Archive for the ‘How to’ Category
Get a sales person license.
Join a decent brokerage.
Get your personal expenses under control so you can survive for 6 months without earning.
Read voraciously to learn about the business.
Hustle like crazy to bring in your first deal.
Work your first deal as hard as you know how.
Ask questions of your broker if you think there’s a chance you might not understand something perfectly.
Deal honestly with everyone and put your clients’ interest before you own.
Close your first deal.
Put the money away so that you can survive for 6 more months.
Close your next deal.
Make sure the world hears about your success.
Keep hustling to meet people.
Keep reading / learning.
Keep doing deals.
Repeat. You’re on your way.
Yesterday, the Eastsider reported on the proposed sale of a piece of land on Temple entitled for 69 units.
That got me thinking about the value of land in Echo Park and how it impacts the income taxes of property owners there. (Warning: This piece is a little heavy on the math, but it’s critically important. Not understanding this cost me thousands of dollars in income tax over-payment for roughly five years until I figured it out.)
When you buy a piece of property, the county assessor assigns a portion of the purchase price to the value of the land and the rest to the value of the structure. Here’s an example, from ZIMAS:
This is the assessor information for 2143 Clinton St., a property in Echo Park we flipped through Better Dwellings back in 2011. Note towards the bottom where it says “Assessed Land Value” and “Assessed Improvement Value”. That’s the assessor making a wild-ass guess and attributing $440,591 to the land (65% of the total) and $235,665 to the structure (35% of the total).
Why does this matter? Unless you instruct them differently, most tax preparers will pick up the assessor’s breakdown for use in calculating depreciation. Remember: Depreciation is a non-cash charge against income (sort of an accounting fiction) that reduces your tax liability (so, you want depreciation to be as high as possible). Depreciation is ordinarily calculated as 1/27.5 of the value attributable to the structure at the time of purchase, charged against income for the first 27.5 years of ownership. So, if the value of the structure is higher, the depreciation will be higher, and your taxes will be lower.
For 2143 Clinton:
- Purchase price of $660,000
- Assuming a stable ratio of structure to total value: $235k / $675k = 35%
- Value of structure at purchase 35% x $660k = $231,000
- Annual depreciation, assuming assessor’s structure value is used = $231,000 / 27.5 = $8,400
That means the owner’s first $8,400 of cashflow from the property will be tax free. Not bad right? Wrong… the owner is probably getting a raw deal.
Consider that the seller of the land on Temple seller is trying to get $4.95MM for 69 units worth of entitled land. That’s equivalent to $4.95MM / 69 = $71,739 per unit of land. That’s pretty high and it’s much, much higher than the price of land at the time 2143 Clinton was purchased. I checked back on some comps for that period and I think the price of land in Echo Park in 2011 was somewhere between $40-60k.
2143 Clinton is on a 5197 sq ft lot (see above). The zoning is RD3, which calls for 3,000 sq ft of lot size for each dwelling unit. Can you see what I see? 2143 Clinton is sitting on land that only allows for building one unit on it (though it’s grandfathered as a triplex). If, at the time the buyer bought 2143 Clinton from me, the value of the land was $60k, that means the value of the structure was $660k (the purchase price) – $60k = $600k.
This means there ought to be $600,000 of value attributed to the structure. This makes sense; after all, most of the value in the property is in the fact that there are three income-producing units in Echo Park (plus the fact that we fixed them up and got high rents for them)!
Assuming $600,000 as the value attributable to the structure, the depreciation ought to be $600,000 / 27.5 = $21,818. That means the first $21,818 of cashflow ought to be tax free. The difference in the depreciation between this number and the original $8,400 is $13,418. Assuming a marginal tax rate of 50%, the difference in the depreciation should result in a tax savings of $13,418 x 50% = $6,709. Annually.
If you have additional tax savings of $6,709 per year for the first 27.5 years you own a property, that’s $184,497 in cash that you got to keep instead of paying out in taxes… which will make a huge difference to your net worth, particularly multiplied across an entire portfolio of properties.
The lesson, as always, is to query all of the assumptions made by your tax preparer. At the end of the day, you’re responsible for keeping money that is fairly yours, and knowledge of land prices and how they affect depreciation ought to be one tool in your tool box.
A few very important caveats:
- If you go around claiming to the IRS that land is 10% of total value, they’re probably going to audit you eventually… probably worth keeping it a bit more reasonable; and
- I’m not an accountant or a tax attorney, so don’t rely on this advice. Consult your own professionals!
A contact just sent me this link to an excerpt from Warren Buffett’s most recent Berkshire Hathaway shareholder letter.
Buffett’s approach is pretty much exactly how I think about multifamily real estate in improving parts of LA:
- Pay a reasonable price, such that the yield in year 1 is acceptable
- Don’t put yourself in a position where you might be a forced seller (so, don’t over-lever)
- Manage for yield
- Ignore swings in market prices, except to buy more when prices get low
- Never sell
If you just do this, my guess is that you’ll end up very happy about your investment(s).
Oh, and if you are interested in investing, you should 100%, absolutely, no question read Buffett’s collected shareholder letters, which are available as a collection on Kindle.
(Hat tip to EZ for the link!)
We have a buyer inspecting one of the properties from Fund 1 today, so I thought this would be a good opportunity to discuss how you ought to behave when you, as a seller, attend a buyer’s inspection of your property.
Here are the key things to keep in mind:
- Be honest. You never, ever want to lie during a sale process. If you get caught, the buyer instantly loses all faith in what you’ve told him through the entire process, making it much harder to make a deal. If you don’t get caught, you’re setting yourself up for a lawsuit later on, once the buyer finds what you’ve hidden from him.
- Admit when you don’t know something. It’s ok not to remember something about the property. A perfectly fine response to a question about, say, whether you replaced the sewer line in addition to the drain lines is to say “I don’t know. Let me get back to you in writing by tomorrow afternoon.” That’s a much, much better answer than lying.
- Don’t ramble. I’m guilty of this one all the time. When someone asks you a question, answer it. But there’s no need take off on a major lecture. The buyer is there to see the property, not interview the seller.
- Give the buyer privacy with his inspector(s). Don’t hover / eavesdrop. It makes everyone uncomfortable and possibly causes the buyer to doubt the veracity of what his inspector tells him (“maybe he was holding back because the seller was there…”). If there’s something wrong with the property, believe me, you’ll hear about it in writing from the buyer or his agent.
- Don’t take things personally. Some buyers like to spend the inspection period pointing out niggling little issues with the property. That’s their trip; you don’t need to go on it with them. Just smile, nod, and move on.
- Be personable, but not overly friendly / jocular. You would be amazed at how many deals go bad because buyer and seller interact and decide they hate each other. It’s hard enough to make a deal without that kind of interpersonal nonsense getting in the way. So, keep it calm and friendly, but also business-like. No need to risk screwing up a deal by rubbing the other guy the wrong way.
Our on-going drought was a big part of Gov. Brown’s State of the State speech today.
One of the iron-clad rules of conservation is that people only conserve when they directly feel the cost of not doing so. And yet, in LA, the majority of households do not pay their own water bills, and therefore have zero incentive to conserve water.
Why don’t people pay their own water bills? Because 60% or so of households are renters, most in multi-unit buildings. Very, very few buildings are separately metered for water, so the landlords eat the water bill for the entire building each month.
Why aren’t buildings separately metered for water?
- DWP makes it incredibly difficult / impossible to do so for all but the largest buildings; and
- Tenants groups would resist a change, because they would be worried about landlords putting this new expense on tenants
But there is an easy solution: Force DWP to institute a program whereby water can be separately metered, just like they already do for electricity and just like the Gas Company does for gas. DWP already charges for new electrical meters; there’s no reason they couldn’t charge for water meters as well. And owners would pay, because even a relatively high upfront cost would be offset by the permanent savings in operating costs.
But what about the tenants? Under the law, you can’t unilaterally change terms of an existing tenancy, so landlords have no right to spring a water bill on tenants while they are in residence. However, if a landlord separately meters his building and a unit turns over, then she can include in the new lease that the tenant will pay for water.
The change outlined above would not correct our conservation problem immediately, since very few units turn over year-to-year. However, over time, as more landlords separately metered their buildings and more units turned-over, we would gradually move from being a city that wastes water to one that conserves it.
Go buy a 2-4 unit apartment building in reasonable condition, at a reasonable price, with reasonable debt.
Don’t sell it, even when the price goes up.
When you’ve saved enough, buy another one.
Do this four times, after which you won’t be able to get another 30 year fixed mortgage.
Then move on to larger buildings.
Don’t sell those, either.
If you carry out the advice above, you will 100% die rich. How long it takes for you to get rich will depend on how quickly you can save up down-payments. But the outcome is not in doubt, so long as you have the fortitude to stick to the plan.
The problem for most people is that they don’t have the fortitude. Do I? Not sure.
I see what people search on Google that brings them to my blog. This was a question yesterday that I thought begged for an answer.
First, let’s review what “NOI” is. It’s “Net Operating Income”, or what’s left over after you take in your rents and pay out all of your expenses, including property taxes, but not including mortgage payments or income taxes.
For example: Say you have a duplex where each unit brings in $2k / month. Let’s say the property taxes are $6k / year and the other expenses (property insurance, maintenance, utilities, etc.) are $10k / year. The rent is $2k x 2 = $4k / month x 12 = $48k / year. The expenses are $6k + $10k = $16k. So, the NOI is $48k – $16k = $32k / year.
Sounds good, right? Well, knowing the NOI number without know the price of the asset is kind of meaningless, and that’s the problem with the question that is the title of this piece.
Imagine you paid $5MM for an apartment building, all cash (so there’s no mortgage payment). If the NOI is $32k / year, the return on your $5M investment is $32k / $5M = 0.6%. 0.6% / year is a horrific return. [Note: Regular readers probably recognize this calculation as a CAP rate, which is NOI divided by price.]
Now imagine you paid $350k for that same asset. Now you’re making $32k on a $350k investment, or $32k / $350k = 9.1%. Getting to a 9.1% cash-on-cash return is pretty incredible!
Bottom line: Knowing the NOI alone is somewhat meaningless. You need to know what someone is asking you to pay for that NOI to figure out if you want to own it.
There are a lot of new readers here recently. Welcome.
You may have noticed that the topics here jump around some. I tend to write about whatever I’m working on at any given moment, and that can vary. But it’s important to me that you get what you are presumably here for – an education about buying, managing and selling apartment buildings in Los Angeles.
Here are some pieces I think are particularly important, grouped loosely by topic. Note that there’s a lot more in the blog… I’ve been writing almost every day for nearly 18 months now, so there’s plenty to dig into if you have the time.
Why you should own apartment buildings:
How to think abiout value and how it increases:
The buying process:
Thinking about managing buildings:
- Introduction to Los Angeles rent control
- Why the tenants and lease are important
- What to keep in mind when you’re managing
Would you believe that a piece of real estate recently made me fall in love with my wife all over again?
Despite the fact that we own pieces of a lot of apartment buildings, we rent our own apartment from a guy who just owns this one building. You can’t imagine how nice it is not to be responsible for maintaining our home, since I’m (ultimately) responsible for maintaining approximately 100 others (with many more in the pipeline).
But, about two months ago, our landlord told us he was going to sell the building. He offered to sell it to us, but his price (at 15-16x rent), while not completely crazy for the area, made it a bad investment decision for us, even though we like the place.
We didn’t want to hang around while a new owner renovated the upstairs unit (young kids and lead paint dust don’t mix), so, we began looking for somewhere to live.
At first, we focused on houses in South Pasadena. Why? Because we’ve got two young sons and one income (mine) which derives from a business famous for its ups and downs, so moving somewhere with a really good public school seemed like it made sense. But, as we began to look closely at the market, it became clear that we were looking at spending $1MM on a house.
Anyone who reads this blog knows I think that single family homes are dubious investments. And shackling myself with a big mortgage seemed like a recipe for a lot of stress.
So, Lucy and I decided to change our strategy. We started looking closely at buying a small apartment building and living in it, alongside some tenants, for a while. And, before too long, we found an interesting fourplex deal in Mid City.
Now, the building we’re considering buying is exactly my kind of deal: A big fourplex on a large lot with parking in an improving area. But the area is definitely not very nice yet. And that brings me back to why I’ve fallen in love with my wife all over again: Despite having style to spare and a real appreciation for nice things and spaces, Lucy has enthusiastically embraced the idea of buying this building.
Why? Because, after taxes, our family will be able to live pretty much for free in the top two units of the fourplex. That means the money coming in from my business will pay for the private school we are so excited to send our kids to, let us to save for another building, and, most importantly, allow Lucy to care for our boys full-time until she wants to go back to work.
At some point in the next few years, we’ll move and rent out the top two units. Then, in addition to paying down the mortgage, the building is going to cashflow, initially only a few grand a month, but later probably much more.
This strategy isn’t rocket science; immigrants have been doing it for generations and many of our clients at Adaptive do it. But I also know a lot of people in the real estate game who recognize it’s the right thing to do financially, but can’t get their spouses to agree. I’m so lucky mine has.
[P.S. If you think your family would be game for something similar, get in touch. My agents help people do these kinds of sensible deals all the time.]
We’re living in a world of rising interest rates, which are already fundamentally changing the real estate market.
As discussed yesterday, as interest rates rise, prices should fall, all other things being equal. That’s because more expensive debt means reduced cashflow and lower returns at a given price.
But, all things are not equal. In general, assuming a normal economy, interest rates should only rise when things are improving. Why? Interest rates are effectively the price of borrowing money. When the economy is bad, and there is not much opportunity, no one wants to invest in new opportunities, so the demand for money is low and the price (the interest rate) falls.
On the other hand, when the economy is promising, everyone wants to borrow to expand their businesses, buy assets, fund consumption (cars, boats, etc.) So, demand for money increases and interest rates rise.
The fact that interest rates are going up isn’t necessarily such a terrible thing. It is, in fact, a strong signal that the economy is improving.
The trick for real estate investors is to figure out how to benefit from an improving economy without being hurt unduly by the rising rates.
Here’s an example of what not to do:
- Pay a high price (say, over 11x) for a rent controlled property with tenants at below market rents
- Use a 3- or 5-year fixed rate loan for a very large portion of the purchase price (say, 75%)
Why is that a bad play?
- You paid a high price, so your cashflow is pretty slim to begin with;
- Your tenants aren’t leaving, so you’re limited to increasing the rent by the city-mandated 3% / year, meaning that you’re not really benefitting that much from improvements in the economy;
- Interest rates go up in the interim, maybe to 6-7% (they were that high as recently as 2008);
- After 3 or 5 years, your rate comes unlocked and your debt payments increase, eating up most/all of your slim cashflow;
- When you go to refinance, depending upon how much multiples have dropped as a result of the increased interest rates, you may find that you lack the equity necessary to refinance and are therefore stuck with whatever rate your loan has adjusted to.
The above is pretty obvious to me, and yet I see poorly advised investors buying exactly this type of deal all the time.
Tomorrow, we’ll talk about some better strategies for investing in a rising interest rate environment.