Moses Kagan on Real Estate

Regular readers will remember that Adaptive Realty Fund 1 bought four deals, three of which have been exited already.

The fourth, 3210 Bellevue, entered lease-up last Friday. Here’s the relevant CL posting.

The units are really special:

• Brand-new bungalow style 2 bed / 1 baths
• Efficient, open-layouts
• Private decks
• Private yards
• 2 outdoor parking spaces each
• Each unit has finished storage / studio space
• Washer/dryer, dishwasher, AC, etc.

Jon and Nicole really outdid themselves this time… I don’t think we’ve ever created nicer living spaces.

As you might expect, two of the four units leased this weekend; I expect the other two will go extremely quickly.

If you know anyone interested in a spectacular apartment in Silver Lake for $2500-2700 / month (depending on the unit), have her/him reach out to Pua [at] adaptiverealty.com.

Every day, I drive to work along Washington and then up Hoover and then Alvarado to Beverly.

As I drive up Hoover, my attention is always drawn to the beautiful old Victorian and Craftsmen homes in that part of town. It’s always sad, though, because the few that remain are on horribly ugly streets surrounded by exactly the same kind of cheap, awful buildings and terrible signage you see in every poor part of LA.

Yes, those remaining buildings are beautiful, so I understand the impulse that drove the city to create the Historic Preservation Overlay Zone designed to protect those buildings in the area east of Hoover, north of Washington, south of Pico and west of the 110. But it was still an absolutely horrible decision.

Think about what’s going on downtown right now. There are 4,000 apartment being built with another 10,000 in various stages of permitting. Plus, office and retail players are moving in to provide work space and the kind of amenities residents love.

That area to the west of the 110 should eventually get better, because you can’t have downtown be great and the area just next to it be a total disaster.

But the HPOZ is going to cause major, major problems.

Why? An HPOZ acts as a major check on development, because:

1. You can’t demolish the structures that contribute to the historical designation. This means those old Victorians have to stay… but they’re totally not suited to the area, which is practically screaming out for dense, multifamily development.
2. If you want to renovate a “contributing structure”, you’re forced to go through a byzantine city process that dictates everything down to the color of the paint you can use. So, our brand of aggressive re-positioning is handicapped, because we’re severely limited in how we can re-shape the buildings. Without access to the full bag of tricks, the achievable rents are much lower, making renovating these properties pretty much a non-started.

If you can’t fix them up and you can’t tear them down, what you have left is a major, permanent brake on development in an area which is absolutely critical to the continuing transformation of the city.

I love beautiful old buildings as much as the next guy (fixing them up is my life’s work!) and there are examples of HPOZs that work OK (Angelino Heights comes to mind). But this one doesn’t. And a few old, dilapidated buildings ought not to stand in the way of the dense, multi-unit housing that LA so desperately needs.

Curbed LA had an alarmist piece yesterday re the increasing “un-afordability” of LA apartments that I think draws attention some important long-term trends shaping the apartment business.

First, here’s the money quote: “…[A] person earning median income in LA would have to spend 47 percent of that income on the median rent. That’s higher than any other city in the US.”

What’s going on? Let’s separate supply and demand.

Supply:

• A large portion of LA’s apartment inventory in “locked up” by rent control (if you’re paying 20% below market, you ain’t leaving… and the more rents around you increase, the less incentive you have to move)
• No one built anything during 2008-2011 because the market was so bad
• It’s incredibly hard to build now, because restrictive zoning makes land extremely expensive
• So, supply is constrained (existing stuff doesn’t turn over, very little new stuff comes into the market, and all the new stuff is high-end to allow the numbers to work with extremely high land prices)

Demand:

• There is a major population bubble percolating through our national demographics… there were a lot of babyboomers, those boomers all had kids around the same time, and those kids are all in the apartment market now
• Many of those kids, particularly the ones who graduated after 2008, were initially unable to find jobs, so they stayed in their parents’ homes
• As the economy has begun to get better, those kids are getting jobs right alongside the kids graduating today… and all of them are looking for their own apartments
• Plus, a whole bunch of older people in their 30s and 40s were foreclosed out of houses in 2007-10 and aren’t interested or able to get new loans to buy, so they’re clogging up the top end of the rental market (where people usually “graduate” into home-ownership)
• Finally, and this is really important, there are a whole bunch of relatively well-educated “renters by choice” who could afford to buy homes but either don’t want to (because they saw friends / family get screwed) or, more interestingly, are priced out of owning the kind of homes they want to own in the neighborhoods they want to stay in… unwilling to compromise on either, they remain renters

So, in LA, we have a very slowly growing supply of apartments and surging demand. Hence, the price increases.

There is going to be a temptation to extend rent control to younger buildings to please increasingly strapped tenants. But this would only repeat the mistake we made in 1978- it would shrink supply further and thereby put even more upward pressure on prices in the spot market (rents).

The answer to our problem is to identify areas well-served by mass transit, dramatically increase the density allowable in those areas, and decrease both the required parking and the minimum unit size. We should be pumping out well-designed micro-lofts with 0 or 1 parking space(s) as fast as we possibly can.

We’re very pleased to announce (belatedly!) the sale of 1012 N Virgil, a 4plex renovated by Adaptive Realty through our first investment fund.

Here are the numbers:

• Purchased for $427,000 in November of 2012
• Renovated for $380,000
• Rent roll upon completion of $111,000
• Approx. $40,000 in cash collected prior to sale
• Sold for $1,274,000 at the end of March 2014

If you do the numbers, you’ll find this was an approx. 50% ROI deal. No the absolute best we’ve ever done, but pretty close!

The new owners are experienced investors with whom we have a very good relationship. We’re going to be managing the building going forward and we expect that the new owners will generate very attractive returns from cashflow, particularly given the cheap leverage to which they had access.

Thought you guys might like to check out this video interview I did with Justin Brown.

When I first started buying buildings, I needed a quick and dirty way to estimate operating expenses.

I hadn’t owned any buildings long enough to have historical data upon which to base assumptions.

At the time, I was using an accountant who knew just enough about real estate to be truly dangerous. I asked him if he had a good rule of thumb. He told me to estimate that operating expenses would be approximately 35% of rents.

That sounded reasonable, so I proceeded to underwrite a whole bunch of deals using that 35% expense margin to calculate the yield I would be able to achieve by buying and renovating apartment buildings. Keep in mind this was 2009, when things were very, very cheap and I was trying to leg into 8% unlevered yields (that was my threshold for whether to do a deal or not).

Do you know why it is really stupid to use a blanket 35% expense margin to estimate NOI for a repositioned building in CA?

1. When you buy a cheap building and renovate it to raise the rents, your property taxes are going to remain pegged to the acquisition price. Since you will presumably add a lot of value to the deal, your property taxes should comprise a lower portion of the expense mix than they would if you acquired the renovated building for fair market value. Treating the renovated building the way you would the acquired building will lead you to over-estimate property tax on the renovated building;
2. There is no difference in the expense an owner bears when renting out a $1500 1 bed / 1 bath vs. an $1800 1 bed / 1 bath. Both units will use  the same amount of water, generate the same amount of trash, break things at roughly the same rate, etc.. If you blindly estimate 35% expense margins, you will be charging yourself 35% of that $300 difference in rents, $105 / month, for no reason. $105 x 12 = $1260 in annual NOI. If you put a 7% cap rate on that, it means you’re stupidly vaporizing $18,000 in value. Spread over, say, 6 units, that could be the difference between doing the deal or not.
3. When you replace all of the plumbing and electric and all of the appliances, as we do on almost every building, you’re going to have lower maintenance bills because **NEWS FLASH** everything is new.

As a result of my stupid reliance on the 35% rule, I systematically over-estimated expenses on every deal I underwrote.

The good news is that the deals we actually did turned out to be 9-10% yields, instead of 8%.

The bad news? I passed on probably 5 deals that I desperately wish I had done. I conservatively estimate the lost earnings to me personally in the low hundreds of thousands of dollars. All because I relied upon a short-cut without actually taking the time to think through the implication.

Do you know what I should have done? Taken the time necessary to get some reasonably accurate estimates for the annual operating cost per unit and applied those to my pro forma stabilized (eg post-renovation) rent roll. That’s what I do now.

Just saw a flip deal go up on the MLS that’s driving me crazy right now.

The flipper bought it six months ago for $725k. He relocated one tenant, superficially renovated two units, (presumably) fixed a big foundation problem, and painted it. Figure he’s all-in for $825k or so. Now it’s listed for $899,000, presumably in hopes of ending up around $925k after a bit of a bidding war.

After roughly 7% cost of sale, this guy is going to net $860,250, or a profit of ~$35,000. Not a great deal, but not bad for a few month’s work, right?

Wrong. This deal drives me nuts, because the opportunity was mostly wasted.

Here’s what should have happened:

• Buy for $725k
• Relocate three tenants (one unit was delivered vacant)
• Renovate all four units plus the exterior
• All in for a bit more than $1MM
• Exit at $1.25MM
• Profit of $160k in a bit more time

Why didn’t I do the deal? At the time, I had committed all of Fund 1 and didn’t have any dry powder. I tried to get one of our fee for service clients to do it, but couldn’t. So, I had to take a very hittable pitch for a strike, instead of knocking it out of the park. Ouch.

Lucy and the boys and I spent the weekend in SF with one of my best friends and his family.

Because I’m me, I spent a bunch of that time looking at buildings. As I was admiring the tall, thin, ornate homes (which must date to the 1890s-1920s), I had a startling realization: Those properties have no front or side setbacks. They’re right up on the street and right next to each other.

If you live in LA, and particularly if you’re in real estate here, you know that almost every single lot in LA is zoned in such a way as to require that 10-15′ in front of each structure and 3-5′ of space on each side remain undeveloped.

To understand the implications of this crazy law, consider a standard LA lot of 7500 sq ft, which is 50′ wide by 150′ deep. Assuming a 15′ front set back and 3′ on either side, at least 1,650 sq ft of the lot are unusable (and that’s before you get into the rear setback, which is often 10-15′ as well). That’s 22% of the lot!!

Why does the city require that 22% of each lot remain unusable? The arguments are basically around health and safety. The theory is that it retards the spread of fire, makes it much less likely that one building’s collapse with imperil its neighbors, gives more rooms windows.

You have to consider what we are giving up with our insane zoning:

1. Most importantly, we’re wasting 22% of the residential land in the city. Think of how crazy that is!
2. By failing to build on that land, we’re artificially decreasing the density of our development, which directly leads to less property value per ft of roads, sewer, etc., which leads to having less property tax revenue than we need to sustain our infrastructure;
3. Because we insist on side-setbacks, it takes 22% longer to walk anywhere;
4. Our front setbacks require front lawns, which are (a) wasted, because no one wants to hang out where there’s no privacy, and (2) insanely wasteful of water;
5. Modern building technologies make it possible to develop structure right next to each other without creating undue risk… otherwise, why does the city allow small lot subdivisions, which are often built 6″ apart?

LA needs to pick a few neighborhoods near transit and radically change the zoning to get rid of the setbacks (and reduce parking requirements). The resulting re-development will have the following effects in those areas:

1. Increase property values (because you’ll be able to build more densely on a given piece of land);
2. Increase housing supply (because people will immediately start building); and
3. Increase property tax revenue (because of all the new building)

If we were really smart, we’d set aside the incremental tax revenue generated by this strategy to fund the expansion of our public transit system, in order to repeat the trick in other areas.

Just sold the second of our Fund 1 deals: 2514 London St., a fourplex just south of the 101 in Westlake / HiFi

This one was pretty good, though not nearly as good as our 1947 Clinton deal.

The numbers:

• In for around $850k
• Took in cash of approx. $20k during ownership
• Sold for $1,150,000
• Net profit of around $240k on $850k
• ROI of 28%, in 14 months

I’m proud to report that the new owner is keeping us on to manage the property*, so nothing will change for the residents or the neighbors. As usual, we’re sad to see the property go, but happy for the new owners and our investors.

*I’m kind of surprised when people don’t keep us on… after all, we know the property better than anyone, we got the rents in the first place, we can easily force vendors to come back and fix any warranty issues, and we want to keep people who buy from us happy!

Just took the whole team over to one of our projects to take a look at progress and opine on the finishes.

We’re getting close… have a look:

We’re going to have four beautiful 2 bed / 1 bath bungalows with private yards, parking, finished studio/storage spaces, etc. Should be ready to rent by sometime next month.