Archive for the ‘Real Estate Math’ Category
A friend of mine from college called me late last week with an interesting problem: He wanted to know how to value a vacant building he was considering buying.
There are two good ways to think about this problem:
The first might be thought of as “price per pound“, where we are looking at the physical land and structure, rather than at the income that land and structure generate. For this kind of analysis, we calculate a reasonable price per square foot for both the land and the structure based on recent, comparable transactions. We also keep in mind the cost of buying a comparable piece of land and building a comparable structure… you rarely want to pay more to buy something than it would cost to build.
The second, more problematic, manner of valuing a vacant building is to use an “estimated income” approach. With occupied buildings, it’s easy to evaluate a property based on it’s income; you just calculate the net operating income (“NOI”) the building is generating, divide it by the price you’re being asked to pay, and compare the quotient, called the CAP rate, to other, comparable deals to see if it’s fair. Obviously, the problem with the vacant building is that there is no NOI.
But you can estimate an NOI. First, you need to estimate the income the building can generate. It’s important you make this guess based on the present condition of the building. (If you estimate income assuming a renovation, then you will end up paying the seller a price for his un-renovated building which reflects the renovations you are going to pay to do!) So, look at the present condition of the building and compare it to other recently rented buildings and those on the market and figure out what kind of rent the building can generate.
Next, you need to estimate the expenses for the building. There are two key mistakes to avoid here: (1) Don’t blindly take the seller’s current expenses… vacant buildings use less heat, power, water, etc. than occupied ones!, and (2) Don’t assume any renovations to reduce costs (more efficient fixtures, heater, etc.)… otherwise, you’ll end up paying the seller for work you’re going to pay to do.
Once you have reasonable estimates for rent and expenses, you can subtract the latter from the former to get the estimated NOI. Then, you divide the NOI by the asking price to determine the estimated CAP rate, which you can compare to other, similar properties recently transacted or on the market.
Think this stuff is too boring / difficult to consider? Vacant buildings are very often where the opportunity is, because sellers and brokers screw up their estimates of income and/or expenses and therefore mis-price their assets. My current house and the Silver Lake fourplex I recently helped my parents buy were both vacant when we acquired them.
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:
- All buildings are worth some multiple of their total annual rent
- In our areas, that multiple is currently 11-13x GRM
- So, $100 of extra rent per month x 12 months x (say) 12x GRM = $14,400 in building value
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).
Had a quick conversation with a loan broker last night about the loans available on 5+ unit apartment buildings right now.
You can now get a 5 year fixed, non-recourse bank loan for 3.62% interest.
Let’s take a look at what that means by using the example of a 5% cap deal, which is a pretty expensive deal for all but the most desirable parts of LA:
- Price of $1MM
- Downpayment of 25% or $250k
- Borrow $750k
- Net operating income of $50k (5% of $1MM)
- Annual debt service of $41k
- Free cashflow of $50k – $41k = $9k
You’re only earning $9k in cash against your $250k downpayment, which is a cash-on-cash return of $9k / $250k = 3.6%. Not great. But that doesn’t consider the amortization of the loan.
By making the monthly payments for 12 months on a $750k loan at 3.62%, you reduce the principal (what you owe the bank) by roughly $12k. To fairly calculate your return, you do need to consider the effect of this principal pay-down, particularly if you plan to hold the building for a while.
If you add the $9k cash plus the $12k principal paydown, you’re looking at a return of $21k on your $250k downpayment, or 8.4% in year one. And, as we’ve discussed before, because of the way that loans work, the amount of principal you retire increases every year (basically, more and more of your fixed monthly payment goes to pay down the debt rather than pay interest on it). So the total return gets better every year.
Am I advocating that everyone rush out and buy 5% caps with lots of cheap leverage? Definitely not. I don’t think the deal above provides enough of a margin of safety for most investors.
But the numbers above do help explain why the market for apartment buildings is so hot right now. With debt that cheap, even bad deals start looking pretty good.
I got a call from a regular reader the other day about his building in Los Angeles. I’m going to share his story and I hope he won’t mind.
This guy has several great, normal tenants and one low-paying, rent controlled tenant who has a kid with pretentions to gang-bangerness. The kid has done all kinds of awful stuff to the building and the neighbors, enough to get the police involved multiple times. He told me he had initiated an eviction case, but that the problems with this tenant were driving him to the breaking point and causing him to consider selling.
I wanted to be sensitive to his situation, so I restrained myself. What I really wanted to say was “You’re an extremely lucky guy”. If I had, he wouldn’t have believed me.
So, instead, we did a back of the envelop calculation on the effect of winning the eviction case.
I’m not quite sure that he believed the numbers. But here’s how they work: The tenant was paying something like $500 for a $1500 apartment (actually, I think he could get more, but that’s just me). That’s $1k / month and $12k / year of potential rent increases. If you apply a (very) conservative 10x GRM to that number, you get $120k in value.
Now, obviously there are some costs associated with cleaning the unit up post-eviction. Let’s say he needs to spend $20k to make the unit really sing.
I know this guy’s time is valuable, but I’m pretty confident that all those hours of dealing with this miserable tenant were worth $100k.
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%.
One of the contractors I use a lot recently did a rehab of a small apartment building in Silver Lake. He bit a lot of our style, but that’s life.
When I asked him about the project, what he told me shocked me. Apparently, the genius who bought the place paid my contractor to turn it from a triplex into a duplex, thus violating one of the key rules of multifamily real estate in Los Angeles:
Never reduce unit count. Ever.
Now, you can imagine what the guy was thinking, right? I bet the units were small and oddly-shaped. I bet he saw an opportunity to make two nice, big units and thought that would make the building more attractive as a flip. And, he could save the cost of doing another kitchen and bathroom.
Bad move. Here’s why:
- Most apartment buildings in Silver Lake are grandfathered in. You could never build them now, because they don’t have enough parking to comply with modern building codes.
- If you reduce the unit count, you are going to struggle to get that unit back at some point down the line. Most likely, once it’s gone, it’s never coming back.
- In general, the smaller the unit, the higher the price per square foot you get in rents. This is because there is a ton of demand at the low end of the market and decreasing demand as you move up into large and larger units.
- So, given a set amount of square footage, you’re always going to get more rent from three small units than two larger ones. (Incidentally, this is why zoning exists in the first place; otherwise, developers like me would just build very, very tall buildings full of studio apartments.)
- Because apartment buildings are valued as a multiple of their rents, converting from a triplex to a duplex resulted in the owner producing a less valuable building.
Now, you might argue that, in removing a kitchen and bathroom, the owner saved himself $15k in rehab costs or something.
But look at the math. The difference in rent between, say, three studios (3 x $1300 = $3,900 / month) and a 2/1 and a 1/1 ($1800+1500 = $3,300/ month) is $600 / month. Assuming 11x annual rents as a multiple, that’s $600 x 12 months x 11 = $79k in value that he left on the table. It’s safe to say he should have spent the $15k to earn another $64k.
Am working with a client considering buying a duplex in LA. The listing broker has the building on the market at $500k. He has no idea what the rent is on the one occupied unit (in what is a rent control building).
To illustrate how insane this situation is, let’s review the numbers:
- List price of $500k
- Two units, both 2 bed / 2 bath
- One unit vacant, should rent for $2k / month
- Other unit occupied, listing agent has no idea of the rent
If the occupied unit is getting $2k per month (very unlikely), the building is doing $4k / month, or $48k / year. That implies a gross rent multiple of $500k / $48k = 10.4x. That’s a total steal for the neighborhood.
If, on the other hand, the occupied unit is getting $1k per month, the building is doing $3k or $36k / year. That implies a gross rent multiple of $500k / $36k = 13.9x. That’s a bad deal for the neighborhood.
Regular readers will know that there’s no easy way to get rid of a rent controlled tenant in LA, unless that tenant fails to pay rent. So, if you buy this property and it turns out the tenant is paying $1k, you’re probably stuck with this guy for life.
It’s not clear to me whether the broker understands LA rent control. If he does, and he still hasn’t taken the time to figure out what the rent is, well, then, I am (unusually for me!), speechless.
I’ve been recommending to every single reader that they check out my post on “How to value an apartment building” for six months now.
In all that time, no one noticed that I had got the equation for calculating a cap rate wrong. Here’s the relevant text with corrections:
“To calculate a CAP rate, you divide the
price of the building by its NOI NOI by the price of the building. So if a comparable building sold around the corner for $1,000,000 and it was generating $75,000 in NOI, the CAP rate can be calculated like this: $1,000,000 / $75,000 $75,000/$1,000,000 = .075, or 7.5%. Another way to think about this is: If you bought that building for $1,000,000, you would be earning $75,000 per year in profits, or 7.5% return on your money. Beats a bank account, huh?”
I didn’t notice either. A helpful reader named Jeff Daniels, who happens to be a very experienced, amazing architect in LA, pointed it out to me today. Thanks, Jeff.
Meanwhile, to the rest of you: If I write something on here that seems stupid… speak up! I write every day and there’s no editor, so sometimes there are going to be errors / omissions / etc. If something doesn’t seem right to you, that’s because it’s probably wrong, not because you’re dumb. Do what Jeff did: Email me and let me know.
Have you ever wondered why there are vacant lots in Los Angeles? Blame Prop 13.
Proposition 13 is an amazing law for California property-owners. Passed through CA’s referendum process in the late 1970’s, Prop 13 sets property tax at 1.25% of a property’s original purchase price and restricts increases to 2% per year (until the property is sold).
What caused CA voters to pass this law? CA property values were increasing very rapidly at that time. People who had bought little bungalows in the 1940s were suddenly “house-rich” and getting hit with rapidly increasing tax bills. Led by Howard Jarvis, property-owners got together, organized, and passed Prop 13 to limit the amount by which their taxes could increase.
Among the unintended consequences of Prop 13 is the underdevelopment of valuable land. Check out this map of the area just south of Wilshire on La Brea (near where I live):
See in the picture where it says “New Condos”? That’s a huge multi-use development project being built on the southeast corner of Wilshire and La Brea. BRE (a big real estate development company) is investing a ton of capital here on the assumption that many people will want to live in this improving part of Miracle Mile.
Now, see where it says “Car storage” on the pic above? Here’s an closer, overhead picture of that lot:
In real estate, we have the concept of “highest and best use” of a piece of land. The multi-use development is an example of the highest and best use. On the other hand, the owner of this lot is using it for car storage, which may be the lowest and worst use. Why is this happening?
To understand, consider what would happen if Prop 13 didn’t exist. The total size of the lot is 11,545 sq ft. and its zoning is C2. C2 can be used as R4 (400 sq. ft. per unit), meaning that the owner could develop 11,545 / 400 = 28 units on this land (you round down in zoning calculations). Even at a bargain price of $50k / unit, the land is worth $1.4MM. If it were taxed at 1.25% of value, the annual tax would be $17,500.
Ah, but Prop 13 does exist. Because the owner has owned this lot since at least the mid 1990’s (and possibly since 1973 – the public records aren’t clear), the total assessed value for the purposes of calculating property tax is roughly $239,000. The owner paid around $3,500 in tax in 2011; effectively, nothing.
From the owner’s perspective, as long as he believes the value of his land will increase by more than the 2% per year maximum tax increase (a pretty low hurdle, given that long term inflation is over 2% / year), there’s zero urgency for him to develop it.
Have you ever wondered why you can easily find big, vacant lots in Los Angeles, despite the fact that this is a huge, vibrant city with tons of demand for housing, offices, retail, etc.? This is one of the biggest reasons why.
Today I spoke with a broker who has an eight unit property in West Hollywood listed at a somewhat reasonable $187,500 / door.
I say somewhat reasonable because the gross rent multiple is 15x. At a list price of $1.5MM, that means the property is generating rents of $100,000 / year. The rents are obviously very low, averaging just a bit over $1,000 / unit / month.
Those tenants are never, ever leaving, because they’re paying 50% of market for their units. And West Hollywood’s rent control law is, if anything, stricter than LA’s, so there’s no way you’re forcing them out.
If we assume, as I usually do, that the net operating margin to the new owner will be approximately 65% of the rent roll, then the property will generate something like $65k in NOI. (That’s very generous, by the way – when you get up to 15x, the property tax the new owner pays is so disproportionately high that the margin shrinks considerably.)
Recall that you can calculate the cap rate (un-levered yield) on a property by dividing the NOI by the purchase price. Even using the generous 65% NOI margin estimate, that means the cap rate on this property is $65,000 / $1,500,000 = 4.3%.
With a return like that, you have to ask: Who would want to bother with being a landlord for this building?
Guess how many offers they have, a week after going on the market…. five.