Recourse vs. non-recourse

There is a major, major difference between recourse and non-recourse loans, as developers all over the country have found out to their distinct displeasure over the past few years.

A recourse loan is a loan where one or more of the borrowers agrees to personally pay back the loan, regardless of what happens to the property. If the loan payments are not made, the loan documents give the bank the right to go after the borrowers’ personal assets, like their houses or other assets. This makes recourse loans pretty safe from the bank’s perspective, and pretty dangerous from the borrower’s perspective. For example, say the neighborhood changes and, through no fault of the borrower, the rents go down, making the building unable to carry the mortgage. If the loan is recourse, that’s the borrower’s problem.

A non-recourse loan is one where the bank’s only choice, in the event of non-payment or other default by the borrower, is to take the property. In California, all residential loans (for properties of 1-4 units) are non-recourse by law. For larger properties of 5+ units, getting the bank to give you a non-recourse loan usually means paying the bank a slightly higher interest rate in exchange. In the example above, the borrower could theoretically walk away from the building, losing whatever downpayment he had but avoiding any additional penalty.

In my opinion, it is nearly always worth paying the premium to avoid recourse (so long as that premium is reasonably priced). Obviously, no borrower ever wants to default. For me, paying back all of the money I have ever borrowed is a point of pride and honor. But you never want to put yourself in a position where a deal going bad could cost your family their home or retirement savings.

One more thing to keep in mind: It’s incredibly important to pay close attention to the loan documents. Almost all non-recourse loans contain what are called “bad-boy carve-outs”. These are terms which mean that, if the borrower takes certain actions, the loan automatically changes from non-recourse to recourse. They’re called “bad boy carve-outs” because the actions they mean to prevent are things like lying on the loan applications, stealing rent money, failing to maintain the property, etc. So even if you have what you think is a non-recourse loan, be careful to continue to behave in an honorable way, lest problems with the asset rebound on you (which is what you were trying to avoid by going non-recourse in the first place!).

How you improve the neighborhood

Sometimes all you need to do to improve your neighborhood is to yell at a priest.

My brother and I own a 16 unit building on Reno St (the one from this story) that’s across an alley from a new church, one of those Latin Pentacostal deals.

The street itself isn’t the nicest one in LA, but it’s not terrible. We try to do our part by making sure that the strip of grass outside our building looks like this:

And here’s how the same strip of grass looks outside the church:

The last time we had our building appraised, I was literally on my hands and knees picking up trash up to the minute before the appraiser arrived because I was so paranoid about the impression the trash would leave on her. (See how glamorous it is to own a building?!)

I’ve been steaming about the trash for months.

Finally, the other day, I was at our building picking up the laundry money (again, the glamor!) and decided on a whim to call the church. I figured I’d get some voicemail, leave a message, and no one would ever do anything about it.

Turns out I was wrong. The minister got on the phone right away and spoke to me (in Spanish). He was super nice and understanding. He assured me the church would clean up. And they did.

Now our litte corner of “Silver Lake -adjacent” is a little less gross. I wonder how many other owners out there would benefit from doing the same thing.

Should I hire a property management company?

Not now, maybe later. That’s it, in a nutshell. Here’s what I mean:

On your first building, likely a 2-4 unit building acquired with an FHA mortgage, you don’t want or need a manager. First, you need to learn a bit about the business –  what it’s like to fill vacancies, collect rents, deal with maintenance issues, etc. Second, the 5% of the rents that you pay a management company is money you want to help pay your mortgage. So I recommend against hiring a management company at first.

But I definitely recommend hiring one later, and here’s why: Management doesn’t scale. As you add more units, you add more headaches. This is why my parents, who’ve owned apartments for 40 years or something, never got to be really big landlords. They always insisted on managing themselves. They got every call in the middle of the night, dealt with all the tenant BS, etc. And because of that, they never felt like going to the next level, because it would have added a ton of stress to their lives.

They should have done what we did at first: Hire a competent management company and focus energy on finding and buying more units. In LA, you can get a good management company for roughly 5% of the rents collected, plus expenses (for things like materials and labor for fixing problems, etc.) – that’s a small price to pay to get back your time.

(Incidentally: keep in mind that managers rarely make money on that 5%. Instead, they manage in order to develop a relationship so you’ll use them as brokers when you buy or sell, which is where they make their real money. Read the management contract closely – you’ll almost always find that it includes the manager getting the right to act as broker should you choose to sell the property during the course of the management contract. This is not necessarily unfair, but you should always be aware of what you’re agreeing to before you sign.)

So go manage your first building yourself. But when you’re ready to move out and buy another one, consider hiring a good manager to take over for you. It costs more in the short term, but it’s the only way you’re going to have the time and energy to buy a lot more units. And that, after all, is what this is all about.

How do apartment buildings increase in value? And how can you benefit?

When you put a bunch of money and time into an asset, you want it to increase in value. Obviously.

So you might ask: How does an apartment building increase in value?

Remember: An apartment building investment made correctly should cashflow to you every month, so you make money as you go along. But an increase in value is the icing. Here’s how it can work:

  1. Rents go up as your building or the neighborhood improves. All things being equal, higher rents equal higher profits. So if you pay $1.43MM for $100,000 in profit (a 7 cap) and the profit goes to $120,000, even without any change to the prevailing cap rates, your property should now be worth $120,000 / .07 = $1.71MM.
  2. More people want to own in the neighborhood, driving prices up and (therefore) cap rates down. Say you buy the 7 cap for $1.43MM. Say the rents and, therefore, the profits don’t change. If the prices are bid up such that the prevailing neighborhood cap rate falls from 7 to 6, your property went from being worth $1.43MM to $100,000 / .06 = $1.67MM.
  3. The combo platter. The best outcome is, of course, the rents go up and the cap rates come down. If your profit goes to $120,000 and cap rates fall to 6, the property you bought for $1.43MM is now worth $2.0MM.

There are two ways to take advantage of increases in value:

  1. Sell. Maybe you sell, do a 1031 exchange, take your profits tax free, and invest them in another building in a part of town that’s cheaper but improving. But I don’t recommend it, since you can…
  2. Re-finance. The amount of debt you have on a building is fixed or trending downward, depending upon the type of loan. So any increase in the building’s value accrues to you, the owner, in the form of equity. More equity means you can borrow more. Say you bought that original $1.43MM building with a loan of $1.07MM and a downpayment of $360,000. Now say it’s worth $2.0MM. You can go re-finance for 75% of the value, or $1.5MM. You pay off the original loan of $1.07MM and pocket the remaining $430,000 tax free AND keep your building. Booyah.

 

Legalese: I’m not a lawyer or an accountant and this is not tax advice. 

 

Should you post a “For Rent” sign on your building?

No.

Or, at least, not unless your building is on a high traffic street.

Why? Because posting a sign does two terrible things:

  1. It makes your building look cheap. Useful signs are large enough for people driving by to see. Signs that large are almost always tacky and horrible. Do you want your building to look tacky and horrible?
  2. Posting a “For Rent” sign is a signal to your other tenants that you have vacancy. This is a golden opportunity for them to come to you for a rent reduction. Do you want to have all your tenants ask for rent reductions?

Given the above, why would I post a “for rent” sign on a building on a high traffic street? If you’re on a high traffic street, and particularly if you’re on a corner, the benefits of posting the sign (in the form of increased rental inquiries) probably outweigh the drawbacks.

But not all signs are created equal.

A good “for rent” sign is done in tasteful colors that attract attention without looking cheap. A good sign has a strong call to action: It tells the person who sees the sign how s/he can can proceed. If you are on-site, a good sign tells people to come on in to see a unit. If you’re looking to get phone calls, then give them a number to call.

If you do end-up posting a “for rent” sign, just remember to take it down IMMEDIATELY after the vacant unit is rented. Leaving it up ensures that you pay the costs of having it posted (see above) for no reason. And that’s just dumb.