Moses Kagan on Real Estate

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Thinking about retirement

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(Not me – don’t get excited.)

Over the past few days, I attended a conference for wealth managers. I won’t lie: My intention was to meet the people tasked with managing assets for affluent investors, with the idea of convincing some of them to steer their clients my way. Turned out to be the wrong decision; these guys can get sued to kingdom-come for putting clients into private deals that go bad, so they’re very reluctant referrers.

But just because the conference wasn’t right for me doesn’t mean it wasn’t interesting. One of the things that kept coming up was the fear that many investors have of outliving their assets in retirement. This got me thinking about how income producing real estate fits into a retirement plan.

The cool thing about income producing real estate purchased with a mortgage is that it is effectively a tax-efficient vehicle for forced retirement savings. What do I mean? Consider the situation of someone who buys a small apartment building in her thirties:

  • Say she puts down $200k on an $800k property with rents of $73k and net operating income of $45k (a 5.6% CAP)
  • To finance the deal, she takes out a $600k mortgage with a standard 30 year amortization and a fixed interest rate
  • Say further than she does a reasonable, but not spectacular job managing the building
  • Each month, before she pays out any cashflow to herself, she makes the mortgage payment, reducing what she owes the bank
  • The interest on the payment is tax deductible
  • And the principal portion of the payment, which is taxable, is more than offset by the depreciation
  • In addition to retiring the mortgage little by little, the building spits out some cash each year

Here’s what happens to our investor as she is hitting retirement age in her 60s:

  • The building pays off its own mortgage 30 years after the acquisition
  • The investor now owns an asset which is worth whatever 2044′s equivalent of $800k is (assuming it increases in value along with inflation; she should do better if the property is well-chosen) – whatever else she did with her money during her life, she has a big asset free and clear
  • Assuming rent and expenses grew at the same rate as inflation, once the mortgage is repaid, she’ll have an income of 2044′s equivalent of $45k / year

Whatever else our investor did with her finances during her life, she’s going into retirement with an income of $45k / year and an asset worth $800k. That doesn’t make her rich, by any means, but it does make her self-sufficient, particularly coupled with her government-provided healthcare (Medicare) and income support (Social Security).

Can you rely on just one apartment building to see you through retirement? That’s probably a bad idea. But, if you manage to get 1-2 of these deals done in your thirties plus behave reasonably responsibly over-all, you’re going to end up just fine.

Written by mjkagan

04/11/2014 at 8:23 pm

Posted in Buying, Uncategorized

How the price of land affects your income taxes

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Yesterday, the Eastsider reported on the proposed sale of a piece of land on Temple entitled for 69 units.

That got me thinking about the value of land in Echo Park and how it impacts the income taxes of property owners there. (Warning: This piece is a little heavy on the math, but it’s critically important. Not understanding this cost me thousands of dollars in income tax over-payment for roughly five years until I figured it out.)

Here goes:

When you buy a piece of property, the county assessor assigns a portion of the purchase price to the value of the land and the rest to the value of the structure. Here’s an example, from ZIMAS:

Screen Shot 2014-04-08 at 9.32.38 AM

 

This is the assessor information for 2143 Clinton St., a property in Echo Park we flipped through Better Dwellings back in 2011. Note towards the bottom where it says “Assessed Land Value” and “Assessed Improvement Value”. That’s the assessor making a wild-ass guess and attributing $440,591 to the land (65% of the total) and $235,665 to the structure (35% of the total).

Why does this matter? Unless you instruct them differently, most tax preparers will pick up the assessor’s breakdown for use in calculating depreciation. Remember: Depreciation is a non-cash charge against income (sort of an accounting fiction) that reduces your tax liability (so, you want depreciation to be as high as possible). Depreciation is ordinarily calculated as 1/27.5 of the value attributable to the structure at the time of purchase, charged against income for the first 27.5 years of ownership. So, if the value of the structure is higher, the depreciation will be higher, and your taxes will be lower.

For 2143 Clinton:

  • Purchase price of $660,000
  • Assuming a stable ratio of structure to total value: $235k / $675k = 35%
  • Value of structure at purchase 35% x $660k = $231,000
  • Annual depreciation, assuming assessor’s structure value is used = $231,000 / 27.5 = $8,400

That means the owner’s first $8,400 of cashflow from the property will be tax free. Not bad right? Wrong… the owner is probably getting a raw deal.

Consider that the seller of the land on Temple seller is trying to get $4.95MM for 69 units worth of entitled land. That’s equivalent to $4.95MM / 69 = $71,739 per unit of land. That’s pretty high and it’s much, much higher than the price of land at the time 2143 Clinton was purchased. I checked back on some comps for that period and I think the price of land in Echo Park in 2011 was somewhere between $40-60k.

2143 Clinton is on a 5197 sq ft lot (see above). The zoning is RD3, which calls for 3,000 sq ft of lot size for each dwelling unit. Can you see what I see? 2143 Clinton is sitting on land that only allows for building one unit on it (though it’s grandfathered as a triplex). If, at the time the buyer bought 2143 Clinton from me, the value of the land was $60k, that means the value of the structure was $660k (the purchase price) – $60k = $600k.

This means there ought to be $600,000 of value attributed to the structure. This makes sense; after all, most of the value in the property is in the fact that there are three income-producing units in Echo Park (plus the fact that we fixed them up and got high rents for them)!

Assuming $600,000 as the value attributable to the structure, the depreciation ought to be $600,000 / 27.5 = $21,818. That means the first $21,818 of cashflow ought to be tax free. The difference in the depreciation between this number and the original $8,400 is $13,418. Assuming a marginal tax rate of 50%, the difference in the depreciation should result in a tax savings of $13,418 x 50% = $6,709. Annually.

If you have additional tax savings of $6,709 per year for the first 27.5 years you own a property, that’s $184,497 in cash that you got to keep instead of paying out in taxes… which will make a huge difference to your net worth, particularly multiplied across an entire portfolio of properties.

The lesson, as always, is to query all of the assumptions made by your tax preparer. At the end of the day, you’re responsible for keeping money that is fairly yours, and knowledge of land prices and how they affect depreciation ought to be one tool in your tool box.

A few very important caveats:

  1. If you go around claiming to the IRS that land is 10% of total value, they’re probably going to audit you eventually… probably worth keeping it a bit more reasonable; and
  2. I’m not an accountant or a tax attorney, so don’t rely on this advice. Consult your own professionals!

Written by mjkagan

04/08/2014 at 10:08 am

Posted in Buying, How to

Thinking of holding a seminar

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I’m considering holding a 1-2 hour seminar on multifamily investment.

Think the topics would include:

  1. Identifying / underwriting good deals;
  2. How the offer process works;
  3. How the diligence process works:
  4. What happens after you close

May also include a tour of some of our properties (below finished and in progress).

If you would be interested in attending something like this, would you please shoot me an email at moses@adaptiverealty.com?

If enough people indicate interest, we’ll set something up for later this month.

Written by mjkagan

04/04/2014 at 4:21 am

Interview with Justin Brown

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Thought you guys might like to check out this video interview I did with Justin Brown.

 

Written by mjkagan

04/03/2014 at 4:17 am

Amateur hour

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Just saw a flip deal go up on the MLS that’s driving me crazy right now.

The flipper bought it six months ago for $725k. He relocated one tenant, superficially renovated two units, (presumably) fixed a big foundation problem, and painted it. Figure he’s all-in for $825k or so. Now it’s listed for $899,000, presumably in hopes of ending up around $925k after a bit of a bidding war.

After roughly 7% cost of sale, this guy is going to net $860,250, or a profit of ~$35,000. Not a great deal, but not bad for a few month’s work, right?

Wrong. This deal drives me nuts, because the opportunity was mostly wasted.

Here’s what should have happened:

  • Buy for $725k
  • Relocate three tenants (one unit was delivered vacant)
  • Renovate all four units plus the exterior
  • All in for a bit more than $1MM
  • Exit at $1.25MM
  • Profit of $160k in a bit more time

Why didn’t I do the deal? At the time, I had committed all of Fund 1 and didn’t have any dry powder. I tried to get one of our fee for service clients to do it, but couldn’t. So, I had to take a very hittable pitch for a strike, instead of knocking it out of the park. Ouch.

Written by mjkagan

04/01/2014 at 5:44 am

Posted in Buying, Development

When to ignore the cap rate

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Have been looking at listings for mid-size apartment buildings today and ignoring the cap rates.

Why? Isn’t cap rate the thing you should care about with investment real estate?

Not when you’re working with brokers who don’t have a good grasp on calculating cap rates.

Here’s an example:

  • Looking at a 10 unit deal priced at 12.8x GRM (in other words, 12.8 x the total annual rent)
  • Broker is calling it a 6% cap rate
  • Let’s do some math…
    • Assume rents of $100k / year
    • That means the price is $100k x 12.8 = $1.28MM
    • At a 6% cap, that means the net operating income is $1.28MM x 6% = $77k / year
    • With rents of $100k / year and NOI of $77k / year, that means expenses are $23k / year

That’s the point I call “bullshit” on the broker.

If you buy this building for $1.28MM, your property taxes alone will be $16,000 / year. On a 10 unit building that’s, say, 7,000 sq ft, your insurance will easily be $4,000. That means you’ve got $3,000 left to cover utilities, management, vacancy, pest control, repair reserve, etc. Bullshit.

What’s the real cap rate on this sucker? Honestly, my guess is that it’s a 3-4% cap rate… awful.

And that’s why you ignore broker-quoted cap rates. Most of them don’t know what they’re doing, and you should not get lured into their world. After all, when the deal closes, the broker goes home with his commission. You’re the one living with the 3% cap.

Are you interested in seeing some deals that don’t suck? Please consider joining my mailing list. We’ll let you know on the rare occasions we find deals worth taking a close look at.

Written by mjkagan

03/24/2014 at 12:16 pm

Posted in Brokerage, Buying

Interesting deal

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I’m looking at an interesting deal for someone to put out roughly $300k in cash.

There’s not enough pop to make it worthwhile for one of our funds.

But it’s a reasonable way to get a 6-7% / year return with a bunch of upside as the neighborhood improves (hint: it will).

If you’re interested, get in touch, and I’ll introduce you to the relevant agent here at Adaptive.

Oh, and if you want to be notified when we come across something like this in the future, please join the mailing list.

Written by mjkagan

03/19/2014 at 4:10 am

Posted in Buying

Housing for the poor

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Yesterday’s NY Times Magazine had a really interesting piece on investors who buy and fix up mobile home parks.

In a somewhat surprising twist, the reporter seemed genuinely to respect the investors who are, after all, providing pretty decent accommodation to people at absolutely the lowest possible rung of the housing ladder.

For investors, I think two points stood out:

1. If you’re looking for above-market returns, it’s worth looking into unpopular businesses. Tons of people are happy to tell their friends about the apartment buildings they own in Beverly Hills. Not too many people want to tell their friends about the trailer parks they own in Yerington, NV. Where there’s less competition to own a given cashflow, the price will be lower and, thus, the yield higher. (Did I spend time looking at trailer park listings after reading the article? What do you think?)

2. The undesirability of trailer parks in California and New York, because it’s too difficult to get rid of tenants who don’t pay rent. Regular readers will remember that I have spent some time writing about the implications for the rental housing business of the increasing “tenant-friendliness” of specifically California’s legal system, but I think it’s worth repeating.

The investor profiled in the Times piece is one of the good guys. He’s not running luxury complexes, but he is keeping his parks up and maintaining order. In order to make money by running decent parks, he needs to be able to get rid of people who don’t pay. If you make this difficult, then he (and other responsible owners) will not run parks in your state.

Do you know who will run them? Slumlords who cut costs to the bone to maximize current cashflow while letting the parks go to hell. Do you know who suffers when this happens? The vast majority of tenants, who are decent people just trying to get by.

Written by mjkagan

03/17/2014 at 11:22 am

Posted in Buying, Development

A deal I can’t do

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I’m looking at a deal right now that doesn’t work for my funds because there’s not enough margin in it to flip or to earn the kind of yields that our investors expect.

But it’s a reasonable deal for an individual willing to roll his/her sleeves up and do some work. How can this be?

The answer is in the leverage available to individuals vs. the leverage available to LLCs.

As an individual investor, you can fix a 30 year loan for $800k at around 4.75% on a 2-4 unit deal. If you can use that kind of leverage on a deal where, fully renovated, you’re in for 11x the rent in an improving area, you’re going to be happy with the result.

Those loans are not available to LLCs. The best we can do on a 2-4 unit deal is something like 65% LTV, fixed for 10 years, interest-only. The cashflow on this will be pretty decent, but there’s not really an exit play. So, we pass.

Wish I had the cash for the deal right now!

Written by mjkagan

03/05/2014 at 11:04 am

Posted in Buying

How I think about LA real estate

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A contact just sent me this  link to an excerpt from Warren Buffett’s most recent Berkshire Hathaway shareholder letter.

Buffett’s approach is pretty much exactly how I think about multifamily real estate in improving parts of LA:

  • Pay a reasonable price, such that the yield in year 1 is acceptable
  • Don’t put yourself in a position where you might be a forced seller (so, don’t over-lever)
  • Manage for yield
  • Ignore swings in market prices, except to buy more when prices get low
  • Never sell

If you just do this, my guess is that you’ll end up very happy about your investment(s).

Oh, and if you are interested in investing, you should 100%, absolutely, no question read Buffett’s collected shareholder letters, which are available as a collection on Kindle.

(Hat tip to EZ for the link!)

Written by mjkagan

02/28/2014 at 10:57 am

Posted in Buying, How to