Moses Kagan on Real Estate

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Beware of setbacks!

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Apologies, in advance, for a fairly technical piece, but this is very important information for anyone doing remodeling in LA.

If you’re rehabbing a property, you need to be extremely careful about touching anything located in any setbacks.

What do I mean by setbacks? They are the parts of any lot in which the city prohibits you from building. Depending on the zoning, they’re typically the areas 3-5′ from the property line on the sides and 15′ from the property line in the back. In the front, the setback varies a lot, but it’s typically 10-15′.

Why is it so important that you take care before touching anything in the setbacks? In a word, “grandfathering”.

There are many properties in LA that have important features that were built prior to the imposition by the city of setbacks. These features include decks and walkways, some of which are essential for accessing parts of properties.

Because these features were built prior to the imposition of setbacks, they are grandfathered in.

The problem is that many of these features, particularly those built in the 1920s, are at the end of there useful life. They are rotted out by moisture, termites, etc. As a rehabber, you will be sorely tempted to rip them out and replace them.

Careful! If you entirely rip out one of these grandfathered features, you will forfeit your grandfathered status. You will then have a hell of a time getting the city to allow you to rebuild it, because the city will hold you modern codes which require you to avoid building in the setback. Getting approval to do so would involve zoning variances, plan approval, etc… not something you want to go through.

So, what’s the solution? Instead of entirely ripping one of these features out, pull a permit for “replacing termite-eaten wood”. Then, replace only the worst areas, leaving the rest, and get the permit finaled. Later, you can repeat the process if you have to.

Side note: Can you see how insane the above situation is? The city is basically incentivizing you NOT to replace potentially dangerous decks, etc… a recipe for unnecessary injuries / death. Instead, they should change the rule to allow you to replace grandfathered features without going through plan-check so long as you do not expand the footprint.

Written by mjkagan

11/12/2014 at 2:24 pm

Posted in Development, How to

Avoiding a pretty painful “oops”

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A reader wrote in to ask me a question about yesterday’s piece, which argued for refinancing and holding, rather than selling, completed repositioning projects.

The question: “Only thing I don’t understand is why not refi on a LTV more than 60% to get back all of your original 2million dollars.”

It’s a reasonable question. After all, with a property value after stabilization of $3.2MM, you might be able to get a bank to loan you as much as 75% LTV, or $2.4MM.

Remember that we invested $2MM in the hypothetical property, so a $2.4MM loan would allow you to get all of your money out and then some. That seems like a pretty great deal, right?

The reason I stuck to a 60% LTV loan in the example is simple: Risk avoidance.

When you have a fully-renovated property with very high rents, you need to be conscious of the fact that rents can fall in the event of a recession. For example, in 2008-9, rents at our 16 unit building on Reno fell roughly 20%.

Recall our example property, which has net operating income (“NOI”) of $160k. Let’s assume that equates to rents of $220k / year (if you think a 72% operating margin is unusually high, you’re right – our unusually high rents make our properties’ margins unusually high). Now imagine the economy tanks and rents fall by 20% to $176k.

In recessions, expenses don’t fall by nearly as much as rents… the tenants are still going to use as much water / sewer as they did during the good times, right? Let’s say expenses decline by 10%, from $60k / year to $54k / year. What happens to your NOI, the money available to service the debt? Well, it falls to $176-54 = $122k.

Recall that at 60% LTV, our annual debt service was $116k. So, even with the 20% decrease in rents, our NOI still exceeds our debt service and we can still pay our loan and even have cashflow (albeit microscopic).

What would have happened if we had borrowed to a 75% LTV? Our debt service on that $2.4MM loan would have been $146k, which would would have serviced with our NOI of $122k… Ooops.

We at Adaptive get paid a lot of money to avoid “oops” moments. So that’s why we wouldn’t ever lever up as high as 75% on a property with maxed-out rents.

Written by mjkagan

10/31/2014 at 10:32 am

Posted in Debt, Development, How to

How a good contractor handles inspectors

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By now, we’ve had a LOT of experience dealing with city inspections.

And we’ve seen how many different contractors handle them.

And here’s what separates the contractors who get their permits signed off from the ones who get endless streams of corrections:

  1. Good quality work (obviously); and
  2. Confidence.

The nature of renovating old buildings is that things are not always going to get built exactly to plan.

You and your contractor are going to have to improvise in order to create the best possible space within the constraints under which you are forced to operate.

The hard part is when the inspector comes in and sees that what has been done deviates from the plans.

Now, if what you have done violates the building codes, there’s not much anyone can do… you’re not going to get away with it.

However, if the work is to code, then you might. If your contractor has a history of doing good work and projects confidence in his own knowledge of the building code, the inspector is likely to allow some deviations without requiring you to go back to plan-check (which can impose weeks or months of delays).

If, on the other hand, your contractor does low quality work and/or lacks confidence in his own knowledge of the building codes, the inspector is likely going to run roughshod over him, which means multiples rounds of additional inspections and / or trips back to plan-check.

With isolated exceptions, we have found city inspectors to be pretty reasonable people. If they think you know what you’re doing, they let you proceed. If they think you’re an amateur, then they force you through the wringer (which, by the way, is how you go from being an amateur to being a pro… trust me!).

Written by mjkagan

10/29/2014 at 10:23 am

Posted in Development, How to

Never lose units

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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.

Written by mjkagan

10/21/2014 at 9:54 am

If I were a broker…

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…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.

Written by mjkagan

10/20/2014 at 10:20 am

Taking apart a deal: An East Hollywood Duplex

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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!

Owner-occupier

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.

Developer

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.

Repositioning

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.)

Conclusion

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?

Written by mjkagan

10/17/2014 at 2:48 pm

How DWP steals your money

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If you manage apartment buildings, you can probably guess what I’m about to write about.

If not, here goes:

  • DWP is criminally under-staffed / incompetent
  • DWP makes huge numbers of mistakes
  • Getting someone on the phone to correct the mistakes and/or request normal service changes takes 30-90 minutes, each time

For an individual trying to do something simple, like turn on the electricity in a new apartment, this is a pretty awful situation, but at least it’s only a once-every-few-years kind of thing.

For an owner who self-manages a few small buildings, the DWP-imposed delays probably take up a few hours a month.

For big property management companies that manage hundreds or thousands of units, the delays imposed by DWP result in employees spending tens or hundreds of hours per month. Pick an hourly wage and do the multiplication and you’ll see that DWP’s disorganization is imposing thousands upon thousands of dollars in costs on property management companies.

Econ 101: Businesses will attempt to pass increased costs on to customers if possible, either by increasing prices or cutting other costs. Management companies will eventually pass on the increased costs to owners. And owners will eventually pass on the increased costs to tenants, in the form of rent increases.

All because a city-owned agency can’t get its act together to answer the phone.

Written by mjkagan

10/02/2014 at 10:35 am

Posted in How to

Why we don’t announce closings

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If you’re at all active in real estate, your email account is spammed daily by brokers announcing the closings of their latest deals.

Why do they do this?

Because doing so:

  1. Shows everyone in the market how active the broker is
  2. Keeps the brokers’ name in front of potential clients, increasing the chances potential clients call them when it’s time to buy or sell

Seems reasonable, right? So why doesn’t Adaptive send out these kinds of emails?

It’s pretty simple, really. We are primarily in the business of placing capital in specific neighborhoods. In order to do this effectively, we spend a ton of time thinking about acquisition prices, rehab prices, and achievable rents. When we find a neighborhood that works, we and our clients want to buy as much fairly-priced product in that neighborhood as possible.

If we sent out emails every time we closed deals, anyone with a brain could figure out what neighborhoods we like and then just piggy-back on our hard work / insight to compete with us.

So, yes, Adaptive closed a bunch of deals last week. But no, we won’t announce the addresses or deal sizes. Because we don’t want you to compete with us / our clients.

Written by mjkagan

10/01/2014 at 4:50 am

Posted in Buying, Development, How to

Adaptive’s proof of funds problem

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When you make an offer on a building, what you’re really saying to the owner is: “Please give me the exclusive right to consider buying your building at this price for the next 21 (or 30 or 60) days.”

For an owner to accept, she needs to be ok with your price and, crucially, as confident as she can be that you have the intention and ability to deliver your price. Otherwise, she has to worry that you’re going to tie-up her building, waste her time, and then not have the dough to close.

In order to give the owner confidence, the listing broker will usually insist on seeing “proof of funds” from the buyer.

The proof of funds is typically a bank statement or something similar showing liquid assets (cash, stocks or bonds) at least equal to the amount of cash the buyer requires to close the transaction. In other words, if you’re offering $1MM for the building with 30% down, the listing broker is going to want to see at least $300k in liquid assets before allowing the seller to accept the offer.

The above is totally fine for rich people, but it creates some real hassle for money managers like me. Why?

I use other peoples’ money to make deals. In order to get the ability to use that money, I usually need to offer a preferred return on it. I say something like “If you give me your money, then I will give you a 5% (or 6% or 7%, whatever) return on the money for the time I have it (plus upside, obviously), before I get to take any of the profits.”

Can you see how this creates a problem for me?

If I get $2.5MM committed on a fund, I have zero interest in calling it down from the investors until I have something to buy. Otherwise, I’m sitting there with $2.5MM in a 0% checking account and accruing $10,416 / month in preferred return (assuming a 5% pref) which I will owe my investors before I see a dime of profits.

So, because I refuse to call money down until I’m confident I’m going to close on a deal, I always end up in these annoying conversations with listing brokers, where I need to convince them that I actually have the money and they think I’m full of it.

What’s especially annoying about this problem is that, of all the potential buyers with whom they might go under contract, I’m nearly always the one most likely to close on the terms I’m offering, because:

  1. I’ve done a million deals, so I know before I make an offer what I’m going to do with the building and how much it’s going to cost;
  2. Because I’m going to renovate, I don’t care that much about the physical condition of the building (so I’m not going to ask for a price reduction because the light switches don’t work); and
  3. Because I do so many deals in such a small area, I try as hard as I possibly can not to chip price, ever… because getting a reputation for doing this is a sure way not to be able to do any more deals going forward

Compared to your typical lawyer or doctor who has $2.5MM sitting there in cash and does a deal every 2-3 years, I’m far, far more likely to actually close.

The good news is that, because we close almost every single time, over time, more and more brokers are seeing that we’re serious. And the second time around, they trust that we’re going to do what we say we’re going to do.

(Obligatory legalese: This post is not a solicitation of investment or an offer to sell any security.)

Written by mjkagan

09/30/2014 at 10:39 am

What we’re against

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Most people think that the way to get ahead is to get a job and work hard.

Their salary goes up a bit.

They save a little money.

They immediately go buy a house with the biggest mortgage they can get.

They think the loan is against the house, but really it’s a loan against THEM.

Now they’re stuck working harder and harder to keep up with the payments.

God forbid they lose their job(s)… bye bye house / credit / etc.

Even if they keep their job, they’re stuck working in it for decades to service that big loan.

They levered up to the hilt to buy an asset with negative cashflow which is likely to appreciate only a bit faster than inflation.

Bottom line: That’s a recipe for being financially dependent forever. There is definitely, 100% a better way of doing things.

Written by mjkagan

09/25/2014 at 10:17 am

Posted in Buying, How to