Capital

Pressure's Intensifying On Housing Innovation Start-Ups To Prove Out Promises

This is Part 1 of a three-part TBD exploration of follow-on impacts of a post-low interest rate era on housing's start-up venture pioneers in construction and real estate.

Capital

Pressure's Intensifying On Housing Innovation Start-Ups To Prove Out Promises

This is Part 1 of a three-part TBD exploration of follow-on impacts of a post-low interest rate era on housing's start-up venture pioneers in construction and real estate.

March 16th, 2023
Pressure's Intensifying On Housing Innovation Start-Ups To Prove Out Promises
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Starting just over a year ago, the Fed took a historically steep path in a belated effort to crush inflation. The policy changed more than 30-year mortgage rate trajectories and homebuyers' and renters' monthly payments, as every business, household, city, and any other brand of financially-fueled organization now well knows.

Everybody and everything worth anything, suddenly started feeling a tug. It was gravity toward being worth less in a post-low interest rate phenomenon (LIRP) new normal. The collapse of Silicon Valley Bank last week and its aftershock -- still roiling and menacing the nation's community and regional banking system – points particularly at a still unclear and evolving consequence of the Fed's tightening and raising the cost of money.

Among other important byproducts of the policy shift, that is the hit to innovation. Specifically, innovation set on addressing America's crisis of housing affordability and shortages is at greater risk.

The ultimate impacts and disruptions to start-ups, early stage ventures, and not-yet-fully scaled construction, real estate, property, and financial technology platforms in the wake of SVB's untimely demise are only now beginning to sort out and settle.

No doubt, however, many founders and investors and stakeholders in new building technology solutions, new robotics, automation, and industrialization initiatives, new VR and AR tools and integrated data visualization and digital twin solutions all feel an intensified urgency to prove out business, operational, and financial performance models and execution on a fast-track.

Even if SVB's death-spiral had never occurred – impacting start-up company access to day to day cash and banking needs, as well as investors' capital – the post-LIRP era set in motion as the Fed began its policy shift toward higher rates began to suggest a shake-out among companies vying to disrupt residential construction and real estate.

Nelson Del Rio, co-CEO of modular residential development innovator Blokable, explains:

Banking problems absolutely have an impact on modular now and down the road.  Generally, developers have gotten used to low-cost construction and takeout financing. Higher cost financing will make modular more attractive as an input, when done properly, as capitalized interest costs are reduced by a faster build process. However, the capitalized interest savings generated is more than offset by the total negative impact interest rates have on real estate underwriting. Projects won’t pencil and every input will be squeezed on pricing. Modular entities will be forced to tighten margins as they try to win bids and keep deals alive. As real estate development tightens, alternative modular providers who are suffering from deals being cancelled or delayed as well as providers of alternative building techniques will push profit margins down or maybe even drive a provider into negative territory to stay alive."
A great line from the movie War Games comes to mind when thinking about traditional modular construction and market dynamics, 'The only winning move is not to play.'”

For that reason, we're diving into an exploration here that would have been necessary in any era other than the easy money days now bygone.

The question pressing harder on pioneers of modular construction, modern manufacturing, industrialization, etc. is whether such companies – offering a full-stack or super-sub capability in a factory setting – can both sustainably profit and, ultimately, impact what would-be renters and buyers would pay for access to these new residences.

One view – that of Blokable founders Aaron Holm and Nelson Del Rio – is that capturing construction efficiencies alone, while necessary, can neither support a long-term financial profit model, nor can it determine lower rents nor home prices.

Why?

The only answer is to disrupt development," says Blokable Co-CEO Aaron Holm. "If we own the technology and manufacturing process and can substantially reduce the cost to develop valuable, appreciating housing assets then it will be the developers who will be commodified. Disruption always threatens, not strengthens the incumbents who invariably have underinvested in innovation and realize too late that there’s a core threat to their model."

Digging into this assertion is critical, so we thought we'd let the deeper analysis and insight come through Blokable Co-CEO Nelson Del Rio's own words, which start with the essential building block of real estate investment, the residual value of property.

The Misconnect

Here's how Del Rio explains new residential rental housing's problem to solve:

The real problem in what we do is that – within the development process, when you look at a piece of dirt you're not certain what it’s going to be entitled for, you don’t know the soil’s condition, you don’t know everything that needs to happen on that site to create a piece of real estate. So, a developer takes a lot of risk. Period. That’s why they make the money they do.”
“You try to negotiate around risks. You try to get options on your dirt; try to get your entitlements and understand your building structure as much as possible before closing on your land. A good developer who knows what he’s doing, will say to themselves, 'I can build that all-in for for say $400 a foot. I have contractors I have worked with, and I trust their ballpark numbers, I think I understand materials pricing risks and market issues. Here’s how much that’s all going to cost, and how fast I can do it, I’ll put a team together and see if I can get the project to entitlements and financing.'”
“So, we have this game, we play. The problem [for the developer] is there is no certainty on the construction side until you have a good understanding of building design and engineering. This is because as you go through the pre-development process you could change building size and appearance, quality of finishes, floor plans and site work, or any number of other things. The soils conditions can come out different than you though requiring foundation adjustments. You have to design for earthquake requirements at the location, you may find you have a high water table or have unexpected infrastructure costs - a lot of different things come into play.”
So, what’s now happened in housing is people have seen the costs  skyrocket, the quality of workmanship has fallen, labor is becoming difficult to find; the time it takes to buy dirt and complete a project has increased and become riskier and more costly – to solve their development problems, developers are turning to modular. So, 'how do I use this modular process to make my development process pencil and less risky? Well, they think that it’s possible to say, 'I’m going to buy a modular version of my vision, that will save money and time. They quickly find out that doesn’t work.”
The developer figures, 'well, maybe if I can get some help from a modular group supported by my architect and engineer, I can come up with something that can pencil.'"
From a business point of view, the biggest issue is, no modular company will be given a a contract for the purchase of units, until the project is designed, the developer knows he has the money to pay for it, and the entitlements are in place. It’s stupidity otherwise.”
That little misconnect is the biggest problem in real estate.”
The risk it takes in acquiring a piece of dirt, entitling it, and figuring out what you’re building and then doing the design and engineering for that building brings too much uncertainty to ever lock a forward modular purchase contract on that property."
What you end up with is a group of modular factories  chasing a developer, who say, 'hey, I’ll do work on spec and if you do the deal with me when its time, promise to work with me in the future.'”
That particular business is a commodity business. What the modular provider sells will always be a commodity. Developers will take advantage of suppliers and use any work done without a contract to get further along in design and to shop for a better deal once entitlements and financing are in place.  The contract rarely goes to the supplier with a high bid.
So it’s the major issue with how things are done.  A modular product cannot deal with unique site conditions and process uncertainty unless engineered to do so.
“The answer: having a structure that doesn’t focus on the commodity itself, but on the creation of wealth. If you do that, then it makes you change your business model and product engineering, and allows you to capture the enormous benefits of advanced manufacturing”

In the next installment of this exploration, we'll look at the pain points and barriers to a fully-integrated modular residential development business model. The benefits, according to Blokable's Aaron Holm, are clear.

(1) Modular Development creates a clear incentive for continuous product development, cost reduction, waste reduction, and higher quality multifamily housing. (2) Modular Development can generate 30x the profits of modular construction. (3) Modular Development can reduce greenhouse gas emissions, construction material waste, vehicle miles traveled, and emitted carbon of new multifamily housing creation at the same time."

ABOUT THE AUTHOR

John McManus

John McManus

President and Founder

John McManus, founder and president of The Builder’s Daily, is an award-winning editorial, programming, and digital content strategist. TBD's purpose is a community capable of constant improvement.

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ABOUT THE AUTHOR

John McManus

John McManus

President and Founder

John McManus, founder and president of The Builder’s Daily, is an award-winning editorial, programming, and digital content strategist. TBD's purpose is a community capable of constant improvement.

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