Why we’re in emerging neighborhoods

Found myself talking about neighborhoods with a new agent of ours yesterday.

We were discussing why our deals (both the ones we do for ourselves and the ones we broker) tend to be grouped in a few main areas, none of which are the Westside, Hollywood, or Miracle Mile.

It’s not that we dislike working in those neighborhoods. In fact, from a purely selfish perspective, it would be great to do business there.

Why?

Because the amount of work it takes to help someone buy a very nicely-kept 4plex in Miracle Mile for $1.7MM is less than the amount of work it takes to help someone buy a beat-up 4plex in Boyle Heights for $550k. And, obviously, we would make a ton more money brokering the former.

So, if we can make more money for less work, why aren’t we doing the deals in the better neighborhoods?

It’s your fault, dear readers.

You see, the vast majority of our brokerage clients come through the blog. And people who read this blog tend to be smart and numerate. And smart, numerate people would laugh in our faces if we tried to advise them to pay 18x GRM, which is what people are paying for 4plexes in Miracle Mile, instead of 11-12x, which you can still find in Boyle Heights (for example).

Honestly, some days I bet our agents would prefer to rep dumb money. But we don’t, and so we’re going to keep grinding out good deals in emerging neighborhoods for smart clients. In the long-run, hopefully that results in a lot of happy, smart clients.

A small problem with putting solar on your roof

There’s a slight problem with putting a solar system on your roof: You may be radically reducing the value of your property.

Now, this doesn’t go for all homes. It’s specifically the case with home in cities where the zoning allows for denser development.

So, for example, consider an old 800 sq ft single family home in Los Angeles on a 6,000 sq ft lot zoned RD1.5.

Regular readers can instantly tell that 6,000 sq ft of RD1.5 zoning allows for the development of up to four units (1,500 sq ft per dwelling unit).

Now, depending on the neighborhood, that property might be worth $400-500k as a home but as much as $800-900k as a small-lot subdivision project.

What does this all have to do with solar?

Well, solar companies typically install panels on your roof for free but require you to enter into a long-term contract to buy power from them (or lease the panels).

Once you sign that deal, that’s it. Neither you nor anyone else can develop the property, because that would mean ripping down the house and removing the panels.

So, if you’re considering putting solar on your roof, make sure that your contract contains some kind of buy-out clause that allows you to get out of it in exchange for a one-time cash payment. Otherwise, you may be massively impairing the value of your property.

[By the way: Hat tip to DL for pointing this out!]

Why I don’t talk about cap rates

About 10 times a week, people ask me what kind of cap rates I expect from our deals. In my answers, I strongly resist using the term cap rate, to the point that people think I’m a little strange.

This is kind of weird, right? Any book you read about investment property is going to go on and on about “cap rate”. So, why don’t I use the expression?

To understand why, you first need to know what it means. “Cap rate” is short for “capitalization rate”. It refers to the annual return, in cash, that an owner can expect to receive by buying a property at a given price WITHOUT a mortgage. You calculate the cap rate by taking the expected net operating income and dividing it by the purchase price.

Notice that the concept is essentially passive: You’re buying a building with NOI in place, for a given price.

For my deals, neither of these is true. I almost always vacate all units ASAP after closing on an apartment building. So, right away, there is no revenue coming in and, therefore, the net operating income is negative (because we still have to pay holding costs, like property tax and insurance, while the renovations are on-going). The net operating income only turns positive after we re-tenant, which is 6-12 months after the project begins.

And, the purchase price is also kind of irrelevant, because we’re going to spend so much money renovating the building. For a typical deal, the purchase price might represent something like 70-80% of the total capitalization of the project. And that’s just the money spent; it does not reflect the ridiculous amount of expertise and effort that goes into transforming a beat up old POS building into a desirable place to live.

What we do is NOT passive; it’s the opposite. You can think of it like this: (new annual revenue – new annual operating expenses)/(acquisition price + rehab cost + holding costs) = “unlevered yield”.

So, that is the expression I use for what we can get: “unlevered yield”.

(In case you’re wondering: Because we do this better than anyone, we can still find deals where the unlevered yield is >8%.)

All about earthquake shut-off valves in Los Angeles

Was at an inspection yesterday and got an interesting question from the listing broker, which I think deserves an answer here.

The building in question, which was built in the late 1980s, had one earthquake shut-off valve installed on each bank of gas meters.

For those who don’t know, an earthquake shut-off valve is a device intended to prevent explosions in the event of a major earthquake. The valve has a mechanism which, when shaken (by, say, an earthquake), shuts off the flow of gas through the gas meter and, from there, into the building. Seems sensible right? You don’t want flammable gas running into a building which might already be on fire.

Here’s a picture of a correctly installed valve:

earthquake, shut off, valve

Anyway, the agent wanted to know if, because this was how the building was built, the building was in compliance with the earthquake value shut-off ordinance.

The answer, per my extremely experienced plumber, is “no”. The requirement is that, prior to close of escrow on any sale transaction, the building must have an earthquake shut-off valve installed for each individual meter.

Obviously, this is annoying, because buying and installing a valve costs something like $300-500 (depending on how many you install – the more you’re doing the cheaper it gets). So, having to install a whole bunch of valves can get pretty expensive pretty quickly.

Still, it’s the law.