Moses Kagan on Real Estate

One of the contractors I use a lot recently did a rehab of a small apartment building in Silver Lake. He bit a lot of our style, but that’s life.

When I asked him about the project, what he told me shocked me. Apparently, the genius who bought the place paid my contractor to turn it from a triplex into a duplex, thus violating one of the key rules of multifamily real estate in Los Angeles:

Never reduce unit count. Ever.

Now, you can imagine what the guy was thinking, right? I bet the units were small and oddly-shaped. I bet he saw an opportunity to make two nice, big units and thought that would make the building more attractive as a flip. And, he could save the cost of doing another kitchen and bathroom.

Bad move. Here’s why:

1. Most apartment buildings in Silver Lake are grandfathered in. You could never build them now, because they don’t have enough parking to comply with modern building codes.
2. If you reduce the unit count, you are going to struggle to get that unit back at some point down the line. Most likely, once it’s gone, it’s never coming back.
3. In general, the smaller the unit, the higher the price per square foot you get in rents. This is because there is a ton of demand at the low end of the market and decreasing demand as you move up into large and larger units.
4. So, given a set amount of square footage, you’re always going to get more rent from three small units than two larger ones. (Incidentally, this is why zoning exists in the first place; otherwise, developers like me would just build very, very tall buildings full of studio apartments.)
5. Because apartment buildings are valued as a multiple of their rents, converting from a triplex to a duplex resulted in the owner producing a less valuable building.

Now, you might argue that, in removing a kitchen and bathroom, the owner saved himself $15k in rehab costs or something.

But look at the math. The difference in rent between, say, three studios  (3 x $1300 = $3,900 / month) and a 2/1 and a 1/1 ($1800+1500 = $3,300/ month) is $600 / month. Assuming 11x annual rents as a multiple, that’s $600 x 12 months x 11 = $79k in value that he left on the table. It’s safe to say he should have spent the $15k to earn another $64k.

Whoops.