From the local government desk, Franz Kafka reporting

Thought I’d relate a story today about the insanity of local government.

We recently purchased a building which we intend to totally renovate.

Due to the age of the building, the number of people who live there and lack of attention by the previous owner, there is a vermin problem in the building.

The county health department cited the old owner and we find ourselves involved in an endless series of biweekly inspections.

We’ve renovated a lot of old buildings. And I can assure you that this type of problem does not go away with local treatment. You need to empty the building, ideally rip open the walls, and fumigate.

Because all of the tenants are scheduled to move out of the building 11/30 and because the tenants themselves object to continued local treatment (eg spraying of chemicals in their apartments), we asked that the department suspend the citation until 12/1, at which point the building will be empty and we will fumigate.

You can imagine how well this suggestion went over.

So, we will continue with the charade of spraying chemicals into peoples’ apartments and meeting the inspectors for biweekly inspections between now and 11/30, despite the fact that the tenants, we and the department know this will not solve the problem.

Some thoughts on high-end home flipping

Have spoken with a bunch of people over the past few days who are involved in high-end home flipping.

This isn’t the kind of stuff that was going on in 2009-2012, where you could buy a foreclosed single family in say, Highland Park, for $400k, dump $50k into it, and sell for $550k.

Those deals are long gone.

What people are doing now is buying higher-end properties in the range of $1-2MM and then either tearing down and re-building or else doing a total re-model / expansion, and aiming to sell for $2-3MM.

There appear to be decent returns to this business. However, the risk is considerable, because:

  1. A lot of this stuff is going on, so the supply of homes in this price range is likely to expand rapidly; and
  2. In this price range, there is no way to get an acceptable rental yield if you are forced, for whatever reason, to hold the home

There’s one other reason I dislike this business: taxes. The IRS treats home flip profits as ordinary income. So your 20% return becomes 10% after tax. Not sure I love that risk-reward profile as an investor.

Do single family home rentals work in LA in 2015?

One of our clients asked an interesting question yesterday that I think worthy of some discussion here:

“Has Adaptive done any single family home deals where the rental numbers would work out to at least cover PITI after fixing up the property?”

In other words, can you buy a single family home as a rental and at least break-even?

The answer is “No”, and here’s why:

In LA, there is a massive single family home ownership premium. By this we mean: People are willing to pay prices for homes which result in monthly payments that are far in excess of what the property can generate in rent.

This is (somewhat) rational, because home prices have tended to rise faster than inflation, so there is a reward for speculating, which is being priced in.
Because of this effect, it is extraordinarily difficult to find a single family home rental deal that breaks even. At this stage of the cycle, the only areas where this might be possible would be areas which are really, really bad (eg where no one else wants to buy and so there is little / no home ownership premium).
Interesting side-note: In 2009-2011, when there were tons of foreclosures and not many buyers, the home ownership premium in many improving areas almost disappeared, allowing investors to buy and rent single family homes and get some kind of yield.

What I did yesterday

From the “This Ain’t Just Capital Deployment” files:

What did you do at your job yesterday?

Me? Oh, I negotiated and then personally oversaw voluntary move-out by a guy who had been arrested for threatening his neighbors with an ax.

Of course, I brought along two armed guards, plus a crew to help move his stuff.

He turned out to be a pretty reasonable, decent guy.

He lived up to his word and I lived up to mine and I’d like to think we both came away from the deal happy.

You might ask why I did this, rather than having one of my employees do it:

  1. I’m not going to ask an employee to take on physical risk, particularly if I wouldn’t take it on. Sometimes being a leader means putting yourself out in front; and
  2. Getting this done was very important from a deal perspective. And we take that kind of thing EXTREMELY seriously… if we were going to fail at this, it was not going to be because I sent someone else.

 

A long term building program

 

Have been doing some thinking about ground up development of small-to-medium size apartment buildings lately.

We’ve not built ground-up before, but we’re getting closer and closer and I believe ground-up is likely to be a big part of our business mix in the coming years.

Here’s how I think about it: Assuming reasonable planning (eg the right product in the right neighborhood) and execution (eg not screwing up the construction), the returns are mostly dependent on the business cycle.

If you buy and build when times are bad, you’re likely to do quite well. And if you buy and build when times are good, you’re likely to do ok but not great.

But, if you take the long-term view that people will always want to live in LA and that it will always be hard to build here, you know that rents are likely to grow faster than inflation.

That means your margins are likely to improve over time. And that means that even OK deals will end up being pretty good ones over a sufficiently long time horizon.

So, I think there’s a strong argument for building a few buildings / year, pretty much every year (with the possible exception of the 1-2 years in each cycle where land prices are really, truly crazy). If you do this consistently for, say, 25 years, you will end up with something like 50 high-quality buildings in good locations.

Some deals will end up better than others, mostly due to extrinsic factors. But, viewed as a portfolio and managed appropriately, you’d have a cashflow monster which ought to spit out increasing amounts of free cash, even accounting for the occasional new roof, etc.