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?

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