Moses Kagan on Real Estate

Taking apart a deal: An East Hollywood Duplex

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Today, I’m going to try something new: Taking a look at a deal in one of our neighborhoods so that we can get a sense for what the numbers look like for the new owner.

So, let’s take a look at an East Hollywood duplex that sold yesterday. I should start out by saying I didn’t offer on the property and do not know the agents, the buyer or the seller. So I have no special information about anyones’ motives here. My intention is just to take a look at the deal from several different perspectives to see if I can figure out why the buyer chose to buy this particular property at this particular price.

Here is the headline information from the MLS and ZIMAS:

  • List price: $549,000
  • Sale price: $563,000 (so, above list)
  • Two 2 bed / 1 bath bungalows totaling 1,443 sq ft
  • 6,200 sq ft lot zoned RD1.5
  • Rents of $851 and $557 (so, $16,896 / year)

And here are some ballpark estimates for the actual annual costs of ownership:

  • Property tax: $563,000 x 1.25% = $7,037.50
  • Insurance: $1,800
  • Water/sewer: $1,200
  • Gardener: $1,200
  • Pest control: $550
  • Repairs and maintenance: $1,800

So, my guess is that the total annual costs of owning the property are approx. $13,600.

Let’s take a look at this deal through a few different lenses in order to see if we can understand what the buyer was thinking.

Buy and hold investment deal

The first, and simplest way to think about this deal is as a buy and hold where the new owner is just hoping to sit there, collect the rent, pay the expenses and keep whatever is left over as a return on his money. For simplicity, let’s start by assuming the buyer pays all cash. Assuming the above numbers are correct, the owner pays $563,000 in cash and gets, in exchange, $16,900 (rents) – $13,600 (expenses) = $3,300 in net operating income.

Then, divide the $3,300 NOI by the purchase price of $563,000 to get your cap rate… or, on second thought, don’t because you’ll plotz (that’s Yiddish for “drop dead”). All I’ll say is that, if you know anyone who’s interested in investing $563,000 of their hard-earned money in exchange for a return of 0.5% annual, please send them my way.

Probably someone reading is thinking “Ah, but what if you borrowed the money, rather than paying cash”? Well, that’s even worse. Say the buyer borrowed 75% of the purchase price ($422,250) at 4.25% fixed for 30 years. His mortgage payment is 2,077 / month, or $24,924 / year. Of course, he’s getting $3,300 in NOI, so his actual annual cashflow is only $-21,624. Another way of saying that is: For the pleasure of investing $140,750 of his cash, he gets the right to lose $21,624 in the first year. Again, not something I’d recommend!

Owner-occupier

Ok, but some of you are thinking, what about if the owner intends to move into one of the units? Does that make this a reasonable deal? Let’s see…

Owner-occupier needs to live in the property, so will have to relocate one of the two tenants. Because both tenants live in similarly sized 2/1 bed units, the city will force the owner to bump the tenant who moved in more recently, which is presumably the one paying $851. The cost of doing so will be around $15k, plus whatever the new owner wants to spend fixing up the unit for him/her to live in.

Let’s assume the new owner buys with a mortgage, because no owner-occupiers buy beat-up duplexes all cash… people that rich don’t live in beat-up duplexes!

What do the numbers look like? Well, the annual expenses are still $13,600. The rent from the remaining occupied unit is $557 x 12 = $6,684. That means the new owner will have to cover $13,600-6,684 = $6,916 / year in expenses out of pocket, or $576 / month. But there’s also the mortgage to consider… which is going to be $2,077 / month.

So, our new owner-occupier would be putting down $140,750 plus $14k for the tenant relocation plus, say $15k for renovations to the unit, for a total of $169,750 for the privilege of paying $2653 / month to live in an apartment which he could probably just rent for $2200. That, friends, is a terrible deal.

Developer

Maybe our buyer is a developer. Maybe he doesn’t care about the existing rents or structures and is instead going to build something new on the lot.

Here’s what he’s thinking:

  • 6200 sq ft lot
  • RD1.5, meaning 1,500 sq ft / dwelling
  • So, 6200 / 1500 = 4 dwelling units (you always round down with zoning calcs like this)
  • That’s [$563,000 + ($18,600 x 2)] / 4 = $150,000 per unit of developable land (the $18,600 is what you’d have to pay to reloc each tenant under the Ellis Act)

The simplest way to go would be to try to build four 800 sq ft apartments. At, say, $200 / sq ft to build, that’s 800 x $200 = $160k / unit in construction costs.

$160k construction plus $150k in land costs = $310k / unit. Assuming rent of $2500 (brand new construction) x 12 months = $30,000 annual rent for each unit, that’s a GRM of $310k / $30k = 10x… decent, but really not anywhere near good enough to justify the hassle.

Repositioning

Hopefully, it’s clear from the above that the buyer is not a buy and hold investor, an owner-occupier, or a developer. He must have more creative plans for the property… perhaps he plans to steal a page from Moses’ book and reposition the property.

Maybe he’s thinking:

  • Buy for $563k
  • Relocate the tenants for, say, $40k total (unlikely, but possible)
  • Renovate for $100k ($50k / unit is cheap for separate structures)
  • All in for $703k (this assumes it’s his money and that he doesn’t need to pay interest on it)

So, what’s the thing worth? Well, maybe he gets $2400 / month in rent / unit. That’s possible if he does a good job. $2400 x 2 units x 12 months = $57,600 / year in rent. Do we have a home-run on our hands? Well, the yield is now $57,600 (rent) – $15k in expenses (up a bit, because prop tax and insurance will be higher in this scenario) = $42,600 / year in NOI. That’s an unlevered return of $42,600 / $703,000 = 6%. Not bad, but, again, not really worth the work

And, unfortunately, the deal’s not flippable. With $57,600 in rent, even at 12x (a stretch with the rents maxed), you’re exiting at a price of $691,000, less than you put into the property (and that’s before paying brokers, transfer taxes, etc.)

Conclusion

Again, I don’t know the people who did this deal. It’s totally possible that they know something about this property that I don’t. But unless it’s sitting on an oil field or something, I can’t, for the life of me, figure out what the buyer was thinking. Any ideas?

Written by mjkagan

10/17/2014 at 2:48 pm

Stocks, bonds and real estate prices

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In case you’ve been under a rock: The stock market has been in free-fall since the beginning of October. Here’s a handy chart:

S&P 500 Year to Oct 2014

The thinking among investors is that the world economy is slowing due to weakness in Europe and China.

Usually, when investors get spooked by stocks, they sell stocks and buy relatively safer government bonds. And, indeed, you can see the result in US Treasury bond yields:

10 year treasury yields

Yields were around 2.50% and then fell very rapidly down to 2.15% (as of noon today).

What does all of this mean for real estate? Well, mortgage rates tend to be pegged to the yield on t-bills. So, as investors get spooked and flee equities in favor of government debt, they are driving down the rate at which you can borrow on homes / apartment buildings / etc. Here’s the relevant graph:

30 year mortgage rates

It’s a bit hard to see, but rates, which were as high as 4.4% in January, are down to 4% as of today.

In real estate, all else being equal, prices rise and fall in an inverse relationship with interest rates (the cheaper the debt, the higher the price someone can pay for the asset and get an acceptable yield, and vice versa). So, if we’re entering another period of low interest rate loans, you can expect prices to stay the same or rise, all else being equal.

Written by mjkagan

10/16/2014 at 1:27 pm

Posted in Development

One way to think about our business

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For a long time, as young professionals aged into their late 20s / early 30s, they would move out of LA to suburbs in search of a big single family home with a yard, etc.

Demand for apartments in LA, particularly in the areas east / north of Hollywood, was therefore mostly constrained to professionals in their 20s and working people who did not have the income or assets to move out to the suburbs. (That’s not to say there weren’t / aren’t exceptions… we’re speaking in broad strokes here.)

It’s not clear what caused professionals to stop moving to the ‘burbs. The trend really began in earnest around the beginning of the Great Recession in 2007-8. So it may have been that professionals didn’t have the money to move or couldn’t get the loans.

Another explanation was that 2007 was when the first of the Millennials (the massive generation born roughly 1979-2000) hit the age when previous generations would have started to consider moving to the suburbs… but the Millennials basically said “nope” to the high consumption, high debt suburban lifestyle.

Whatever the reason, LA finds itself with a major problem / opportunity: The Millennials are staying in the city and competing with more traditional renters (the young and the working class) for housing, driving rents through the roof. So either the city is going to find some way to allow developers to massively increase supply, or we’re looking at rapid rent increases for the foreseeable future.

Written by mjkagan

10/15/2014 at 10:00 am

Posted in Development

Another seminar?

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Have been thinking about holding another seminar / property tour.

Think this one would focus on one property we’re currently renovating.

We’d examine the initial listing, our thinking in pursuing the deal, how we got it, what the issues were in diligence, and our pro forma.

Then, we’d go walk the property to take a look at the construction underway.

I’m not sure we’re going to do this… It feels like we’d be giving away a lot of information. But I also think it might be great for the right kind of person: someone with considerable resources to invest and am interest in how this stuff works.

If that sounds like you, please email me at Moses (at) adaptiverealty (dot) com and let me know the following: whether you own properties already, your experience with renovation projects, how actively you are pursuing deals, and anything else that might be helpful for me in getting to know about your suitability for this kind of intense seminar.

Written by mjkagan

10/14/2014 at 9:48 am

Posted in Uncategorized

Off market-deal

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Not to beat a dead horse, but:

We have a reasonably interesting, off-market 4plex deal that we’re going to send out tomorrow.

It’s not going to set anyone’s world on fire, but we think it’s a worthwhile project for someone who likes Silver Lake and is willing to do some work to add value.

And the end result would be a fully-renovated building in an area which is already great and still improving rapidly at a material discount to the cost of just buying something similar on the open market.

If this is the kind of deal you’re interested in seeing, do everyone a favor and join the mailing list.

Written by mjkagan

10/13/2014 at 3:45 pm

Posted in Buying, Development

3210 Bellevue is sold

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We finally sold the last Fund 1 property yesterday and I thought I’d take the opportunity to share the (unaudited, unofficial) numbers:

  • Purchased 5/23/2013 for $690,000
  • Spent ~$410k renovating (including all fees to Adaptive)
  • So, all in for $1.1MM
  • Took in ~$40k from rents while we owned it
  • Sold 10/9/2014 for $1.42MM
  • Net sale proceeds of ~$1.32MM
  • Profit of ~$260k on $1.1MM
  • ROI of 24% in 17 months

As on the other Fund 1 deals, we did not use any leverage. That had the effect of hurting the ROI but, obviously, reducing the risk.

When Jon and I set out to raise Fund 1, we had no idea if we were actually going to be able to get the money together. There was no Adaptive brokerage or property management team. There were no fee-for-service deals. In fact, none of the people who now make Adaptive so awesome were with us yet. It was just Jon and me in a tiny office on 7th and Grand Downtown.

We went out and asked friends and family if they would invest with us. A bunch said “no”. Some said “yes”. And some people who are savvy investors but who were not then friends of ours said “yes”, too. It wasn’t that much money ($3.57MM), but it was enough to build a business.

Now, exactly two years later, it feels really great to be able to go back to those investors who believed in us, hand them their profits (they already got back all their capital) and say, as I always do in every single letter I ever write them, “Thanks for trusting us with your capital” and to know that that trust was rewarded.

Written by mjkagan

10/10/2014 at 2:55 pm

Building a reputation

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One of our agents and I just signed a listing agreement on a 4plex we will be bringing to market shortly. (If you want to hear about it before it goes on the MLS, I recommend joining the mailing list right now.)

When we were preparing our pitch to the owner, my colleague pulled all of the relevant comparable sales over the past year.

Guess what?

There are 26 4plexes marked as “sold” by the MLS in the areas in which we are interested (the improving parts of NELA) in the last six months. That means there were 52 “sides” (each transaction has a buy-side broker and a sell-side broker).

Adaptive accounts for six of those sides. No other brokerage accounts for more than two.

And we also sold two others off-market (four more sides because we represented buyer and seller) and another on market deal is closing today (knock on wood!).

I’ve thought for a long time that we were better than any other brokerage at helping clients navigate the complexities of buying smaller income properties in NELA. Now, it seems, the market is catching on.

Written by mjkagan

10/09/2014 at 10:00 am

Help wanted

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We’re looking for help in the following roles:

1. Assistant project manager. This one is pretty straight-forward. We have a ton of renovation projects going on right now and need one more set of hands to assist with purchasing and arranging material deliveries, liaising with contractors / subs, etc. We’re offering $15 / hr for this 30-40 hr / week position. If you know of anyone who might be interested, have them send a resume and short covering note to moses [at] adaptiverealty [dot] com.

2. Researcher / writer. Looking for someone to help with the blog. This role is all about coming up with creative ideas for content (written, video, infographic, etc.), executing, and then getting bloggers, etc. to link to the content. This is a part-time position for which I am willing to pay $30-40 / hr to the right person. Interested applicants should get in touch with me directly.

Written by mjkagan

10/06/2014 at 10:13 am

Posted in Building Adaptive

Only in LA…

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broadway adaptive re-use

Vacant buildings on Broadway

…would you have huge buildings on Broadway, where studios rent for $4 sq ft, totally vacant above the first floor.

Why haven’t the owners used the adaptive re-use ordinance to re-purpose these interesting old buildings as either condos or apartments?

Simple: Prop 13.

The owners probably bought the buildings a million years ago for pennies, their property taxes are likely incredibly low. And the rate of growth in the buildings’ values is dramatically outpacing the growth in the carrying costs (principally property tax, capped at 2% annual increases). If you have a $5MM asset growing in value at, say 5% / year ($250k) and costing you, say $25k in carrying costs, you’re in no rush to sell.

At some point, someone will tempt these owners will very high offers for their buildings and then convert them. But, in the meantime, in the midst of a dire shortage of housing, we have prime real estate sitting vacant.

Written by mjkagan

10/03/2014 at 11:58 am

Posted in Development

How DWP steals your money

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If you manage apartment buildings, you can probably guess what I’m about to write about.

If not, here goes:

  • DWP is criminally under-staffed / incompetent
  • DWP makes huge numbers of mistakes
  • Getting someone on the phone to correct the mistakes and/or request normal service changes takes 30-90 minutes, each time

For an individual trying to do something simple, like turn on the electricity in a new apartment, this is a pretty awful situation, but at least it’s only a once-every-few-years kind of thing.

For an owner who self-manages a few small buildings, the DWP-imposed delays probably take up a few hours a month.

For big property management companies that manage hundreds or thousands of units, the delays imposed by DWP result in employees spending tens or hundreds of hours per month. Pick an hourly wage and do the multiplication and you’ll see that DWP’s disorganization is imposing thousands upon thousands of dollars in costs on property management companies.

Econ 101: Businesses will attempt to pass increased costs on to customers if possible, either by increasing prices or cutting other costs. Management companies will eventually pass on the increased costs to owners. And owners will eventually pass on the increased costs to tenants, in the form of rent increases.

All because a city-owned agency can’t get its act together to answer the phone.

Written by mjkagan

10/02/2014 at 10:35 am

Posted in How to