Ways into the apartment business

I met with a reader of this blog last week (hi Christina!) to discuss how she could get started in the apartment business. I spent a bunch of time blabbering to her and then realized that some of what I had said might interest those of you who are also considering making a career in this industry.

We discussed several ways into the business. The first was through the property management side. I suggested to Christina that she try to find a resident manager position at a large apartment complex.

Resident managers are typically employees of either the owner or the management company. Their job is to handle maintenance issues (by taking complaints from tenants and making arrangements for repairs), rent vacant apartments, collect rents, and generally keep an eye on the building.

In exchange for the above, resident managers typically receive a free or discounted apartment. And, most importantly for someone trying to get into the management business, they offer experience plus face-time with the management company. Do a good job as a manager of one complex and you are likely to find yourself offered a job with the management company overseeing multiple complexes.

Where do you find these sorts of positions? Well, Craigslist is, as always, a good place to start. You want to go to the main page and click “real estate” in the “jobs” section. Look for listings with “resident manager”, “on-site manager”, etc. in the title. I just looked for five minutes and found seven suitable jobs.

Incidentally, I’ve never understood why more people don’t look for these kinds of jobs – even people who aren’t that interested in real estate. If you don’t have a lot of money and you’re looking to get rich, you could do a lot worse than finding a way to live for free (and thereby accumulate capital by saving).

Selling notes

Here’s an angle on real estate that some lenders pursue: Selling notes.

I was trying to explain this business to Lucy two nights ago as we were lying in bed. Needless to say, it put her to sleep. So please stop reading if you have anything important to do this morning.

Anyway, here’s how the business works: Say a hard-money lender loans a borrower $300k as a first trust deed against a $600k apartment building. The interest rate is 10% / year, interest only. The term is two years. At the end of the two years, the borrower has to pay back the principal ($300k). And let’s say the borrower also pays the lender a 4% fee ($12,000) to close the deal.

During the course of the  two year loan, the borrower is going to pay the lender:

  • $12,000 as a fee
  • $60,000 in interest
  • $300,000 in principal

That’s $72,000 on $300,000 invested for two years, or 12% / year. So far so good.

But the lender has a problem: He needs to wait for two years before he can make another loan. What if, instead, he immediately finds someone to buy the note from him? For example, say he sells the note for $315k to a rich old guy just looking for an easy yield.

The lender immediately gets back his $300k principal. He keeps the $12k fee, plus he gets $15k as a profit. He can turn around and do the same deal again and again, earning fees and profit all along.

Meanwhile, what about the rich old guy? Didn’t he get screwed? Not really: He did not work and is going to collect $60k in interest over two years. So he gets $60k on $315k invested over two years, or 9.5% / year. Not bad, right?

P.S. There are actually brokers out there who do the above without any money of their own at risk at all. They just connect borrowers and lenders and take fees and profit on each deal. It’s a pretty sweet position to be in, but you need to have connections with a bunch of rich people (on one side) and a bunch of hungry borrowers (on the other).

What is the Los Angeles REAP program?

Spend enough time looking at Los Angeles apartment listings and you will find one that says something like “Property in REAP. Looking for an all-cash buyer”. Or, much worse, you might get a letter from the Los Angeles Housing Department (LAHD) threatening to place your property in REAP if you don’t comply with their demands.

So, what is REAP?

“REAP” is the acronym for the Rent Escrow Account Program. It is a city-administered program originally designed to punish slum-lords but now used as a sanction to get all landlords to comply  with Housing Department orders.

Here’s how a property gets into REAP:

  1. A building is found to have problems negatively affecting habitability, either as a result of the regular Systematic Code Enforcement Inspections (SCEP) or an inspection brought on by a tenant complaint;
  2. LAHD sends a “notice to comply” to the landlord specifying the issues, what the landlord must do to fix them, and the date by which the issues must be resolved. Note that LAHD posts the notice on the building and sends it to whatever address they have on file for the landlord; if the landlord has moved and doesn’t ever receive the notice, that’s the landlord’s problem;
  3. If the landlord does not fix the issues, he receives a “notice of a general manager’s hearing” directing him to appear before Helen Morales, the hearing officer, to discuss the violations;
  4. If the landlord doesn’t appear or appears but does not convince Ms. Morales that he is addressing the issue, Ms. Morales sends a “decision letter” placing the property in REAP;

Once you’re in REAP, you’ve got major problems:

  1. Depending on the severity of the violations, your tenants will receive  notice informing them of their right to pay some portion, between 50-100% of their monthly rent, into a rent escrow account controlled by the city instead of to you. Now your cashflow is reduced and your ability to service your mortgage is under threat;
  2. The city records a notice on title of the property being placed in the REAP program. This alerts potential buyers and, more importantly, their lenders, that there is a problem with the property. Until the notice is cleared from title, no one will lend to you or to anyone trying to buy the property from you.
  3. You are charged an administration fee of $50 per unit per month beginning when your property is placed in REAP and continuing until it is removed. These fees are automatically deducted from the rent escrow account and, if there is a negative balance in the account when you try to exit REAP or sell the building, you will have to cover the outstanding fees.

To get out of REAP, you need to:

  1. Fix the original violations (which can be difficult if you have angry tenants who break what you’ve just fixed and / or call in new complaints)
  2. Call in one of the city’s outside tenant habitability contractors for an inspection (more on these guys some other time)
  3. Assuming the contractor passes you, call in a city inspector for another inspection (which you’re billed a few hundred bucks for)
  4. Assuming you pass that second inspection, wait for the property to be voted out of REAP by the city council at their next meeting (this is assured if you pass the inspections, but you still have to wait for the meeting and accrue fees in the interim)
  5. If there is a negative balance in the rent escrow account, pay off the difference in cash;
  6. Get a letter from the city attesting to the fact that the property is out of REAP; and
  7. Get the relevant city functionary to remove the REAP notice from title so that you can freely sell or borrow against the property again.

If you’ve stuck with me so far, you can see that getting your property placed in REAP is a major disaster, mostly because your cashflow from rents is choked off at exactly the time you need the money to pay for repairs and city fees. This dynamic of lower cashflow and higher expenses has forced many, many smaller LA landlords into foreclosure.

I’ve never had a property I’ve owned be placed into REAP, but I’ve bought plenty of properties that were in it when I bought them (we almost always pay cash, so the inability to get a loan isn’t an issue for us). And I’ve had to fight the city to keep them from putting one of my properties in after a SCEP inspection turned up an un-permitted unit.

My advice to anyone facing REAP is to do everything possible to avoid getting your property put in the program.

If it’s too late, and you’re already in, be careful. There are a lot of so-called “consultants” who make money preying on landlords desperate to avoid getting put in REAP (I know,  because I’ve been ripped off by two of them). If you need help, get in touch, and I will direct you to the people who have helped us. You’ll still end up paying plenty of money, but at least you’ll know you’re getting the best possible help.

Should you hold real estate in an LLC?

Lots of buyers ask me about holding properties within an entity like an LLC, instead of in their own names. I’ll share the advice I give them with you, but only if you promise to remember that I am not a lawyer and this is not legal advice.

First, let’s be clear about why someone would want to hold a property in an entity. The advantage is mostly liability protection. By creating a separate entity to own the real estate, you are theoretically placing a shield between the property and your personal wealth. The idea is that, if something bad happens to the property, the badness stops at the entity level, rather than getting to you personally.

Now, let’s consider the downsides:

  1. Tax headaches. If you hold properties in separate LLCs, each one needs to file state and federal tax returns and issue you a K1 each year. That’s a lot of accountants’ time and, therefore, a lot of your money.
  2. Administrative headaches. In order to preserve the liability protection afforded you by the LLC, you need to be careful not to create the impression that there is no distinction between yourself and the LLC. This means separate letterhead, checking accounts, etc. – in other words, more hassle.
  3. Minimum LLC tax. In CA, an LLC with no revenue still owes the state $800 / year in taxes. This number goes up once revenue exceeds $200k (I think).
  4. Incompatible with owner-occupier mortgages. Banks are VERY familiar with the trick of putting an entity into bankruptcy in order to avoid foreclosure. While they’re willing to tolerate (and often encourage) LLCs for commercial properties (in this case, apartment buildings with 5+ units), they don’t like to see them on residential properties (1-4 units).
  5. Dubious liability shield. Courts have sometimes found that there is no distinction between an owner and the LLC (particularly if you screw up #2 above) and thereby allowed plaintiffs to “pierce the corporate veil” to go after the owner’s other assets. The law is somewhat unsettled on this point but you should be aware that the liability shield is far from absolute.

For most starting investors using owner-occupier mortgages, #4 above means that using an LLC is off-limits. If you’re just starting out by buying a small property for investment purposes with cash or an investor mortgage, I still don’t think I’d bother. But once you start getting into multiple properties, I’d try and move them into one LLC (if they’re small) or into separate entities (if they’re large).

For larger investors, funds, syndicators, etc., the gold standard is having each property in it’s own LLC (a so-called “single asset entity”).

All about earthquake insurance

Potential apartment building owners occasionally ask me about earthquake insurance, which is not included in a standard property insurance plan. It’s kind of scary for owners with commercial mortgages, because recourse loans require you to pay up, even in the event of the building being seriously damaged or destroyed.

 

I’ve never bought EQ coverage on any of my properties, mostly because of a vague sense that it was unaffordable (and because we don’t use recourse leverage). But I thought I’d dig into this a little to learn for myself and for you, my dear readers.

 

I therefore arranged to interview John Place, from Winston Insurance via email. I met John when I was buying my first deal and realized literally on the day of closing that I had not arranged any insurance coverage. In a panic, I called him because he had arranged coverage on the building for the previous owner. John got us covered that day, which was amazing. And he’s had all my business since.

 

He doesn’t know this (well, now he does!), but I occasionally shop around to see if his quotes are legit and no one has ever beat him by a material amount.
That said, here’s the interview:

 

Can you get earthquake insurance for a 4 to 12 unit apartment building in Los Angeles?

 

Commercial earthquake insurance is available for habitational risks of four units and up, however, some carriers have a minimum requirement of five units.

 

Is there a good way to estimate the cost based on the number of units or the square footage? (Would appreciate as much detail as possible on this one.)
There are many risk factors underwriters consider to determine pricing; they include the buildings age, construction type, location, if its secured to the foundation, the total insured value, etc.  The biggest price determinant being what EQ zone the property is located in.

 

Do you sell much earthquake insurance to LA apartment building owners? Why or why not?

 

We insure quite a few clients with multiple unit dwellings.  While the potential catastrophic damage that may occur from an earthquake is a concern for most of our clients, it does not appear to be a strong motivator for acquiring earthquake coverage.  For many, the cost is prohibitive.  I also believe the longer we go without a major earthquake the less important the coverage seems to be.
Is there anything in particular a building owner should know before he goes shopping for earthquake insurance?
An owner should understand that the decision to obtain coverage is a personal one.  There’s no right or wrong answer…the coverage is not required by law.  Earthquakes are inevitable, however, they’re unpredictable in both their magnitude and destruction.  The decision to obtain coverage is simply a matter of affordability and ones own risk tolerance.
Can you give me a ballpark quote on earthquake coverage the following building:
  • 8 units
  • 4800 sq ft
  • Zip code 90026
  • 1960s
  • Stick / stucco construction
  • No tuck-under parking
  • Rents of $1,000 / month each, so $96,000 / year
Including loss of rents of $96,000 for the example given and depending on the deductibleselected; the pricing  ranges from $0.74 /$100 of property value ($8,100 pure premium at 15% deductible) to $1.12/$100 of property value ($12,300 pure premium at 5% deductible).

 

The insurer  would then add taxes/stamp fee (3.25% of premium) and any inspection/policy/broker fees to the premium.

 

These property rates may fluctuate slightly from carrier to carrier.

If someone wants to buy insurance through you, how should they get in touch with you?
For a quote [MK: on EQ insurance or any other type], I can be reached at 909.581.7218, or email me at john@winstonins.com.