Archive for the ‘Due Diligence’ Category
Recently, the question of when to order the appraisal has caused problems for us on two deals, so I thought I would address it here.
Just so everyone is clear on what we’re talking about: When you use a loan to buy a building, the bank requires an appraisal be conducted. Depending on the size of the deal, the appraisal will cost anywhere from $800 all the way up into the low, single digit thousands.
There is a temptation for the buyer to put off ordering the appraisal. After all, she wants to do her inspections, find out if there is anything wrong, and then figure out if the relevant problems can / will be addressed by the seller before going ahead and risking the money for the appraisal.
But giving in to this temptation is a major mistake.
Here’s why: The whole aim of a well-conducted contingency period is to get the buyer into position to buy the building as quickly as possible. When I say “into position”, I mean “in possession of all of the relevant information regarding the property, including the physical condition, the tenancies, (critically) whether the bank will make the loan necessary to close”.
Once the buyer is in position to buy the building, it’s pretty easy to work out a deal between buyer and seller to address any issues with the property. The reason it’s easy is that the buyer can say “Buyer hereby agrees to remove all contingencies (and move forward with the deal), conditional upon Seller agreeing X”. This is a great position to be in, because the Seller’s broker can really lean on the Seller to accept, knowing that, if she does, the deal is done.
How does this relate to the appraisal issue? Well, the longer the Buyer waits to order the appraisal, the more time it takes for the Buyer to get in position to move forward with the deal. During that time, the Seller is, quite understandably, getting antsy… Did something come up on the inspections? Have they decided to buy something else? Are they planning some insane price chip? The longer this goes on, the more trust is lost and the harder it is to negotiate any credits necessary to make the deal palatable to the Buyer (eg the “X” in the above example).
So, here’s the deal: When you’re buying with a loan, inspect the property on day 1 of the contingency period. Assuming there are no obvious, huge, horrible red flags, order the appraisal immediately thereafter.
Yes, there is a chance you’ll have wasted that money. But the more likely scenario is that, because you will be in a position to remove contingencies sooner, you will be in a much better position to negotiate the removal of contingencies, where the amount of money at stake make the $800 appraisal fee look like peanuts.
One of the interesting issues with managing other people’s money is having to decide how exactly to allocate that money among projects.
At any given fund size, you need to decide whether you should do a small number of big deals or a large number of small deals.
All the theory points toward diversifying. After all, assuming that all projects have similar return characteristics, if you spread the money among many projects, 1-2 going badly won’t destroy your results. And, indeed, the docs governing many investment funds require that they refrain from allocating more than a certain percentage of their equity to any given deal for exactly this reason.
But real life, of course, can be more complicated than theory, because:
- Sometimes (not often, but sometimes) the larger project(s) promise better returns than the smaller ones that are available at a given time; and
- In our business, which is extremely hands-on, managerial attention is at a premium, so spreading it among many, smaller deals may mean worse performance than if the attention were concentrated on fewer, larger deals
So, what do we do? We:
- Keep in mind that, all things being equal, diversification is better;
- Are willing to concentrate, because we:
- Limit ourselves to deals where we believe there is a considerable margin of safety (eg deals that are sufficiently profitable to absorb bad news)
- Limit leverage, which is the factor most likely to lead to disaster in our business
- Refrain from doing deals on brick- and un-reinforced soft-story buildings (because these can both collapse in earthquakes, the other major risk)
Will the above prevent us from losing money for our investors? No. There is always the chance we screw up. But we believe the above gives us a reasonable degree of safety while allowing us to chase attractive returns (which, after all, is the whole point of doing this).
Today, I’m going to try something new: Taking a look at a deal in one of our neighborhoods so that we can get a sense for what the numbers look like for the new owner.
So, let’s take a look at an East Hollywood duplex that sold yesterday. I should start out by saying I didn’t offer on the property and do not know the agents, the buyer or the seller. So I have no special information about anyones’ motives here. My intention is just to take a look at the deal from several different perspectives to see if I can figure out why the buyer chose to buy this particular property at this particular price.
Here is the headline information from the MLS and ZIMAS:
- List price: $549,000
- Sale price: $563,000 (so, above list)
- Two 2 bed / 1 bath bungalows totaling 1,443 sq ft
- 6,200 sq ft lot zoned RD1.5
- Rents of $851 and $557 (so, $16,896 / year)
And here are some ballpark estimates for the actual annual costs of ownership:
- Property tax: $563,000 x 1.25% = $7,037.50
- Insurance: $1,800
- Water/sewer: $1,200
- Gardener: $1,200
- Pest control: $550
- Repairs and maintenance: $1,800
So, my guess is that the total annual costs of owning the property are approx. $13,600.
Let’s take a look at this deal through a few different lenses in order to see if we can understand what the buyer was thinking.
Buy and hold investment deal
The first, and simplest way to think about this deal is as a buy and hold where the new owner is just hoping to sit there, collect the rent, pay the expenses and keep whatever is left over as a return on his money. For simplicity, let’s start by assuming the buyer pays all cash. Assuming the above numbers are correct, the owner pays $563,000 in cash and gets, in exchange, $16,900 (rents) – $13,600 (expenses) = $3,300 in net operating income.
Then, divide the $3,300 NOI by the purchase price of $563,000 to get your cap rate… or, on second thought, don’t because you’ll plotz (that’s Yiddish for “drop dead”). All I’ll say is that, if you know anyone who’s interested in investing $563,000 of their hard-earned money in exchange for a return of 0.5% annual, please send them my way.
Probably someone reading is thinking “Ah, but what if you borrowed the money, rather than paying cash”? Well, that’s even worse. Say the buyer borrowed 75% of the purchase price ($422,250) at 4.25% fixed for 30 years. His mortgage payment is 2,077 / month, or $24,924 / year. Of course, he’s getting $3,300 in NOI, so his actual annual cashflow is only $-21,624. Another way of saying that is: For the pleasure of investing $140,750 of his cash, he gets the right to lose $21,624 in the first year. Again, not something I’d recommend!
Ok, but some of you are thinking, what about if the owner intends to move into one of the units? Does that make this a reasonable deal? Let’s see…
Owner-occupier needs to live in the property, so will have to relocate one of the two tenants. Because both tenants live in similarly sized 2/1 bed units, the city will force the owner to bump the tenant who moved in more recently, which is presumably the one paying $851. The cost of doing so will be around $15k, plus whatever the new owner wants to spend fixing up the unit for him/her to live in.
Let’s assume the new owner buys with a mortgage, because no owner-occupiers buy beat-up duplexes all cash… people that rich don’t live in beat-up duplexes!
What do the numbers look like? Well, the annual expenses are still $13,600. The rent from the remaining occupied unit is $557 x 12 = $6,684. That means the new owner will have to cover $13,600-6,684 = $6,916 / year in expenses out of pocket, or $576 / month. But there’s also the mortgage to consider… which is going to be $2,077 / month.
So, our new owner-occupier would be putting down $140,750 plus $14k for the tenant relocation plus, say $15k for renovations to the unit, for a total of $169,750 for the privilege of paying $2653 / month to live in an apartment which he could probably just rent for $2200. That, friends, is a terrible deal.
Maybe our buyer is a developer. Maybe he doesn’t care about the existing rents or structures and is instead going to build something new on the lot.
Here’s what he’s thinking:
- 6200 sq ft lot
- RD1.5, meaning 1,500 sq ft / dwelling
- So, 6200 / 1500 = 4 dwelling units (you always round down with zoning calcs like this)
- That’s [$563,000 + ($18,600 x 2)] / 4 = $150,000 per unit of developable land (the $18,600 is what you’d have to pay to reloc each tenant under the Ellis Act)
The simplest way to go would be to try to build four 800 sq ft apartments. At, say, $200 / sq ft to build, that’s 800 x $200 = $160k / unit in construction costs.
$160k construction plus $150k in land costs = $310k / unit. Assuming rent of $2500 (brand new construction) x 12 months = $30,000 annual rent for each unit, that’s a GRM of $310k / $30k = 10x… decent, but really not anywhere near good enough to justify the hassle.
Hopefully, it’s clear from the above that the buyer is not a buy and hold investor, an owner-occupier, or a developer. He must have more creative plans for the property… perhaps he plans to steal a page from Moses’ book and reposition the property.
Maybe he’s thinking:
- Buy for $563k
- Relocate the tenants for, say, $40k total (unlikely, but possible)
- Renovate for $100k ($50k / unit is cheap for separate structures)
- All in for $703k (this assumes it’s his money and that he doesn’t need to pay interest on it)
So, what’s the thing worth? Well, maybe he gets $2400 / month in rent / unit. That’s possible if he does a good job. $2400 x 2 units x 12 months = $57,600 / year in rent. Do we have a home-run on our hands? Well, the yield is now $57,600 (rent) – $15k in expenses (up a bit, because prop tax and insurance will be higher in this scenario) = $42,600 / year in NOI. That’s an unlevered return of $42,600 / $703,000 = 6%. Not bad, but, again, not really worth the work
And, unfortunately, the deal’s not flippable. With $57,600 in rent, even at 12x (a stretch with the rents maxed), you’re exiting at a price of $691,000, less than you put into the property (and that’s before paying brokers, transfer taxes, etc.)
Again, I don’t know the people who did this deal. It’s totally possible that they know something about this property that I don’t. But unless it’s sitting on an oil field or something, I can’t, for the life of me, figure out what the buyer was thinking. Any ideas?
Just ran across this while checking up on the competition on Craigslist:
We obviously run all our applicants’ credit checks ourselves, so we’re not particularly vulnerable to this kind of behavior. But many landlords will take a credit check form provided by the tenant and that’s definitely unwise, given the above.
With rent control and the sorry state of the LA eviction courts, letting some psycho into your unit can be an incredibly costly mistake. You’re looking at some combination of 2-3 months of unpaid rent, a few thousand dollars in legal expenses, potential damage to the unit, and, most importantly, a lot of your precious time.
For what it’s worth, credit check companies ought to provide a service where the credit is checked once (or periodically) and then the person whose credit is being checked should have the right to designate landlords to see the report, possibly at a low, per-viewing price. That way, the tenant is spared the negative effect (and cost) of a ton of credit checks, while the landlord can be confident that the report is legitimate.
I was trying to buy a small office building in East Hollywood.
Because it was a former gas station, we were concerned it was contaminated.
I spent an enormous amount of time trying to structure a deal that would put the risk on the owner, not me.
Eventually, it became clear I couldn’t do it in a way that made sense and allowed me to get the financing I wanted.
One of my competitors jumped in and took the risk on the environmental.
The property came up clean. He’s closing next week.
“When you’re buying a rent controlled building,” I said to the buyer during an inspection yesterday, “the tenants are at least as important as the physical condition of the building.”
This is kind of counter-intuitive, right? After all, tenants come and go, but you plan to own the building for a long time.
But, under rent control, tenants don’t necessarily come and go. Instead, they often stay for long periods of time. And, if you’ve inherited them, you probably also inherited the terrible leases they are operating under. Here are some examples of terrible legacy tenancies I’ve run across recently:
- One tenant in a 9 unit complex has in his lease that he can pay rent on the 15th, not the 1st like everyone else, so we have to make two trips, every month, to that one building to get the rents;
- Many leases contain an attorney’s fees clause saying that, if the tenant doesn’t pay and the landlord evicts and wins, tenant has to pay landlord’s legal expenses. Sounds good, right? Except that judges in CA have interpreted those clauses as bi-directional, meaning that, if the landlord sues for eviction and loses, landlord has to pay tenant’s legal bills. Tenant advocacy lawyers love that one, because they opt for a jury trial and you’re potentially stuck paying them tens of thousands of dollars if you lose;
- No security deposits. If you have a tenant with no security deposit who doesn’t care about his credit / eviction record, the tenant has zero incentive not to stiff you on the rent/destroy the place. What’s the worst that happens? He sticks around rent free for 2-3 months and then moves out when the sheriff arrives;
- A landlord who intentionally scratched out the pet provisions in his lease, and thereby allowed a tenant to move in four extremely aggressive pitbulls;
- Resident managers working with no employment agreements and without leases, leaving the landlord open to failure-to-pay minimum wage litigation and (possibly) a tenant in an apartment at zero or close to zero rent.
There are a million more of these kind of problems. All are avoidable / manageable with the right leases and the right tenant screening process. (In fact, I’ve never had to evict a tenant from one of our renovated buildings… knock on wood!). But, if you buy something with old leases / badly screened tenants, watch out.
What does this mean for buyers?
- Value those new tenancies more highly. If the leases are good and the tenants are screened and have security deposits, you will definitely have an easier time managing the property; and
- You need to carefully review the leases during the diligence process. If you (or your broker) know what to look for, you can mitigate some of the problems. But you definitely can’t if you don’t know what you’re looking for.
Right now, one of the biggest problems I see across multiple deals is the total lack of understanding of LA rent control among bank underwriters.
Underwriters are the guys (and gals) who review the property and the borrower to help the bank decide whether- and how much- to loan on a given deal.
Because they see a lot of rent rolls, they tend to think they know the rents in different areas. But, without understanding how rent control works, seeing a rent roll can actually lead you far astray.
For example: Say you, the underwriter, look at five rent control deals in Silver Lake in a row. All contain one bedroom apartments with legacy tenants paying between $600-1250. You think you’re now an expert on Silver Lake rents. You probably think that the right range for market rents for 1/1s in Silver Lake is $1000-1250.
You’re totally wrong. Market rent for a decently renovated unit in Silver Lake is easily $1500 and probably more like $1600. But you, the underwriter, don’t know that, because you’ve seen a bunch of rent rolls with rent-controlled tenants paying less.
So, then, when I bring you a building with a few vacancies and I tell you the rent for those units will be $1500-1600, you think I’m bullshitting you. But I’m not. You just don’t know what you don’t know.
When I buy apartment buildings (or help other people buy them) I am ruthlessly focused on the cashflow they generate in year one.
I don’t factor in rents increasing, nor do I factor in price increases stemming from rent increases. I want to know what the cashflow is RIGHT NOW.
Many buyers to factor in rent increases and price increases. They look at a 4% cap, factor in some rent increases, and assume they can exit at a 4% cap in five years. Here’s the math: Let’s say year one rents are $250k and net operating income (NOI) is $162,500. You buy the building for $162,500 / .04 = $4,062,000.
These buyers then assume 3% / year rent increases. In year five, they assume rents will be $281,000 and NOI will be $183,000. If you 4% cap that NOI, you get $183,000 / 0.04 = $4,572,000. So you’ve collected a bunch of cash and your building is worth $500k more than when you bought it. Sounds great, right?
Ah, but what happens if interest rates on multifamily assets increase from their current historical lows? Say they go from 4% (where they are now) to 6%. That probably means cap rates are going to go from 4% up to at least 6%, maybe more.
If you 6% cap the $183,000 NOI in year five, you get a building valuation of $3,050,000. In other words, you vaporized $1,000,000 in asset value, even accounting for the 3% annual rent increases.
It’s important to understand that the above is totally irrelevant as long as you’re happy with the in-place cashflow and have no need to sell quickly. In that situation, you just hold the building for longer and collect the rents until some combination of rent increases and cap rate compression eventually takes your building value back up over par.
But if you’re investing with someone who is slinging a “we’ll buy and hold for five years and then get out” strategy right now, I advise you to give all the tires a good kicking.
Almost forgot to post, which would have broken my streak!
We’re in the process of selling a 16 unit building we rehabbed over the past few years. The buyer brought along an inspection company we’ve never seen before.
After watching them work for an hour or so, without planning it, both Jon and I separately asked the buyer where he found these guys, because we both thought they were pretty good. A little nitpicky, if you ask me, but pretty good.
We usually use La Rocca for inspections on deals that need it (some don’t, because we’re planning to gut anyway). But I’m thinking of adding these new guys to the rotation. There’s such a paucity of talented people in this business that, when you find one, you need to grab him or her for your team.
Am doing an inspection today on a building where the owners’ disclosures indicated that they previously had a mold problem. They also gave mold disclosures to some tenants.
So we’re bringing a mold inspector to the inspection. Here’s how they work (I didn’t know this until yesterday):
- You pay an inspection fee (they quoted $750 or something but quickly offered a “discounted” rate of $450)
- Then, you pay $90 / sample for them to take samples and send them to a lab to be tested
- They have a three sample minimum
- You get the sample results back in 48 hours
The concept is that the lab results give you a sense for whether the mold in the building is your garden-variety “moisture issue”, which can usually be cured by fixing whatever’s leaking and then swapping out the affected drywall / tiles, or whether it’s something more serious.
My general feeling is that these mold inspections are an unnecessary cost. But we’d feel kind of stupid, if, having seen the disclosure, we went ahead and bought the building without checking and then found ourselves with a major problem.