What we’re against

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.

How we value apartment buildings (part 2)

In my last post, I talked about how our approach to valuing apartment buildings derives from my experience as an investment banker trying to value media and technology companies.

Simply put: When you’re trying to get a sense for the value of an asset in an illiquid market, you want to use all of the tools available to you.

For apartment buildings, here’s what we do:

1. Consider the property as a straight buy-and-hold / yield deal

This one is pretty simple. We assume the buyer of the property will be a rational investor looking to achieve a reasonable yield on the cash she will use to acquire the property.

We build a model of the property incorporating the rents it commands, reasonable estimates of the expenses, and appropriate financing structure(s). Then, we input a range of potential valuations, which results in the model outputting a range of potential yields an acquirer could expect to achieve.

Since we’re working with loads of buyers at all times (and buying for ourselves as well), we have a good sense for the yields buyers demand in the areas in which we’re active. One good way to think about valuation is to select the price at which a buyer would achieve the minimum yield which we have found buyers willing to accept.

2. If 2-4 units, consider as owner-occupier deal

Ah, but not all deals are acquired by rational investors. For certain properties, usually 2-4 units with at least one unit desirable, 2+ bedroom unit delivered vacant, an owner occupier will sometimes be willing to pay more than a rational investor would.

Why is this? People are irrationally excited to own their own homes. All the proof you need is right there in the sales data for single family homes. In Southern California, you can easily rent a home for $4,000 / month which would sell for $1,000,000. At 20% down and $800k borrowed at 4.5%, the owner’s monthly out of pocket expense is something like $5,500 / month. One way to think about the difference between the $4,000 and $5,500 numbers is that this is the premium people are willing to pay to be an owner rather than a renter.

So, when we are asked to value an income property which might appeal to an owner-user, we try to price in an ownership premium for the owner’s unit… in other words, we can confidently consider valuations for the building which result in the new owner paying more out-of-pocket each month than the unit would rent for.

3. Evaluate as re-positioning opportunity

There is a big category of deals that just don’t make sense as buy-and-hold / yield deals. These are typically properties with tenants paying far under-market rents. At a certain point, the rents are so low that a price derived from applying a standard yield to the expected cashflow would result in a ridiculously low price / sq ft or price / unit.

These are the deals we love to buy. So, we know the economics better than anyone.

By working backwards from the new rents possible in the property and incorporating an estimate of the profit a new owner would want to achieve for doing the hard work of repositioning the building, we can get at the maximum price this kind of buyer would be willing to pay for the property.

4. Evaluate as a development deal

You would be amazed at how few brokers think to check the zoning of properties they are valuing for sale. This is usually not a huge deal, because pretty often the existing structures are built pretty much to the maximum density that the lot allows. But, every so often, there are major, major exceptions.

I’ll give you one from my own career: I bought a 15 unit (with 1 additional, non-conforming unit) in 2009. Without stopping to consider the zoning, I totally rehabbed the building and re-tenanted it. Then, sometime later, I realized that the property was zoned for 26 units. I might have been better-off tearing down the building and building 26 units in its place.

Anyway, whenever we are valuing a property, we consider what a developer would do with the lot. We look at how many units can be built, how much it would cost to build them, what the resulting building would be worth, and how much profit a developer could expect.

Usually, the valuation resulting from this method is lower than from the other methods (after all, it implicitly values the existing structure at zero). But, every once in a while, it turns out that the land is more valuable for development than in its existing configuration.

Pulling it all together

The result of the above valuation methodology is to clarify what prices different kinds of buyers can afford to deliver for a property. This gives us (and the owner) a sense for the highest price likely to be achieved in a sale.

And, very importantly, it lets us know how best to market the property. For example: If what you really have is a land deal, it does no good to spend a bunch of time and money on staging and taking pics for the MLS, since the likely buyer is going to tear the place down, anyway. On the other hand, if you have a property that will work owner-user, then you want to spend some time and money really marketing that owner unit, because that’s how you’re going to get the best price.

Are you considering selling? Want to make sure your sale process is run in an intelligent manner? Get in touch and we’ll come run the numbers for you and discuss the right strategy for extracting maximum value.

Amnesty for illegals (apartments, that is)

Per the LA Times (and via Curbed): Landlord and tenant groups in LA are uniting around an initiative to allow landlords to legalize non-conforming apartments more easily.

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:

  1. 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;
  2. 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!


The math behind discovering a new neighborhood

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).

An effective wealth building strategy

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.