Moses Kagan on Real Estate

Archive for the ‘Income Property Benchmarks’ Category

A pretty amazing success story

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Yesterday, I got a call from one of the first people for whom I ever brokered a deal.

He is in the process of refinancing the mortgage on the small apartment building I helped him buy. He was calling to see if I had any tips for his upcoming appraisal.

As I always do before an appraisal, I pulled the comps to see where the value was likely to come out (and maybe provide the appraiser with some PARTICULARLY relevant comparable transactions).

Before I tell you where value came out, let me set the stage. He bought his ~3,000 sq ft building in Echo Park for ~$730k. He put down ~$36k (was an FHA loan) and spent maybe $75k on renovations.

The comps are showing a valuation range of $400 / sq ft. That implies a value of around $1.2MM. (Though, of course, who knows where an appraiser will come in!?)

So, ignoring transaction costs and not accounting for loan amortization since the transaction (because I’m being lazy), his $111k investment is now worth ~$506k.

How did this happen? Pretty simple, really: Lots of leverage and spectacular timing.

Written by mjkagan

12/03/2014 at 10:29 am

If I were a broker…

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…who didn’t also renovate tons of apartment buildings, I would:

  • Run rent surveys across all relevant neighborhoods, all the time
  • Constantly poll my clients about construction costs for different finish levels and unit sizes
  • Constantly poll my clients about eviction / tenant relocation costs

Why would I do all these things?

Because, without the above information, I would:

  • Ignore some deals which I absolutely should push my clients to buy; and
  • Push my clients to buy some deals they absolutely should not buy.

Both of the above mistakes would cost my clients money (either in bad deals or missed opportunities) and therefore cost me credibility.

Fortunately for me and for our clients, Adaptive does so many renovation projects in the relevant neighborhoods that we know better than anyone what the above numbers actually look like. That doesn’t mean we don’t make mistakes, but it does mean those mistakes are rarer and less costly than they would otherwise be.

Written by mjkagan

10/20/2014 at 10:20 am

Taking apart a deal: An East Hollywood Duplex

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Today, I’m going to try something new: Taking a look at a deal in one of our neighborhoods so that we can get a sense for what the numbers look like for the new owner.

So, let’s take a look at an East Hollywood duplex that sold yesterday. I should start out by saying I didn’t offer on the property and do not know the agents, the buyer or the seller. So I have no special information about anyones’ motives here. My intention is just to take a look at the deal from several different perspectives to see if I can figure out why the buyer chose to buy this particular property at this particular price.

Here is the headline information from the MLS and ZIMAS:

  • List price: $549,000
  • Sale price: $563,000 (so, above list)
  • Two 2 bed / 1 bath bungalows totaling 1,443 sq ft
  • 6,200 sq ft lot zoned RD1.5
  • Rents of $851 and $557 (so, $16,896 / year)

And here are some ballpark estimates for the actual annual costs of ownership:

  • Property tax: $563,000 x 1.25% = $7,037.50
  • Insurance: $1,800
  • Water/sewer: $1,200
  • Gardener: $1,200
  • Pest control: $550
  • Repairs and maintenance: $1,800

So, my guess is that the total annual costs of owning the property are approx. $13,600.

Let’s take a look at this deal through a few different lenses in order to see if we can understand what the buyer was thinking.

Buy and hold investment deal

The first, and simplest way to think about this deal is as a buy and hold where the new owner is just hoping to sit there, collect the rent, pay the expenses and keep whatever is left over as a return on his money. For simplicity, let’s start by assuming the buyer pays all cash. Assuming the above numbers are correct, the owner pays $563,000 in cash and gets, in exchange, $16,900 (rents) – $13,600 (expenses) = $3,300 in net operating income.

Then, divide the $3,300 NOI by the purchase price of $563,000 to get your cap rate… or, on second thought, don’t because you’ll plotz (that’s Yiddish for “drop dead”). All I’ll say is that, if you know anyone who’s interested in investing $563,000 of their hard-earned money in exchange for a return of 0.5% annual, please send them my way.

Probably someone reading is thinking “Ah, but what if you borrowed the money, rather than paying cash”? Well, that’s even worse. Say the buyer borrowed 75% of the purchase price ($422,250) at 4.25% fixed for 30 years. His mortgage payment is 2,077 / month, or $24,924 / year. Of course, he’s getting $3,300 in NOI, so his actual annual cashflow is only $-21,624. Another way of saying that is: For the pleasure of investing $140,750 of his cash, he gets the right to lose $21,624 in the first year. Again, not something I’d recommend!


Ok, but some of you are thinking, what about if the owner intends to move into one of the units? Does that make this a reasonable deal? Let’s see…

Owner-occupier needs to live in the property, so will have to relocate one of the two tenants. Because both tenants live in similarly sized 2/1 bed units, the city will force the owner to bump the tenant who moved in more recently, which is presumably the one paying $851. The cost of doing so will be around $15k, plus whatever the new owner wants to spend fixing up the unit for him/her to live in.

Let’s assume the new owner buys with a mortgage, because no owner-occupiers buy beat-up duplexes all cash… people that rich don’t live in beat-up duplexes!

What do the numbers look like? Well, the annual expenses are still $13,600. The rent from the remaining occupied unit is $557 x 12 = $6,684. That means the new owner will have to cover $13,600-6,684 = $6,916 / year in expenses out of pocket, or $576 / month. But there’s also the mortgage to consider… which is going to be $2,077 / month.

So, our new owner-occupier would be putting down $140,750 plus $14k for the tenant relocation plus, say $15k for renovations to the unit, for a total of $169,750 for the privilege of paying $2653 / month to live in an apartment which he could probably just rent for $2200. That, friends, is a terrible deal.


Maybe our buyer is a developer. Maybe he doesn’t care about the existing rents or structures and is instead going to build something new on the lot.

Here’s what he’s thinking:

  • 6200 sq ft lot
  • RD1.5, meaning 1,500 sq ft / dwelling
  • So, 6200 / 1500 = 4 dwelling units (you always round down with zoning calcs like this)
  • That’s [$563,000 + ($18,600 x 2)] / 4 = $150,000 per unit of developable land (the $18,600 is what you’d have to pay to reloc each tenant under the Ellis Act)

The simplest way to go would be to try to build four 800 sq ft apartments. At, say, $200 / sq ft to build, that’s 800 x $200 = $160k / unit in construction costs.

$160k construction plus $150k in land costs = $310k / unit. Assuming rent of $2500 (brand new construction) x 12 months = $30,000 annual rent for each unit, that’s a GRM of $310k / $30k = 10x… decent, but really not anywhere near good enough to justify the hassle.


Hopefully, it’s clear from the above that the buyer is not a buy and hold investor, an owner-occupier, or a developer. He must have more creative plans for the property… perhaps he plans to steal a page from Moses’ book and reposition the property.

Maybe he’s thinking:

  • Buy for $563k
  • Relocate the tenants for, say, $40k total (unlikely, but possible)
  • Renovate for $100k ($50k / unit is cheap for separate structures)
  • All in for $703k (this assumes it’s his money and that he doesn’t need to pay interest on it)

So, what’s the thing worth? Well, maybe he gets $2400 / month in rent / unit. That’s possible if he does a good job. $2400 x 2 units x 12 months = $57,600 / year in rent. Do we have a home-run on our hands? Well, the yield is now $57,600 (rent) – $15k in expenses (up a bit, because prop tax and insurance will be higher in this scenario) = $42,600 / year in NOI. That’s an unlevered return of $42,600 / $703,000 = 6%. Not bad, but, again, not really worth the work

And, unfortunately, the deal’s not flippable. With $57,600 in rent, even at 12x (a stretch with the rents maxed), you’re exiting at a price of $691,000, less than you put into the property (and that’s before paying brokers, transfer taxes, etc.)


Again, I don’t know the people who did this deal. It’s totally possible that they know something about this property that I don’t. But unless it’s sitting on an oil field or something, I can’t, for the life of me, figure out what the buyer was thinking. Any ideas?

Written by mjkagan

10/17/2014 at 2:48 pm

How Adaptive thinks about valuing apartment buildings

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The first time someone asked me to come in to talk to them about listing their property for sale, I was pretty unsure about how to handle the meeting.

Of course, I had my own ideas about the value of the property. But I was also concerned about the possibility of losing the assignment by being too conservative about the proposed listing price. After all, there a lot of brokers, some of them very successful, who “buy” listings by telling sellers what they want to hear, instead of what reality is.

In the end, I decided to fall back on my training as an i-banker. In that job, a few times a month, we’d be invited in to pitch for the sale of $20-250MM media / technology companies. Of course, the most important question from the potential client would be: “What’s my company worth?”.

This was a difficult question to answer, because companies are so different from each other.

The best approach was to use a combination of methods. We would do a discounted cashflow valuation of the company’s free cashflow. We would do an analysis of comparable sale transactions to get at a reasonable multiple of revenue and earnings (usually EBITDA, for the accounting nerds out there… which is an insane profit measure to use, but that’s another rant). Then, we would look at how the public markets valued similar, publicly traded companies (again, extracting revenue and EBITDA multiples).

Individually, these methods were unreliable. But, if you did the work and then put the value estimates together and took a range, you could get a pretty accurate sense for the market value of the company in an auction situation.

It turns out this is a very good way to think about valuing apartment buildings, too. So, in the next day or two, I will set out the way we here at Adaptive go about valuing apartment buildings here in Los Angeles for the purposes of selling them.

Written by mjkagan

09/16/2014 at 10:41 am

We’re not charging enough

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One of the advantages we have in this business is that our units tend to command top-of-the-market rents.

The reason is pretty simple: We spend a ton of time and money making each unit we renovate into the kind of place that we, ourselves, would want to live in.

But I’ve been doing a lot of research on Craigslist for Silver Lake, Hollywood, Miracle Mile, etc. and I’ve come to the following conclusion: We’re not charging enough.

If you go online right now and start looking at two beds under $2500 in the aforementioned neighborhoods, your eyes will bleed. The units themselves are uniformly horrible – bad flooring, cabinets, window treatments, you name it. And, on top of that, the marketing is horrific… the pictures mostly look like the owners are actively trying to avoid leasing their apartments (bad lighting, no staging, weird angles, etc.)

I understand that not everyone is capitalized to do gut renovations of apartments. But I can’t, for the life of me, understand why anyone who is undertaking a renovation right now would use, for example, granite countertops or generic Home Depot cabinets. The cost difference to use good stuff is negligible (particularly when amortized over 10+ years) and the difference from the tenants’ perspective is massive.

So, given how terrible the competition is, I’m going to need to take a close look at our asking rents and see if there’s room to increase them.

Written by mjkagan

07/03/2014 at 4:40 am

When a foot isn’t a foot

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I’m mostly a price per sq foot buyer. Because I always renovate, I’m not very interested in the income of the building prior to acquisition. I am, however, extremely interests in the structure I am buying, since that structure is the raw material we will work with to produce the eventual product we are selling: Wonderfully renovated apartments.

I told the people who attended our seminar recently that I start to get interested around $200 / sq ft. But that brings us to the subject of today’s post: The fact that all square feet aren’t created equal.

Here are some examples of situations where a $200 price / sq ft still isn’t cheap:

1. Where you have wasted space. Picture a standard 1920s center hallway building. The center hallway is often 5′ wide. If the building is 100′ long, you’re wasting 5 x 100′ = 500 sq ft per level on hallways. No one pays rent for hallways, but, as a buyer you’re still paying for the space and, as a renovator, you’re still paying to fix it up. So, center hallway buildings need to be priced at a discount to $200 / sq to be interesting.

2. When you have huge units. The economics of our business are to a large extent determined by the achievable rent per sq ft. What kind of units generate the highest rent per sq ft? Studios. Think about it: A renovated 375 sq ft studio in Silver Lake can get $1300 all day – $3.47 / sq ft. A renovated 600 sq ft 1 bed / 1 bath gets $1700 – or $2.83 / sq ft. A 1300 sq ft 3 bed / 2 bath gets $3000 – $2.31. As you can see, the larger the unit, the lower the price / sq ft achievable.* Therefore, the return to the buyer of a building priced at a given $ / sq ft declines as the unit size increases. A building with lots of studios priced at $200 / sq is likely to be considerably more attractive than a building with lots of 3 beds priced at $200 / sq.

3. If there’s no land. Price per sq ft looks at the structure, but that’s not the only component of building value. For example: Look at our deal at 3212 Bellevue. We’re going to sell that thing at a price which will equate to $425 / sq ft or something. Sounds really high, right? But you have to consider that Bellevue is on 10,000 sq ft of land. That much land allows us to give all the units parking, storage, private outdoor spaces, decks, etc. The result: Very high rents / sq ft. And very high rent / sq ft imply a very high price / sq ft on exit. The opposite is also true: If you have a $200 / sq ft building with no space available for parking / outdoor space, then your rents are going to suffer, which means that $200 / sq ft may not work.

If you start to consider the above rules in reference to lots and lots of deals, you will find that there are all kinds of interesting interactions that take place when you combine buildings of varying configurations with  units of varying sizes with lots of varying sizes. Deals which don’t look great reveal themselves as almost certain winners. And deals which superficially look like winners end up looking very risky indeed.

*Incidentally, this is one of the reasons zoning limits the number of units on a given lot… otherwise, developers would build huge buildings full of lots of very small studios.

Written by mjkagan

05/19/2014 at 9:41 am

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