A Buffett-esque Approach to OZ Development

Moses Kagan

The Opportunity Zone Expo Podcast
A Buffett-esque Approach to OZ Development


Moses:0:00Based on how I saw the lawyers being treated in those deals. I decided I probably didn't want to be a lawyer. Got Kinda tired of London, came to visit my brother, one February. Walk out of LAZ, in mid February and there are palm trees and it's like 75 and I realized that I was kinda done with London and then I want to move to Las Angeles.
Announcer:0:19Moses Kagen of Adaptive Realty has renovated 80 Los Angeles apartment buildings since 2008. Learn about his company's perspective on creating tremendous long-term value by applying Warren Buffett's investing model to Opportunity Zone investing on this episode of the Opportunity Zone podcast.
Announcer:0:42Welcome to the OZExpo podcast, where we talk with the people who really know the Opportunity Zone market. From investors, fund managers and developers to tax experts, politicians and attorneys. The most influential voices in the Opportunity Zone industry are here on the OZExpo podcast.
Jack:1:05Welcome back to the Opportunity Zone podcast. I'm your host Jack Heald, and we're here today. Moses Kagan of Adaptive Realty. Moses, welcome to the show.
Moses:1:16Thanks for having me, Jack. Excited to be here.
Jack:1:18It's really good to have you. As you know, we talk about all things Opportunity Zone related here. So, let's start by talking a little bit about who Moses Kagan is about Adaptive Realty and then we'll dive into the Opportunity Zone business itself. So, who are you, what should folks know about you?
Moses:1:38Uh, great question. So, let me see. I'm, 39 years old, originally from upstate New York. I always say I'm from the cold part, not the cool part. Um, moved out to Los Angeles probably 11, 12 years ago. Um, have a couple of kids and a great wife and I'm a real estate obsessive. I have been blogging at Kagansblog.com for probably 10 years. There's a lot of material there about buying and renovating apartment buildings. Um, and the way that I got that material is that since 2008, I have renovated 80 apartment buildings in Los Angeles. Yeah. So, and then I guess, let me, let me quickly talk a bit about Adaptive Realty. That's the company that I own with my partner John Chris. We have built adaptive from zero assets under management, when we incorporated the various entities in 2011 to 100 million in assets under management as of today. So, you know, we're real a relative minnow and the real estate world, but um, definitely have built a, a, you know, a sustainable and repeatable business model.
Jack:3:01All right, So, let's, let's focus on the Opportunity Zone market itself then. There's 8,700 Opportunity Zones identified around the country. I'm sure plenty of them are, are there in your neck of the woods? Um, one question that comes to mind immediately was, did you have any deals in the works when a Opportunity Zone, when the Opportunity Zone, um, law was passed that you've benefited over and above what you had anticipated?
Moses:3:45No, the answer's not. We have done 20 deal in areas that were subsequently designated Opportunity Zones in Los Angeles. So, we have tons of experience in operating in those areas. We happen not to have one for which we were raising capital at the time the law cam into effect.
Jack:4:07Now before the show you talked to me a little bit about your process. I thought that was really good and I'd like to hear you talk a little bit more about it. When you guys buy multi-family
Moses:4:16Sure, let me give you some background on Adaptive, because I think it will help the listeners. The way we think about adaptive is that we're a real estate private equity shop. We are focused on specifically Los Angeles. Probably only five or six neighborhoods in Los Angeles currently. We do sub institutional scale multifamily deals. So, what I mean by that, yeah. So, um, our typical deal sizes range anywhere from on the low end, as small as 2.5 million total capitalization and on the large end around 10 million total capitalization. So, you know, those are much smaller deals in your standard kind of institutional real estate company would undertake. Um, but we have found, that because of that there's, there's less competition and less sophisticated competition and therefore we've been able to generate what I would describe as super normal results. So, um, like I said, we're doing sub institutional multifamily deals. Um, they are all value add deals.
Moses:5:33Um, but I want to kind of make a distinction, your standard real estate private equity, value add play is, you know, you buying a big apartment complex and you go in and you change the counter tops and you change the carpet and paint the walls and raise the rent by a hundred bucks or two. Um, that's not us. Um, in general, we buy buildings, we vacate the tenants, we got the buildings to the studs. We replaced all the major building systems, so, you know, plumbing and electric and windows and stuff.
Moses:6:08W reallocate the square footage of the building to kind of optimize it for modern tenants, and that allows us to generate, you know, market leading per square foot rents. So, it's a, I would call it sort of an extreme value add in the sense that it's not lipstick on a pig, it's the other thing. It's getting our hands really dirty with these, with these projects. But the results, go ahead. Sorry.
Jack:6:40Well, I think that's important to highlight because of some of the restrictions of the Opportunity Zone program itself. Lipstick on a pig is not going to cut it in Opportunity Zone project.
Moses:6:53Exactly. And let me talk a bit about the financial implications of what we do and then we can talk about how it maps onto Opportunity Zones. The net result when we finish one of these projects is always that we have added a considerable amount of value over and above the cost of doing the project . So, what that means is that we are able to go to a bank and get the bank to appraise at a higher price and then go take a loan against the building which is sufficiently large to allow us to return some very large portion of the total capital employed in the project to the investors. And then, unlike pretty much every other real estate private equity firm, we don't sell. Like our job, we're not IRR maximizers, we're not trying to flip these things. Once you've got an amazingly renovated building in an improving neighborhood in Los Angeles, the right move is to refinance it with some reasonable debt and then hold it forever. And so, that's, that's the model that we have evolved.
Jack:8:01There are some things there that make sense in terms of Opportunity Zone investments and some things that would disqualify from an Opportunity Zone investment. Talk about how your business model maps into the Opportunity Zone.
Moses:8:21Sure, so the standard kind of rehab model does not work for Opportunity Zones. A, because you're not putting enough capital into the building to qualify and B because you are trying to turn and burn the building, quickly. And obviously for Opportunity Zones, the intent the law is to have developers put a very substantial amount of capital into a given building. Um, and also, to maximize the benefits from the perspective of the investors to hold the building for at least 10 years. Um, and so, our model, which is, you know, uniquely capital intensive actually turns out to work extremely well, with the Opportunity Zone law. IIt's true that, that we have, we sort of aim for permanent holds and um, and, and the law definitely does envision sales after 10 years, but I think it's important to realize that, because of the fact that we refinance after about 18 months and return a very large portion of the investor's capital, even if the, even at the point 10 years down the road when the investors have their, original capital gains bill come due, they've already received the vast majority of their capital back from us, you know, during year two.
Jack:9:53Then if the investor is getting taken out early in the 10 year period, how do you structure that so that he still gets the tax benefits?
Moses:10:07Oh God. Yeah, that's, that's an important point. I'm glad you asked. I know he's not being bought out. The investor remains a major. He's getting tax free refinance proceeds is going to ride along with us, and is going to remain an owner forever with us.
Moses:10:32But he's going to, he's just going to get, almost all, you know, he's going to get a huge portion of his investment backed out, via the refinance kind of around month 18.
Jack:10:43Alright. There we go. I was baffled there for a moment.
Moses:10:49No, no, listen, it's an unusual model and it usually takes people a while to wrap their minds around it. I think one thing to say, and this is something that I've come to realize over the years of doing that doing this is that if you look around Los Angeles, okay. There are thousands of people whose names you do not know who are very rich from owning a relatively small number of apartments. Okay.
Moses:11:20And the business model is real simple. They just bought buildings and they held them and then periodically they bought more buildings and they held those too. And over time in Los Angeles, over the last, let's say a hundred years rent, and therefore building values have grown at a rate which exceeds inflation. So, in other words, if you just hold on, you're compounding the value of your asset at a rate, which is faster than inflation in real terms. You're, becoming richer.
Moses:11:55So, there are so one of the paradoxes though, a, of, of investing in real estate in Los Angeles, is that there are all these people who with their own money buy and hold and have done extremely well, but just standard real estate, private equity play is to buy the building with a lot of debt, fix up as quickly as possible and sell it right, to maximize IRR.
Moses:12:25Right. But and it's great from the perspective of the sponsor, the guy who's running the deal, he gets to, he probably gets some fees along the way and he gets to crystallize his promoted interest. You know, he gets cash in his pocket and he gets to walk around telling people about how great his IRR so he can raise more money so he can do it again. Okay.
Jack:12:52What's interesting about this model is, from a philosophical standpoint, it's much more in line with the longterm goals of the Opportunity Zone, because some of the complaints is not a good word. Some of the criticisms of the Opportunity Zone program, if the goal is to create wealth for the people who actually live in the Opportunity Zone, there's this 10 year window where there is an anticipated rush for the exit. Once they hit that 10 year return they can cash out.
Moses:13:56Yep, yeah that's not us. As I said before, it's really nuts to sell things things. Provided you have a building that's in good shape and is performing. The cash flow you are receiving from it and the value of the building is growing at a rate that exceeds inflation. So Investors have the vast majority of their capital back early on. It doesn't make any sense to sell. Um, and what it, so the standard real estate private equity model kind of has the effect, I guess of enriching the sponsors, but it's not, it's suboptimal from the perspective of the investors because you're kind of going in and out and therefore paying a bunch of capital gains taxes, and brokers and escrow fees and title and transfer taxes and all that other kind of stuff that vaporizes value. Right? So, what we have done is created a model that is considerably, in my opinion, more investor friendly. It allows for investors to do what smart people do with their money when they invest in real estate, which you don't sell the building.
Jack:14:52I want to ask about surprises. Have you run into some Opportunity Zone opportunities? God, I love that they use, Opportunity Zone but I need another word for opportunity.
Jack:15:07In zones that surprised you, in neighborhoods that surprised you, that were designated Opportunity Zones.
Moses:15:21Well, yea, I mean thats a good point. As I said earlier on the call we kind of tend to focus on five or six neighborhoods and those neighborhoods I would characterize as improving. They're certainly not fancy, fancy. They're, typically kind of midway. They've got some amenities that are maybe, but definitely still plenty rough around the edges. So, that's where we've always been because that's where we've always found value and opportunity. There's that word again. It was kind of amazing from our perspective to find out that several of the neighborhoods where we've been doing business for more than 10 years, were designated Opporunity Zones because it meant that we didn't have to go, you know, go learn a new area or start taking risks on things that we don't know. We're just kind of doing the same thing that we've been doing. It's just suddenly there's some tax benefits. Um, I guess I say, I kind of said earlier that we focused on these, this small number of neighborhoods. And then you, you might ask why.
Moses:16:37Yeah. I mean, look, I would do deals on the moon if I, if the numbers made sense, right? But, we're constantly looking at deals all over Los Angeles, running a fairly simple calculation to determine whether those deals are interesting to us. But there are, when you're doing smaller deals, the only way to efficiently put out a relatively large quantity of capital is to do a lot of projects at the same time. So, we have built an organization that's capable of renovating 10 or 20 buildings at once. And, though in part of the way that we do that is by keeping the project relatively, sort of centered on, you know, on our office basically.
Jack:17:30Geographically centered you mean?
Moses:17:33Yes, exactly. So, that my partner who oversees our design and construction management can come visit all the construction sites every day. And I think we think that, particularly in the renovation business, um, there's an enormous amount of, what you'd call audibles, that get called. You know, you sometimes you open up the wall somewhere and you find out that the joists were running one way when you thought they were running the other way and that maybe creates some opportunities to, you know, make a better space or, or add another bathroom or something like that. And, and so having my partner be able to be there on site every single day to call those audibles, I believe adds real value to our projects.
:18:28But, the other thing to say is that when you, if you're investing all over the place, right, you're basing your rent forecast on some relatively superficial research that you're doing, basically on craigslist or whatever, to figure out what asking rents are in a neighborhood. Okay. We have 600 units in our management portfolio. The vast majority of which are renovated in a manner that is similar to the one that we employ for ongoing deals. I personally set the asking rents and approve all of the tenants for all of those units. And so I am constantly feeding information regarding leasing back into our acquisitions calculations, back into our pro formas. So, we are not guessing about the rent that we were going to get on this particular two bedroom apartment. We are basing our forecast on the two bedroom apartment that we have, that we're managing around the corner and the one that we have two streets away and et cetera. So, it provides a real informational advantage to us that I'm not keen to give up.
Jack:19:54That makes a lot sense and that provokes me to wonder where did you come from? How did you go from 11 years ago in upstate New York to L.A. What is your education background or experience background? How did you get there?
Moses:20:05Sure. So, I guess maybe I'll give you a quick bio. I went to a, went to Andover for boarding school. I was the first person my family ever to do that. Then, got into Princeton. Definitely the first person to do that kind of degree from Princeton. Went to London School of Economics, for a year of what I thought was kinda going to be screwing around before law school, and was living with a buddy.
Jack:20:34You thought you were going to be screwing around at the London School of Economics
Moses:20:38Yeah, I know that sounds crazy, but, I, yeah, I thought, you know, I thought I'd hang out in London for a year and then, and then go to law school and start real life. But, my buddy at the time was helping this billionaire buy Eastern European media companies at the time. And based on how I saw the lawyers being treated in those deals, I decided I probably didn't want to be a lawyer. Um, and my buddy ended up getting me, what became my first job at this tiny little investment bank in London that was helping the billionaire, and other people do small to mid market media mergers and acquisitions. So, I spent a couple of years doing that, got kind of tired of London, came to visit my brother one February who was living in Los Angeles at the time, um, walk out of LAX mid February and there are palm trees and it's like 75. And my little brother picks me up in this a sweet little Mercedes convertible that he was driving. And I realized that I was Kinda done with London and then I wanted to live in Los Angeles.
Jack:21:47[Laughs] I am in the valley of the sun myself. I am in Phoenix. That story is very similar to the story that people tell of how they ended here in Phoenix.
:21:47Yea, I mean you realize and I'm from, and you know London is obviously really rainy. But I'm from Troy, New York, which is up near Albany, and I sholved every day in the winter when I was a kid. It turns out you don't have to live like that. You can just move somewhere better.
Jack:22:18All right, let's drill down into your particular expertise, it sounds like in terms of you and the partnership, you're partner is the sticks and bricks guy, and you are the deal and money guy. Does that make sense.
:22:35That's right, that's exactly right.
Jack:22:35So, That may make the question that I am going to ask you but, what are you best at?
Moses:22:47Sure, you know, its a good question. And, I think the best thing to do is relate it back to what I just said about not being a lawyer. I think that I am about as risk averse as a person can be and still pull the trigger on a deal. Does that make sense? So, I am not a gambler. by nature I shoot fish in a barrel, if that makes sense. So, you know, it's been a curse in some ways because you know, if I had been more risk accepting over the last 10 years, our business will be a lot bigger. And I personally would be a lot richer but, I kind of live my life according to the Warren Buffet's two rules of investing. Rule One, don't lose money and rule two is don't lose money. Look what, you can't take all the risk out of a real estate deal, but I think I'm pretty good at getting most of it out.
Jack:23:45Well, that brings us to my favorite question in all of these interviews, what drives you crazy?
Moses:23:56Boy, there's another good one. I try to be a pretty even tempered guy and I don't, I wouldn't say that I'm sitting around my office crazy all the time. I think it is when people kind of confuse the concepts of value and price. So, let me explain what I mean by that. You know, oftentimes a broker will pitch me a deal and they'll say "Ah, you know this is $250 a door, but that the comps for this neighborhood are $300 a door. Ok like, someone just bought a building for $300 a door. So, this is a good deal. Okay. That broker is talking about price, right? He's talking about what price other people paid and what price I can buy this building at. But I don't care what other people pay. It is totally irrelevant to me what other people pay. Because what I care about is the value that I put on a building. What do I see? What can I do with that building? What is it worth to me? Does that make sense? And so, the price other people pay, like I, people ask me, you know, what is it like compared to the comps? And I literally, I don't know because I don't care. I care about what we're going to do to a building and what that's going to mean for my investors.
Jack:25:11So, let's talk about the Opportunity Zone Program specifically as it affects you. What is your single biggest concern? How are you managing that?
Moses:25:24Good question. I think, let me say that my biggest concern from a perspective from someone who has done a lot of real estate deals, who is looking at how this is unfolding now. Is that there's a bit of a gold rush mentality, where people have put their hands up and said, I'm raising 500 million, I'm raising 1 billion. Some of those sponsors are obviously extremely credible people, whov'e got a lot of experience, who can be trusted with large amounts of capital. On the other hand, many of them, I think are people who should not be trusted with capital in those quantities.
Jack:26:08So, it's not really the program itself that is concerning you? It's who it's attracting.
Moses:26:16Yeah. I mean, I look at, it's just like any other gold rush. I mean you're going to have some people who know what they're doing and some people who don't, and some people who get lucky and some people who get really unlucky. I think there's the tax benefits are pretty good. And I think there's obviously a lot of people who would like to realize some of their capital gains from this, long in the tooth bull market that we're all living in. I think that, I think that there are a lot of mistakes that are going to be made by you know, sponsors and therefore by their, by investors. Um, in terms of, in terms of the deals that are going to get done.
Jack:26:53So, I guess the answer about how your managing that concern, is that you are a very careful investor.
Moses:27:05Yeah, I think that's right. I mean, we're not trying to do anything that we haven't done before. We're doing literally exactly what we've been doing for the last 10 years. So, I think one way that maybe were over also a little bit different from I think how many of them many people have been approaching Opportunity Zones is that we are capitalizing these deals on a deal by deal basis. In other words, we're not trying to raise a big commingled fund. Because I think that puts pressure on the fund managers, to put capital out. Obviously they have investors who have, you know, who have clock's ticking and capital needs to be deployed. And anytime, in my experience, anytime you're trying to do a deal, with a ticking clock behind you, the chances that you're going to do a bad deal obviously increase exponentially. So
Jack:28:14So, how do you handle the pressure, though, of the ticking clock of the program itself? The 180 day window and 7 month window. Those are real ticking clocks that have to be dealt with.
Moses:28:20Sure. So, our strategy is to find a deal first and then go figure out the strategy for that deal and then go take it around to people who might be interested in liquidating some assets that they currently have. And using and invest in the capital with us as opposed to realizing the capital gains. The idea is to give someone a real choice, look, you're holding a bunch of Amazon stock. Would you rather own that stock or would you rather own 50% of this building? Does that make sense? And so it's not a right, instead of being kind of a nebulous concept where you're, you're trusting that some, fund sponsor is going to go find some things that will work for you. We're saying we are going to close on this building at a specific date. Would you like to be involved?
Jack:29:10Is it turning into a Bull market for sellers?
Moses:29:14You know, I'm, I'm not enough of an expert just to give you, to give you a real scientific read for Los Angeles in general. Um, I would say in the neighborhoods in which we are interested, um, it seems that there is a lot of heat on entitled ground up projects that that may be come available for sale.
:29:39Because our model is so unusual, our model of renovating existing apartment buildings. And because it's so unusual to capitalize those as Opportuity Zone deals, I have not seen more heat in that area than you would ordinarily be the case. I mean, look, this is a tight market right now. I mean it's, you know, pricing has gone pretty bananas regardless of whether you're an Opportunity Zone or not. Um, but I have not to seen pricing for the type of things that we buy go crazy. Go any more crazy and Opportunity Zones and it has and the rest of the city, if that makes sense.
Jack:30:22That makes sense. It's funny, I had a gut feeling that was the case but I don't have any emperical evidence one way or another. I think if I tried to explain it to myself, the reason is that there's just so much still that's unknown about this program, exactly.
Moses:30:36You know, I think that's right and it is just like anything else where the rules are kind of being created as you go along and presumably there's some opportunity. I guess I just want to caution everyone listenting to this conversation, that you want to really make sure that you are doing business with someone who knows what he or she is doing because the last thing that you want is to have liquidated that Amazon stock and find that you are paying the capital gains tax.
Jack:31:27Well Moses, I have really enjoyed the conversation. If folks want to get ahold of you, what's the best way for them to do that?
Moses:31:38Sure, if you Google my name Moses Kagan, you will find both my blog, kagansblog.com and you'll also find the website for Adaptive Realty. My email moses@adaptiverealty.com so I am easy to get in touch with and I'm always happy to talk to people who are, who have questions. So, fire away.
Jack:31:59Alright. And I do want our listeners to know, as always you will be able to find all of Moses Kagan's contact information on the podcast website. Well, Moses, I appreciate you being with us here today. All right, well I am Jack Heald for the Opportunity Zone expo. Thank you for joining us today and we will see you again next time.
Announcer:32:22This podcast is for informational purposes only and does not constitute legal tax or investment advice. For specific recommendations, please consult with your financial, legal, or tax professional.
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