Why we avoid pre-1920s buildings

I love buildings built in the 1920s, but I rarely buy buildings built before that.


It has to do with how the buildings were built.

By the 1920s, Los Angeles construction practices were not that different from today’s. Layouts, door width, ceiling height, spacing between studs, size of lumber used – all are quite similar to how we do things today (or better).

Prior to the 1920s, however, there was a lot more variation in construction practices. Some buildings were well-built; others are janky. They have illogical layouts, narrow doors, low ceilings, irregularly or widely spaced studs, and make use of thinner, weaker lumber.

As a renovator, the building you buy places meaningful constraints on the finished apartment product you can deliver. And the constraints created by pre-1920s buildings generally tip the scale against doing those projects.

Another idea for real estate entrepreneurs

At the ULI discussion last night, I was asked about opportunities I see for young entrepreneurs wanting to get into real estate.

I gave a fairly macro answer about the middle class returning to big cities and how that is going to continue to drive increases in rents and property values in urban centers.

But I really have another idea that I’d like to kind of noodle on today.

Here it is, in bullet points:

  • No young people can afford houses in the areas they want to live without major help from family
  • They are unwilling to move to the suburbs like their parents did
  • So, they are going to remain renters for longer (forever?)
  • But, people still like the idea of owning something

So, the question is, if you’re a renter devoting a large portion of your income to rent in a cool urban neighborhood and therefore unable to save a down-payment, what can you own?

I think some people are going to make a lot of money figuring out how to create ownership opportunities for this demographic, whether in the form of inexpensive condos, innovative financing (maybe with the developer holding notes with low downpayments), and innovative second- or vacation-home products.

Maybe some of you slightly younger folks can take it from here?

Why I don’t talk about cap rates

About 10 times a week, people ask me what kind of cap rates I expect from our deals. In my answers, I strongly resist using the term cap rate, to the point that people think I’m a little strange.

This is kind of weird, right? Any book you read about investment property is going to go on and on about “cap rate”. So, why don’t I use the expression?

To understand why, you first need to know what it means. “Cap rate” is short for “capitalization rate”. It refers to the annual return, in cash, that an owner can expect to receive by buying a property at a given price WITHOUT a mortgage. You calculate the cap rate by taking the expected net operating income and dividing it by the purchase price.

Notice that the concept is essentially passive: You’re buying a building with NOI in place, for a given price.

For my deals, neither of these is true. I almost always vacate all units ASAP after closing on an apartment building. So, right away, there is no revenue coming in and, therefore, the net operating income is negative (because we still have to pay holding costs, like property tax and insurance, while the renovations are on-going). The net operating income only turns positive after we re-tenant, which is 6-12 months after the project begins.

And, the purchase price is also kind of irrelevant, because we’re going to spend so much money renovating the building. For a typical deal, the purchase price might represent something like 70-80% of the total capitalization of the project. And that’s just the money spent; it does not reflect the ridiculous amount of expertise and effort that goes into transforming a beat up old POS building into a desirable place to live.

What we do is NOT passive; it’s the opposite. You can think of it like this: (new annual revenue – new annual operating expenses)/(acquisition price + rehab cost + holding costs) = “unlevered yield”.

So, that is the expression I use for what we can get: “unlevered yield”.

(In case you’re wondering: Because we do this better than anyone, we can still find deals where the unlevered yield is >8%.)

Adding value to apartment buildings: Sometimes more art than science

One of the problems we wrestle with is how much to spend on improvements to a building where the impact on rents in unquantifiable.

With most improvements, we have internal numbers we use to predict how much additional rent we’ll get. These internal numbers derive, in part, from so-called “natural experiments” we have conducted in the past, where we’ve been able to compare tenant demand for similar units with / without different features.

Because we have these numbers, it’s trivial to back-calculate how much we can spend on each of those improvements. For example, if we think adding a washer / dryer adds $50 / month to the rent and we’re targeting a 9GRM for the whole project, we know that we can spend up to $50 x 12 months x 9 = $5,400 to add that washer/dryer.

But what about improvements where the impact is impossible to quantify.

For example, take a look at the picture below. We could patch that stucco or re-stucco the whole building. The questions is, therefore, what is it worth to have all new stucco on a building?

stucco, exterior, apartment building



Well, all new stucco makes a building look brand-new, which is cool.

But it’s tough to estimate exactly what “looking brand-new” does to the rents. That’s because we can’t do the kinds of experiments we’ve done in the past… because new stucco affects the whole building, you really need to do building vs. building comparisons, and there are too many other variables at work (location, unit layouts, etc.) to draw really firm conclusions.

No matter how scientific you try to make this business, ultimately some decisions are going to come down to gut feel. And that’s where judgement, tempered by long experience, comes in.

Why it all comes back to judgement

One of the under-appreciated qualities that go into doing what we do is judgement.

Almost every project brings with it unanticipated problems, from the trivial to the potentially severe.

At this point, I think it’s fair to see that we’ve seen the majority of these problems before and know the solutions.

But, even now, after having renovated 40+ buildings (I know… crazy, right?), new things crop up.

If they’re easy, someone else deals with them before they get to me.

If they’re complicated, they land on my desk.

And it’s my job to figure out the least bad way to resolve them.

But I’m rarely an expert at whatever the problem is. So, what I do is call on the relevant expert(s) and then make a decision based on my experience and the values of our company; in other words, I make a judgement call.

I know, with 100% certainty that I don’t make the right decision all the time.

But the goal is to be be right most of the time and, to make the decisions quickly so that things keep moving forward, and to avoid doing anything that compromises our integrity or puts our investors’ money at risk.