Archive for the ‘Buying’ Category
Back in the 1980s, Japanese companies flush with cash acquired a ton of office buildings (and maybe hotels, too?) in LA at very high prices.
In the recession of the early-to-mid-1990s, they got their asses handed to them.
Now, there is a wave of Chinese developers flush with cash buying up office buildings, hotels, and development projects in LA.
But there is a ton of apartment / condo / hotel product getting built right now, especially downtown, where many of the target properties are located.
The question these developers need to ask themselves is pretty simple: Will the current cycle persist long enough for the market to absorb all this new product?
I’m not ready to say that the Chinese money is going to get crushed the way the Japanese money did.
But I’m not sure I’d be making the bets they’re making.
As prices continue to rise for the kind of beat-up, badly managed assets that are our bread-and-butter, we are spending more time looking at new neighborhoods.
Am I going to tell you which ones I’m focusing on? No, because a bunch of people who compete with me read this blog.
But I will share with you the way that I think about these things.
There is an equation that underpins our whole business: (rent – operating expenses) / (acquisition price + rehab) = yield
1. The cost of renovating a building doesn’t change much, no matter where you do it. No one charges you less for washer / dryers because you’re putting them in Compton, or more for ACs because you’re putting them in Beverly Hills.
2. The operating expenses don’t change much, no matter where in the city you are. You pay roughly the same amount for property taxes, water, management, repairs, etc. wherever your building is.
Given that your rehab and operating expense stay proportionately the same, what does move around?
1. The acquisition price of the building. Obviously, in the equation above, the lower the acquisition price, the smaller the denominator, and the higher the yield (all things being equal).
2. The rents. The higher the rents, the larger the numerator, and therefore the higher the yield (again, all things being equal).
What does all of this mean? Because all the stuff in the middle (the capex and the opex) doesn’t change much, you need to look for neighborhoods where you can buy cheap and rent expensive. Those are the areas where you ought to be able to generate excess yields.
The trick, of course, is to distinguish a truly improving neighborhood (one where you can buy cheap but rent dear) from a dumpy one (where you can buy cheap but can’t get the rents to work).
One couple, two incomes.
Live on one, save the other.
Buy first 4plex FHA.
Live in one unit, accelerating savings.
Accumulate downpayment for building #2.
Buy building #2 with 25% down.
Resist temptation to increase spending; saving accelerates due to income from building #2.
Buy building #3.
Assuming we’re talking about 4plexes that cost in the range of $800-900k, repeating the above strategy four times results in you retiring with $3+MM (maybe much more, depending on how good the deals were) in equity in today’s dollars 30 years from now.
I spend a lot of time on this blog talking about preventing bad things from happening on deals.
That’s what due diligence is all about: Trying to identify all of the things that could potentially go wrong on a deal and then either ensuring they do not or else planning to mitigate the negative consequences.
But sometimes deals surprise on the upside.
What do I mean by that? Sometimes you inspect and find out the units have more potential than you thought. Sometimes you find that rent controlled units you thought were occupied are, in fact, vacant. Sometimes the electrical was upgraded with permits, saving you from having to do it yourself. And so on.
The thing is, you never get to benefit from these positive surprises if you don’t make offers, get into escrow and see.
Now, I’m not advocating tying up deals that are way off working in hopes that something amazing will come to light that will save you. That’s unrealistic, because the likelihood of a material upside surprise is pretty low.
But, if a deal is on the margin, there is often something to be gained by being aggressive and getting control of the deal.
Sometimes, you find out that what was marginal is actually pretty sweet.
In Los Angeles, the law requires that every building that changes hands needs to have low-flow toilets and shower-heads installed in the bathrooms (to preserve water). The law is enforced by means of a single form that is required to be completed prior to close wherein a contractor, licensed plumber or real estate agent attests that the relevant fixtures have been installed.
For newer or newly renovated buildings, any toilets or shower-heads that passed plumbing inspections comply with the code. For older buildings, it is pretty likely that the owner will not have made the necessary changes.
So, the question that crops up on sales of older buildings is: How will installation of the required fixtures be handled?
Many buy-side brokers opt not to request that the seller handle the retrofit prior to close, in hopes of making their offers marginally more appealing to sellers (who will therefore not have to spend the money).
But this causes the following problem: Either (a) the buyer is going to have to pay for the retrofit prior to closing (in other words, pay for work to be done on a building she doesn’t own) OR (b) a contractor, plumber or agent is going to have to lie on a government document.
Would it surprise you to hear that “b” is chosen pretty often?
We’re in this business for the long haul, so we’re not going to risk our reputation or those of the subs with whom we work closely by lying on forms. That means we will almost always insist on the seller doing the work prior to close. If it means we have to offer slightly better terms in our offer to compensate, that’s ok.
Recently, I’ve been mulling the idea of buying an industrial building and cutting it up into affordable artist studios.
I have observed that these kinds of deals can work pretty well if you get the property very cheaply and keep your renovation costs low. You obviously also have to be in an interesting area… but we obviously know a few of those.
Why do I like the strategy? Artists tend to pioneer interesting areas because they look for very cheap space to work. The kind of people who hang out with artists (often, creative types who work in more traditional jobs) end up being drawn in and pretty soon small design / tech shops start to get interested, too.
The problem with this kind of deal is that the numbers are very unlikely to look good up-front. Yes, you can probably find a good building pretty cheap. But the rents are going to be low to begin, so the yield is not going to be very good.
So, why do this kind of deal? Well, one reason is that I like art because I grew up around it… check out this picture my dad, Larry Kagan, just sent me of his latest piece (yes, that plane is comprised entirely of shadows cast by the wire “clouds” above it… pretty sweet, huh?):
But there’s also the opportunity for increased rents and, therefore, yield if you get the branding and tenant mix right.
I can’t do this kind of deal with the funds we’ve raised; they’re for apartment. But if anyone out there is interested in kicking in some money alongside us on this kind of project, reach out. Maybe we can find a way to do it together.
In our business, we frequently have clients come to us with pre-approvals from direct lenders like Bank of America, Wells, etc.
The clients love the banks because they promise high loan amounts and low interest rates.
And, on simple deals where there are no real issues with the borrower or the property, the direct lenders do fine.
So, why do we strongly recommend to our clients that they use a loan broker instead of a direct lender?
Because, when problems come up in a deal, which they almost inevitably do when you’re wading through shit, the direct lenders just decline the loan and head for the hills.
Why do they do this? Bank of America does not care about closing your loan. They’re going to close a million loans. All the bank cares about is not doing anything non-standard so as to avoid upsetting regulators. So, when a problem pops up, it’s much better for the bank to run away. There’s always another loan to do.
Contrast this with a loan broker who gets paid to close deals. All he cares about is closing the loan. If the lender raises an issue with the property or the borrower, the loan broker is there to figure out a creative way to jam the loan through. Because, if she doesn’t, she doesn’t get paid. And, if she does jam a questionable loan through, it’s the bank’s problem, not the loan broker’s.
Now, it should be noted that you’re going to pay for a loan broker’s services. The loan may be a hair more expensive.
But you’re paying for a greater certainty of closing. And, in our business, where the problem is the lack of reasonable deals, the last thing you want to happen as you near the finish line is to have some drone at a big bank tell you they can’t close.
I really, really hate chipping price during escrow. Do you know what I mean by “chipping price”? It’s when the buyer, after doing his diligence, comes back and requests a price reduction from the seller in exchange for removing contingencies and moving forward with the deal.
Why do I hate it? I do an enormous number of deals in a relatively small area. I see the same brokers again and again. Sure, I might be able to chip someone once, but what happens the next time I want to do a deal with that broker? Likely, he’s going to tell his client that they can’t trust my offer, because I’ll just come back and lower it. So, in order to make sure that I and my clients get the absolute best shot at every attractive deal that comes on the market, I make it a point not to to screw around.
That being said, there are occasionally situations where asking for price reduction is unavoidable. For example, we sometimes come across buildings where the square footage as measured during inspections is materially different (by more than 1,000 sq ft) from the public records. In those situations, you can’t not ask for a reduction.
So, what do you do?
Here’s what I do: I present the seller with two signed documents:
- Signed cancellation instructions; and
- An amendment removing all contingencies conditional upon a price reduction to $X (whatever price I need to make the deal work)
Why do I do it like this? Pretty simple, really. The point is to show the seller that we’re not just screwing around and trying to chip price for no reason. We’re saying the property is really not what we thought it was and the deal absolutely does not work at the price, so we’re willing to walk away, and all the seller needs to do to make that happen is to counter-sign the cancellation instructions and we’re done.
If, on the other hand, the seller is amenable to the price reduction, he can simply sign the amendment and be confident that the deal is now non-contingent and no further price reductions will be requested / required.
This article in the Times is worth reading.
The argument is basically that we’re entering bubble territory in single family home pricing in the main coastal cities.
I think the rent estimates they’re using may not reflect the rents that are actually getting paid.
That said, when I see small houses on small lots in B+/A- areas trading at $1MM, I get nervous for the buyers.
I’m mostly a price per sq foot buyer. Because I always renovate, I’m not very interested in the income of the building prior to acquisition. I am, however, extremely interests in the structure I am buying, since that structure is the raw material we will work with to produce the eventual product we are selling: Wonderfully renovated apartments.
I told the people who attended our seminar recently that I start to get interested around $200 / sq ft. But that brings us to the subject of today’s post: The fact that all square feet aren’t created equal.
Here are some examples of situations where a $200 price / sq ft still isn’t cheap:
1. Where you have wasted space. Picture a standard 1920s center hallway building. The center hallway is often 5′ wide. If the building is 100′ long, you’re wasting 5 x 100′ = 500 sq ft per level on hallways. No one pays rent for hallways, but, as a buyer you’re still paying for the space and, as a renovator, you’re still paying to fix it up. So, center hallway buildings need to be priced at a discount to $200 / sq to be interesting.
2. When you have huge units. The economics of our business are to a large extent determined by the achievable rent per sq ft. What kind of units generate the highest rent per sq ft? Studios. Think about it: A renovated 375 sq ft studio in Silver Lake can get $1300 all day – $3.47 / sq ft. A renovated 600 sq ft 1 bed / 1 bath gets $1700 – or $2.83 / sq ft. A 1300 sq ft 3 bed / 2 bath gets $3000 – $2.31. As you can see, the larger the unit, the lower the price / sq ft achievable.* Therefore, the return to the buyer of a building priced at a given $ / sq ft declines as the unit size increases. A building with lots of studios priced at $200 / sq is likely to be considerably more attractive than a building with lots of 3 beds priced at $200 / sq.
3. If there’s no land. Price per sq ft looks at the structure, but that’s not the only component of building value. For example: Look at our deal at 3212 Bellevue. We’re going to sell that thing at a price which will equate to $425 / sq ft or something. Sounds really high, right? But you have to consider that Bellevue is on 10,000 sq ft of land. That much land allows us to give all the units parking, storage, private outdoor spaces, decks, etc. The result: Very high rents / sq ft. And very high rent / sq ft imply a very high price / sq ft on exit. The opposite is also true: If you have a $200 / sq ft building with no space available for parking / outdoor space, then your rents are going to suffer, which means that $200 / sq ft may not work.
If you start to consider the above rules in reference to lots and lots of deals, you will find that there are all kinds of interesting interactions that take place when you combine buildings of varying configurations with units of varying sizes with lots of varying sizes. Deals which don’t look great reveal themselves as almost certain winners. And deals which superficially look like winners end up looking very risky indeed.
*Incidentally, this is one of the reasons zoning limits the number of units on a given lot… otherwise, developers would build huge buildings full of lots of very small studios.