Moses Kagan on Real Estate

Archive for the ‘Buying’ Category

Where are interest rates going?

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I have no idea and anyone who says they know for certain is either:

  1. A liar; or
  2. Should be trading interest rate futures on Wall Street

That said, having a view on interest rates is pretty important in our business.

Why? Because the price of income producing real estate is highly dependent upon the cost of borrowing money.

If interest rates move up, cap rates (the “unlevered return”) move up, and the price of income producing real estate falls. If interest rates drop, cap rates drop, and the price of income producing real estate rises. (For more on this subject, check out this post.)

Given that the future prices of the assets I invest in are heavily dependent on interest rates, I have to have a view, so:

  • Believe we’re in for a period of sustained low rates
  • This is due to a huge glut of savings (worldwide, but also among baby-boomers who are all at peak net worth right now) chasing returns… eg competing to loan money
  • Also do to sustained weakness in almost all of the major developed economies, with the exception of the US
  • Persistently low inflation in the US, causing the Fed to fear deflation (as happened in Japan)

I have no idea if the above is correct. And, even if it is, it doesn’t mean rates will stay as low as they are now… just that it will be a long time before mortgages are 6-7% again.

Written by mjkagan

11/25/2014 at 2:58 pm

Posted in Buying, Debt

Ballpark returns

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Had an interesting conversation today with a guy looking at building condos / small lot.

One of the questions he had was what kind of returns a developer can expect.

I’m far from an expert on ground up, but I’ve run the numbers on a lot of projects.

Right now, here’s where I think you end up for smaller projects (say, 5-20 units):

  • As a rental: If you know what you’re doing, think you can build into a 6.5-7.5% unlevered yield. That means you buy the land all cash and build all cash and, when it’s done, you get roughly 6.5-7.5% on your money annually. You can improve this number by using a construction loan to build and/or refinancing post stabilization.
  • For sale: I have seen several 20% ROI deals. Again, this assumes building all cash. Remember, too, that building for sale projects is more of a 24 month project (since the entitlements take longer to secure than those for rental housing)

Just to clarify, it’s not like deals like this are falling off trees. You have to hunt them, know what you’re looking for, and know how to execute. And, of course, there are all kinds of risks with ground-up construction… the scariest of which is the market moving against you during the project.

Still, if I had a ton of my own money, I think I’d be buying pretty high quality land, building rentals on it, and holding them. Long term, owning high quality, non-rent controlled assets in good parts of LA is probably a winner, even with the relatively high cost of land at the moment.

(Note: This post is not a solicitation for investment nor a guarantee of any kind of performance on any particular deal.)

Written by mjkagan

11/24/2014 at 3:24 pm

We missed…

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Just missed on a deal I really wanted and I’m upset because I didn’t follow my own advice.

When I’m brokering deals and people ask me what to bid, here is what I always tell them:

  • It’s impossible to know what others will bid
  • Instead, play with the numbers to figure out the highest price you can pay while still getting an acceptable return
  • Bid that price knowing that, if someone bids more, you don’t mind losing the deal

So, what did I do?

I bid a price where the returns were very tasty.

I could have bid more and had the deal end up at an acceptable number.

But I didn’t and I lost the deal.

Now, I’m filled with regret.

Written by mjkagan

11/20/2014 at 9:58 am

Posted in Buying

Concentration vs. diversification

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One of the interesting issues with managing other people’s money is having to decide how exactly to allocate that money among projects.

At any given fund size, you need to decide whether you should do a small number of big deals or a large number of small deals.

All the theory points toward diversifying. After all, assuming that all projects have similar return characteristics, if you spread the money among many projects, 1-2 going badly won’t destroy your results. And, indeed, the docs governing many investment funds require that they refrain from allocating more than a certain percentage of their equity to any given deal for exactly this reason.

But real life, of course, can be more complicated than theory, because:

  1. Sometimes (not often, but sometimes) the larger project(s) promise better returns than the smaller ones that are available at a given time; and
  2. In our business, which is extremely hands-on, managerial attention is at a premium, so spreading it among many, smaller deals may mean worse performance than if the attention were concentrated on fewer, larger deals

So, what do we do? We:

  1. Keep in mind that, all things being equal, diversification is better;
  2. Are willing to concentrate, because we:
    1. Limit ourselves to deals where we believe there is a considerable margin of safety (eg deals that are sufficiently profitable to absorb bad news)
    2. Limit leverage, which is the factor most likely to lead to disaster in our business
    3. Refrain from doing deals on brick- and un-reinforced soft-story buildings (because these can both collapse in earthquakes, the other major risk)

Will the above prevent us from losing money for our investors? No. There is always the chance we screw up. But we believe the above gives us a reasonable degree of safety while allowing us to chase attractive returns (which, after all, is the whole point of doing this).

Written by mjkagan

11/19/2014 at 2:10 pm

Apologies for the lack of posts

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Didn’t write Friday or Monday because I’ve been slammed.

We were finishing up diligence on the first deal for Adaptive Realty Fund 3, our latest investment vehicle.

Late last night, we removed contingencies, with closing to come early next week.

On top of that, my very capable assistant has been out sick, so I’m doing more of the grunt work than I usually do on one of these deals.

Anyway, we’re super-excited about this latest building and will provide details when its prudent to do so (eg not for a while).

Written by mjkagan

11/18/2014 at 12:45 pm

Posted in Buying, Development

Some stats on our business

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Jon and I are hiring a photographer to go back and document all of the buildings we’ve renovated.

She asked for a list, so I went back through my records to produce one.

Thought you would be interested in the results of my research:

  • Completed gut-renovations on 25 buildings totaling 156 units
  • Renovations in progress on 10 buildings totaling 103 units
  • Six buildings totaling 40 units awaiting renovation
  • In escrow on two buildings totaling 16 units

Assuming all goes well, by this time next year, we will have completed 43 buildings comprising 315 units in seven years.

I’ve excluded from the list another 10 properties totaling 61 units which we bought renovated or intend to renovate at some point in the indefinite future.

Not bad for starting in this business in early 2008, huh?


Written by mjkagan

11/11/2014 at 11:03 am

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!


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.


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.


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.)


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

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

Why we don’t announce closings

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If you’re at all active in real estate, your email account is spammed daily by brokers announcing the closings of their latest deals.

Why do they do this?

Because doing so:

  1. Shows everyone in the market how active the broker is
  2. Keeps the brokers’ name in front of potential clients, increasing the chances potential clients call them when it’s time to buy or sell

Seems reasonable, right? So why doesn’t Adaptive send out these kinds of emails?

It’s pretty simple, really. We are primarily in the business of placing capital in specific neighborhoods. In order to do this effectively, we spend a ton of time thinking about acquisition prices, rehab prices, and achievable rents. When we find a neighborhood that works, we and our clients want to buy as much fairly-priced product in that neighborhood as possible.

If we sent out emails every time we closed deals, anyone with a brain could figure out what neighborhoods we like and then just piggy-back on our hard work / insight to compete with us.

So, yes, Adaptive closed a bunch of deals last week. But no, we won’t announce the addresses or deal sizes. Because we don’t want you to compete with us / our clients.

Written by mjkagan

10/01/2014 at 4:50 am

Posted in Buying, Development, How to

Adaptive’s proof of funds problem

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When you make an offer on a building, what you’re really saying to the owner is: “Please give me the exclusive right to consider buying your building at this price for the next 21 (or 30 or 60) days.”

For an owner to accept, she needs to be ok with your price and, crucially, as confident as she can be that you have the intention and ability to deliver your price. Otherwise, she has to worry that you’re going to tie-up her building, waste her time, and then not have the dough to close.

In order to give the owner confidence, the listing broker will usually insist on seeing “proof of funds” from the buyer.

The proof of funds is typically a bank statement or something similar showing liquid assets (cash, stocks or bonds) at least equal to the amount of cash the buyer requires to close the transaction. In other words, if you’re offering $1MM for the building with 30% down, the listing broker is going to want to see at least $300k in liquid assets before allowing the seller to accept the offer.

The above is totally fine for rich people, but it creates some real hassle for money managers like me. Why?

I use other peoples’ money to make deals. In order to get the ability to use that money, I usually need to offer a preferred return on it. I say something like “If you give me your money, then I will give you a 5% (or 6% or 7%, whatever) return on the money for the time I have it (plus upside, obviously), before I get to take any of the profits.”

Can you see how this creates a problem for me?

If I get $2.5MM committed on a fund, I have zero interest in calling it down from the investors until I have something to buy. Otherwise, I’m sitting there with $2.5MM in a 0% checking account and accruing $10,416 / month in preferred return (assuming a 5% pref) which I will owe my investors before I see a dime of profits.

So, because I refuse to call money down until I’m confident I’m going to close on a deal, I always end up in these annoying conversations with listing brokers, where I need to convince them that I actually have the money and they think I’m full of it.

What’s especially annoying about this problem is that, of all the potential buyers with whom they might go under contract, I’m nearly always the one most likely to close on the terms I’m offering, because:

  1. I’ve done a million deals, so I know before I make an offer what I’m going to do with the building and how much it’s going to cost;
  2. Because I’m going to renovate, I don’t care that much about the physical condition of the building (so I’m not going to ask for a price reduction because the light switches don’t work); and
  3. Because I do so many deals in such a small area, I try as hard as I possibly can not to chip price, ever… because getting a reputation for doing this is a sure way not to be able to do any more deals going forward

Compared to your typical lawyer or doctor who has $2.5MM sitting there in cash and does a deal every 2-3 years, I’m far, far more likely to actually close.

The good news is that, because we close almost every single time, over time, more and more brokers are seeing that we’re serious. And the second time around, they trust that we’re going to do what we say we’re going to do.

(Obligatory legalese: This post is not a solicitation of investment or an offer to sell any security.)

Written by mjkagan

09/30/2014 at 10:39 am