Archive for the ‘How to’ Category
Right now, if the Housing Department catches a landlord with an illegal apartment, here’s what happens:
- LAHD cites landlord for un-permitted unit, orders her to either get it permitted or vacate it
- Landlord attempts to permit; discovers that it’s nearly impossible to do (because adding a unit always requires adding parking and adding parking is nearly impossible)
- Landlord decides to vacate unit
- Tenant is evicted; receives $8-19k from landlord (ouch), who must also pay to remove the kitchen and bathroom
The net result of the above is that the tenant is out a place to live and the landlord is out a bunch of money and receiving less rent going forward.
You can see why landlords and tenants have an incentive to band together to try to change city policy. And, lo and behold, they’re trying: The idea is to get the city to make it easier for the landlord to bring the unit into compliance so that the tenant can stay.
I’ve permitted a non-conforming unit before and it’s no joke. The problems break down into two categories:
- Bringing the unit itself up to code. That means appropriate ingress/egress, windows, fire protection, etc. This is almost always possible to do, so long as there is sufficient money… and the value-add from adding a unit would almost always justify the cost;
- Adding the parking. In my case, I was able to squeeze in another parking space by moving a giant electrical panel at the cost of $30k. But, generally, this is impossible, because there’s just not enough space on the lot and digging out subterranean parking would be totally financially infeasible.
So here’s the rub: If the city is going to make it easier to permit non-conforming units, it’s going to have to waive the parking requirements. And the city has generally been very wary of anything that would reduce parking and therefore anger neighbors.
Have rents got so high that politicians are willing to consider allowing alienating homeowners by allowing landlords to reconfigure existing buildings to add more units? I doubt it. But I hope I’m wrong… because my business would get much, much better if it did!
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).
One couple, two incomes.
Live on one, save the other.
Buy first 4plex FHA.
Live in one unit, accelerating savings.
Accumulate downpayment for building #2.
Buy building #2 with 25% down.
Resist temptation to increase spending; saving accelerates due to income from building #2.
Buy building #3.
Assuming we’re talking about 4plexes that cost in the range of $800-900k, repeating the above strategy four times results in you retiring with $3+MM (maybe much more, depending on how good the deals were) in equity in today’s dollars 30 years from now.
Sometimes I’m guilty of throwing around yield numbers on this blog without providing specifics. I’ll say “we legged into a 9% un-levered yield” or “the cash-on-cash yield on this deal is 6%”.
Some of you are probably sitting there thinking that you can compare those yields with, for example, what you can get by lending money on Lending Club or buying treasury bills or whatever.
Those aren’t apples to apples comparisons, but those aren’t apples to apples comparisons, because they don’t take into account the tax treatment of the cashflow coming in.
To start, you need to understand that interest income of any type is taxed at normal interest rates. That means, for someone in the highest marginal tax bracket, making a loan to someone at 8% nets you something like 4% / year post tax.
Rental income is also taxed at normal income tax rates, with one big difference: You get to take advantage of depreciation.
Consider the following example of an 8% yield deal:
- Buy a property for $1MM cash
- Collect net operating income (rents less all operating expenses, including property tax) of $80,000 / year
- That’s an 8% yield ($80k / 1MM = 8%)
- But we’re not done…
- Assume of the original $1MM price, 50% of the value attributable to the structure (eg not the land)
- Depreciate the $500k structure straight-line through 27.5 years, implying 18,182 of annual depreciation
- To calculate the after tax yield, deduct the depreciation from the NOI…$80k – 18k = $62k
- Pay 50% tax on $62k, leaving $31k after tax PLUS the $18k that was sheltered by depreciation
- Total post tax cash of $31k + 18k = $49k
- $49k / $1MM = 4.9% after-tax yield
So, two different investments, each boasting an 8% yield. But one gets you 4% after taxes and one gets you nearly 5%.
If you don’t think that’s a big deal, then I invite you to mail me an annual check equal to 1% of your post-tax income from investments.
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.