The Pursuit of Passive Income

With rising energy costs and soon to follow, rising restrictions I expect to see a lot more legislation passed to save energy. Personally, I’m all for it. However, there is a cost to the conversion and with the budget fight in Washington, don’t expect the folks who pass the restrictions to help fund the conversions.

The last 100 watt light bulbs will be pulled from the shelves in January 2012. You should still be able to buy 75 watt, 40 watt, and 25 watt ones, but the 100 watt ones will be obsolete. (I can see the eBay folks stocking up to sell them in a few years at a premium - like the folks who stocked up on “Old Coke” when the “New Coke” formula was released).

California lawmakers are just about to pass the most agressive alternative energy laws. If passed, California Public utilities will be required to produce one-third of their energy using alternative means- to be phased in over the next few years. Wow….is that even possible? 

I was an early adopter of the CFL bulbs at my properties. We soon learned that the reduced heat produced, significantly longer life and lower energy use made it worth the time to retrofit our fixtures. We also learned that our residents loved these bulbs so much, that they began to steal them. We went one step further, converting our fixtures to the cartridge style bulbs. 

I remember walking into one of my leasing offices with a ceiling dotted with 120 watt reflector bulbs in the middle of the summer. It was really hot and those 20+ bulbs were heating up the place even more. We replaced them with 13 watt CFL reflectors and then replaced/retrofitted all the exterior fixtures. The result was we cut our electric use by 30% and our maintenance staff rarely had to replace a bulb (they last for 10,000 hours). The clubhouse/leasing office was as bright, but noticeably cooler.

Our next step was to work on the water costs. Water is expensive in Phoenix…

We replaced our old toilets with 1.6 gallon ones, added better quality low-flow shower heads and replaced the valve stops for all fixtures with 1/4 turn ball valves. Next we split our water systems, adding a second city meter just for irrigation (is avoided charges for sewer on water that was used for the pool and landscaping).  Our savings were were over 40% - and some cities actually rebated us up to 1/2 the cost of the upgrades. 

We made our landscaper adjust the sprinklers to the minimum water needs of the property and quickly addressed the source of any puddles that formed - chnging broken heads and adjusting flow. 

It didn’t take long before we had our properties running better and with reduced maintenance.

If you own a master metered property, I would certainly suggest these changes plus adding your own interior fixtures that use only energy efficient bulbs. If residents buy their own fixtures, they won’t choose the ones that use less energy and produce less heat. 

It’s clear to me that if we are forcing our utility providers to find alternative sources of energy, it won’t be long before our properties, shopping centers and office buildings will be required to employ them too. 

As always,

Open to your comments and suggestions.

John

Is there really such thing as a “Bad” property? Can a good operator make the difference? Every property has it’s unique location, construction and functional differences. How much weight do you assign to the operator vs. the building in determining if it will be a star property? 

I have to admit I’ve sold some buildings with a long history of poor operations, through several management and ownership changes; it seemed like no one could get it right. I’ve also sold and owned great properties with a long history of good operations and the new owner then has horrible luck in matching the past operations. Is it the operator or the building to be blamed?

I’ve been pleasantly surprised to see the successes of first time operators who, as some would say, “don’t know any better,” turn around an historically poor operating property. Sometimes it’s as simple as their attitude, other times they have played to the building’s perceived faults (small units, transitional sub-market, student population, etc). Instead of fighting the building and forcing it into their operational mold, they work it’s strengths.

A few years ago I attended a luncheon where the keynote speaker was a former advisor to the White House on Latin Affairs. He challenged the audience (made up of mostly regional and national owners) to give some examples of what their Hispanic tenants want in a property. Then he listed what his group had learned through their surveys of traditionally strong Hispanic neighborhoods/communities. 

The audience listed things like having materials in both English and Spanish, having bi-lingual staff, etc. But the speaker went far beyond the basics. He explained how quickly the Hispanic population was growing in the US, how closely tied the families and communities were, the type of social activities they participated in and how they were slow to complain to outsiders. The colors that they would paint the buildings, what services they would appreciate, the office hours that worked better with their schedules, even flexibility in rent collection days due to their payroll periods. It was enlightening to hear how minor changes created a stronger property, decreased turnover and actually engaged the residents. 

In a market with so many housing choices, it may be smarter to understand the strengths of your asset, core tenants and the community that you are part of to gain market share. The fundamental premise of consumer marketing changed over 50 years ago when we realized we needed to figure out what the consumer wanted, cater to them and produce it rather than produce a product and figure out how to sell it to them. How can we we produce a product that the consumer wants? What does your core tenant group need? What makes your property more attractive, and conducive to their lifestyle?

Think outside of the box, otherwise you’re just another vacancy sign on the street…

As Always, open to your comments and suggestions.

John

The study of Urban Planning has always interested me. Examining population growth and migration from the Fertile Crescent to the growth of European cities, to Manifest Destiny in the US. People have migrated and congregated based on factors specific to the era. 

Since the industrial revolution we have seen a steady migration to the job centers. People have been following the jobs. It’s interesting to note in comparing our current recession to the Great Depression, we haven’t yet seen mass migrations of the workforce to any particular market. (Re: scenes from the movie The Grapes of Wrath, with lines of overloaded cars heading west.)

One observation by Mick Cornett, the current Mayor of Oklahoma City, who has been working to redesign his city; Mayor Cornett believes “… People used to follow jobs. In the future, jobs will follow people to where they want to live…” He has been trying to build a diverse, world class city to attract great people who will bring the jobs.

I think there may be something to this idea. In a world where companies can have virtual headquarters, organizations can be defined not by location but by association and we are at whole new levels of connectivity, why wouldn’t you choose to live where you feel is best?

Could this explain why the “Rust Belt” continues to rust? Were places like Detroit, Cleveland and Pittsburgh appealing to industry but less appealing to workers? 

If you could keep your job, but choose to live anywhere where would that be? 

Before you comment, think bigger. Think globally. With Broadband access, Saas/Saap systems, VOiP, international cell phone plans, international banking, social media, etc, you are only limited by your imagination. 

Part of that decision might be proximity to other family members, quality of primary education, access to world class healthcare, political and environmental safety/security and other factors that would be subjective. 

The Phoenix MSA experienced true net migration from those who have a choice. One of those groups are retirees. Though they spent their working years in cities where the work was located, when they retired and were no longer economically tied to that market, they chose to move to Phoenix. 

Given the more fluid nature of careers, people will choose to live where they want to live and the jobs will follow to those talent centers. Metropolitan Phoenix will appeal to many because of our relatively low cost of living, ample housing, newer infrastructure, expanding cultural attractions and quality of life. But, we are competing against other cities both here in the US and abroad which are quickly embracing the new workers (As evidenced by the two links I’ve attached to studies of the best places to live in the US and world).

http://www.kiplinger.com/magazine/archives/10-best-cities-2010-for-the-next-decade.html

http://www.smashinglists.com/10-best-places-to-live-in-2011-quality-of-living-index/

Though Phoenix is ranked 100th on the best places to live in the US (2010) we are now competing globally. Our ability to attract higher earning residents won’t just be tied to our ability to create industry anymore.  Our politicians and leaders so focused on job creation should also be concerned with making our cities more livable. 

As Always, open to your comments and suggestions..

John 

I’ve often talked about how the costs of operations continue to creep up over time. Every line item in our operating budget has increased while income/rents have moved in the opposite direction. This is one of the reasons some owners who don’t reassess their budgets and projections annually will find they are losing income and can’t explain why. 

What’s happening in Japan is beyond my words. A horrendous earthquake, followed by a tsunami, snow storms, food shortages, and what seems like an inevitable nuclear disaster. Those poor people.

Todays news in the US brought us the first wave of how this crisis is going to effect us in ways most of us wouldn’t have anticipated. As one of our largest trading partners (we are a net importer of Japanese Products) some US factories announced that they were slowing production or shutting down because they could not import key products necessary to their production that produced in Japan. 

The second growing wave of impact is the international backlash and concern for the safety of nuclear energy. Germany reversed it’s decision to extend the use of their plants, Switzerland actually shut down their plants (pending further review) and the planned development of several key plants in Texas are probably going to be stalled. All at a time when the world has been trying to reduce it’s dependence on fossil fuels. 

You might remember the utility cost run up of the early 2000’s. California electricity costs spiked. Arizona and other states power grids were pushed to their limits. Local utility companies scrambled to impose emergency rate increases. 

The lesson for many apartment building owners was that their commercial power costs were not regulated, therefore the higher costs were immediately passed along to users. Residential users rates are regulated by most states. 

I can remember owners of master metered properties who were almost driven out of business. I can also remember quite a few owners who shut down the use of their laundry rooms. The costs to operate them had grossly exceeded the income (because the property electric meter was a commercial account). 

The growing international backlash against nuclear power at a time when very few alternatives exist will put more and more pressure on fossil fuels worldwide. The costs to rebuild Japan will put further strains on the supply of fossil fuels. 

I fully expect to see sharp increases in the cost of energy. I fully expect these increases to effect us in ways we can’t possibly yet appreciate.  

Hoping for the best.

John

A long time developer/owner, friend of mine and I were talking yesterday afternoon about “Ah..Ha ” observations that changed his perception, influenced his course of action and saved him from a few mis-steps in the market. 

We were discussing how important it is to visit your own properties without warning and at random. He told me he learned more about about his properties from his residents and staff that didn’t know who he was because he had stopped by a property early in the evening, on a weekend and dressed in his street clothes, then he learned from the monthly management reports. 

He told me the moment he realized the market was over heated in the last run-up in the late 1980’s. He said before we all realized what the tax law changes were about to do to the investment market and before the first Savings & Loan faltered, he saw how his parking lots we filling up with workman’s trucks. His newly built properties were full of pick-up trucks with toolboxes and racks. He continued that the trucks were still displaying license plates from everywhere but Arizona. 

His concern and “Ah..Ha..” realization was that his management teams were reporting strong occupancy and proforma busting income, but he saw that his renters were transient workers who had commuted to Phoenix to find work and since the construction market had already stalled, he knew these folks would soon move on to markets still building. Leaving him with empty units. He stopped building and started to sell out before the market toppled.

He came back after the crash, bought into the market and built when the timing was right. Again selling off the majority of his assets early in this cycle and keeping a few key buildings with good locations and very low debt.

He still regularly visits his buildings and noticed over the past year how much worse his parking lots are looking. There are more older cars, more residents working on their cars in the parking lots and the newer cars are falling into dis-repair (bald tires, cracked windshields, missing parts, etc) While his occupancy has been increasing and they have seen some rent increases, he is convinced that he’ll soon see much higher delinquency and evictions. He points to a weakening job market (more unemployment, under-employment) and higher fuel costs. He says his residents are forced to fill up their tanks first, then ration their remaining dollars between rent, food, clothes, etc. Fixing their cars is last on their list and to him it means they are cutting corners they can’t afford to cut. 

Increased costs for staples like food and gas are considered a disproportional tax on the people living from paycheck to paycheck. A monthly increase of $50 in fuel for a family comes directly out of another part of their budget. As we are witnessing, an increase in oil prices effects not just gasoline, but food costs. 

Rising oil prices have the effect of siphoning the dollars we would have hoped to have captured as rent increases. 

Whether my friend’s observations and conclusions play out as he suspects is yet to be seen.

As Always, I’m open to your thoughts and comments. 

John Kobierowski 

Phoenix and for that matter, most of the southwest has been a population draw because of the lower costs of living. It’s no surprise that the primary reason for the lower cost of living has been cheaper, plentiful housing alternatives. For as long as I can remember Phoenix has ranked as an affordable city as compared to places like San Diego, Denver, Seattle, etc. The cost of housing cost in Metro-Phoenix was generally understood to be about 30% of household income. 

Some cities like San Diego have housing costs that eat up upwards of 60% of household income. With a limited number of new units being built, huge constraints to growth and steady population growth, owners have enjoyed strong occupancy and increasing rents.

Having roommates and doubling up to share housing costs in these cities is normal. 

For Phoenix and the southwest, it’s a newer phenomenon. People are doubling up, families are sharing housing out of necessity. The trend includes young adults who move back in with their parents (or never leave), college students who are forced to commute to the local university rather than attend an out of state school or live on campus to friends and families who take in other friends and families when their homes are foreclosed. 

To go one step further, my dentist now offices with three other dentists, and my barber just agreed to combine shops with guy down the street. It seems like doubling up is the new cool thing to do.

In the multifamily circles, I’ve heard this described as “Shadow demand market”. Potential renters that are out of the market because they are sharing housing. Some analysts are pointing to this as further justification for continued rent growth and demand. When these folks get back on their feet, they will begin to seek out their own places….which would be predicated on a strengthening economy, job growth and net wage growth. 

Being the eternal devil’s advocate I felt it prudent to point out how the “Children of the Great Depression” have always been referred to as the frugal generation. That our grandparents who survived the Great Depression were great savers, lived cheaply and were proud to reuse and buy used. If we’ve taught ourselves to be frugal again why would we, or our renters be so quick to go back to our old ways? Have we spawned a new era of living below our means and is it not only acceptable to share but smart? Is the era of the McMansion over? 

Good Things Are Ahead.

John 

I’ve been reading a lot about the positive changes in our market lately and I’m encouraged by both the multifamily sales activity in metro-Phoenix and the reports of higher occupancy. Most notable is the recent sale of the partially completed Center-Pointe high rise development in Tempe. 

The word from the buyers is that they will restart the construction by summer and intend to make these rental units, not for-sale condos as they were originally designed. Assuming they keep the same unit layouts, there will be 384 more rental units added to the Tempe market.

Center-Pointe is one of the high profile failures in this last market cycle, so it’s good to see something happening to revive it. 

It wasn’t too long ago that Tempe felt we had too many rental units. The study I’m referring to prompted a moratorium preventing construction of rental units in the late 1990’s. It was determined that 80% +/- of the housing units within a mile of the ASU campus were rentals and something like 60% of the housing units within 3 miles of the campus were rentals. The city of Tempe determined this was not a healthy ratio and imposed the moratorium to control the development of additional rental units. 

It seems interesting that after all the efforts to create a high density overlay to encourage for sale housing in downtown Tempe, some of the projects that the city put so much stock in have rolled back to rentals.

I’d really love to see the project analysis. I had the opportunity to review engineering and construction reports to complete the property as well as proformas running the asset as a hotel, student housing, rentals and condos that were prepared by other potential buyers. I’ll just say it was a stretch to make any sense of the project. Clearly the new buyers have a better approach. 

But isn’t that what we all need? A better approach?

Let’s hope for hope they pull it off. I’m rooting for them (and Tempe).

I enjoy good debate. Not that I enjoy to argue, but rather I enjoy the opportunity to respectfully defend, dissect and explore a subject from all sides without getting emotionally attached to the argument. This past week I found myself in a discussion about simple methods investors use to evaluate a property.

In an age of complex modeling software, spreadsheets and apps for you phone we still use the simplest “Back of napkin” approach of quickly reviewing a property.

The method we were discussing was the one where you assume a ratio of the gross income to determine expenses, what can be serviced by debt and the remaining margin (profit). The idea that an apartment building should run expenses at approximately 40% to 45% of the gross income. This would allow up to 30% to 40% for debt service and the remainder for profit.

I argued that this approach is flawed because it assumes there is a static relationship between gross income and expenses. We are in a time of higher vacancy (economic), lower rents, more turn over and increasing expenses. The relationship between our expenses and income is inverse. The costs to operate our buildings hasn’t decreased in relation to the lower income, the expenses have increased.

Which explains why I have underwritten so many buildings over the past year that proved to be without an NOI (Net Operating Income). In simpler terms, operating at current market levels of rent, occupancy, etc a building owned free and clear of debt, may be operating at a net loss. (which might explain why some lenders have foreclosed, emptied and demolished buildings in recent years rather than trying to re-tenant, stabilized and sell them)

An interesting concept, but why not? Isn’t there point of diminishing returns in all business modeling? A point where the cost to operate exceeds the income?  Haven’t we seen factories shut down and stores closed not because they aren’t making money, but because the current market can no longer support the model due to higher cost of production, higher wages, higher costs of doing business, increasing taxes and decreased margins?

The bottom line is, no matter how good you are at running your property, there is a good chance that expenses may continue to outpace your income. To turn this around, or better yet, to get us to a break even, to where we were some years past, we will need to see rents higher than they were at the top of this past cycle.

Don’t get me wrong, I’m hoping for higher rents and lower vacancy too, but common sense tells me that if we are entering into an inflationary market cycle (QE2), for every dollar of increased rents that I get, I will see a proportional increase in expenses.

As always, I welcome your comments (and encourage debate)

John