Seeing the matrix

Do you remember The Matrix, the amazing 1990s sci-fi flick with Keanu Reeves? In it, Keanu’s character learns to see the numbers behind the invented reality he inhabits.

Why am I talking about this on a real estate blog? Because it occurred to me this morning as I was taking out the trash from our office that I see the matrix, too (or, at least, a part of it). Stop laughing.

Take a look around you. Do you see buildings? If you do, what you’re really seeing are the physical manifestations of capital and the cashflows that capital commands.

What’s capital? Capital is stored, excess value. You work, generate income, and consume less than you generate. The remainder, which you save, is capital, which can be put to work productively, either by you or by others to whom you give it (via equity investment or loans) in exchange for a cashflow of some kind.

And capital and its attendant cashflows are physically manifested all around us, all the time.

Do you see a house? That’s capital provided by a bank which commands a cashflow from the borrower who “owns” the house (I put “owns” in quotes because, of course, the bank has first call on the value of the house until the lien is satisfied). There’s also an implicit stream of cash flowing to the owner in exchange for his equity which he enjoys in the form of the right to use the house and benefit from the appreciation.

Do you see an apartment or office building? That’s a stream of rent, less expenses, flowing to the owners and to whichever bank financed them.

Do you see an owner-user commercial building (like a factor owned by the company that produces things there)? The company doesn’t pay rent to itself. However, the company’s profits are higher because it’s not paying rent and the difference between what the company’s profits are and what they would be if the company had to pay rent for the space represents an implicit cashflow owing to the company because it owns the asset.

Depending on, inter alia, interest rates, the rate of decay or improvement of the physical structures themselves, and long-term changes in the desirability of different neighborhoods, the values placed by the market on the cashflows constantly change. Understanding those values and being able to anticipate how they can and will change is at the heart of what we do.

Remember this as you walk around looking at buildings.

History repeating?

Back in the 1980s, Japanese companies flush with cash acquired a ton of office buildings (and maybe hotels, too?) in LA at very high prices.

In the recession of the early-to-mid-1990s, they got their asses handed to them.

Now, there is a wave of Chinese developers flush with cash buying up office buildings, hotels, and development projects in LA.

But there is a ton of apartment / condo / hotel product getting built right now, especially downtown, where many of the target properties are located.

The question these developers need to ask themselves is pretty simple: Will the current cycle persist long enough for the market to absorb all this new product?

I’m not ready to say that the Chinese money is going to get crushed the way the Japanese money did.

But I’m not sure I’d be making the bets they’re making.

The math behind discovering a new neighborhood

As prices continue to rise for the kind of beat-up, badly managed assets that are our bread-and-butter, we are spending more time looking at new neighborhoods.

Am I going to tell you which ones I’m focusing on? No, because a bunch of people who compete with me read this blog.

But I will share with you the way that I think about these things.

There is an equation that underpins our whole business: (rent – operating expenses) / (acquisition price + rehab) = yield

1. The cost of renovating a building doesn’t change much, no matter where you do it. No one charges you less for washer / dryers because you’re putting them in Compton, or more for ACs because you’re putting them in Beverly Hills.

2. The operating expenses don’t change much, no matter where in the city you are. You pay roughly the same amount for property taxes, water, management, repairs, etc. wherever your building is.

Given that your rehab and operating expense stay proportionately the same, what does move around?

1. The acquisition price of the building. Obviously, in the equation above, the lower the acquisition price, the smaller the denominator, and the higher the yield (all things being equal).

2. The rents. The higher the rents, the larger the numerator, and therefore the higher the yield (again, all things being equal).

What does all of this mean? Because all the stuff in the middle (the capex and the opex) doesn’t change much, you need to look for neighborhoods where you can buy cheap and rent expensive. Those are the areas where you ought to be able to generate excess yields.

The trick, of course, is to distinguish a truly improving neighborhood (one where you can buy cheap but rent dear) from a dumpy one (where you can buy cheap but can’t get the rents to work).

City growth, affordability and the decline of the middle class

The NY Times has an interesting piece today on middle class people leaving increasing expensive coastal cities (SF, NY, etc.) and going to more affordable cities in the interior of the country.

The underlying dynamic is pretty straight-forward: Without the liar’s loans that were available in 2005-6, there’s no way for middle class people with stagnant wages to afford homes / apartments in the coastal areas where prices / rents continue to increase. Rather than live marginal existences on the coasts, lots of people are choosing to move to Oklahoma City, parts of Texas, etc.

If you carry this dynamic to its logical conclusion, you end up with coastal cities that are bifurcated between very well-off people who can afford property and immigrants who are willing to tolerate difficult economic circumstances in order to fill jobs servicing the wealthy people.

To me, that sounds like a pretty awful future. I would prefer to live in a city where the population is diverse in terms of ethnicity / race and also in terms of income.

How do we ensure that middle income people can remain in coastal cities like LA? There are three broad options:

1. Impose restrictions on prices and or rents. Policies like rent control do make it easier for low and middle income people to remain in expensive areas. However, the costs of these policies are disproportionately born by two groups: Owners of the effected real estate (who are unable to get market rates for their property) and people who do not qualify for the assistance (because the rent / price restrictions act in practice as supply reductions, increasing the prices of whatever remains in the market).

2. Have government intervene to create more supply. An example would be government providing tax credits to developers to build affordable housing units. This kind of intervention works (new units are created) but it is impossible to scale. Why? Because it would be ruinously expensive for the government to create enough affordable units to make any kind of dent in market prices. (By the way, one main reason for this is that government often requires developers of affordable projects to use union labor, dramatically increasing the costs of construction.)

3. Change the zoning.

As many of you already know, I am a major proponent of #3. Why?

  • It’s costless upfront. At the stroke of a pen, city government can re-zone land from sparse, single-family to dense multi-family. Developers will immediately jump in, buy up the newly re-zoned land, and start building units. The more permissive the re-zoning, the more units you’ll get.
  • Increasing infrastructure costs can easily be offset. Yes, new apartments require more roads, water pipes, subway stations, etc. But it’s trivial to price this in to the cost of the project by extracting development fees from developers (we already do this).
  • The costs are canceled out. Yes, some people who currently live in the single family areas will bear the cost of much of the new development (they will end up with big apartment buildings on their streets). But the value of their properties will increase materially, giving them the opportunity to sell out at a huge profit, then decamp for areas more in-line with their personal preferences

Bottom line: We have a solution for the lack of affordability of our coastal cities. We just need government to be willing to do what needs to be done.

Airbnb and the Ellis Act

There’s a big fight brewing up in SF over landlord’s use of the Ellis Act to get into the short-term rental business.

What’s the Ellis Act? Well, in CA, the law is that no one can force a landlord to remain in the rental property business. So, the Ellis Act creates a procedure whereby a landlord can declare his intention to take his apartment building out of the rental market and then force out rent control tenants by paying them approx. $19,000.

The Ellis Act is most often used by condo-converters who buy a rent controlled apartment building, force out the tenants, get a condo map approved, and then sell of the units individually. This is, itself, a controversial business, because it removes apartments from the rental market, and LA, among other cities, has created some pretty tough rules intended to make conversion much harder.

Now landlords have identified a new opportunity to use the Ellis Act: Airbnb.

If you have a fixed up apartment in SF or in a desirable part of LA, you can get $200+ / night by renting your unit out on Airbnb. That’s $6,000 / month, or, say, $3,600 assuming 60% occupancy. Even if you spend $1,000 / month on expenses ($12,000 / year, much more than you would spend to operate a standard apartment), you’re still netting $2,600 x 12 months = $31,200 net per year.

Compare that to a rent controlled tenant at $1500 / month. That’s $18,000 gross, less, say $6,500 in annual expenses, or $11,500 net.

Assuming that, in our present low interest-rate environment, landlords are happy with a 7.5% return, they would be willing to spend $266k to get that additional $20k / year in net operating come.

So, you can see that spending the $19k on the Ellis Act, plus, say, $50k fixing up the apartment, is a very good deal from the landlord’s perspective.

The question, though, is whether it is fair to use the Ellis Act in this manner. I don’t see much of a distinction between renting a unit out on a standard lease and renting one out short-term. That, to me, doesn’t rise to the level of “exiting the rental business”, which is supposed to be the standard for Ellis Act evictions.

As regular readers know, I’m not a fan of rent control. But, so long as we have rent control and other laws governing the relationship between landlords and tenants, we ought to enforce them. To me, this case is pretty cut-and-dried… renting your units out on Airbnb is not exiting the rental property business and is therefore an improper use of the Ellis Act.