Moses Kagan on Real Estate

Archive for the ‘Development’ Category

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

See awesome construction pics

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Adaptive finally has an Instagram account with tons of pics of our ongoing renovation projects.

The tech-savvy among you can follow @adaptiverealty for on-going updates.

The less tech-savvy (including, for example, me), can check out the pics here:

Going forward, we’re going to document all of our on-going projects (and there are a ton!) roughly once every three weeks. So, you’ll be able to watch the progress of all of them, which I think will be pretty cool.

Written by mjkagan

11/13/2014 at 11:09 am

Beware of setbacks!

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Apologies, in advance, for a fairly technical piece, but this is very important information for anyone doing remodeling in LA.

If you’re rehabbing a property, you need to be extremely careful about touching anything located in any setbacks.

What do I mean by setbacks? They are the parts of any lot in which the city prohibits you from building. Depending on the zoning, they’re typically the areas 3-5′ from the property line on the sides and 15′ from the property line in the back. In the front, the setback varies a lot, but it’s typically 10-15′.

Why is it so important that you take care before touching anything in the setbacks? In a word, “grandfathering”.

There are many properties in LA that have important features that were built prior to the imposition by the city of setbacks. These features include decks and walkways, some of which are essential for accessing parts of properties.

Because these features were built prior to the imposition of setbacks, they are grandfathered in.

The problem is that many of these features, particularly those built in the 1920s, are at the end of there useful life. They are rotted out by moisture, termites, etc. As a rehabber, you will be sorely tempted to rip them out and replace them.

Careful! If you entirely rip out one of these grandfathered features, you will forfeit your grandfathered status. You will then have a hell of a time getting the city to allow you to rebuild it, because the city will hold you modern codes which require you to avoid building in the setback. Getting approval to do so would involve zoning variances, plan approval, etc… not something you want to go through.

So, what’s the solution? Instead of entirely ripping one of these features out, pull a permit for “replacing termite-eaten wood”. Then, replace only the worst areas, leaving the rest, and get the permit finaled. Later, you can repeat the process if you have to.

Side note: Can you see how insane the above situation is? The city is basically incentivizing you NOT to replace potentially dangerous decks, etc… a recipe for unnecessary injuries / death. Instead, they should change the rule to allow you to replace grandfathered features without going through plan-check so long as you do not expand the footprint.

Written by mjkagan

11/12/2014 at 2:24 pm

Posted in Development, How to

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

My thoughts on the anti-gentrification march on York this weekend

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So this weekend a bunch of residents held an anti-gentrification march on York Blvd. in Highland Park.

Here’s a description from the Eastsider: “A group of anti-gentrification protestors – some of them masked and waving banners – paraded down the sidewalks of York Boulevard tonight, taping “Eviction Notices” on new businesses…”

Neither I nor anyone in my immediate family have ever lived anywhere long enough to form an attachment strong enough to cause me to protest if I were forced to move. But I’ve spoken with enough people going through relocation to know that being pushed out of your home can bring feelings of sorrow, powerlessness and, for some, rage.

While I think that posting mock eviction notices on the windows of new businesses along York is obnoxious behavior, it says something quite positive about the people who protested yesterday that they were able, despite their feelings, to keep things more or less under control.

There’s always going to be disagreement about the morality of gentrification. But we should all be proud to live in a society where people can lawfully protest and where that protest can take place without property destruction or loss of life.

Written by mjkagan

11/10/2014 at 10:59 am

Posted in Development

Are there any good deals out there?

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Well, I’ve written 4-5 offers this week.

And I just stumbled across a deal that’s going to end up being somewhere between an 8.5-9.5% unlevered yield (eg cap).

Of course, these things aren’t just falling off trees.

You need some combination of superior local knowledge, skill / experience, and sufficient capital.

Inventory is definitely tight, but, if you have what it takes to add value, there are good moves to be made.


Written by mjkagan

11/07/2014 at 11:51 am

Don’t be an ostrich

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In our business, shit happens.

That’s just the way it is. Tenants try to short you on rent. Contractors try to extort money through bogus change-orders. City inspectors call you out for things you know are fine. Buyers try to chip price. Sellers lie about their rent rolls. And on and on and on.

When one of these problems arises, there is a natural tendency to avoid picking up the phone when we call you to discuss it. You’re hoping that, if you just avoid answering, someone else will figure out a way to resolve the issue.

I have never, in my life, been an ostrich. Neither has Jon, my partner. When shit happens, we get MORE interested in the project, spend more time on it, and don’t stop until we have some kind of resolution.

There’s never any kind of guarantee in our business, except this: If you try to avoid problems and hope they go away, your deals will get screwed up.

(Can you tell we’re dealing with someone on a project right now who doesn’t like to pick up his phone?) 

Written by mjkagan

11/03/2014 at 11:12 am

Posted in Development

Avoiding a pretty painful “oops”

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A reader wrote in to ask me a question about yesterday’s piece, which argued for refinancing and holding, rather than selling, completed repositioning projects.

The question: “Only thing I don’t understand is why not refi on a LTV more than 60% to get back all of your original 2million dollars.”

It’s a reasonable question. After all, with a property value after stabilization of $3.2MM, you might be able to get a bank to loan you as much as 75% LTV, or $2.4MM.

Remember that we invested $2MM in the hypothetical property, so a $2.4MM loan would allow you to get all of your money out and then some. That seems like a pretty great deal, right?

The reason I stuck to a 60% LTV loan in the example is simple: Risk avoidance.

When you have a fully-renovated property with very high rents, you need to be conscious of the fact that rents can fall in the event of a recession. For example, in 2008-9, rents at our 16 unit building on Reno fell roughly 20%.

Recall our example property, which has net operating income (“NOI”) of $160k. Let’s assume that equates to rents of $220k / year (if you think a 72% operating margin is unusually high, you’re right – our unusually high rents make our properties’ margins unusually high). Now imagine the economy tanks and rents fall by 20% to $176k.

In recessions, expenses don’t fall by nearly as much as rents… the tenants are still going to use as much water / sewer as they did during the good times, right? Let’s say expenses decline by 10%, from $60k / year to $54k / year. What happens to your NOI, the money available to service the debt? Well, it falls to $176-54 = $122k.

Recall that at 60% LTV, our annual debt service was $116k. So, even with the 20% decrease in rents, our NOI still exceeds our debt service and we can still pay our loan and even have cashflow (albeit microscopic).

What would have happened if we had borrowed to a 75% LTV? Our debt service on that $2.4MM loan would have been $146k, which would would have serviced with our NOI of $122k… Ooops.

We at Adaptive get paid a lot of money to avoid “oops” moments. So that’s why we wouldn’t ever lever up as high as 75% on a property with maxed-out rents.

Written by mjkagan

10/31/2014 at 10:32 am

Posted in Debt, Development, How to

To sell or not to sell

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One of the problems a beginning money manager has is deciding whether to sell or hold completed projects.

To understand dilemma, you first need to understand what we’re generally left with when a project is completed:

  • Fully renovated building with all new plumbing, electric, etc.
  • High quality tenants on modern leases with good security deposits
  • An un-levered yield on cash invested in the deal of 7-9%

Implicit in the final bullet point above is a bunch of value creation and, therefore, unrealized capital gain.

To understand why, consider a hypothetical deal into which we invested $2MM and which is now generating an 8% unlevered yield… so NOI of $160k.

We’re theoretically in a 5% cap market (though, for maxed-out properties, probably more like 5.5-6%), so that property is potentially worth $3.2MM. Assuming 7% cost of sale, that’s a net value of $3MM and an unrealized gain of $1MM or 50% on the $2MM investment.

The incentives for selling ASAP are clear: Return capital and realize profit.

The above sounds pretty compelling, right? After all, the whole point is to make a lot of money quickly.

But the downside of the above is the requirement of paying taxes.

To keep things simple, assume the manager is entitled to 20% of the gain and the investors the rest. That means the investors are taking $800k of the profits… a 40% ROI.

But the problem is that they are going to pay taxes. In CA, depending on your income, you’re looking at paying 25-30% in taxes. Assuming 25%, the investors are looking at $600k net.

And guess what? They’re left with the problem of where to invest both the original $2MM AND the $600k profit. If they just buy plain old 5% cap properties, they’re looking at generating NOI of $130k… worse than holding the original property (even accounting for the manager’s take)!

What’s the better solution?

Refi at 60% LTV on the new valuation. Pull out $1.9MM in cash. Assuming a 4.5% interest rate on the $1.9MM loan, that means annual debt service of $116k and free cashflow of $160k-116k= $44k. That’s a 44% return on the $100k in equity remaining in the deal.

And the $1.9MM in loan proceeds that the investors get back? That’s tax free money.

Much better solution, right?

Written by mjkagan

10/30/2014 at 9:47 am

Posted in Development

How a good contractor handles inspectors

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By now, we’ve had a LOT of experience dealing with city inspections.

And we’ve seen how many different contractors handle them.

And here’s what separates the contractors who get their permits signed off from the ones who get endless streams of corrections:

  1. Good quality work (obviously); and
  2. Confidence.

The nature of renovating old buildings is that things are not always going to get built exactly to plan.

You and your contractor are going to have to improvise in order to create the best possible space within the constraints under which you are forced to operate.

The hard part is when the inspector comes in and sees that what has been done deviates from the plans.

Now, if what you have done violates the building codes, there’s not much anyone can do… you’re not going to get away with it.

However, if the work is to code, then you might. If your contractor has a history of doing good work and projects confidence in his own knowledge of the building code, the inspector is likely to allow some deviations without requiring you to go back to plan-check (which can impose weeks or months of delays).

If, on the other hand, your contractor does low quality work and/or lacks confidence in his own knowledge of the building codes, the inspector is likely going to run roughshod over him, which means multiples rounds of additional inspections and / or trips back to plan-check.

With isolated exceptions, we have found city inspectors to be pretty reasonable people. If they think you know what you’re doing, they let you proceed. If they think you’re an amateur, then they force you through the wringer (which, by the way, is how you go from being an amateur to being a pro… trust me!).

Written by mjkagan

10/29/2014 at 10:23 am

Posted in Development, How to