Moses Kagan on Real Estate

Got to thinking over the weekend about plumbing and electric. (Bored already? Sorry.)

As you probably know, we almost always replace both systems when we renovate a building. Often, the last time the systems were replaced was sometime in the 1950s or 1960s.

I was idly considering whether anyone would ever have to replace these systems again in our buildings. After all, the new plumbing and electric ought to last for 50 years or more and many of our buildings were built in the 1920s. Is it really going to be worthwhile to replace them again sometime in the 2060s, when the buildings are 120+ years old?

The answer, baring some kind of major change in Los Angeles land use law*, is “yes”.

Why? The most important single fact about 1920s buildings is that you could not re-build them to the same designs today. Why? Because they are under-parked for today’s zoning code.

There is no way you could build, for example, 117 N Reno, a 16 unit building with 0 parking spaces. Under today’s code, you’d need ~20 spaces, which would require either subterranean parking or else much more expensive, multilevel construction.

Because today’s parking codes are so onerous, there is an incredibly strong incentive to keep those old buildings standing up (and, therefore, grandfathered in).

So, the likelihood is that some kid who will be born in the 2030s is going to spend his late 20s and 30s re-wiring / re-piping all these buildings we’ve done, because the alternative would be to scrape them and build new, and that would be insane, given how the difficulties with the code.

*Note: I can already see the glimmer of such a change, and it starts with Uber and Google’s robocar experiments. If we’re really all going to have robo-cars available on demand, perhaps that will be the things we need to jettison our antiquated parking requirements, opening up cities for massively dense in-fill development.

Have been spending a lot of time looking at both apartment and single family home listings.

In general, am absolutely appalled at both the properties on offer and the way in which they are marketed.

Here is what people want:

• Clean, straight lines
• Open spaces
• Minimal detailing
• Many / large windows
• White walls
• Real materials (real wood, real stone, etc.)
• Modern conveniences like washer / dryer, dishwasher, AC, etc.
• Outdoor space with access via sliders

Do you know why people want those things? Because they allow people to project their own fantasies onto the space, rather than having to accept someone else’s (awful) idea of style.

The amazing thing is that the above is not that difficult to deliver. And the premium you get in rent / sale price very often makes it worth doing the work to give people what they want.

Sometimes I get wrapped up in thinking about buildings as financial abstractions. I think about the cost of buying and renovating them, the rents we can achieve, the likely operating costs, the expected yield, the value on exit, the transaction costs and the profit.

I have the luxury of doing this because our very able team takes over the buildings shortly after I handle the buy and then I don’t really have anything to do with them until just before lease-up begins.

So, just to kind of remind myself that we’re talking about real buildings, real apartments, real neighborhoods, etc., I periodically stop by one or more of our construction sites.

If, like I sometimes am, you’re in danger of thinking about buildings in terms of numbers on a spreadsheet, here’s a useful reminder that we’re in the business of transforming tangible things:

Here’s something true about real estate: It is much easier to find highly profitable small deals than highly profitable large deals.

Why is this true? Well, the smaller the deal, the more likely it is that the owner and /or listing broker are inexperienced / inept. Those kinds of decision-makers frequent screw up the management and sale of assets, creating opportunities for large profits.

On the other hand, larger assets tend to be controlled by sophisticated players who do a good job extracting close to maximum value, whether from on-going operations or from sale processes.

My business is all about deploying capital into profitable opportunities. Can you see the problem I face?

I am constantly tempted to reach down into smaller opportunities where I can see the potential for out-sized profits, at least on a percentage basis.

And yet it is extremely inefficient to deploy capital in such small chunks… you need to do a ton of deals to equal the capital deployed in one big one.

So, I constantly look for big deals to do and face some pressure to try to live with worse numbers, because doing big deals is very efficient from a capital allocation perspective.

What’s the solution? There isn’t one. I will continue to try to grab the absolute best smaller opportunities while getting involved in only those larger deals where the numbers work (even if they don’t work as well as the numbers on the smaller ones).

That kind of discipline is, I think, what separates someone who wants to have a long career doing this from someone who wants to make some very large heads-I-win-tails-my-investors-lose bets, cross his fingers, and pray.

Can you see what’s screwed up about this picture:

What kind of an idiot doesn’t make that railing continuous?

Here, in a nutshell, is our whole business: Everyone we hire to do things wants to do whatever is expedient and cheap. Even our clients often want to do what is expedient and cheap.

But someone needs to be the advocate for the project. Someone needs to be enough of a hard-ass to go tell the metal guy to fix that railing.

I don’t know him personally, but I really like Councilman Jose Huizar of Council District 14.

Here are some relevant, recent positions:

1. He’s trying to lift the insane ban on bars / restaurants that opened on Colorado in Eagle Rock after 1992 staying open past 9PM. If we’re going to be a real city, we need to get rid of these kinds of anti-urban regulations. It’s Colorado Blvd., the main commercial street in Eagle Rock… surely you ought to be able to get a beer at 10PM on a Saturday night.

2. He’s the main motivating force behind Bringing Back Broadway, an initiative aimed at returning Broadway to life downtown. Prior to this initiative, Broadway was a crummy, street-level retail market with very high vacancy rates in the office space in the floors above street level. Now, through a combination of street improvements, a street car and regulatory changes, Broadway is one of the hottest areas of the city for new retail and residential development.

3. Huizar helped Geoff Palmer get a skybridge approved connecting his monstrous developments along Temple downtown. Now, I’m no fan of Palmer’s work… I think those buildings are anti-human fortresses which basically raise a gigantic middle finger to street life in their area. That said, Palmer’s request for a skybridge was self-evidently reasonable – once you allow a guy to build two fortresses, it seems kind of petty to force the residents to go out onto a blighted part of Temple to access amenities.

Taken together, you can see a councilman who is pro-development and interested in seeing LA turn from a sprawling collection of loosely-linked suburbs into a real, global city. Seems like my kind of guy.

What’s City West? It’s the neighborhood directly east of downtown… you might know it as Pico Union.

City West is seeing a ton of development of huge projects these days. Holland Partner, for whom a good friend of mine works, has already done two huge deals there and just broke ground on a 600+ unit development.

Here’s the money quote in the article I link to above:

“The complex will offer studio to three-bedroom apartments ranging from about 500 to 1,300 square feet. Rents are expected to start around $1,500 and go to slightly under $4,000…”

So, at the smaller end (which is typically the more expensive end of the price / sq ft spectrum), they’re asking $3 / sq ft for brand new, highly amenitized units in a crappy area.

I personally would rather live almost anywhere else and I think our tenants would agree. That said, $3 / sq ft is pretty cheap for what you’re getting – developers downtown and in Hollywood are expecting closer to $4 for similar product. Why is it so cheap?

That question gets to why there is so much action in City West right now. Hint: It’s not because everyone wants to live there.

What’s going on is that City West has it’s own zoning code which is much different than the code prevailing in the rest of the city. CW zoning allows for much denser, taller construction than is permitted elsewhere, even denser than R4.

There are two direct results of this more permissive zoning:

1. Developers can build huge projects. Since developers make money based on a percentage of the project cost / profit, generally speaking, the larger the project the better. In City West, you can build huge projects, so developers are naturally going to build there, even if the neighborhood is not particularly desirable.

2. The lower per-unit land costs mean that developers can charge lower rents ($3 vs. $4) for the same product and still make money. That’s good for the developers but it’s also good for the city.

So, City West is on its way up due to permissive zoning. Think anyone in the city is paying attention?

One of the advantages we have in this business is that our units tend to command top-of-the-market rents.

The reason is pretty simple: We spend a ton of time and money making each unit we renovate into the kind of place that we, ourselves, would want to live in.

But I’ve been doing a lot of research on Craigslist for Silver Lake, Hollywood, Miracle Mile, etc. and I’ve come to the following conclusion: We’re not charging enough.

If you go online right now and start looking at two beds under $2500 in the aforementioned neighborhoods, your eyes will bleed. The units themselves are uniformly horrible – bad flooring, cabinets, window treatments, you name it. And, on top of that, the marketing is horrific… the pictures mostly look like the owners are actively trying to avoid leasing their apartments (bad lighting, no staging, weird angles, etc.)

I understand that not everyone is capitalized to do gut renovations of apartments. But I can’t, for the life of me, understand why anyone who is undertaking a renovation right now would use, for example, granite countertops or generic Home Depot cabinets. The cost difference to use good stuff is negligible (particularly when amortized over 10+ years) and the difference from the tenants’ perspective is massive.

So, given how terrible the competition is, I’m going to need to take a close look at our asking rents and see if there’s room to increase them.

This is a question I get all the time. And it makes sense, right? We have all of the resources in-house to buy screwed up single families, renovate them and sell.

So, why don’t we do it? A few reasons:

1. While the returns can be somewhat decent on a percentage basis, they’re small in absolute terms. Yes, it’s cool to make 20% on your money in 6 months, but it’s not cool when that 20% is $80k and I have to share 2/3 of it with my investors.

2. It’s not that much easier to do a house than it is to do a small apartment building. In fact, because buyers of homes are pickier than renters, to really max out the value of a home flip you need to spend considerable amounts of time and money optimizing things like layouts, finishes, etc. This stands in contrast to apartment deals, where we can bang out our formula in our sleep.

3. Competition means prices are high and margins are thin. This creates a strong temptation to do un-permitted work. Unfortunately, the vast majority of flippers succumb to this temptation. Because buyers don’t seem to care that much about whether the work was done with permits, your choice is either to cheat like your competition or lose out on deals. We categorically refuse to do unpermitted construction, so we’re at a permanent disadvantage in the flipping world.

4. Risk. As the competition intensifies in the single family home space, most flipping companies are headed up-market. The model is to buy for $700k, spend $200k and hope to sell for $1.1MM. That’s fine if it works. But if the market turns and you’re forced to hold, there’s no way you can rent that out at a number which will make you happy about the yield. I shoot fish in a barrel for my investors, which is to say that I try as hard as I can to limit the deals I do to the ones where the downside is limited… and being stuck in a low-yield deal with no chance to get out doesn’t qualify.

PA, a regular reader, sent me a link to an article that sets out the basic data behind the explosion in rents that we have been seeing over the past 2+ years.

The trend lines in the graphs all go the direction you would expect… more rented units, lower vacancy, increasing rents.

What isn’t graphed, but is discussed, is the effect of increasing rents on households. Would be nice to see showing the portion of income claimed by housing over time, which I’m sure is growing.

One interesting thought the graphs bring to mind is the cost of the economy of the increasing price of shelter. Each additional dollar of rent needs to come from somewhere else in a family’s budget. What this means is that there is less money for food, clothes, education, etc.

And I guess the next thing to note is that rental housing is not very employment intensive. For example: We collect probably $200,000 / month in rents (with a lot more coming online soon) with a pretty minimal staff. My guess is that a restaurant that collects the same amount of money would need a lot more employees.

Consider what that means nationwide: The growth in rents is probably holding down employment growth and thereby keeping the economy smaller than it could be.

You would think that strong demand for rentals would result in a rapid expansion of supply. But, as we’ve discussed a million times here, in desirable areas, developers face governmental restrictions which severely restrict their (our?) ability to add supply to the market.

So, the net result is that owners of rental properties are benefiting from artificial supply constraints to earn disproportionate returns. Great for me and my investors. Terrible for the economy.