My current catch-22

There are some deals right now that:

  • Aren’t right for our current fund (because the near-term returns aren’t high enough), but
  • I want to buy (because I think they have a lot of potential down the road)

One obvious solution to this problem would be to buy the deals with non-fund money, either my own or from a JV-partner.

The problem is that doing so might come pretty close to the line from a fiduciary perspective, because I’ve committed to my fund investors that I will give the fund my best ideas.

If I go buy these deals with separate money, the investors in my fund might get the idea that I haven’t lived up to my moral and legal obligations. And that’s not something I’m willing to let happen.

So, I’m going to let these pitches go by. How annoying.

How an HPOZ can screw up a deal

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.

Never lose units

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.

If I were a broker…

…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.

Stocks, bonds and real estate prices

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.