State of Multifamily Housing - Related’s Bill Witte Interviewed by Richard Green

Richard Green: Let’s start (Bill) by having you talk about what Related is up to at the moment here in California.

Bill Witte: We kind of have three different businesses. We develop affordable housing all over the state. We are one of the larger affordable developers in both San Francisco and San Bernardino counties. We have projects now in Lake Tahoe, South Lake Tahoe, Santa Rosa, and we just won an RFP in Los Angeles to do a half affordable/half homeless project in Echo Park with A Community of Friends.

We have a market-rate division that typically has built high-rise, luxury, high-end, mostly apartments, but some condos in urban core markets--San Francisco, Los Angeles, and Santa Monica. We now have a large presence in Silicon Valley. Our first market-rate project, the largest of all, a 42-acre site in Orange County adjacent to South Coast Plaza. We have a 99-year lease with the three families that own this old shopping center, and we’re in the process of entitling this for a large mixed-use development that we hope to build out ourselves.

Lastly, with our mixed-use group out of New York, we have two large-scale master developments with a mix of uses. The Grand Avenue project on Bunker Hill in LA--the second phase of which is nearing completion. A 240-acre public golf course site in Santa Clara, opposite the 49ers stadium, is fully entitled and we hope to begin work on for up to 8 or 9 million square feet next year.

They each have different challenges I will say that. There’s more money, more demand, and more city sponsorship of affordable projects than there’s ever been, but there’s not enough resources, bond allocations, and tax credits to fund all of them. It’s a question mark even as there’s so much activity.

Richard Green: Let’s continue by talking about two things. Where we are in time is we have certain central city markets that saw big increases in vacancy as a result of Covid, and as a result of that, declines in rent. I’m thinking of places like San Francisco and Downtown LA. We have seen some recovery in rents, but not complete recovery in rents in those markets yet. While that dynamic is happening, the other things that’s happening is that construction costs are rising quite rapidly. In a world where cap rates are pretty low but return on cost is also pretty low, how do you underwrite given things that might not be opening for another two to three years?

Bill Witte: I always say, when we hear about some new project that seems ambitious, “there’s no law against making up a low-market return.” I will tell you the way we are looking at things. We have at least nine market-rate projects that are entitled throughout the state that we are positioning to start in the next year or two. Costs are up, certainly in San Francisco, where we have been very active, 30 percent over the last three years. That’s against the backdrop of rents in these core markets dropping 15 to 20 percent from their peak during the pandemic, but almost counterintuitively, they’ve mostly come back up. People think that the world ended, it didn’t.

Before, we might’ve been looking for a 5.5 plus return on cost. Now, we kind of hold our nose and say we’ll build to a 5 because there’s a cap rate compression. By the way, we make a couple of assumptions. We’re not assuming construction costs drop; we’re assuming they are going to normalize. They’re still too high. We’re assuming that rents get back to their peak.

I’ll give you some examples. We have new projects entitled that we hope to start: one in Santa Monica, a high-rise in San Francisco, one in Santa Rosa, and a few others. What we’re doing a little differently for us is we’ve always been in just these core downtown markets. We were already beginning to max out, but because of Covid, we’re entering some suburban markets where we hadn’t previously been.

We just signed a letter of intent with the family that owns the Bishop Ranch project in San Ramon in the East Bay. It’s one of the nicest suburban retail and office complexes I’ve ever seen, and there’s no residential. For our Orange County project, we envision 2200 to 2500 multifamily units over time. We hadn’t been in these kind of markets before, but we believe in some of these markets, if you can use some of the lessons from our high-end urban product, whether that can be transit-orientation or the quality, then you will get premiums. These are markets we haven’t been in. We’re not abandoning the urban markets, but we are moving further afield. 

Richard Green: CEOs were saying employees were going to come back in September, now they’re saying January, and some are saying never at all. Do you have any sense of that dynamic—will people be coming back for these jobs? I would imagine that in Santa Clara, people actually returning to work at the Googles, Apples, and Twitters of the world is going to be key to demand. Do you have a view on that? 

Bill Witte: As I alluded to earlier, in the peak of the pandemic, we had 1,300 units in lease up in San Francisco, and they were getting the highest rents in each of their sub-markets. The rents dropped 20 percent almost overnight. They’re now 90 percent of the previous rents, and people still aren’t back in offices. Does that mean they are anticipating on going back to work? Did they take advantage of a slightly more favorable rent? What we don’t know is how deep the demand is.

In LA, we have projects downtown and in Hollywood. We had a somewhat similar experience, maybe not quite the loss of rent, but they’re pretty much back. We don’t see a big return to the office physically yet. Personally I just think the notion that all people are going to work remotely is overrated.

I think the other thing that people miss is new employment. San Francisco has had certainly a bleeding out of jobs, not necessarily out of state, but to Sacramento and the suburbs. But, there’s also more startups in San Francisco than anywhere else in the country. I can’t tell you why. We know it’s too expensive, quality of life sucks. You hear about how Google and Apple and Facebook are expanding all over the country. They are continuing to expand in the Bay Area like you wouldn’t believe. I cannot explain that other than the synergy of talent. I think there are similar dynamics with the diverse workforce in LA. Look at Culver City. There is still growth in these markets. Yes, there’s going to be a hybrid workforce, but you can’t live in two places. You still have to pick one place. If you’re going to go into the office two or three days a week, you’re not going to live two hours away.

By the way there’s one other factor. I have never seen home prices like this. I know, low interest rates, cumulative demand, people didn’t buy during the pandemic. Not everybody can do that. That helps the luxury rental market.

The studies I’ve seen show that home prices are not going to continue to escalate. This isn’t 2008 or 2009, we don’t have a surplus of product. Home prices are going to remain high, and that’s going to keep more people in the renter market than might have otherwise been the case.

Richard Green: The sorts of projects you’re talking about take decades to complete. You may not just go through one real estate cycle, but more than one real estate cycle. How do you manage that risk? How do you make sure that these are sustainable?

Bill Witte: If I was being honest, I would tell you I don’t know. I think you have to look at it this way. There are going to be cycle risks in these master-planned communities. Number one: we look at supply and demand variables. Number two: we don’t make our entire business off of those. If that’s all you did, you would be waiting a long time for returns. The merely 300 or 400 unit apartment projects are where you tend to live or die.

Again, if you look at where these are, a master-planned community in Texas, a place where it’s easy to build, that’s a lot more risk. You have cycle risk, but you also have supply/demand risk. The other thing is we are planning for the long haul. You have to be careful about the product. I’ll give an example, in Santa Clara where we started out in 2013, there were going to be two department stores. Department stores don’t even exist anymore.

You have to have enough flexibility in your plans. You can’t be stuck with a series of entitlements and even community benefits that are undeliverable. There’s political risk. The last series of elections were all over the map, but we saw in most of the cities that we are involved in, from Santa Monica to Santa Ana, city councils became a lot more politically progressive. You have to be very careful to what you’ve committed to, what you agreed to, and to be able to flexibly pivot in the entitlements where possible.

Richard Green: As you mentioned, this is a less risky place to do business in some regards than Texas, particularly for large communities because of barriers to entry, but there’s a point where the regulatory burden becomes so extreme that you just don’t do anything. From the standpoint of someone doing real estate development, what is the ideal regulatory environment and how far did we depart from that here in Southern California?

Bill Witte: First of all, something I left out in the answer to the last question is in terms of cycle risk and the ability to hang in there depends on your source of capital. Because our financial partner and parent company in New York is very well-capitalized, we tend to fund most pre-development, unless there’s big land acquisition, internally. We don’t have an equity parent looking over our shoulder until we’re really entitled and ready to go. We’re not merchant builders, for example, who have the capacity or the investment horizon to be patient. It’s not just IRR driven.

         Let me tell you what I think we’re looking at. It’s not all bad. In Seattle, another tech capital, because they don’t have CEQA and the planning process is simpler, they’ve been creating something like 3 housing units for every new job. In San Francisco, which has approved housing at a more rapid clip than any time in its history, it’s like ten to one. Why? You can approve things, but under the best of circumstances, and it’s somewhat true in LA, it takes three years to get approved. The annual delivery of units does not keep up with that.

Here’s a positive thing. You’ve all read about how when Governor Newsom came into office he sued the City of Huntington Beach. He said their arena numbers and housing elements were going backwards. I am informally advising friends who are advising city councils in Laguna Beach and Newport Beach. They’re taking this seriously; they have never thought about this before. There’s not going to be a sudden surge of housing in these places, but the governor’s people are serious about keeping their foot on the gas in pushing cities on regulatory stuff. There’s a lot more pressure and cities are feeling it. Not necessarily in LA, but suburban areas are kind of taking this seriously. If you’re thinking about ability to do more, I think you have some wind at your back. I do think there is a more positive environment.

I think there is a tendency at a high level, I’ve seen this in that apartment REITs have been on the sidelines interesting for new development as of late. Some of the reason is the regulatory environment. It takes too long, and there’s the politics and the taxes. I’ve had one head of a REIT tell me they aren’t going to go to San Francisco, LA, or Seattle for the next three years. They have to deal with Wall Street. Wall Street says, “What do you mean it takes three years?” It’s just an interesting dynamic. There are other players entering the picture, so there’s no shortage of developers. It’s different from the middle of the boom cycle.

Audience Question: I have four SB 35 projects going on right now. As far as construction costs are concerned, I had five projects that have been approved for apartment houses on podiums, and every one of them didn’t work, so I sold them all to assisted living. With the cost of construction the way it is, how you can actually build apartments and make anything work out?

I should’ve mentioned SB 35. We’d use SB 35 on affordable projects, but never on a market rate project because SB 35 triggers labor standards. A lot of state legislation meant to encourage development has that feature. It is not completely straightforward and simple. There are ways to bridge that gap, but we just haven’t gotten there yet.

You mentioned assisted living. I didn’t mention that Related has made a partnership nationally with a major senior living provider, Atria Senior Living, to do luxury, high-end senior living that spans the gap from independent to memory care to assisted living. We’re opening our first project in San Francisco in three months. We have two sites in Silicon Valley and we’re negotiating on two sites in LA. The numbers are better, the residual land value is greater, but it’s a very select, targeted market.