively were getting 80%, 85% in some cases, bridge loans a year ago, think they could be in trouble because we've seen values tick down with rates going up. And many of these bridge loans are one, two, three years typically at most where they're going to have a capital event that loan's going to come due. And if you're 85% and your rent projections are less than you thought they'd be and you need to refinance a year from now, you might not be able to take that loan out, right? So we think some of these investor groups that got very aggressive over the last couple of years, could see some challenges in the next couple years.

Ed Aloe:

Hey Josh, one thing we haven't talked about is sort of time horizon, because we're professional real estate investors, so different than an individual who might buy an apartment building and own it forever. We raise money from high net worth individuals, they expect to get a return on that investment. So let's talk a little bit about typically how we look at a deal, a value add deal, a workforce housing deal from a time horizon standpoint, and how that might relate to the type of financing that you get on it.

Josh Holman:

So when we are underwriting our deals, we're typically looking at a seven to 10 year time horizon for underwriting. And that's a function of a few different things. One, we are getting fixed rate financing, and we're looking at terms that are generally around seven to 10 years on the financing. And so, what we do in that regard is we'll get a certain amount of what's called interest only period. And so, you would only have to pay interest on the loan for the first say three to five years. It really depends on how much you want and what the project needs, but the purpose of the interest only for us is to really allow us to give us some time to execute our renovation, our value add strategy, and so, that we can pay investors money while we're renovating the property, while we're getting it stabilized. And so, we'll have a period of an additional five years or so where we're paying principle and interest on the loan before the loan matures.

Josh Holman:

And so, we want to make sure we give ourselves enough time so that we can execute our strategy and then some flexibility if say in five years from now the market turns and rents go down, occupancy is a challenge. We're not forced to sell. We don't have a bridge loan and we don't have a maturity issue coming up. We stay conservative on the amount of debt we're taking, and we stay conservative in terms of going for fixed rate versus variable rate financing. We try to give ourselves some interest only period to help with cash flow. I think we're probably a little unique in this is that we give ourselves some flexibility that we can sell at what's called par, or close to par, so we can sell and only have to pay back the loan amount, not have a prepayment penalty at some point in the future.

Ed Aloe:

So essentially we think it's smart to pay a few more basis points up front when we get a loan and just have that flexibility where if we need to or want to, we can pay that loan off earlier than holding it for 10 years.

Josh Holman:

I've seen that we've outperformed on the revenue side consistently. I think that's because we're pretty good at being a quality operator and people will pay rent, and if you're delivering a quality product and you're taking care of their work orders, et cetera. But I think one thing that we learn pretty early in the process is that you need to be realistic about your expense assumptions. One of the earliest lessons was dig into the numbers and be realistic about what your expenses are going to be, because they're typically going to be higher than you anticipate. Things cost more in the real world versus the proforma. And so, I think that that was really a hard lesson, but an early lesson that I learned analyzing these deals in proforma, and these value add opportunities.

Ed Aloe:

Josh, that's a good point. The fact that we have CALCAP properties, a property management arm, where we now can really analyze real time expense data, not only from properties that we own, but also fee properties that we may manage for others where it helps us become a better investor because now we can really see, okay, across the board, what are these expense lines running and even by specific geography. So I think having that insight as a boots on the ground property manager really helps us with that constant feedback to make us better when we acquire.

Josh Holman:

Yeah, that's definitely has been beneficial having our property management boots on the ground team. And I think some of the other things that I've learned from being careful when you're analyzing a deal, be careful of some of the other income items that you can see. And if a property has a lot of other income, really dive into that and understand that. And what I mean by other income, it's everything that's really after your rent. It's the items like late fees and lease break fees, and those are the things I call bad other income. And so, when you're looking at a property, a value add property and one that may have been mismanaged, you'll see that there might be a lot of other income that you really don't want to have on a go forward basis.

Josh Holman:

And then one of the other things that's been interesting and kind of eye opening is some things you think are going to be really positives are not actually in the long run, very positive for operations and for your cash flow. For example, we've had properties that have had fenced yards, and so, well, I mean that sounds great. You can charge more rent for a fenced yard, but this is perhaps it's on a 40-year-old property and those wood fences are deteriorating. And so, you're going to be spending quite a bit of money repairing those wood fences and spending a substantial amount each month going and doing repairs, replacements. And so, really understanding that upfront and maybe putting in more into your capital budget to make those repairs is something that I've seen happen that when you're first underwriting the deal, but you need to understand what those expenses could be down the road.

Ed Aloe:

Right, so even though we're able to get a higher rent for that unit, the expense side, because of the upgrade we did that didn't last, or whatever the reason, sort of negated any positive income.

Josh, are there trends that you see going forward in the industry, specifically in the workforce housing business?

Josh Holman:

I think what's going to happen as more calls for rent restrictions come into place, if we head into a recession, I think that those are going to go away. I think that we're potentially going to see calls for rent restrictions, because, if you think about it, they don't work to fix the supply issue, right? They just put a cap on the rents. You can only charge so much for the rent. It does nothing to impact supply. And I think that areas where you're seeing a lot of people move to, I think they understand that and instead of putting in rent control, they're actually encouraging new development. And so, it's hard to deliver workforce housing as new construction. It is possible. It is. There are affordable deals that get built, and then there's also just new construction that's designed to be more affordable than your high end luxury class A property. And I think that areas that our governments and local cities that have that supply constrain are going to encourage more development. And that's what I hopefully see going forward as a trend.

Ed Aloe:

Yeah, I totally agree with you. It's a supply issue that needs to be solved, right? Capping someone's rent sort of artificially tries to do it, but anywhere in the country that we've seen some type of rent control typically fails. And then you get people gaming the system, like a place like Santa Monica where somebody might have a lease from 20 years ago and they sublease it out at market rents today at a rent that's 5X what they're paying for it.

Josh Holman:

And the other trend I do see is just more of a trend towards sustainability, especially on new construction. Just a firsthand example, we're working on a project in Tucson and the city council just came out and said that every new development is going to be required to have electric vehicle charging stations. And so, what does that actually mean in terms of how many, what does that do to your parking requirements? I mean, they come out with these requirements and it hasn't been fully vetted, but I think that is definitely the trend is going to be more sustainability, especially on new construction. Significant droughts in a lot of the southwest and west here, and I think that there's going to be hopefully more incentives coming out to lower the usage of water and electricity in existing properties as well. And hopefully they do that through incentives.

Ed Aloe:

As we talked about, we're typically buying eighties or newer product, renovating it, doing the value add like we talked about, but we kind of had a unique opportunity now where for the first time we're actually going to be developing down there.

Josh Holman:

Yeah, it's an interesting deal. We acquired 140 units in Tucson that had about four and a half acres of undeveloped land right next door. And so, when we bought the property, we underwrote the 140 units and basically the land was just part of the acquisition. It didn't have any value per se to the existing owner. It came with the acquisition. And so, for us, we felt like this was a good opportunity for us to look at potentially, at least entitling that land in getting it entitled for workforce housing. And so, we're actually in the process of designing a 90 unit development next to our existing 140 units. We essentially have a zero land basis. So we think that gives us an advantage.

Ed Aloe:

Thank you, Josh, for coming on today. I think it was a really educational, informative show and hopefully our listeners will feel the same way.

Josh Holman:

Thank you, Ed. I really appreciate the opportunity. Let's do it again.

Ed Aloe:

I'm excited to bring you more episodes with interesting and informative experts to help you navigate your way to wealth in real estate investing.

Susan Rangel:

Thanks for listening to the Real Estate Wealth podcast. The Real Estate Wealth Podcast is produced by Gusto, a Matter company. Our producer and audio engineer is Jeanette Harris-Courts, with support from Gabe Gerzon and Susan Rangel. Maia Laperle is our writer. For show notes and more information about this podcast, visit edaloe.com. And for more information about CALCAP advisors, visit us at www.calcap.com or follow us on Twitter @CALCAPAdvisors.

Ed Aloe:

I'm your host at Ed Aloe, and thank you for listening.