Moses Kagan on Real Estate

Archive for the ‘Income Property Benchmarks’ Category

How following one dumb rule of thumb cost me thousands of dollars

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When I first started buying buildings, I needed a quick and dirty way to estimate operating expenses.

I hadn’t owned any buildings long enough to have historical data upon which to base assumptions.

At the time, I was using an accountant who knew just enough about real estate to be truly dangerous. I asked him if he had a good rule of thumb. He told me to estimate that operating expenses would be approximately 35% of rents.

That sounded reasonable, so I proceeded to underwrite a whole bunch of deals using that 35% expense margin to calculate the yield I would be able to achieve by buying and renovating apartment buildings. Keep in mind this was 2009, when things were very, very cheap and I was trying to leg into 8% unlevered yields (that was my threshold for whether to do a deal or not).

Do you know why it is really stupid to use a blanket 35% expense margin to estimate NOI for a repositioned building in CA?

  1. When you buy a cheap building and renovate it to raise the rents, your property taxes are going to remain pegged to the acquisition price. Since you will presumably add a lot of value to the deal, your property taxes should comprise a lower portion of the expense mix than they would if you acquired the renovated building for fair market value. Treating the renovated building the way you would the acquired building will lead you to over-estimate property tax on the renovated building;
  2. There is no difference in the expense an owner bears when renting out a $1500 1 bed / 1 bath vs. an $1800 1 bed / 1 bath. Both units will use  the same amount of water, generate the same amount of trash, break things at roughly the same rate, etc.. If you blindly estimate 35% expense margins, you will be charging yourself 35% of that $300 difference in rents, $105 / month, for no reason. $105 x 12 = $1260 in annual NOI. If you put a 7% cap rate on that, it means you’re stupidly vaporizing $18,000 in value. Spread over, say, 6 units, that could be the difference between doing the deal or not.
  3. When you replace all of the plumbing and electric and all of the appliances, as we do on almost every building, you’re going to have lower maintenance bills because **NEWS FLASH** everything is new.

As a result of my stupid reliance on the 35% rule, I systematically over-estimated expenses on every deal I underwrote.

The good news is that the deals we actually did turned out to be 9-10% yields, instead of 8%.

The bad news? I passed on probably 5 deals that I desperately wish I had done. I conservatively estimate the lost earnings to me personally in the low hundreds of thousands of dollars. All because I relied upon a short-cut without actually taking the time to think through the implication.

Do you know what I should have done? Taken the time necessary to get some reasonably accurate estimates for the annual operating cost per unit and applied those to my pro forma stabilized (eg post-renovation) rent roll. That’s what I do now.

Written by mjkagan

04/02/2014 at 5:44 am

What is a good NOI?

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I see what people search on Google that brings them to my blog. This was a question yesterday that I thought begged for an answer.

First, let’s review what “NOI” is. It’s “Net Operating Income”, or what’s left over after you take in your rents and pay out all of your expenses, including property taxes, but not including mortgage payments or income taxes.

For example: Say you have a duplex where each unit brings in $2k / month. Let’s say the property taxes are $6k / year and the other expenses (property insurance, maintenance, utilities, etc.) are $10k / year. The rent is $2k x 2 = $4k / month x 12 = $48k / year. The expenses are $6k + $10k = $16k. So, the NOI is $48k – $16k = $32k / year.

Sounds good, right? Well, knowing the NOI number without know the price of the asset is kind of meaningless, and that’s the problem with the question that is the title of this piece.

Imagine you paid $5MM for an apartment building, all cash (so there’s no mortgage payment). If the NOI is $32k / year, the return on your $5M investment is $32k / $5M = 0.6%. 0.6% / year is a horrific return. [Note: Regular readers probably recognize this calculation as a CAP rate, which is NOI divided by price.]

Now imagine you paid $350k for that same asset. Now you’re making $32k on a $350k investment, or $32k / $350k = 9.1%. Getting to a 9.1% cash-on-cash return is pretty incredible!

Bottom line: Knowing the NOI alone is somewhat meaningless. You need to know what someone is asking you to pay for that NOI to figure out if you want to own it.

Written by mjkagan

08/26/2013 at 4:41 am

Why every last dollar of rent matters

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Sometimes people question why it’s so important to get that last dollar of rent.

On a $2800 apartment, does an extra $100/month matter? After all, $100 is only 3.6% of $2800… no a big deal, right?

Wrong. Here’s how we think about rent in our business:

So, if you ask me to take $100 / month less in rent, you’re asking me to light $14,400 on fire. Which I’m probably not going to do.

A final note: Implicit in the above calculation is the idea that you are going to sell the building. If you’re not, then getting that last dollar is a bit less important. After all, charging a bit less rent reduces turn-over (because your units are a bit under what the tenant can find somewhere else). So, particularly in a non-rent control building, it’s not unreasonable to take a bit less, once you factor in the costs of turning units over (maintenance, lost rent while its vacant, leasing commission to refill it).

Written by mjkagan

07/29/2013 at 11:36 am

How not to act in a rising interest rate environment

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We’re living in a world of rising interest rates, which are already fundamentally changing the real estate market.

As discussed yesterday, as interest rates rise, prices should fall, all other things being equal. That’s because more expensive debt means reduced cashflow and lower returns at a given price.

But, all things are not equal. In general, assuming a normal economy, interest rates should only rise when things are improving. Why? Interest rates are effectively the price of borrowing money. When the economy is bad, and there is not much opportunity, no one wants to invest in new opportunities, so the demand for money is low and the price (the interest rate) falls.

On the other hand, when the economy is promising, everyone wants to borrow to expand their businesses, buy assets, fund consumption (cars, boats, etc.) So, demand for money increases and interest rates rise.

The fact that interest rates are going up isn’t necessarily such a terrible thing. It is, in fact, a strong signal that the economy is improving.

The trick for real estate investors is to figure out how to benefit from an improving economy without being hurt unduly by the rising rates.

Here’s an example of what not to do:

  • Pay a high price (say, over 11x) for a rent controlled property with tenants at below market rents
  • Use a 3- or 5-year fixed rate loan for a very large portion of the purchase price (say, 75%)

Why is that a bad play?

  • You paid a high price, so your cashflow is pretty slim to begin with;
  • Your tenants aren’t leaving, so you’re limited to increasing the rent by the city-mandated 3% / year, meaning that you’re not really benefitting that much from improvements in the economy;
  • Interest rates go up in the interim, maybe to 6-7% (they were that high as recently as 2008);
  • After 3 or 5 years, your rate comes unlocked and your debt payments increase, eating up most/all of your slim cashflow;
  • When you go to refinance, depending upon how much multiples have dropped as a result of the increased interest rates, you may find that you lack the equity necessary to refinance and are therefore stuck with whatever rate your loan has adjusted to.

The above is pretty obvious to me, and yet I see poorly advised investors buying exactly this type of deal all the time.

Tomorrow, we’ll talk about some better strategies for investing in a rising interest rate environment.

Written by mjkagan

07/11/2013 at 12:25 pm

Whole lotta building going on…

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In our areas (Silver Lake / Echo Park / etc.), there are tons of small lot subdivision projects in the works.

Off the top of my head, I can think of at least four projects going in right now, and there are definitely more that I’m forgetting.

So, the question for all of us apartment people, is: What will be the effect on rents in our neighborhoods from the coming wave of for-sale single family homes on tiny lots?

To answer that question, we need to be able to compare the monthly expense of renting to owning.

From speaking with a lot of developers of this kind of product, the pricing developers expect is generally in the $650k+ range for a 1500 sq ft home ($433 / sq ft). At 4.5% interest, the monthly payment required for a $520,000 mortgage (80% of $650k) is around $2,634. Property tax is around $680. Insurance is probably $150. And there are probably home owners’ association dues of $50. That’s a total of around $3,500 / month.

It’s important to remember that almost all of that is pre-tax money (since both mortgage interest and property tax are tax deductible) – so that $3500 is equivalent to paying something like $2000 in after tax money.

If you know our area at all, you know that renting a 1500 sq ft home in very good condition is likely to be $3,000+ / month in after-tax money (since rent is not tax deductible).

That means there’s roughly $1,000 / month in after tax savings if you buy. That’s $12,000 / year on your downpayment of $130k (20% of $650k), or 9%.

Bottom line: If you’re looking for a large place, you’re probably going to be better-off buying rather than renting, assuming you have the dough and the credit. So all of us in the apartment business need to be considering whether the rents we are getting on larger units are sustainable.

Written by mjkagan

07/02/2013 at 5:01 am

University Park Rent Survery

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Today, we’re looking at rents in the USC University Park area. It’s an older neighborhood, centered on the University, with loads of old Victorian and Craftsmen homes in various states of repair.

Situated between downtown and South Los Angeles, there is easy access to the 110 and 10 freeways and the Expo Metro line.

Given the proximity to campus, much of the rental housing is geared towards students, pushing rents higher than usual for an area where the median income is under $20,000. Unlike many of the other neighborhoods surveyed recently, there is quite a bit of inventory, albeit at much higher prices.

Here are the highlights of our survey:

  • Median asking rent for one bed / one bath units was $1395 / month
  • Median asking rent for two bed units was $1900 / month.
  • Median asking for three bed /on bath units was $2,200 (the sole 3/3 unit was listed for $3,000)

Aspiring landlords in the area ought to remember that renting to students is not like being a normal landlord. You end up dealing with turn-over every year, loads of wear-and-tear on the assets, and rent collection issues. My strong advice if you’re thinking of becoming a student housing landlord is to get the parents to co-sign all leases and collect very large security deposits. Consider yourself warned!

The fine print: For our rent survey, we looked at apartments for rent in the area defined as USC University Park by the LA Times neighborhood mapping project. Here’s the raw data: University Park Rent Survey 3-12 (1) 

Written by mjkagan

03/14/2013 at 9:32 am

Silver Lake income property numbers from Q4 2012

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Small apartment building pricing in Silver Lake continues to be very strong, driven by continued gentrification-driven demand, low supply and historically low interest rates.

We ran the numbers on deals for 2-4 unit buildings in Silver Lake (as defined by the LA Times) that closed between September 1 and December 31, 2012, are here’s what we found:

1. 17 deals closed. That’s an active quarter, but not a crazy one. 

2. Sale prices came in at 99% of list. There were very few instances where buyers got real bargains; mostly, sellers got what they asked for.

3. Median price per square foot was $286. This one was influenced by REOs and at least one property that is a tear-down and sold for land value only.

4. Median gross rent multiple of 15.2x. Unbelievable. There’s little to no return on the cash used for a downpayment if you pay 15x. So these buyers are basically betting on appreciation. Not a crazy bet, but why not just buy a house and save yourself the hassle of dealing with tenants?

If you own one of these properties, now would be a good time to think about investing to see if you can capture higher rents and, thereby, increase the value. But we’re not quite at the point in the cycle where I would advise selling, unless you’re a pro looking to crystalize profits you’ve already created.

The fine print: This data came from a search of closed deals on, augmented by my estimates of rents for units which were vacant at closing. Here is the underlying data: Silver Lake 2-4 Unit Sales Q4 2012.

Written by mjkagan

01/11/2013 at 3:58 am

Checking in on the East Hollywood income property market

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I’m on the record repeatedly extolling the virtues of owning in East Hollywood. I generally think owners there underestimate the achievable rents and that buyers can therefore occasionally find deals that makes sense, even at today’s inflated prices.

Today, I figured I’d check in on the income properties on the market in East Hollywood to see what I can see. Note that, for the purposes of this piece, I am using the LA Times neighborhood map for East Hollywood but excluding the area to the west and south of the 101. Why? Because I don’t think those areas have the same appeal to tenants as the areas closer to Silver Lake.

Here’s a map of the area under consideration:

As of November 25, here are the numbers on 2-4 unit income properties in the area:

  • 12 total properties (excluding what is technically a duplex on Sunset but which is being used as a commercial property currently)
  • Median price per square foot of $249
  • Median gross rent multiple of 14.6 (ludicrously high, in my opinion)
So, what’s going on here? A few thoughts:
  • Some of these properties have been sitting on the market for a while (for obvious reasons)
  • Because these are 2-4 unit deals, its conceivable the sellers / brokers are hoping that an owner occupier will come along and over-pay because they fall in love with the property (don’t be this kind of sap, please!!)
  • Brokers and owners may be becoming aware of what is possible rent-wise, but don’t have the means or the energy to remove their rent controlled tenants. So they are pricing the properties without regard for the rent control and hoping a buyer stupid enough to ignore the rent control will come along (this happens, believe me).

Big picture: If landlords in East Hollywood are going to ask Silver Lake prices, so might as well just buy in Silver Lake.

Written by mjkagan

11/27/2012 at 4:18 am

West Hollywood Rent Survey – November 2012

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This week, we’re looking at rents in West Hollywood. Keep in mind that West Hollywood is its own city, separate from Los Angeles and with its own rent-control law. Also, West Hollywood has historically had a fairly progressive view on development, meaning that the city is dense and there are lots of apartments.

All of that said, let’s check the rents for November 2012:

  • Median rent for a studio apartment was $1225 / month, with 50% of the units having parking
  • Median rent for 1 bed / 1 bath apartments was $1599. There was quite a range – the cheapest 1/1 was $1195 and the most expensive was $3550;
  • Median rent for a 2 bed / 1 bath was $1900. Supply was limited, with only nine units on the market when we checked.
  • Median rent for 2 bed / 2 bath was $2298. Almost all units had parking and there were plenty to choose from, with 34 units on the market
  • Finally, for families, there were five 3 bed / 2 bath units on the market with a median rent of $3200.

The fine print: Our survey was based on a search of Craigslist apartment listings using the keyword “West Hollywood” on 11/4-5/2012. We checked all addresses to ensure the units were in West Hollywood (as defined by the LA Times neighborhood mapping project); any units without an address specified were removed from the survey. For the raw data, click here: Final West Hollywood Rent Survey – Nov. 2012

Written by mjkagan

11/14/2012 at 9:29 am

Venice Rent Survey – September 2012

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Time for another look at rents in a gentrifying (gentrified?) neighborhood in Los Angeles. This time, we’re heading over to the Westside to take a closer look at Venice.

Here are the highlights:

  • Median rent for studios was $1,275 (lower than I would have expected);
  • Median rent for one bed / one baths was $2,575;
  • Median rent for two beds was $3,690; and
  • Median rent for three beds was $4,300;

Interestingly, for 1/1s and larger, almost every single unit came with parking, which is definitely not the case in some other gentrifying neighborhoods (Silver Lake and Echo Park, for example).

The most expensive unit on the market is the Venice Beach Penthouse, a pretty amazing two bed on top of a building right on the beach. That one will set you back $12,500 / month. (For what it’s worth, that’s your payment on a $2.5MM mortgage!)

The cheapest unit was a $900 studio about a block from the beach. But don’t get too excited… you have to share a bathroom with the other units on your floor. Still, it’s $900 in Venice.

Finally, a note about the data in this survey: It’s only the 17th of September as I write this. Usually, apartments don’t rent until the third weekend of the month. But when I went back to pull out the best deals to post here, all of the ones I liked were already taken. That, right there, may be the most salient data point of all about the Venice apartment market.

The fine print: Our survey was based on a search of the apartment listings on Craigslist for the word “Venice” on September 13, 2012. We only included listings where an address was available and the property fell within the boundaries of Venice as defined by the LA Times neighborhood mapping project. For the raw data, click here: Venice Rent Survey – September 2012.

Written by mjkagan

09/18/2012 at 4:28 am