When to order the appraisal

Recently, the question of when to order the appraisal has caused problems for us on two deals, so I thought I would address it here.

Just so everyone is clear on what we’re talking about: When you use a loan to buy a building, the bank requires an appraisal be conducted. Depending on the size of the deal, the appraisal will cost anywhere from $800 all the way up into the low, single digit thousands.

There is a temptation for the buyer to put off ordering the appraisal. After all, she wants to do her inspections, find out if there is anything wrong, and then figure out if the relevant problems can / will be addressed by the seller before going ahead and risking the money for the appraisal.

But giving in to this temptation is a major mistake.

Here’s why: The whole aim of a well-conducted contingency period is to get the buyer into position to buy the building as quickly as possible. When I say “into position”, I mean “in possession of all of the relevant information regarding the property, including the physical condition, the tenancies, (critically) whether the bank will make the loan necessary to close”.

Once the buyer is in position to buy the building, it’s pretty easy to work out a deal between buyer and seller to address any issues with the property. The reason it’s easy is that the buyer can say “Buyer hereby agrees to remove all contingencies (and move forward with the deal), conditional upon Seller agreeing X”. This is a great position to be in, because the Seller’s broker can really lean on the Seller to accept, knowing that, if she does, the deal is done.

How does this relate to the appraisal issue? Well, the longer the Buyer waits to order the appraisal, the more time it takes for the Buyer to get in position to move forward with the deal. During that time, the Seller is, quite understandably, getting antsy… Did something come up on the inspections? Have they decided to buy something else? Are they planning some insane price chip? The longer this goes on, the more trust is lost and the harder it is to negotiate any credits necessary to make the deal palatable to the Buyer (eg the “X” in the above example).

So, here’s the deal: When you’re buying with a loan, inspect the property on day 1 of the contingency period. Assuming there are no obvious, huge, horrible red flags, order the appraisal immediately thereafter.

Yes, there is a chance you’ll have wasted that money. But the more likely scenario is that, because you will be in a position to remove contingencies sooner, you will be in a much better position to negotiate the removal of contingencies, where the amount of money at stake make the $800 appraisal fee look like peanuts.

Beware of setbacks!

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.

Avoiding a pretty painful “oops”

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.

How a good contractor handles inspectors

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!).

Never lose units

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.