When builders or developers present Teddy Karatz with a potential investment opportunity, the first thing he asks is “What’s the story about the location? What makes it special?”
Karatz is a vice president with the private equity firm GTIS Partners, perhaps best known in housing circles for its financial support of Texas-based LGI Homes, with which GTIS currently has six deals. LGI’s “story” has been its ability to convert renters to home buyers with inexpensive homes that require no downpayment. It’s been selling six to 10 homes per community per month, and is returning 30% on GTIS’s investment.
Private equity has become a fact of life for more builders during the housing recession, as banks have scaled back or restricted their lending to this sector. So it wasn’t surprising that a seminar on private equity financing for home building at the International Builders’ Show on Wednesday drew an overflow audience looking for clues about what four investment firms were favoring.
What they heard was that investors’ expectations of annual returns on housing-related projects, while a bit lower than a few years ago, were still in the low to mid 20% range; that investors focus on projects that have the potential to double their investment dollars; that market expertise is a critical component investors look for in their builder-partners; and that the window of opportunity for development and construction financing is slowly but steadily closing for private equity, as banks ease their way back into the lending picture.
The importance of this topic to builders was accentuated by the unannounced appearance at this seminar of NAHB’s incoming chairman Barry Rutenberg, who urged builders seeking financing to get answers to their questions. Rutenberg added that NAHB would be releasing a white paper later this year that discusses the futures of the secondary mortgage market and the government-sponsored entities Fannie Mae and Freddie Mac.
Marriages of Necessity
Until a few years ago, private equity and the housing sector were “a bad fit,” observed Louis Friedel, a vice president with Angelo, Gordon. And even over the past two years, raising money for housing-related deals was still a challenge, said Charles Schwartz, co-founder of Avanti Properties Group, because investors in general remain skeptical about the housing market and wonder when it will bounce back.
But as builders’ traditional sources of capital—community and commercial banks—withered when the housing market collapsed, private equity was some builders’ only means of keeping projects going forward, even with its higher costs.
Friedel explained that private equity became more interested in housing as an investment avenue when investors’ ability to acquire land and lots at steep discounts improved, which in turn shortened the time investors had to stay in deals to realize their profit goals. (Friedel alluded specifically to one project of half-finished homes and lots with a $65 million debt note attached that Angelo, Gordon bought for $15 million.) Schwartz added that he’s bullish on the industry because the country’s population continues to expand and household formation is recovering. He anticipates that unsold inventory of homes will reach an equilibrium point by 2015, and that annual housing starts will return to 1.2 million units.
That being said, “it still takes a fairly steep return for us to make a profit” in a housing project, said Scott Cox of IHP Capital Partners. “So I can’t afford to do things that look iffy.” Consequently, he looks for builder partners who understand that all projects have risks, and are ready to share losses as well as gains.
All of the panelists are seeking long-term relationships with builders, preferably ones that lead to multiple deals. But none has any interest in managing projects in the field. “We want a real partner,” said Cox. “We’re not trying to run the project.” Indeed, Friedel noted that the worst deals his company has entered into were those with builders that took on projects “outside of their comfort zone,” which usually meant outside of markets they were familiar with.
As for the future of private equity in the housing and development sectors, the panelists believe that institutional investors will have a role to play for at least the next two years. Karatz spoke of “an alignment of interests” between investors and builders with a goal of making money by getting stalled projects restarted.
However, the panelists sounded resigned to the fact that, at some point, cheaper capital than private equity would re-enter the market. And while there are good deals out there, finding broken projects or cheap land is getting tougher.
Regardless of how they finance their projects, however, Cox warned builders and developers in the audience about biting off more than they can chew. “Builders have a tendency to seek money without thinking about how it will make their businesses more successful,” he said.
John Caulfield is senior editor for Builder magazine.
