Every day, I drive to work along Washington and then up Hoover and then Alvarado to Beverly.
As I drive up Hoover, my attention is always drawn to the beautiful old Victorian and Craftsmen homes in that part of town. It’s always sad, though, because the few that remain are on horribly ugly streets surrounded by exactly the same kind of cheap, awful buildings and terrible signage you see in every poor part of LA.
Yes, those remaining buildings are beautiful, so I understand the impulse that drove the city to create the Historic Preservation Overlay Zone designed to protect those buildings in the area east of Hoover, north of Washington, south of Pico and west of the 110. But it was still an absolutely horrible decision.
Think about what’s going on downtown right now. There are 4,000 apartment being built with another 10,000 in various stages of permitting. Plus, office and retail players are moving in to provide work space and the kind of amenities residents love.
That area to the west of the 110 should eventually get better, because you can’t have downtown be great and the area just next to it be a total disaster.
But the HPOZ is going to cause major, major problems.
Why? An HPOZ acts as a major check on development, because:
- You can’t demolish the structures that contribute to the historical designation. This means those old Victorians have to stay… but they’re totally not suited to the area, which is practically screaming out for dense, multifamily development.
- If you want to renovate a “contributing structure”, you’re forced to go through a byzantine city process that dictates everything down to the color of the paint you can use. So, our brand of aggressive re-positioning is handicapped, because we’re severely limited in how we can re-shape the buildings. Without access to the full bag of tricks, the achievable rents are much lower, making renovating these properties pretty much a non-started.
If you can’t fix them up and you can’t tear them down, what you have left is a major, permanent brake on development in an area which is absolutely critical to the continuing transformation of the city.
I love beautiful old buildings as much as the next guy (fixing them up is my life’s work!) and there are examples of HPOZs that work OK (Angelino Heights comes to mind). But this one doesn’t. And a few old, dilapidated buildings ought not to stand in the way of the dense, multi-unit housing that LA so desperately needs.
Curbed LA had an alarmist piece yesterday re the increasing “un-afordability” of LA apartments that I think draws attention some important long-term trends shaping the apartment business.
First, here’s the money quote: “…[A] person earning median income in LA would have to spend 47 percent of that income on the median rent. That’s higher than any other city in the US.”
What’s going on? Let’s separate supply and demand.
- A large portion of LA’s apartment inventory in “locked up” by rent control (if you’re paying 20% below market, you ain’t leaving… and the more rents around you increase, the less incentive you have to move)
- No one built anything during 2008-2011 because the market was so bad
- It’s incredibly hard to build now, because restrictive zoning makes land extremely expensive
- So, supply is constrained (existing stuff doesn’t turn over, very little new stuff comes into the market, and all the new stuff is high-end to allow the numbers to work with extremely high land prices)
- There is a major population bubble percolating through our national demographics… there were a lot of babyboomers, those boomers all had kids around the same time, and those kids are all in the apartment market now
- Many of those kids, particularly the ones who graduated after 2008, were initially unable to find jobs, so they stayed in their parents’ homes
- As the economy has begun to get better, those kids are getting jobs right alongside the kids graduating today… and all of them are looking for their own apartments
- Plus, a whole bunch of older people in their 30s and 40s were foreclosed out of houses in 2007-10 and aren’t interested or able to get new loans to buy, so they’re clogging up the top end of the rental market (where people usually “graduate” into home-ownership)
- Finally, and this is really important, there are a whole bunch of relatively well-educated “renters by choice” who could afford to buy homes but either don’t want to (because they saw friends / family get screwed) or, more interestingly, are priced out of owning the kind of homes they want to own in the neighborhoods they want to stay in… unwilling to compromise on either, they remain renters
So, in LA, we have a very slowly growing supply of apartments and surging demand. Hence, the price increases.
There is going to be a temptation to extend rent control to younger buildings to please increasingly strapped tenants. But this would only repeat the mistake we made in 1978- it would shrink supply further and thereby put even more upward pressure on prices in the spot market (rents).
The answer to our problem is to identify areas well-served by mass transit, dramatically increase the density allowable in those areas, and decrease both the required parking and the minimum unit size. We should be pumping out well-designed micro-lofts with 0 or 1 parking space(s) as fast as we possibly can.
Every April 15, I go through the same emotional two-step:
1. Outrage. Since we’ve got Adaptive on a firm footing, I’ve been writing fairly large, annual checks to the IRS. It’s painful every year, because it feels like the government puts a major impediment in the way of anyone trying to turn earnings into wealth. It doesn’t seem fair that, as my income surpasses the level necessary for my family to have a decent lifestyle and begins to allow me to accumulate capital for investment, the government helps itself to 50%.
2. Acceptance / appreciation. If you look back through human history, our situation is quite rare. On the one hand, the government provides the safety, security and contract enforcement necessary to undertake our kind of complex projects. On the other hand, the government also allows us the freedom to do so, without requiring bribes or special familial lineage or anything like that. We live in an amazing country where, if you are ambitious, disciplined and honest, you can do almost anything. And paying taxes supports / enables that state-of-affairs.
Am I going to over-pay my taxes in thanks? Hell no. But I will think about the people who created this amazing place and the people who have worked so hard to keep it amazing, smile, and sign the check.
Happy tax day.
We’re very pleased to announce (belatedly!) the sale of 1012 N Virgil, a 4plex renovated by Adaptive Realty through our first investment fund.
Here are the numbers:
- Purchased for $427,000 in November of 2012
- Renovated for $380,000
- Rent roll upon completion of $111,000
- Approx. $40,000 in cash collected prior to sale
- Sold for $1,274,000 at the end of March 2014
If you do the numbers, you’ll find this was an approx. 50% ROI deal. No the absolute best we’ve ever done, but pretty close!
The new owners are experienced investors with whom we have a very good relationship. We’re going to be managing the building going forward and we expect that the new owners will generate very attractive returns from cashflow, particularly given the cheap leverage to which they had access.
Today, I’m throwing a question out to you, the readers.
First, the backstory:
- As most readers know, we raise discretionary investment funds to buy and reposition apartment buildings
- Generally, the capital for these funds comes from affluent people (many of them close friends or family of mine) who are happy to put $100-200k to work with us
- While we very much appreciate the right investors at that level (we’re picky about who we’ll partner with), it’s far more efficient for us to raise money in larger chunks
- But, we don’t know many families that can afford to write $1-5MM checks
Why don’t we know these larger families? For better or worse, Jon and I are “hands dirty” guys. We know exactly what deals to buy and how to reposition them for maximum value (and have a track record to prove it). But neither of us spends a lot of time playing golf or squash. And, because neither of us comes from a particularly wealthy family, we don’t have those connections to tap.
So, with all of that said, here’s my question: What’s the best way to go about building that kind of network? Should I join a country club? Attend wealth management conferences and network with accountants? Hang out outside Santa Monica airport?
There’s a ton of wisdom / knowledge / contacts out there among the readership and I’d love to tap into it. If you’re willing to share guidance, would you please send me an email at email@example.com?
Thank you, dear readers. And, I promise to let you know if this little experiment works (obviously respecting confidentiality!).
[Some obligatory legalese: This blog post is not an offer to sell or a solicitation of an offer to buy an interest in any investment fund.]
When I first started buying buildings, I needed a quick and dirty way to estimate operating expenses.
I hadn’t owned any buildings long enough to have historical data upon which to base assumptions.
At the time, I was using an accountant who knew just enough about real estate to be truly dangerous. I asked him if he had a good rule of thumb. He told me to estimate that operating expenses would be approximately 35% of rents.
That sounded reasonable, so I proceeded to underwrite a whole bunch of deals using that 35% expense margin to calculate the yield I would be able to achieve by buying and renovating apartment buildings. Keep in mind this was 2009, when things were very, very cheap and I was trying to leg into 8% unlevered yields (that was my threshold for whether to do a deal or not).
Do you know why it is really stupid to use a blanket 35% expense margin to estimate NOI for a repositioned building in CA?
- When you buy a cheap building and renovate it to raise the rents, your property taxes are going to remain pegged to the acquisition price. Since you will presumably add a lot of value to the deal, your property taxes should comprise a lower portion of the expense mix than they would if you acquired the renovated building for fair market value. Treating the renovated building the way you would the acquired building will lead you to over-estimate property tax on the renovated building;
- There is no difference in the expense an owner bears when renting out a $1500 1 bed / 1 bath vs. an $1800 1 bed / 1 bath. Both units will use the same amount of water, generate the same amount of trash, break things at roughly the same rate, etc.. If you blindly estimate 35% expense margins, you will be charging yourself 35% of that $300 difference in rents, $105 / month, for no reason. $105 x 12 = $1260 in annual NOI. If you put a 7% cap rate on that, it means you’re stupidly vaporizing $18,000 in value. Spread over, say, 6 units, that could be the difference between doing the deal or not.
- When you replace all of the plumbing and electric and all of the appliances, as we do on almost every building, you’re going to have lower maintenance bills because **NEWS FLASH** everything is new.
As a result of my stupid reliance on the 35% rule, I systematically over-estimated expenses on every deal I underwrote.
The good news is that the deals we actually did turned out to be 9-10% yields, instead of 8%.
The bad news? I passed on probably 5 deals that I desperately wish I had done. I conservatively estimate the lost earnings to me personally in the low hundreds of thousands of dollars. All because I relied upon a short-cut without actually taking the time to think through the implication.
Do you know what I should have done? Taken the time necessary to get some reasonably accurate estimates for the annual operating cost per unit and applied those to my pro forma stabilized (eg post-renovation) rent roll. That’s what I do now.