Building Through Cycles: It’s All Related in California Housing

- Good afternoon everyone. I'm Richard Green, I'm director of the USC Lusk Center for Real Estate here with Lusk Perspectives and we're very happy to welcome as our guests, the senior management of Related California Bill Witte, the chair of Related California, and Gino Canori, president of Related California. And I've had the pleasure of knowing Gino and Bill for a good long time now and they both have great stories to tell. And so what we're gonna do is, what we always do with our guests is we're gonna ask them to talk a little bit about their own journeys to where they are. And then we're gonna start getting into what they're really good at. And multifamily housing is a particularly important thing here in California and nationwide. And there are no two better people to talk about it, both the market rate sector and the affordable sector than Bill and Gino. So guys, thanks so much for joining us and Bill, let's start with you. Just tell us a little bit about your story, about how you got from where you were to where you are now.

- So as I like to say to younger people when I talk to them, I have an unusual trajectory and I don't necessarily put it forth as a model. I was an undergraduate Urban Studies major at University of Pennsylvania in the 70s. Worked briefly for the city there in the mid 70s. Moved to Washington DC in the late 70s. Ended up the last year of the Carter administration as an executive assistant to the Federal Housing Commissioner at HUD, which was a big break because it exposed me to a much wider audience of potential places to go. And as I had to think about what would I want to do next, then soon to be elected in her own right, mayor of San Francisco, Diane Feinstein called my boss, the FHA Commissioner Larry Simons and said, you know, all the money at the time was in Washington. And she said, you know, I need a housing person. Do you know anyone you could recommend? He turned to six of us and said, anyone know anyone who'd be interested? Well, I was single at the time, I raised my hand. He called her, he's very loyal and said, I have just the guy for you. I did have an interview, but that was pretty much it. I wasn't really qualified at the time, but that was okay. Moved to San Francisco, worked for her. She added economic development. So I was in charge of housing and economic development for her for eight years, briefly for 18 months, a deputy mayor for her successor, Art Agnos. And again, I reached a point where I thought, you know, I've been a city planner, housing policy person all my adult life. I don't really, I feel like a referee. I want to do something more. And my brother, my younger brother and a partner had formed a partnership with Steve Ross, the chairman of Related in the late 80s, ironically, to do office development in California. Been introduced by a broker who knew both. And Steve said to him, you know, we've always done affordable housing, but we've never done anything in California. And my brother said, well, you should meet my brother. I met him, I interviewed with him and I'll always remember at the end of the interview, he said, I don't know if you know what you're doing, but you sound good. So let's see if this can work. I started out just me, no staff involved in the most complicated project, maybe we've ever done, the redevelopment of a 35 acre public housing site in the Harbor City area of LA called Norman Terrace. And after seven years of effort closed on financing to, first we had to relocate all the tenants, demolish the 400 units that were there. Wartime era barracks style housing, built 400 low income rental units with project based Section 8 and with a home builder partner, 223 for sale single family homes and town homes that were interspersed by a cluster in this 35 acre site. Had that project not proceeded, there would be no Related California. In any event, went from there and started ramping up doing a lot more affordable housing. And I saw though I didn't come from the traditional background of finance or construction or business or anything, that I really liked being able to actually do things, not just enable things or plan things, but do things. And I think it was Gino, 2001 maybe that we interviewed, this young guy turned out to be Gino for a job with us in our Orange County office that we'd opened. Yeah, I think he'd one year out of USC having worked for Carmel Partners, a market rate department developer. And all I remember about the meeting is we offered him 50,000 a year and he would not leave 'til he got 55,000.

- It was a bit higher than that, 60 to 65.

- So Gino, he started you at 50 and you got 'em up to 65?

- No, it was, it was 60,000.

- I was gonna say, if you, if you got 'em from 50 to 65, I never wanna negotiate against you.

- So I'll take it from there. So in 2001, after spending a year at Carmel Partners, I was hired as an assistant project manager. And I would say Related California at the time was, I would say coming out of its infancy stages. If I recall correctly, they had 16 or 1800 units. They had a robust pipeline. They had just begun their hiring and you kind of did everything at that time, right? Whether it was applications for tax credits and bond financings and/or sourcing deals and closing those deals and largely becoming a formative player in the production of affordable housing. With that came a lot of knowledge and a lot of learning in structured finance, which I've always told anybody who wants to get into real estate, the best thing about affordable housing is they are very difficult to finance. And when you're trying to put together three or four different sources of financing and how that works structurally, how you're leveraging one against the other in order to make these project work, you learn a lot in that process. You know, 'cause you're not just dealing with one lender, you're dealing with three or four lenders. So as we continued through the growth of the company, I would say for the first six or seven years, it was mostly acquisitions of existing affordable housing and preservation and new construction, nine and 4% deals. And we were so busy.

- Gino tell us what nine and 4% deals are.

- Yeah, so 9% tax credits are the part of the federal low income housing tax credit program. Those are credits that are, you know, authorized by the federal government, doled out by the state, that then you go and syndicate and/or sell those credits to become what eventually is the equity partner within a low income housing tax credit project. And so the difference between a nine and a 4% deal is a 9% deal is, is you get more credits for that project on the cost basis with taxable debt, on a 4% project, you get less credits, but you get to let leverage tax exempt debt. So that's two different ways of building and, you know, nine and 4% projects and/or preserving and rehabilitating those projects. So for I would say six or seven years, because the company was so busy, I was getting laps and doing a deal or two a year, right? Very different than market rate where you're doing one or two every three or four years. So I got a ton of experience. And then Bill, you know, had always wanted to expand into more mixed income market rate, diversify the company. And so, you know, we said, listen, you know, our parent company does a lot of these 80/20 financings. Nobody is using the tax exempt bond cap at the state for mixed income projects. And at the time there was I think two and a half billion dollars. So we built a business incorporating affordable housing within market rate projects and pursuing tax exempt allocation through the state, through what's called the mixed income pool. And so those projects work well within what is in our DNA of like building in the urban cores. So San Francisco, Los Angeles, parts of Orange County. And so we went after that business very hard and actually utilized, I think just about all of the available tax exempt proceeds and allotment that was available before they turned off that spigot. So, you know, that enabled us to build upwards of, you know, 2,800 units, you know, with that two and a half billion dollars, while also providing 20% affordability in every single one of those buildings without using any city subsidy.

- Gino let me just interrupt that point 'cause that's all true. But what really I think got us started is in the late 90s, or actually before I started, my brother working with Steve Ross had won the rights to develop an office high rise at 3rd and Mission Streets in San Francisco. Then the commercial recession hit in the 90s and the New Yorkers said, you know, we've always done high-rise residential. I know nobody out there does that, have you considered that? Long story short, we converted the approval to high-rise residential and to Gino's point, we utilized the tax exempt bond mixed income 80/20 program, which Steve Ross had, if not pioneered, heavily utilized in Manhattan to build what became the paramount of 487 unit 40 story mixed income high-rise, which we still own today, that I think no one from New York said go do market rate housing. But I got a little bored with just tax credit stuff. Gino was this young whipper snapper who was, had some market rate background and at the rest, as Gino said, is history. And for a long stretch that model, easy access to tax exempt bonds, huge savings on debt, short term commercial floating rate debt worked.

- So just one thing and I'm gonna get in the weeds before I wanted to get into the weeds, but on the tax exempt bonds for the mixed income stuff, can you do all of your debt financing through that? Or is there a pro rata share that?

- So it was purely, it was usually a function of size of the deal and how your project scored. So depending on how competitive the cycle was for the mixed income pool, sometimes you would have to layer on a taxable component of that debt, but by and large, but it was still taxable bonds, not taxable debt in the traditional sense. So the price is better and it's marketed as seven day paper variable rate demand notes. So you know, the first deal we did was a hundred million, the last deal we did was 500 million. So by and large, the majority of the portfolio is tax exempt. And you know, tI would say that's what saved us during COVID is because even though interest rates went crazy, you know, tax exempt paper trades at a significant discount. So even though we had a lot of issues and pain points with assets we've owned in Los Angeles and in San Francisco with eviction moratoriums and so on and so forth, the cost of that debt and where interest rates were, especially during COVID, which were near zero, enabled us to ride out the storm of that period of COVID and the period of rising interest rates.

- So I guess what I'd like to do is let's spend some more time on affordable housing and affordable housing finance and then we'll get into the market and then talk about California, this market specifically, market rate stuff. And then California specifically. But I wanna back up, Bill, so I can't help but ask, so you must have known Donna Shalala when you were in the Carter administration?

- Well, I had met her.

- But she was running PDNR at the time.

- I knew her not well. I was there for a year, but yeah, I knew her.

- She was my first boss as a professor. She was at the University of Wisconsin when I started out and I'm a big fan of hers. So I was wondering, but when you did your first affordable deal, that would've then been, if I'm doing the chronology correctly, before low income housing tax credits existed?

- No, that's actually not true. The tax credit program was authorized by Congress in the 1987 tax reform. It took a few years, you know, I think for states to organize, to implement the program. And in the early years of the program, for the first six, seven years, almost all the financing, the tax credits were raised through the Merrill Lynches of the world to individuals selling tax breaks. And the program required 15 years of affordability. And that's how these interests were sold. Somewhere by the mid 90s, early to mid 90s, the corporations started entering the fray and the program made a sea change in two ways. First of all, in most places, the affordability requirement was extended to 30 years from 15, in California, ultimately to 55 years. But the entire market became corporate buyers, mostly banks, insurance companies, large entities with long-term tax needs and who didn't need, you know, they weren't tech companies going up and down kind of steady state companies. Banks also got credit under the Community Reinvestment Act for doing this. And along the way, the value of the tax credits as the program became more regularized, increased dramatically. I can remember an early stage deal where a tax credit deal generated 43 cents on the tax credit dollar, then it went up to over a dollar. Now it's back in the 80eighties and may drop again a little because the corporate tax rates may drop.

- Right.

- So, you know that that's, from a financing point of view, that's kind of how it happened. And then in California, at least, at least in much of California as costs rose, simply raising equity from the tax credit program wasn't sufficient. And a typical deal might have maybe 50% of the cost was from the sale of tax credits in equity, which only got tax credits and maybe a modest return. So it was almost like equity or almost like pure debt with almost interest rate. Maybe 20 to 30% would be conventional, as Gino said, taxable debt, just the lower, you know, there was NOI of X and it generated a permanent loan of Y equal to maybe 30% of the cost, but that left another 20 plus percent that had to be funded from some other local or state source of funds. And the growth in those programs is what's helped, I think, move the program, at least in California.

- So, I mean, a couple of things I think are worth stopping and talking about. So first, I think of the tax credit as really like a 10 year treasury, right? And it's money from the government. So as long you follow the rules, you're gonna get it. So you buy it upfront, you're gonna discount it at basically the 10 year treasury rate. And so it seems to me the price, so that 43 cents, the other thing that was going on is in 1990, of course 10 year treasury rates were in the neighborhood of eight, nine, 10%.

- Correct.

- Instead of four or five. So just the present value of that 10 years is going to be much lower.

- You were also selling to individual investors, not banks or insurance.

- And then the other thing is this phenomenon that you refer to is the alternative is how much taxes are you saving? And if tax rates go down, ironically, that means that the tax credit is going to have less value than it otherwise would. And so as we think about, you know, we're in this world now, we're probably gonna have 10 year treasuries in the four or 5% range for a while. We have the one Big Beautiful Bill, which has the tax characteristics that you described. What do you think will happen to the value of tax credits going, I know this is an unfair question, but I'm gonna ask it anyway. What do you think is gonna happen to the value of these credits going forward?

- Well, I don't know. I think the corporate tax rate and possibly the re-inclusion of Fannie Mae and Freddie Mac as buyers of tax credits, that will have more impact on the value of the tax credit. I think what the provisions in that bill do is they increase the amount of tax credits available, both in this, as Gino said, the 9% program, the credit volume will increase by about 12%. So more deals can get tax credits. And in the 4% credit bond program, by reducing the required debt, accompanying the 4% credit from 50% of the cost to 25% of the cost, it will make eligible many more projects. What we don't know in California at least, is what is the impact, the short term impact, if you look at, on the one hand, high cost, less public subsidy, more available bonds, and 4% credits should lead to a higher, much higher volume. Like in the earlier years of the program of acquisition rehab projects as opposed to new construction, many of which would be 15 year tax credit deals seeking refinancing or resyndication and fewer new construction deals, simply because they're harder to make the numbers work. And there'll only be so many, you know, as Gino pointed out in the earlier years of the program, if you applied for tax credits, you're probably gonna get them.

- Right.

- In the last five to seven years, there's been a huge surge of demand, some of which is because of all the money thrown at homeless projects, some of which is just the continued political pressure to do more affordable housing. And it became highly competitive and a lot of deals were unsuccessful. In theory, it should be easier and there should be more acquisition rehab. This state will always give a priority to new construction. It just will.

- I think though it's an interesting question 'cause you asked about pricing, Richard, and there is a lot of advantages with the adjustments, the tax credits and lowering the 50% to 25%, but it also, with the expensing of R&D and all of the other provisions for corporations should inevitably boost corporate profit, which then would require their appetite to shelter more of those profits within a system like the low income housing tax credit, which a lot of the investors, insurance companies, large corporations, banks with CRA needs and so on and so forth. I think potentially, depending on how efficiently this flushes through the system that we could see pricing that maintains well into the 90s, you know, it's in the 80s right now because all the tax adjustments. But I think once, if, you know, stock market's doing well, you know, these companies are posting amazing profits. They have the ability to now expense all these large R&D and factories and equipment and everything else. The onshoring of all of this, you know, should help the, you know, should help the pricing I would think.

- Okay, well help me. So this is, it's exactly those deductions though that make me, so, walk me through this. So let's just say because of your ability to expense R&D, your profits go down to zero. I'm making an extreme case. Okay, now you don't need a tax credit.

- Correct.

- You aren't paying taxes anyway. So that's what I mean. The more favorable the tax climate is to corporations, the less valuable any kind of tax credit program is going to be. And so where am I failing here? What am I getting wrong?

- Well, I guess I'm looking at it differently, and maybe I'm looking at it the wrong way. Because if you produce a hundred dollars of profit and you're expensing down all of your equipment, you're saying, okay, I'm not producing any profits for a period of time. But I guess the ratio calculation is how much of that versus how, you know, how much of that's available versus the overall investment over what period of time? I guess that's the question mark. In my mind, I was thinking if they have this added benefit of these tax provisions, are they gonna be able to produce more or less profit as a result of that? I think you're saying it's probably less.

- In terms of, you know, paper,, I'm talking about taxable profit, not actual profit.

- So there's another variable here, Richard, which is why I'm a little more bearish, is that it's true that this is sort of just like a treasury note and you're just waiting for your 15 year holding period to extend. But in order, in my opinion, for prices to rise, there'll have to be more players in the market. The market's been pretty fixed, banks, insurance companies, et cetera. So few others. If there were more others in the market, it could help bid up pricing a little bit to get deals. And you have to accept that this is real estate. There's theoretical risk, although not much real estate risk. You know, you could be an investor in a project where tenants start complaining about something, you know, as Gino said, banks get community reinvestment act credit for frankly not doing very much in my opinion, but they get it. So it's useful. If you're just a corporation, like for example, Silicon Valley companies have not done much investment in tax credit deals. You know, they're used to higher risk, higher return type investments. Having money sitting there for 15 years is not their MO usually. So we'll see, but I don't know that there's going to be a major expansion of players in the market. So whether Richard, you're right or not, I don't see pricing going up, but hey, we'd be happy to see it.

- Of course you would. Well, the other thing, somebody I,, and I don't remember whether it was Gino or Bill who brought up the GSEs, but well I'm supposed to be asking the questions. I'm gonna just make a comment. I'm very skeptical about this IPO. So they're talking about a range of value between 500 million and 30 billion. Well, a couple of things. One is the treasury has, the treasury's paid capital as 120 billion. So either you're gonna have to pay that off or you're gonna be next in line for getting any money, which won't make it a very appealing thing to invest in. And the other thing is, they guarantee over $7 trillion worth of securities, and in no world is less than 30 billion sufficient paid in capital to bear the risk of $7 trillion worth of outstanding security. So I would be in, so I'm willing to embarrass myself in a year from now I prove to be wrong. But I am very skeptical that they're actually gonna be players in this market.

- Well, let me clarify. I was not referring to the potential IPO about, which I have no real opinion. They used to be active buyers of tax credits. And in 07-08 recession they exited. And now in the bill, I believe, or in some bill there's talk of having them come back, but more to help underserved areas, rural areas, et cetera. You know, that's not really our turf. And I haven't really thought much about the IPO, Gino may have a thought. I'm not holding my breath.

- I would agree and I would agree with what Richard said is I don't know how an investor can underwrite the underlying guarantee structure for what amounts to the 30 trillion. It's 30, right? It's 30 now. 29, 30 trillion outstanding.

- Oh, you mean GSE? Single family mortgage. No, it's not 30, it's single family is like seven. And then add another couple for 7 trillion and then add a couple for, let's say 10.

- 10,.

- Yeah.

- Okay.

- Yeah. So talk a little bit about, so you talk about rehab versus new construction, and you know, one of the things I've learned is we just passed this law in Southern California, in Los Angeles County called Measure A, which is supposed to fund new affordable housing. And what I learned is under the referendum, nobody looks at the fine print. More than three quarters of that has to be new construction. Only a quarter can be preservation, which personally frustrates me. But talk a little bit about, just so our audience knows the difference in cost between doing something ground up and rehabilitating something that's existing.

- Well, it depends on the quality of product, but new construction, you know, you could be, depending on how dense the product, what project type is wood frame, concrete, et cetera.

- Location.

- Yeah, location. You could be spending 800,000, a million dollars a unit to develop a project like that. You could acquire a solid class B asset for X and spend 40 or 50,000 a unit Gino, not more necessarily.

- Yeah, it depends on what vintage and age and location. But yeah, a $50,000 a unit rehab is pretty significant.

- And then what would the acquisition cost be more or less? I know it varies a lot depending on where you are.

- Well, let's just say it's that class project, class B project, and it's not in Brentwood. It's in a middle class location. Let's call it a middle class location.

- Somewhere in the San Fernando Valley.

- I don't know what things are tradings for. I would think 350, 400,000 a door, Gino.

- Yeah, I would say three to 400,000. And if you're taking your traditional garden or you know, garden plus three or four story building, that's about what you're gonna pay for it right now, where cap rates are and cost of financing, right. So it's clearly a better deal. And you know, I've been banging this drum forever, although it's, you know, I'm not convinced it's been handled well vis-a-vis the JPAs is that the acquisition of existing of B plus B product, throwing a regulatory agreement on it, inquiring those units for four, you know, in some cases 400,000 or less, putting the rehab together on them is a much better use of the money right now. Because it's all compounded. I mean, you know, in San Francisco, as soon as you do an affordable housing project, and even most parts of LA, it's a PLA or it's prevailing wages or it's union requirements, which drive up the cost 25%.

- Tell our audience what a PLA is,.

- Oh, sorry. Project labor agreement by which you are required to build every single component of the project with union labor, not a bad thing. However, the wage differential between what is open shop, meaning anyone can bid on your project and prevailing wages, which is a wage set standard and a PLA, which are wages set standard for specific subs is astronomical. So it can increase from anywhere from 20 to 30% of your cost basis.

- So Richard, let's come back to that issue and Measure A. August 20th, there's a meeting of the board of the La Casa, it's called the board that administers those Measure A funds. I've been asked by people advocating your view, frankly, to testify. I'm debating whether I want to bother.

- Well, I'll be there.

- So the debate, which you allude to is this, as I understand it, there has been resistance to acquisition, not because people oppose acquisition, but because developer, well, I shouldn't say developers, the constituency, mostly nonprofit that wants to develop or feels the need for homeless and very low income housing doesn't want to divert proceeds away from that. And that's not, in my opinion, a good analytical judgment. It's a political judgment. And that's why I've been asked to appear to not so much debate that, but to explain along the lines of Gino was saying, and I said earlier of the value of the dollar going further to essentially take existing units at much less cost off the speculative market, thereby preserving long-term affordable housing, but at a much lower cost. And there's a lot to be said for that. There are a few efforts like that that have been tried. It's challenging because the constituency are people who don't think about this issue. The constituency of I'll call workforce housing are people who would benefit affordable rents closer to where they work. But that's not an act of constituency in the housing policy wars. And I think that's what's going on and will be debated at that board meeting.

- So it's, you know, the other, the sort of broader debate is, do we want to target people who require shallower subsidies? So say people at 80% of area median income, which would allow for far more units to be whether new or rehab, because the size of the subsidy you need for each person is smaller. Or do we wanna target those in greatest need? And you can't either, if you're gonna just target those in greatest need. I mean, there's an argument for that, but it means you're gonna get many fewer units outta your money.

- Correct.

- Go further up the income distribution.

- Well, not only that, and what I'm about to say is politically very difficult. I don't have a solution to this. So much money is gone, including a couple of things we're feed developing on right now to homeless housing. Homeless housing does not really add to the supply of housing. It takes homeless people off the street. And yet a very significant amount of resources that are available in this space is going to that, that's the opposite of, you know, creating more units for workforce people who are the people who are leaving California.

- Yes.

- That's the fundamental problem is the workforce. The people between 80 and 120% of AMI, depending on where you are and you know, the numbers keep moving in terms of the incomes that are moving out. But in San Francisco it's up to $175,000. If you're making less than $125,000, you're moving. That seven years ago, that number was 125 or a hundred thousand. LA you know, Richard, you may have better numbers on that recently than I do, but I think the number is 120 to 150 now.

- Well, no, so we are, I don't know why I just said no, we're releasing a report on August 18th and this podcast will be released after August 18th called SOLACHAN for State of Los Angeles County Housing and Neighborhoods. And one of the things we find is the home ownership rate among those making between a hundred and $150,000 a year has plummeted in just the last 13 years. I mean, plummeted, I don't have a number, but it was such a shocking number. I asked our people to make sure that it was right before we put it out there. And yeah, I mean, it is, I don't know how median income so the median income household in LA County makes between 90 and a hundred thousand dollars a year, which in most of the US would be a solid middle class income. I do not know how you raise a family on that income in Los Angeles County.

- By the way. You have to look no further than what has just happened in the New York Mayors race to see what happens when the people making nearly 150,000 a year throw up their hands and say, the status quo doesn't work for me. Oh, somebody's come in saying he's gonna fix it, I'm for him.

- Yeah, yeah. I think there's other stuff going on too.

- Well, that's true too.

- But that's absolutely part of it.

- The problem is it's the same dynamic that you described.

- So we could spend the rest of our time talking about the affordable housing sector, but I do wanna get into the market and I wanna frame this by starting out by how do you see, and let's talk about California broadly because you guys work in Northern and Southern California, but then we will hone in a little more on Southern California. But since Gino got hired in what did you say, 2001, Bill?

- 2001.

- 2001. How have things changed here? How is it different to do business here to be a developer of housing here now compared to how it was 24 years ago?

- So, you know, that's a broad question. We operate in eight different sub-markets throughout the state. So I think independent of each one of those sub-markets, the answer is a little different. I think it's a function of, you know, what our business plan started out as and how we have continued to evolve to adapt, you know, to follow our customer, to move into places that make more sense to us. And so what I would say is, you know, traditionally we've been, you know, one of the largest providers of affordable housing, right? We took that expertise, we started doing a lot of mixed income housing in urban cores. That business strategy was great. It was great in Los Angeles, it was great in, you know, parts of West LA and San Francisco until we had the Black Swan event of COVID and you had mass exodus, you had political issues, you know, crime, all the things that we have now, we're seeing ourselves working through. And you know, we had flight of our customer, right? You know, you had flight of our customer out of California. You had flight of our customer into other markets in California. We build great products. So we still stand by that product. It's actually doing very well in both markets now. But, you know, when you looked at what was happening with COVID and the psychology and how companies were adapting, you know, how quickly tech left and how quickly tech is coming in, mostly fueled by AI in San Francisco, we said, where's everybody going now, now that the future is probably not five days a week. And so we looked to the East Bay, you know, there's three markets out there. We settled on one, we went to the North Bay because huge demand for housing. And you know, we started in Orange County. I'm from Orange County, and I made a concerted effort to try and find a very large site in Orange County. And you know, that became the impetus to us re-anchoring ourselves in Orange County with a very large 41 acre site. And what we deemed to be a very good location that meets the demand of our customers, that is walkable to retail, that is near job centers, that is, you know, various transportation nodes that can get you any, you know, a bunch of different places very efficiently. And so our strategy has been defense asset manage everything that we own right now in the urban cores. We're seeing a return on that investment. Everything I would say is going from fine to good over the last year, and probably good to great next year, interest rates and the way that we financed our projects are all headed in the right direction. Orange County is, you know, the top five, you know, market in the country, demand for housing, income ratios are great, demographics are great, job centers are great, and so on and so forth. So in terms of anchoring ourselves there for the future, you know, it's what I believe to be the right move for the future of the business. So now you get back to, okay, you know, how has it changed? And we're constantly evolving, right? Customers change, you know, what product we build changes, cost structures change, operating expense loads have changed. And what I would say is coming out of COVID, you know, the multifamily industry, the hotel service industry, the senior housing industry, any industry that was heavy in operations got hammered, expenses, you know, for most of Bill's career were max three, three and a half percent, 4% a year, like clockwork.

- You mean that they would grow?

- That they would grow, yeah. Incomes, again, three to 4%. If your expense ratio was under 40%, that math always worked. It was predictable. You could underwrite it, you know, coming outta COVID with the stimulus and other things that were going on. You had huge escalation. You know, there was not a function in Excel that said, in the case of expenses increasing 40% over two years, this is what you do. Nobody underwrites that. And that was largely driven by insurance, right? Cost of labor in our core markets, the cost of labor is more expensive, it's more expensive to live in San Francisco and Los Angeles. Turnover costs, you know, were, you know, got crazy because of labor and construction costs. So anything with regards to the stimulus and the inflation, you know, hammered those businesses. So we're coming out of all that now. It's normalizing, you know, we're on our first year where expenses have normalized, we're back to the two to 3% based upon swallowing the 40%. But it takes a long time to absorb that increase and your 40% expenses and digging yourself out of a hole on the rents. And I see from this point going forward, you know, we're in a much better place than where we were. But, you know, you had to fight to survive pretty hard through, you know, 22, 23 and most of 24. It turned the corner in November of 24. And what I would say is that our product in San Francisco is basically full, 99% full. We are leasing occupied units. Our rents are up 15 to 16%. LA we're in the mid to high 90s. The rents aren't quite back, but it's stable because there's no product being built. And that's gonna be that way for a while. But in terms of like, where do you go, what is an easier place to entitle? Because of the budget deficits now, and I've always said this, we don't really have a SQA problem anymore. We have a capital markets problem. We have an inability because to actually move projects forward because of cost of financing and the overreaching concern with investment in urban core markets in California, you know, because of what's occurred with the politics. So Orange County is known to be more moderate. So we're playing there, East Bay more moderate, but we have plenty of entitlements. So we don't really have a SQA problem. So all these reforms that are going through, they're not gonna do much until the capital market situation turns around.

- Another issue that each of those suburban markets represent, and a project we just opened in Santa Clara and Silicon Valley is historically, while it was more expensive to build in the urban cores, the rents were considerably higher there over the suburbs. In my judgment now Gino, the gap has shrunk. So if you look at Santa Clara or the nicer locations in Orange County, the rents are approaching what you got in the urban core and it's much less expensive and time consuming to develop, making those far more desirable, purely from a financial point of view.

- So one thing, I mean, you talk about--

- And so real, real, real quick. We are being very conscious on the cost of operating these buildings now because I'm not quite sure how you underwrite where that's all going right now. I'm hoping the insurance market is stabilized. I have very big, big concerns with the labor market, especially when you're trying to provide a customer service expectation and trying to drive rents and, you know, the overall cost to, you know, to operate these buildings, mainly utilities, you know, every single year they're going up. So, you know, it's much harder to underwrite these projects going forward.

- And they're going up because they have to bury power lines in order to prevent fires from happening again.

- Right. Correct.

- I mean, one of the things though, where California does have an advantage over other places is the property tax expense. So we know in much of the US, property tax increases were a real killer for people in Texas and Florida. And here so long as you own the building, they can't go up by more than 2% a year. I mean, do people focus on that at all or is all the other political stuff which we'll get into in a minute matter more? Do you ever hear people talk about, well, at least I know what my property taxes are gonna be for the next 10 years.

- It's been embedded in the system so long that it's just, it's just something you, you assume, right? It's never something I'm sitting there going, gosh, I'm worried about the property taxes. The only thing we do is when we complete the project is we do arm wrestle with the assessor in terms of what the value if is, you know, of the project is 'cause they have an antiquated way of looking at it. But overall, it's not something we really think about. I'm concerned about labor, I'm concerned about insurance, and I'm concerned about utilities.

- So let's talk about labor and where is it gonna come from? And I think we could break it down into two components. There's construction labor and then there's operating, the labor you need to operate your property. So tell us what you see going on right now on both of those elements.

- Bill, go ahead.

- On the affordable side, where we've just started construction on a few deals, you know, the combination of labor concerns and tariffs, it's led to some, maybe additional contingencies. But at the moment, I think I shouldn't put it this way, the worst is yet to come, not so we don't know about tariffs, honestly, but on labor there is a great concern because it's been quite a while now that there's been labor shortages in construction because they have a great deal of difficulty getting kids coming outta school to go into that business, even if it's union labor or well paying. So they already have labor shortages. Now, on the bottom end, if you have the immigration pressures that you have, it's not a good, not just in construction, but in any service, in hotels, any service industry. I don't know that we've seen the formal outcome of that cost-wise, but I think people, we are all very wary.

- Yeah, and to add to that, I mean, I think tariffs is too early. We have done a whole analysis within related company-wide, nationally, we've determined based upon how we build our buildings that we're two to 3% max. And we think we can probably squeeze that out through a competitive bidding process. So other than moving forward with our normal contingencies, we're not thinking there's that much of an issue as it stands right now, with regards to, you know, the labor and the potential for additional, you know, deportation. Like we're coming off of delivering four buildings. We haven't had any issues on site even in Santa Monica where there were a couple of raids. Now that could be subcontractor management, that could be that there's, you know, those subs are not employing people that are not, you know, in this country illegally, I don't really know. But it's not disrupted us on, call it 1,000,000,002 of projects, which is about 1100 units between Santa Clara, Santa Rosa and Santa Monica. But again, you know, this is just ramping up. So again, it's early days.

- You don't find that there are people who are just not showing up to work because of fear.

- You know, if you talk to smaller contractors, at least that we have like, people might work on your house, right? You know, they'll say maybe 10%, you know, not 50%. Where I think where I would worry, and you guys just alluded to it, is there's not that much being built right now relative to demand. And there's a lot of stuff that's entitled, if all the things Gino talked about were to take off, you know, this is always cyclical, all of a sudden there's a lot of stuff that's trying to get built, then the labor shortage is really gonna kick in.

- I mean, we would have a problem if everything went forward, right? But San Francisco, you know, the union halls are full, there's not one crane in the air right now unless it's finishing, you know, a public private project or something that, you know, carried over. But in terms of housing, there's no cranes in the air in San Francisco for production of housing. I think last year was the least amount of units produced in its history. Maybe it was three or 400 or so, which was mostly carry over, which is why we're seeing rents go up as fast as we are.

- I mean, San Francisco is at the fastest rent increases of any city in the country.

- I mean, Richard, I don't see an end in sight. Every week, there's a huge office lease every week. And what helps propel San Francisco. I mean, we can get into the mayors doing a great job, but in the operating agreements with all this venture funding for the AI companies, it mandates four days a week in the office. That's what all those investors are requiring. So that became the catalyst. And then everybody else is following suit because it's eventually going to become a talent grab. We just did this analysis, I'll send it to you, I'll send it to you in an email, which, what are the average household incomes in our buildings in San Francisco and how has that changed over the course of a year? Their incomes are up 30 to 40%.

- Wow.

- Bill, I sent that email to you.

- Yeah I saw it.

- This morning.

- And you did mention the mayor. So tell us a little bit, I mean, he's been in office for what, about eight months now? I mean, you read headlines that suggest that things are changing. Do you believe it?

- I mean, I lived through the worst part of that. You know, we had major defense on our projects and I think he is doing an excellent job. He's very accessible. He's transparent, he's out there, he's focusing on the things that he said he would, which was crime and policing and dealing with homelessness. And he's on the phones constantly with corporations trying to get them back to the office, trying to get them to bring conventions back in. He's approving projects, he's endorsing projects, you know, this is somebody who is really gets how business operates and is providing a very good playing field and bringing people back at a much faster rate than I ever thought possible. Furthermore, the investment is back. You know, when they say you're early, you're late, you know, a lot of family offices, a lot of tech billionaires bought up the city on the cheap. I was reluctant to even look at that. I didn't know who the customer was because I didn't realize how fast AI was gonna come screaming back. But anyone who made investments and bought buildings at the basis they did, they're gonna do extremely well. And you're seeing it, and there's just not enough to go around. There's eight million square feet this month that is out looking for space.

- So Richard, I would make an interesting analogy with Mayor Lurie, with Mayor Feinstein. 'cause you have two things and they're different in many ways, but there's two good things going on. One, even as he got elected, things were somewhat on the upswing. They were doing better. When Mayor Feinstein came in the early 80s, things were beginning to do better, coming out of the high interest rate time. And you have mayor promoting the city, pro business, but also sensitive to the fact that there are big minority and low income communities in the city. And Lurie is out on the streets, which may seem symbolic, but it matters to voters who normally think people in city hall don't know what they're going through. So when you have those two things going on, you know, things tend to get a lot better. The other other thing, I don't know, this is as big an issue as some have made it, the board of supervisors is now majority moderate versus progressive. Makes it a little easier to get things through, get things done. So you have all those things going on, but you do have to give a lot of credit to the mayor.

- Well, my contrarian take two years ago was that San Francisco would come back much more rapidly than anybody thought. And it's a very simple kind of calculus. San Francisco is unique. There's no disputing that. It has room for about 850,000 people. So at 900,000, there's excess demand for it. At 800,000, there's excess supply of it. In a country of 340 million people, you only need a swing of a hundred thousand people who wanna live in San Francisco. And it's suddenly a hot real estate market again.

- Well, and then the economy, the size of the Bay Area economy. Not California, obviously California is the fourth largest economy in the world, but the Bay Area economy is larger than just about every state except for five.

- And LA of course and San Francisco. Just 'cause it has more people on a per capita basis. When people point out things like, you know, the US doesn't lead the world in GDP per capita, but the country's ahead of us, like Qatar is, which is a petro state. Well, if you go to Midland, Odessa, Texas, which is our little petro state, their per capita GDP is higher than Qatar. If you look at Singapore, it's higher than the US but if you look at the Bay Area as our Singapore, the Bay Area swamps Singapore in terms of per capita GDP. So yeah, just a really productive place and I think productive people want certain amenities and are willing to pay for it. And the uniqueness of San Francisco, I mean you could still screw it up.

- Here's another stat, and I wanna send this to you because I thought it was a huge eye opener to me, percentage of people that pay rent are, you know, the amount of income they're paying on our rent, which are considered, you know, some of the highest rents in the city is between 12 and 14% of their income. Not the 25, not the 30, it's higher in Santa Rosa it's 24%. Santa Clara is 16 to 18%, but San Francisco is 12 to 14% rent to income ratio.

- Richard, that's the most amazing of the statistics that I saw.

- Which means there's plenty of growth within that to, to grow your rents, right?

- Okay, so we have only a few minutes left and so I want to ask again a sort of a blocking and tackling question, but one of the things you guys do, which we talked about at the very beginning is you do mixed income buildings and there are people who say from a property management standpoint, that's a difficult thing to pull off. So what do you do that you pull it off, that you make people comfortable living with a fairly large heterogeneity of income within a building?

- Well, I'm gonna make a high level comment and Gino can make some more detailed comments. First of all, like our affordable properties, we do screen all tenants as we should. And our experience with mixed income is for the most part, if someone qualifies to get into one of those units, they are loathed to do anything to lose that unit. Not that anybody is, but we, I think Gino, it's not completely incorrect to say over time I look at the Paramount, we've probably had more problem with market rate tenants than low income tenants in that building, not even close. So that's the first point. The second is the units are distributed throughout the building, so nobody know, oh, that's the low income quarter or that's this. And then lastly, now this is sort of, I say this partly tongue in cheek. In today's tech world, you look at people coming outta the elevator, how they're dressed. The low income people are probably dressed better than the market rate people. So not only do we not identify, people don't self-identify, the units are mixed and people don't want to, you know, if you're paying 1200 a month for a unit that rents for 4,000 a month, you don't wanna lose that unit.

- You reminding me before Gino, the survey we did of LA renters during COVID, we found that low income renters were less likely to take advantage of the eviction moratorium. And it's the highest income renters who are most prone to take advantage of the eviction moratorium.

- And I'm living proof of that. Our building in Hollywood, which is the only building that doesn't have any affordability, I think I told you the story. The highest rate of people not paying rent in that building and they ran it through the system and those were six and $7 a foot rents 10 to 12,000 a month and the state was reimbursing. That was the shame in all of that because you're right, the low income housing renters in our portfolio largely paid, a couple instances where there were hardships and we helped them through that. But these market rate tenants who were still gainly employed, they were just gaming the system. It made me very upset.

- So Gino, you want to provide any color or detail to what Bill just said on how you manage the mixture?

- Yeah, so I don't know that I would say anything other different than Bill because the units are dispersed because we do the screening. The tenant base is usually well behaved. They're appreciative. They live in, you know, some of the nicest buildings in the cities that they reside. You know, there's great service in those buildings. There's no distinguishing anything from one tenant to another. And it's something we've always done. So affordable housing is in the DNA, the market rate housing in this case had paid for the affordable housing. And, you know, we don't really shy against it, away from it. And the other part is, I don't really, we've never really had problems that would convince us to not continue to do that business, is what I would say.

- It's literally just economics to us. We make this clear to people and we go into a city negotiating a new deal. We say you know, I know words are cheap, but look at our portfolio, how much mixed income housing we have. We don't, like, some might feel we don't have a problem with having lower income people in our buildings. It does affect the economics. So if you want to negotiate a development agreement with a city, for example, we focus on the economic side of it. Like, okay, you want so many community benefits, that's one of them. What's important to you? What's a priority? At some point, the deal is no longer feasible.

- But you know, markets like Santa Monica, Los Angeles, San Francisco, there's an acceptance and I think, you know, people don't feel like they deserve something more than someone else. And that, you know, what we're doing is a good thing.

- Well, Gino, Bill, thank you very much for taking an hour with us this afternoon. I think our audience is going to find this very informative and entertaining.

- Well, thank you Richard. And maybe I'll see you on the 20th.

- I hope so, I really hope so Bill, I'll be nice to you, I promise.

- Yeah, you may be the only one.

- Okay, all right.

- Thank you Richard.

- Thank you Gino. This is Lusk Perspectives Podcast that the Lusk Center for Real Estate puts out about every two weeks. Thank you for watching.