Moses Kagan on Real Estate

Dave C commented on yesterday’s post asking, in effect, what can be done about a rent control building which is deteriorating. The short answer is: nothing.

The reason is one little equation.

If you’re the owner of a rent-controlled building with below-market tenants in Los Angeles, your tenants are never leaving. You can’t raise the rent, except by the city-mandated 3% per year. So there’s little incentive to invest in your building, because there’s no way to earn a return on that investment.

Understanding this problem, the city created the Capital Improvement Program. Administered by the usual suspects over at LAHD, the Capital Improvement program is intended to provide a way for landlords to get compensated for (part of) the cost of fixing problems in their buildings.

Here’s an example of how the program works: You spend $30k re-piping your 8 unit, 1920s building. Then you apply to the city for a small, temporary rent increase from your tenants to cover the cost.

Except here’s how the city calculates the rent increase:

“For applications filed after September 30, 1989 the allowable capital improvement cost is 50% of the costs approved by the Department. Thus, the landlord divides the total allowable capital improvement cost by 60 and then divides this monthly increase equally among all units benefitting from the capital improvement. (LAMC 151.07 A)… For capital improvement rent increase applications filed after September 30, 1989 the cumulative rent increase (s) for a unit cannot exceed $55…”

What this means, in plain English, is that you will only ever re-coup 50% of the cost of that $30k re-piping. And you will only do so through rent increases of $55 / month on your eight tenants, or $440 / month. So, the city is saying, lay out $30k of your hard-earned money and you’ll get back $15k in $440 chunks over the next 34 months.

Would you take that deal? Neither would anyone else! And that’s why no one fixes the systems in slum buildings without first getting rid of the tenants so that the rent can be bumped to market. All because of that 50%.

Have been seeing a lot of searches coming through from owners of single family homes currently being used as rentals in Los Angeles.

Want to clear up some confusion: If you own a single family home on its own lot, your property is not covered by the Los Angeles Rent Stabilization Ordinance (rent control).

That doesn’t mean you can do whatever you want to the tenants. Obviously, the terms of any lease that you signed apply. And there are also some basic tenant protections in California state law (as distinct from city law). You can find more details regarding these state-wide protections in the pdf here.

But, bottom line, owners of single family rentals have a LOT more flexibility than owners of multifamily properties here in LA. And that makes sense, right? If you own a home, you ought to be able to kick people out of it if you feel like it.

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).

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.

It’s time to continue our regular survey of Los Angeles rents. We do these surveys to give renters, landlords, developers, lenders, and appraisers access to up-to-date information on the rental market. This time, we’re focusing on Los Feliz.

Things to note:

• This was a whopper of a survey, because Los Feliz is a huge neighborhood, stretching from Western all the way over to the LA River;
• There are different sub-neighborhoods in Los Feliz, including the apartment-dense section to the west, the extremely pricey single family homes north of Los Feliz Blvd., and the walkable, restaurant- and bar-studded Los Feliz Village at the northern ends of Vermont and Hillhurst;
• Generally, supply decreases and price increases as you move from east to west west to east.

Here are a few great deals that we came across:

• A nicely renovated 1/1 at $1,250 with all utilities included
• A studio with parking near the Silver Lake border for $750
• A two bed / 1 bath with parking on Griffith Park for $1,400

The fine print: Our survey was based on a search of Craigslist apartment listings using the keyword “Los Feliz” on 7/24/2012. We checked all addresses to ensure the units were in Los Feliz (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: Los Feliz Rent Survey – July 2012 

When I re-position a building, the numbers often look something like this: I buy the building for $1MM, spend $500k on renovating it, and then ask a lender or buyer to believe that the building is now worth $2MM, based on the rents I am achieving from the new tenants.

Now, obviously, the lender or buyer is going to have some questions, the most important of which is: “How do you expect me to believe that this building you just bought for $1MM is suddenly worth $2MM?!”

The answer to this question is that the new valuation is justified by applying a market cap rate to the new net operating income or a market gross rent multiple to the new rents. (For more information about how this work, please click here.) So the new valuation is entirely dependent on the new rents.

The goal is to be in a position to demonstrate the true profitability of the building to a lender or potential acquirer. You do this by sending them the actual profit and loss statements (P&Ls) generated by your accounting software, often called the “actual P&Ls” or “actuals” (as opposed to “pro forma P&Ls”, which are estimates of profitability).

Why are actuals important? You’re not going to believe this, but there have been occasions where people in the real estate business have fudged those new rents. They’ve signed leases with higher rents and then kicked the tenants back cash under the table to reduce the effective rents. Or they’ve got their friends to move in and sign leases at high rents, knowing that the owner won’t evict them for non-payment. Or the owner is successful is tricking people into signing leases but the tenants break their leases and move out after living in the building for a short time because it’s not worth the money.

So, lenders and buyers are justifiably nervous about accepting the new rent roll as gospel. Instead, they want to be able to look at your actuals and see the money flowing in from the rents and out to cover the expenses for a reasonable period of time, usually 3-12 months, depending upon the lender or buyer. The more months of P&Ls you can show, the more apt they are to believe you.

When you first buy a building, you’re likely to be approached by someone, often the management company you hire, about signing a laundry lease. It will be pitched to you as a convenience for your tenants and an opportunity for you to make some extra cash. Be careful!

What’s a laundry lease? It’s an agreement whereby a laundry company agrees to place, operate, and maintain coin laundry machines in your building. In exchange for allowing them to do this, they offer to give you some share of the revenue. Sometimes they even kick in a few grand as a bonus. Sounds good right?

Here are the problems:

1. The contracts are usually very long and very, very hard to cancel. You need to send them a cancelation notice written in lamb’s blood on third full moon after Easter seven years from now. If you forget, the contract renews for another 10 years. Etc., etc.
2. There are usually monthly minimums below which you get nothing. The contract might say something like, we (the laundry company) get the first $100 of revenue and the rest is split 50-50 with you. If this number is set too high, you may never see a penny from the machines.
3. Auditing the revenue is almost impossible. You’ll get a a statement every month or quarter showing how much the machines brought in and how much you’re entitled to, along with a check (hopefully). But you’ll get very, very suspicious that you’re not getting your fair share. And there’s no way to audit the numbers, because it’s all cash coming in to them.
4. You usually can’t put any other laundry machines in the building. If you later want to raise your rents by adding washer / dryers to the units, too bad. The lease usually stipulates that you can’t put any competing machines (coin operated or free) in the property.

I’ve got two good ones about laundry leases:

1. On our first building, the contract was short, so we were able to buy it out for around $3k and replace the company’s machines with our own. Cool, right? Well, it turned out that the company had been shorting us by roughly $150 / month, a fact which we discovered once our new machines were installed and we started collecting the money ourselves. Turned out to be a very good deal.
2. In order to get another laundry company out of one of our buildings so that we could put washer / dryers into the units, we had to pay (I’m not making this up) $16,000 in order to get them to cancel the agreement. Do you know how much they had been paying us per month up to that point? Around $50. Bastards.

My advice: Don’t ever, ever sign one of these things without reading it carefully. Insist on a short period without automatic renewals. Insist on a low monthly minimum. And pay attention to the reporting. A 16-unit building ought to produce $200 / month or so in laundry income, maybe more. If your company’s reporting much less to you, they’re probably stealing.

Just completed our semi-regular rent survey for Echo Park north of the 101, and the results are pretty interesting:

• Median asking rents for 1 bed / 1 bath apartments was $1,450, up a whopping 26% since February
• Median asking rents for 2 bed apartments was $1,995, down by 15% compared to February
• Median asking rents for studios was $1,043, basically unchanged from our February survey
• The three 3 bed / 2 bath rentals available ranged from $2,590-3,195

A few other observations:

• As of May 25, there were only 24 units on the market in Echo Park north of the 101. That’s a really small number given Echo Park’s name recognition.
• Many of the units look to have been renovated recently. It looks like word is (finally!) getting out among property owners that tenants are willing to pay for higher quality product

The fine print: As always, our survey looked at Craigslist postings tagged with the name of the neighborhood (in this case, Echo Park) and cross-checked against the LA Times neighborhood map. In this case, we arbitrarily removed the piece of Echo Park south of the 101, which has very different demographics and rental rates. Here’s the raw data: Echo Park Rent Survey – May 2012

You might think that your job, as a Los Angeles landlord, is always to get your tenants to pay rent. And you’d be wrong.

There is one situation where you absolutely do not want to accept rent from your tenant under any circumstances: When you have a tenant you want to get rid of and the tenant has done something which may give you the ability to get rid of him.

For example: Say your tenant doesn’t pay rent on the 1st of the month. You post a “3 day notice” (which basically says, “pay rent within three days or move out). Three days elapse without the tenant paying rent. On the fourth day, you should not, under any circumstances, accept rent from the tenant.

Why? Because accepting rent from a tenant in that situation could be viewed by a judge as you implicitly ratifying a new lease with the tenant. By accepting the rent, you are saying “I understand you failed to do what you were supposed to do (in this case, pay rent within three days of receiving the notice) but I am accepting your continued tenancy in my building.” Obviously, that’s not what you want to say.

How do you refuse to accept the rent? You photocopy the check for your records, then send it back via registered mail (return-receipt requested) along with a letter telling the tenant you are refusing to accept the rent. Then, you proceed with whatever action you are going to take (in this case, presumably initiate an unlawful detainer / eviction action).

One more thing to keep in mind: It’s not enough for you to personally understand and internalize the above. You also need to ensure that your entire organization (bookkeeper, property manager, etc.) is clued in. Because it’s super easy for an oversight by someone who works for you to cost you the ability to get rid of a bad tenant.

[Note: I am not a lawyer and the above is not legal advice. If you need help evicting a problem tenant, I recommend you get in touch with Dennis Block.]