Moses Kagan on Real Estate

Archive for the ‘Development’ Category

How an HPOZ can screw up a deal

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Am looking at an interesting deal, but it’s in an HPOZ (Historic Preservation Overlay Zone).

Because the structure was built during the time-period the HPOZ is intended to protect, it is categorized as a “contributing structure”.

It is extremely hard to do anything to a contributing structure.We would need prior approval for any work on the exterior and that approval will not be granted for anything that changes the original design.

That means we can’t, among other things, move or enlarge the windows, insert sliding glass doors, build our standard fencing, etc.

Because we can’t use most of our normal tricks, we need to project lower rents for the completed units than we would if we were not constrained.

Because we are projecting lower rents, the deal goes from being a marginal “yes” at the list price to a strong “no”.

On my numbers, the reduction in building value due solely to the HPOZ designation is something like $100,000, or 10-15%.

It’s not unfair to wonder what, exactly, the city is getting in exchange for that diminution of the property value.

Written by mjkagan

10/23/2014 at 1:45 pm

Posted in Development

Never lose units

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Saw that someone arrived on the blog yesterday using the following search term “convert duplex into single family home”.

Here’s my advice: Don’t do it. Or, at least, don’t do it with permits.

Regular readers know I’m strongly in favor of using permits for every single construction project. It’s a bit more expensive, but you want to be able to sleep at night knowing that the work was done properly and is in compliance with relevant city codes.

So, why am I advocating doing any conversion of a duplex into a single family without permits?

This is one piece of work that can cause severe, permanent value destruction.

Why? Many older buildings have grandfathered units. For example: You might have a 4plex on a lot which is now zoned only for duplexes.

If you go to the city and ask for a permit to remove a unit in the aforementioned building and turn it into a triplex, they will happily give it to you. But later, when you want to re-convert the triplex into a 4plex, you will not be able to.

Why does this matter? After all, it’s not like, in converting from a 4plex to a triplex, you’re losing square footage.

But, as we’ve discussed previously, generally the smaller the unit, the higher the rent per square foot. Given the choice, you’d always rather have more units rather than fewer in any given square footage.

So, it’s insane to remove a unit, because you will impair the achievable rents and, therefore, the value. And the change is likely to be irreversible.

Written by mjkagan

10/21/2014 at 9:54 am

If I were a broker…

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…who didn’t also renovate tons of apartment buildings, I would:

  • Run rent surveys across all relevant neighborhoods, all the time
  • Constantly poll my clients about construction costs for different finish levels and unit sizes
  • Constantly poll my clients about eviction / tenant relocation costs

Why would I do all these things?

Because, without the above information, I would:

  • Ignore some deals which I absolutely should push my clients to buy; and
  • Push my clients to buy some deals they absolutely should not buy.

Both of the above mistakes would cost my clients money (either in bad deals or missed opportunities) and therefore cost me credibility.

Fortunately for me and for our clients, Adaptive does so many renovation projects in the relevant neighborhoods that we know better than anyone what the above numbers actually look like. That doesn’t mean we don’t make mistakes, but it does mean those mistakes are rarer and less costly than they would otherwise be.

Written by mjkagan

10/20/2014 at 10:20 am

Stocks, bonds and real estate prices

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In case you’ve been under a rock: The stock market has been in free-fall since the beginning of October. Here’s a handy chart:

S&P 500 Year to Oct 2014

The thinking among investors is that the world economy is slowing due to weakness in Europe and China.

Usually, when investors get spooked by stocks, they sell stocks and buy relatively safer government bonds. And, indeed, you can see the result in US Treasury bond yields:

10 year treasury yields

Yields were around 2.50% and then fell very rapidly down to 2.15% (as of noon today).

What does all of this mean for real estate? Well, mortgage rates tend to be pegged to the yield on t-bills. So, as investors get spooked and flee equities in favor of government debt, they are driving down the rate at which you can borrow on homes / apartment buildings / etc. Here’s the relevant graph:

30 year mortgage rates

It’s a bit hard to see, but rates, which were as high as 4.4% in January, are down to 4% as of today.

In real estate, all else being equal, prices rise and fall in an inverse relationship with interest rates (the cheaper the debt, the higher the price someone can pay for the asset and get an acceptable yield, and vice versa). So, if we’re entering another period of low interest rate loans, you can expect prices to stay the same or rise, all else being equal.

Written by mjkagan

10/16/2014 at 1:27 pm

Posted in Development

One way to think about our business

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For a long time, as young professionals aged into their late 20s / early 30s, they would move out of LA to suburbs in search of a big single family home with a yard, etc.

Demand for apartments in LA, particularly in the areas east / north of Hollywood, was therefore mostly constrained to professionals in their 20s and working people who did not have the income or assets to move out to the suburbs. (That’s not to say there weren’t / aren’t exceptions… we’re speaking in broad strokes here.)

It’s not clear what caused professionals to stop moving to the ‘burbs. The trend really began in earnest around the beginning of the Great Recession in 2007-8. So it may have been that professionals didn’t have the money to move or couldn’t get the loans.

Another explanation was that 2007 was when the first of the Millennials (the massive generation born roughly 1979-2000) hit the age when previous generations would have started to consider moving to the suburbs… but the Millennials basically said “nope” to the high consumption, high debt suburban lifestyle.

Whatever the reason, LA finds itself with a major problem / opportunity: The Millennials are staying in the city and competing with more traditional renters (the young and the working class) for housing, driving rents through the roof. So either the city is going to find some way to allow developers to massively increase supply, or we’re looking at rapid rent increases for the foreseeable future.

Written by mjkagan

10/15/2014 at 10:00 am

Posted in Development

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

3210 Bellevue is sold

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We finally sold the last Fund 1 property yesterday and I thought I’d take the opportunity to share the (unaudited, unofficial) numbers:

  • Purchased 5/23/2013 for $690,000
  • Spent ~$410k renovating (including all fees to Adaptive)
  • So, all in for $1.1MM
  • Took in ~$40k from rents while we owned it
  • Sold 10/9/2014 for $1.42MM
  • Net sale proceeds of ~$1.32MM
  • Profit of ~$260k on $1.1MM
  • ROI of 24% in 17 months

As on the other Fund 1 deals, we did not use any leverage. That had the effect of hurting the ROI but, obviously, reducing the risk.

When Jon and I set out to raise Fund 1, we had no idea if we were actually going to be able to get the money together. There was no Adaptive brokerage or property management team. There were no fee-for-service deals. In fact, none of the people who now make Adaptive so awesome were with us yet. It was just Jon and me in a tiny office on 7th and Grand Downtown.

We went out and asked friends and family if they would invest with us. A bunch said “no”. Some said “yes”. And some people who are savvy investors but who were not then friends of ours said “yes”, too. It wasn’t that much money ($3.57MM), but it was enough to build a business.

Now, exactly two years later, it feels really great to be able to go back to those investors who believed in us, hand them their profits (they already got back all their capital) and say, as I always do in every single letter I ever write them, “Thanks for trusting us with your capital” and to know that that trust was rewarded.

Written by mjkagan

10/10/2014 at 2:55 pm

Only in LA…

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broadway adaptive re-use

Vacant buildings on Broadway

…would you have huge buildings on Broadway, where studios rent for $4 sq ft, totally vacant above the first floor.

Why haven’t the owners used the adaptive re-use ordinance to re-purpose these interesting old buildings as either condos or apartments?

Simple: Prop 13.

The owners probably bought the buildings a million years ago for pennies, their property taxes are likely incredibly low. And the rate of growth in the buildings’ values is dramatically outpacing the growth in the carrying costs (principally property tax, capped at 2% annual increases). If you have a $5MM asset growing in value at, say 5% / year ($250k) and costing you, say $25k in carrying costs, you’re in no rush to sell.

At some point, someone will tempt these owners will very high offers for their buildings and then convert them. But, in the meantime, in the midst of a dire shortage of housing, we have prime real estate sitting vacant.

Written by mjkagan

10/03/2014 at 11:58 am

Posted in 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

What I do all day

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Mostly, it’s underwriting deals.

Here’s what happens:

  • Either I find a deal on the MLS, Loopnet, etc. or else a broker or client sends it to me
  • I get my hands on the rent roll (surprisingly hard, sometimes)
  • I look at the property on google maps to get a sense for the location and, critically, the style of building
  • I look at the property on ZIMAS to get the square footage and unit mix
  • Based on our experience renovating about a million deals, I concoct a plan for the property which seeks to maximize the yield post-renovation; everything is on the table, from moving walls to expanding to outdoor space… you name it
  • I make a little model that looks at the cost of buying, the cost of rehabbing, the estimated rents, and the estimate expenses to get at an expected yield
  • I speak with my partner Jon to confirm / fix my assumptions
  • If the deal meets our target yield, we write an offer

Sounds pretty simple, right? The reason is works is that we do so many deals that we (1) know pretty quickly what the optimal plan for the building will be; (2) how much it will cost / how long it will take; and (3) what the rents and expenses will be.

It’s not that we are never wrong; there are surprises in every business, ours included. It’s just that we’re wrong very, very rarely.

Written by mjkagan

09/29/2014 at 9:28 am

Posted in Development