Moses Kagan on Real Estate

Today’s NY Times has an interesting comparison of 5% down FHA and conventional loans. (For more about the basics of FHA loans, read this.)

It turns out that the increased mortgage insurance premiums currently demanded by FHA make FHA loans a worse deal than 5% down conventional.

If you’re considering buying with little money down (always a risky move, by the way!), it’s worth reading this article and then asking your lender or loan broker some tough questions.

Have been mulling over an idea for a few months that I’d like some feedback on.

Here goes: I would like Adaptive to help one deserving family which currently rents become owners of a small apartment complex.

Here’s how it would work:

• We identify a family to help
• We help the family find and offer on a sensible building
• We cover all of the costs associated with inspections, appraisal, etc.
• We help the family arrange an FHA loan
• We rebate our buy-side commission (typically 2.5%) to cover most of the down-payment, with the family contributing the rest (likely to be around $3-5k)

The effect of this project would be to give a deserving family a chance to go from being permanent renters to being small-time landlords with a stake in the city. That’s how my immigrant family and countless others got into the middle class.

Here’s my problem: I have no idea how to identify a deserving family. I think I have the following criteria:

• A family born and raised in LA
• Need to come from a working-class background without access to family capital (rich people don’t need more help!)
• Need at least one member to be working at an above-board job for at least two years and to have filed tax returns
• Need the working family member to have reasonable credit
• Need the family to be of good character – I’m not helping criminals, gangsters, etc.
• Need the family to be willing to have the whole process documented on this blog

If you know a family that fits the above criteria, get in touch.

I’ve only been doing this for five years or so. I jumped in in 2008, meaning that I’ve never seen a normal, healthy, strong real estate market in Southern CA.

I think I’m seeing one now, and I have to tell you: It’s not pretty for multifamily investors.

Go check out the apartment buildings listed on Loopnet and the MLS for your standard gentrifying areas (East Hollywood, Silver Lake, Echo Park, etc.). What you’ll find is, generally speaking, a collection of over-priced junk.

Why “junk”? Rents have gone up by something like 10% in those areas this year. Anyone who sells a building with rents doing that is either a professional with investors to pay out (like me!) or else has a truly crappy building that, for reasons of tenancies (rent control) or physical condition, is incapable of taking advantage of the run-up in rents.

Why “over-priced”? There are basically two ways to look at apartment buildings:

• On an income basis: For simplicity’s sake, let’s take GRM (which looks at the relationship between total annual rent and purchase price). Paying more than 11x GRM for a building pretty much guarantees little or no cashflow. For the most part, you can’t touch anything in the areas I’ve mentioned for less than 12-13x. And there are plenty of deals being marketed at 15x+. There ought to be a warning label attached to deals like this, something like: “Warning: At this price, this building is a weapon of mass cashflow destruction”.
• On a sq ft basis: Sometimes buildings don’t work on a GRM basis but they’re still reasonable because you’r getting the thing cheap on a per sq ft basis (bonus points if you realized this only happens when the rents are very low). I renovate buildings for a living. To take your standard PoS 1920s building and make it perfect, you’re looking at spending $50-70 / sq ft, easily. That means, to make a deal make sense, you’ve got to buy it for something like $200 / sq. But that’s not where most of these screwed-up buildings are priced right now… they’re at $250 / sq (and 15x GRM). If you buy something like that with the intent to renovate, you are very likely going to lose money.

So, where does that leave buyers?

Two choices:

1. Pay retail for renovated projects.  For example: My 1947 Clinton St deal, which was fully renovated with good tenants, was priced at around $310 and 11.5x GRM. The guys who have it in escrow are getting a steal (assuming they close). If you’re going this route, make sure the quality of the renovations is high (hint: check for permits!).
2. Roll up your sleeves and add some value. There are definitely deals out there where you can leg into a good cash-on-cash return if you’re willing to hustle. You just need to be well-capitalized and willing to take the risk of buying something with some hair on it (vacancy, physical issues, evictions in progress, city problems, etc.). If you’re going to take on something like this, you better be prepared to spend your time on it.

Bottom line: 12-18 months ago, you could make money by buying almost anything. Now you have to be smart and careful.

Spent a bunch of time this weekend considering weekend homes.

Don’t worry: I’m not about to get into that part of the real estate business. (For the record: I think buying a vacation home with a mortgage is totally insane, unless your personal balance sheet is very, very strong.)

The analogy that got me going was: Hudson Valley:New York City :: (________):Los Angeles

For those who don’t know it: The Hudson Valley is the part of upstate NY that is north of the city, stretching from the north of Rockland and Westchester counties all the way up to Troy (where I’m from). The Hudson Valley is generally pretty rural, with little economic opportunity and consequently low real estate prices.

Loads of New Yorkers who live most of their lives in tiny, extremely expensive apartments spend their weekends in cheap, beautiful farm houses on big spreads in the Hudson Valley. And businesses catering to these relatively sophisticated weekenders have sprung up – there are good restaurants, food stores, antique shops, etc. If Lucy and I lived in NY, we would join them.

So, my question is: What is the analogous area for LA? Where can you find relatively cheap land with interesting stuff to do within, say a 3 hour drive from LA?

Hi Moses

It’s been about a month since escrow closed on my purchase of [redacted]. I want to thank you for directing me to David and let you know that I’m really pleased with the way he helped me find and manage the deal.

The deal was great for multiple reasons including a foreclosure that left 3 of the 4 units vacant at the time of sale and a selling agent that underestimated the market rents and therefore the value of the property. Long story short, I just finished doing a little rehabbing largely based on David’s advice, have rented the vacant units and now have a building with a GRM of 8.03 [!] in a gentrifying area that’s pretty decent.

Barring any major issues with the property, I plan to hold onto this building for a long time. I’ll definitely be doing business with David and Adaptive Realty in the future. Thanks.

Sincerely,

Paul

Had a client ask us to take a look at the comps on a small apartment building before making an offer.

I think this brings up an interesting difference between our business (taking a rigorously quantitative approach to evaluating income producing real estate) and that of brokers who do single family homes.

In the single family home market, comps are king. There’s really no other way to determine whether you are doing a good deal or not than to look at sale of similar buildings. So, you look at price per sq foot, or price per bedroom, or something, and you say “am I paying more, less, or about the same as everyone else?”.

In our business, cashflow is king, not comps.

The relationship between the cashflow and the price you pay for it (roughly, the CAP rate), more-or-less determines what your return will be on your investment, assuming an infinite hold period (I recommend 27.5 years, because that’s when your depreciation runs out).

Before moving forward with the deal, you want to compare your estimated return with all of the other things you can potentially do with the money (not just the other buildings you can buy!).

If you like the return, you should buy the property. And, conversely, if you don’t like the return, it shouldn’t matter that the price is “fair” compared to what other people are paying.

Have been reading Warren Buffett’s collected shareholder letters. Strongly recommend them to anyone interested in business / investing.

One of the things that Buffett does in his letters is to set out his acquisition criteria. And, interestingly, as you read through the different years, you see that putting it in the letter works – he actually buys companies recommended by his shareholder-readers.

So, here, with no further preamble, here are our criteria for acquisitions:

1. Apartment buildings from 2 units all the way up to 30+ units

2. In a gentrifying area: Hollywood, East Hollywood, Silver Lake, Echo Park, Highland Park, Glassell Park, China Town, Mid City, etc.

3. Owner willing to sell at $200 / sq ft or less. (If you don’t know the square footage of the building, you can find it by going to zimas.lacity.org and entering the address in the “search” box.)

4. I don’t care about low rents, deferred maintenance, structural problems, city problems, etc.

5. Not on the MLS / Loopnet / CoStar / etc. (I look at these 50 times a day)

If you own or know someone who owns a building that fits the above criteria, get in touch. If you give me an address, a rent roll, and an asking price, I will tell you within five minutes if we are interested.

We pay all cash and can close in 10 days, if speed is desirable for the seller.

We protect brokers and intermediaries. That means that, if you bring us an idea or opportunity that fits the above criteria, we’ll figure out how to compensate you. And, if we can’t reach agreement regarding your compensation, we will not disclose your idea or opportunity to anyone else without your permission.

Have an opportunity? Get in touch.

If you take a look at the apartment market in our areas, you will see a stalemate between buyers and sellers that is keeping properties on the market for longer than sellers would probably prefer. (I know I’m getting sick of staring at the same properties day after day!)

For 2-4 unit deals:

• Many sellers are asking 12+x GRM
• At those multiples, there is no cashflow
• So, there needs to be a lot of upside in the deal to attract buyers like me, who will fix the building and raise rents to get a good return
• But sellers want GRMs that scare off buy-and-hold investors and prices per sq ft that scare away re-positioners
• However, there is still some action for really good properties at 11-12x GRM, because some investors believe in the areas enough to accept relatively little cashflow now

For 5+ unit deals:

• The days of selling these at 12+ GRM are done
• Why? Because you can’t lock a 30 year fixed loan on 5+ units and interest rates have moved up and will move up more
• At a high GRM, in-place cashflow is bad AND (because of the loan situation) you’re exposed to interest rate risk
• So, there are a bunch of properties sitting around on the market at around 11x, with no one to buy them

Until sellers get the memo and re-price 2-4 units deals in the 11-12x GRM range and 5+ unit deals in the 10-10.5x GRM range, this stalemate will persist.

One of my agents ran across an interesting deal in an improving neighborhood in NELA.

It needs a bit of work, say, $30k, but would work as a great owner user or investor property.

If you are an owner-user, you could potentially use an FHA loan on it, which would allow you to buy with 3.5-5% down.

There aren’t many deals in this market that work both on a price per sq foot basis AND on a GRM basis. That’s because, to get a low price per sq, you’re usually required to buy something beat up with low-paying tenants, implying a high GRM. And, if you find something with a reasonable GRM, it’s typically because the rents have been maxed out, implying a high price per sq ft.

For reasons that I can’t divulge here (because I don’t want the agents who read this to steal my ideas – hi guys/gals!), this property works both ways.

So, if you’re interested, get in touch and I’ll put you in touch with the relevant agent.

Here’s how I see the market for apartment buildings now:

There are very few deals that make sense on their own, as simple cashflow plays. It’s not that they don’t exist, it’s just that you need to hunt a lot harder for them than before.

But there are plenty of value-add plays, if you’re willing/able to roll up your sleeves and do the hard work of turning around poorly managed and maintained properties.

In order to take advantage of these value-add deals, you need to:

1. Know what you’re looking at. You need to know the cost of turning around the building, what kind of rents you will achieve on completion, and what the building will be worth at that time. Guess wrong, and you either miss deals you should have bought or buy deals you should have passed on.
2. Be very well capitalized. Many of these deals are so screwed up that getting a loan is difficult / impossible. Even if it were easy, you’d still be at a disadvantage against your competitors, who will be all cash on any good opportunity. And, however you buy the thing, you’re going to pour a whole-bunch of money into fixing it up.
3. Be able to move quickly when the opportunity presents itself. When something that might work pops up, you need to jump on it, because other investors definitely will.

How can we help?

1. For people / institutions with access to a lot of money (say, $1MM+ cash to invest), we do “fee-for-service” deals, where they take care of #2 and #3 and we take care of #1.
2. For your more garden variety accredited investor with, say $200-500k to invest, we run investment funds where we pool together the money of a bunch of individuals in order to cover #1,2 and 3 in one entity.

If you’re not one of the lucky duckies above, don’t despair. For people who aren’t wealthy, but who have $50-250k and want to buy their first building (maybe even to live in), we can help you find one of the needle-in-the-haystack buy-and-hold deals. They’re hard to find, but we’re good at it.

[Note: The above blog post is not an offer to sell anything or a solicitation for investment.]