Moses Kagan on Real Estate

1. You don’t like confrontation. Inevitably, you are going to have tenants who screw things up and need to leave your building. No one is going to care about it as much as you do, so you’re the one with whom the buck is going to stop. If you can’t stick up for yourself / your family, don’t buy a building.

2. You can’t tolerate risk. Apartment buildings are little businesses. No matter how much you plan / prepare / etc., there is still risk to owning them. Earthquakes happen. Fires happen. Market prices and rents swing. Working with a good agent and being smart about what you buy and how you buy it can mitigate risk to a large extent, but it can’t remove risk entirely. This is a big boy / big girl game.

3. You hate negotiating. In business, I’ve found, everything is a negotiation, whether you realize it or not. When you own a building / business, you’re going to be employing all kinds of people and companies. Many of them will try to take advantage of you. You don’t have to “win” every negotiation (often, you’re willing to happily pay a price the other side is happy to accept), but you need to be aware that you are, indeed, negotiating. And you have to not despise the process.

4. You’re disorganized. There is an unbelievable amount of paperwork that accompanies owning buildings. There are a million different regulatory agencies, tax authorities, insurance companies, banks, managers, etc., all of whom want documentation, bills paid on time and in full, etc. If you’re the kind of person who avoids opening mail, either make sure you hire someone to do it (that’s what I do) or stay out of the business.

5. You don’t like numbers. This isn’t a video game. There isn’t a big “You Win” or “You Lose” screen that pops up. The business is about patiently husbanding your capital, placing it, watching it grow, limiting your expenses, mitigating your risk, etc. All of this involves thinking about numbers. If you don’t like numbers, do something else.

6. You don’t like to learn. I’m still learning a lot, every single day, roughly five years into doing this for a living. If you want to do a good job with buying and owning apartment buildings, you have to keep your ears open for new ideas, your eyes open for new neighborhoods or changes to existing neighborhoods, and your mind open to thinking about existing assets / threats / opportunities in new ways. If you’re closed off and hate new ideas, don’t start buying buildings.

Have recently had a lot of buyers interested in using FHA loans. We’ve discussed why this is a difficult time to get these loans done before. But, obviously, being able to buy an apartment building with 5% down is pretty appealing. So I thought I’d post a quick FHA refresher.

FHA is a program for first time home buyers. Because the government considers 2-4 unit properties “residential”, as opposed to commercial, they qualify as well. Because of the incredible leverage you get from FHA (basically, put down 5% of the purchase price and borrow 95%), FHA can be incredibly attractive. But, obviously, the more leverage you use, the more risk you’re taking on, since leverage magnifies outcomes.

With that caveat, here are the maximum loan sizes for FHA loans in Southern California:

• Single family home: $729,750
• Duplex: $934,200
• Triplex: $1,129,250
• Fourplex: $1,403,400

Remember, this isn’t even the maximum price you can pay; it’s the maximum loan size. To get the maximum amount you can pay, just divide each of the above numbers by .95. So the maximum prices you can pay for FHA deals in Southern California are:

• Single family: $768,158
• Duplex: $983,368
• Triplex: $1,188,684
• Fourplex: $1,477,263

As you can see, the maximum loan limits are very high. There are few, if any, deals west of La Brea that you couldn’t do FHA, in theory. The problem, of course, is getting sellers and brokers to believe you can close. But that’s a topic for another day.

Have had this question a few times in the past few weeks so I figured I’d answer it for everyone: How are security deposits handled in a sale?

First, owner typically do not maintain a separate account for security deposits. When a tenant moves into the building, he gives the landlord a check for the deposit and the landlord notes the amount on the lease and, often, a separate security deposit receipt. The landlord then deposits the check in his general operating account. The tenant’s assurance that he will receive his deposit back when he moves out is that, if the landlord unlawfully withholds the deposit, the tenant can sue and win triple damages.

But, if the money is simply deposited by the owner of the building, what happens when someone buys the building from the owner? Does the old owner have to write a check to the new one to transfer the deposits?

Fortunately, the answer is “no”. Escrow handles the transfer, in the form of a debit to the seller and credit to the buyer. During the escrow period, the escrow officer reviews the rent roll (and, if the buyer’s agent is smart, the estoppels) and calculates the total amount of security deposits. Then, the escrow officer simply reduces the price the buyer will pay for the property by the same amount. So the seller keeps the deposits, but the buyer gets an equivalent price reduction.

One wrinkle to keep in mind is that tenants in Los Angeles are notionally entitled to earn interest on their security deposits. Calculating the interest and paying it out is an unbelievable pain in the ass and, because interest rates have been so low for so long, the amounts of money involved are ridiculously small. So, most landlords and tenants ignore the law.

It’s worth mentioning here, though, because, in the event that there are long-term tenants in a building, the interest owed on their deposits can actually end up being a meaningful amount of money. Escrow is supposed to calculate the interest owed and add it to the deposit credit the buyer receives, but most escrow officers are too lazy to do this. This is another case of caveat buyer (or, if you’re properly represented, caveat agent).

When it comes down to it, most brokers who sell residential properties don’t know a lot about marketing income property. (One easy way you can tell is that most of them don’t include information that is absolutely critical to an income property investor – like the rents! – in their MLS listings.)

But why does it matter if a broker doesn’t know a lot about income properties? After all, don’t all brokers just post a listing on the MLS and wait for offers to roll in? After all, isn’t marketing a property as widely as possible the best thing you can do to maximize price?

I don’t believe so, and here’s why:

• As a buyer, when you offer on a property on the MLS and have your offer accepted, you know you’re the winning bidder in an auction;
• This means, by definition, that your bid was higher than everyone else’s;
• This means that, once you’re in escrow, you might be able to chip the price (by raising all kinds of issues about the physical condition of the property, etc.), because there’s probably some room between your (highest) bid and the next one down.

So, if you’re listing your property on the MLS, you are almost definitely going to see the buyer try to chip you in escrow. Contrast this with an offer that comes through a “quiet”, off-market marketing period.

With a “quiet” marketing period, the listing broker puts out the word that the property may be available if a buyer is willing to pay the full price. He puts it out to his own buyer list and also to select agents he knows have serious buyers ready to make a deal.

Assuming the broker does his job well, several strong offers should come in. Then, the broker can run a quick “best and final” counter process to clean up the contract terms and maximize price before finally accepting an offer and opening escrow.

Consider the situation this buyer is in: He has a deal that has not been widely exposed. If he tries to chip price, he knows the seller can always cancel and take the property to market, where someone else will certainly buy it. Because the threat of cancelation is credible, he’s much, much less likely to try to chip price. Mission accomplished.

And, the best part is, if, for whatever reason, an acceptable offer does not emerge during the “quiet” marketing period, the seller can always just go ahead and put the property on the MLS, anyway.

So, if the above is clearly the best strategy for marketing properties, why don’t all brokers do it? The ones who don’t just don’t have sufficient contacts among the relevant market participants (buyers and brokers) to effectively get the word out. And those are the brokers you don’t want selling your property in the first place.

Got a call today from a guy who inherited control of a screwed up apartment building. I have a lot of sympathy for people in that situation, since it happened to my family back east.

The dilemma is this: You know you have an asset which is not performing. You know that it will cost a lot of money and (more importantly) time to untangle all of the problems and get it performing again. You want to sell, but you know you’re not going to get a full price, because the building is screwed-up.

The temptation in this situation is to try to hire someone to fix the problem for you. And, of course, there are plenty of people and management companies out there who will listen to your problems and tell you they have the answer if you just pay them a few thousand dollars.

Don’t hire one of these charlatans. Remember: People who know how to do this stuff (like me) make a lot of money sorting out troubled buildings. Why on earth would we do it for a few thousand dollars?

No one will care enough about a few thousand dollars to do the hard work necessary to clean your building up. They will instead be happy to take your money for a while and not deliver any results. That’s what happened to my family and to this guy I spoke with today.

Instead of hiring a charlatan, choose from one of these two options:

1. Commit to sorting out the building yourself. This is painful and risky. It will require more of your time than you can imagine. You will spend a lot of money. However, the payoff could be sweet.
2. Sell the building. You won’t get top dollar for it. But you will not go through the pain and heartache that comes from doing one of these projects.

That’s it. Do it for yourself or sell to someone else who will do it for himself.

What’s a BATNA? Jabba tried to feed Skywalker to it.

Just kidding. It’s the acronym for “best alternative to negotiated agreement”.

BATNA is a term of art in the world of negotiations. It’s intended to represent your best choice besides taking whatever deal is on the table.

For example: Let’s say you have only one offer to buy your building. If you don’t consider any alternatives besides selling, you’re basically at the mercy of the person across the table, because that’s the only game in town. But, if you are willing to consider alternatives, you might realize that you could also re-finance, pull out some cash, and hold the property.

Once you realize that your BATNA isn’t so bad, two things probably happen:

1. You get confidence in your negotiating position and stand firmer, knowing the alternative to striking a deal isn’t so bad; and
2. Your negotiating partner, recognizing your willingness to go another direction, moderates his demands.

So, far from endangering the negotiation, considering your alternatives actually has a way of making it more likely that you negotiate a fair deal.

There are no perfect deals right now. Think about it: People don’t generally sell perfect buildings where everything is going great. They definitely don’t right now, when the alternative to owning the building is to hold the money in their money-market account earning 0.25%.

Does that mean you shouldn’t buy anything? No. There are definitely good deals to be done, both relative to the other stuff out there and also in absolute terms. Just yesterday I came across a fairly large, non-rent control deal that a savvy investor could get into for less than 9x the rent in a good area. That works out to a 6.7% cap, which is probably an 8+% / year cash-on-cash return with some decent leverage.

Is this deal being marketed as a 6.7% cap? Absolutely not. It’s more expensive than that on its existing rents. To understand its potential, you need to understand where the neighborhood is going and what you can do to improve the apartments and raise the rents.

In The Wire, McNulty and Bunk, two detectives, talk about having “soft eyes” when they look around a crime scene. What they’re referring to is the ability to avoid jumping to conclusions and to see all the different possibilities. That’s exactly what you need to do good deals now: soft eyes.

I remember when I first got started buying and renovating apartment buildings, a broker told me that if you haven’t been sued yet, you’re not really in the business. Fortunately for me, I’ve avoided being sued so far.

But that doesn’t mean I haven’t had to discuss settlements with people. Everyone once in a while, in business, someone wrongs you or you wrong someone and you need to come to some kind of agreement about making things right.

But there’s a problem when you want to talk to someone about a settlement: How do you go about doing so without giving them ammunition to use against you in court if the settlement talks don’t work out?

I asked this question recently to my lawyer, Bob Levinson (who I highly recommend, incidentally) and this is what he told me (Disclaimer: The following is not legal advice and should not be relied upon. Consult your own lawyer!): Settlement negotiations are not admissible as evidence.

What this means in practice is that, if you clearly label a communication with the other party as a settlement offer, they can’t throw it back in your face as a tacit admission of guilt during a trial.

It’s very reasonable, if you think about it. It’s almost always in everyone’s interest to settle cases before they go to court, because it saves everyone money and time. The law doesn’t want to do anything to make it more difficult to settle. Quite the contrary; the law wants to encourage you to settle. So, the law protects either party that makes an offer to do so, in order to help get the ball rolling.

Every once in a while, in business, you run across something that’s well thought-out and reasonable and it makes you smile. This is one of those things.

Further to our earlier conversation about ways into the apartment business…

Another good way into the business is through leasing. Technically, you are supposed to have a real estate license to lease apartments. However, many management companies use unlicensed leasing agents, in part because very few licensed sales agents are willing to work for the relatively small commissions available in leasing.

Here’s how the leasing business works: You get hired by a management company to fill units. Generally, you are responsible for posting ads in the relevant places (Craigslist, Westside Rentals, etc.). You take the calls, arrange showings, take applications, and then close leases.

Generally, the pay is something like $100-400 per closed lease, depending upon who you work for, the rents you’re getting, etc. Obviously, the less your management company wants to charge relative to market, the easier it is for you to close leases, and the less they’ll want to pay you.

The career path in leasing has two different branches. Someone who can close should probably go get a real estate license and then start selling property on her own, because the upside is much better in sales (tens of thousands of dollars, instead of hundreds).

Another possibility is to stay in leasing, but move to high-end, luxury properties, particularly ones that are just opening. Because these buildings desperately need occupants (in order to stabilize their rent roll and be able to re-finance their expensive construction loans), the companies that manage them are generally willing to pay very high lease commissions. You could do pretty well closing 20-30 leases at $750-1,000 / lease at one of these buildings.

I met with a reader of this blog last week (hi Christina!) to discuss how she could get started in the apartment business. I spent a bunch of time blabbering to her and then realized that some of what I had said might interest those of you who are also considering making a career in this industry.

We discussed several ways into the business. The first was through the property management side. I suggested to Christina that she try to find a resident manager position at a large apartment complex.

Resident managers are typically employees of either the owner or the management company. Their job is to handle maintenance issues (by taking complaints from tenants and making arrangements for repairs), rent vacant apartments, collect rents, and generally keep an eye on the building.

In exchange for the above, resident managers typically receive a free or discounted apartment. And, most importantly for someone trying to get into the management business, they offer experience plus face-time with the management company. Do a good job as a manager of one complex and you are likely to find yourself offered a job with the management company overseeing multiple complexes.

Where do you find these sorts of positions? Well, Craigslist is, as always, a good place to start. You want to go to the main page and click “real estate” in the “jobs” section. Look for listings with “resident manager”, “on-site manager”, etc. in the title. I just looked for five minutes and found seven suitable jobs.

Incidentally, I’ve never understood why more people don’t look for these kinds of jobs – even people who aren’t that interested in real estate. If you don’t have a lot of money and you’re looking to get rich, you could do a lot worse than finding a way to live for free (and thereby accumulate capital by saving).