Thank you!

I’ve been writing this blog for around three months now, give or take. And I just want to take the time today to say “thank you” to all of you.

I have met amazing people here: first timers, seriously experienced investors, flippers, money guys, brokers, you name it.

Without giving away names, I can tell you that our little community contains an amazing cross-section of the people who comprise the LA apartment market.

My career has been enriched immeasurably by all of you. Thanks!

Grandfathered zoning in LA

What does “grandfathered zoning” mean with respect to apartment buildings? To understand that, you first need to understand that zoning in Los Angeles has generally become stricter over time.

For a long time, there wasn’t any zoning. You could just buy a few single family homes, rip them down, and put up an apartment building. If you drive around the streets to the south of Sunset in Silver Lake, you will see some rather large buildings on streets which are otherwise full of single family homes. These are examples of buildings built before zoning.

Over time, homeowners in the city forced the government to impose some restrictions on building apartment buildings in single family areas. Now, much of the city is zoned R1 or R2, zones which generally make building apartments impossible. But what about those old apartment buildings standing in what are now R1 or R2 zones?

Well, it would have been an unconstitutional taking for the city to rip the buildings down without fairly compensating the owners. And buying out all those apartment building owners would have been ruinously expensive. So the city just left those buildings alone.

That is the meaning of “grandfathered in”. Because they’ve been in those zones since before zoning existed (or, at least, before it got strict), those buildings are allowed to stay. In fact, an owner of one of these buildings can generally get what is called a “re-build” letter from the city, which gives him the right to re-build the building if it falls or burns down, even though the zoning wouldn’t allow the owner to build the same building on the lot if it hadn’t existed in the first place.

But no one can build another apartment building on those streets. And that’s why those buildings are valuable. Because they will never have any more competition for renters than they do right now.

How to value a building that needs work

Rarely do you come across an apartment building in Los Angeles that’s in truly mint condition. Everything’s got a few dings on it; that’s just part of buying older buildings. For those normal, everyday buildings, you figure out a range for the multiples of annual rent in the neighborhood, multiply the annual rents times the mid-point of that range, and boom – there’s your starting point for valuation.

But what about the real disasters? The ones where the galvanized piping’s worn out and leaking, there are holes in the roof, the floors are a uneven because the floor joists are rotten, the heaters don’t work, etc. How do you even begin to put a value on those buildings?

Here’s what I like to do: Work backwards. Imagine the building totally renovated. Now estimate the rents. Then multiply those rents times the neighborhood gross rent multiple. The resulting number is the value of the completed building. For example, say it’s a 10 unit building, all one beds that, renovated, rent for $1,500 and it’s located in Silver Lake, where those kinds of buildings trade for 12x annual rents. The fully renovated value is $1,500 x 10 units x 12 months x 12 grm = $2,160,000.

Next, total up the cost of the repairs. If you’ve done this a million times like my partner Jon Criss, you can probably estimate it on site.  If you haven’t, bring some experts you trust to help you. However you do it, get that number. In our example, let’s just assume your experts estimate the cost of renovating the entire building is $500,000.

Now, subtract the cost of the repairs from your estimate of the value of the fully-renovated building. In our example, this means $2,160,000 – $500,000 = $1,660,000. Is that the value of the building? No!

You have to account for two other factors:

  1. The cost of the money: Unless you’re rolling in cash, you’re going to have to borrow some of the money for the project. So you need to figure in some interest costs. If the renovation would take 6 months and you’re borrowing $1,000,000 (total), at 5%, that’s an extra $25,000 of interest costs you need to include.
  2. The value of your time: If this is going to take you six months to do, you need to include a reasonable amount of money to compensate you for your time and risk. This is what appraisers term the “entrepreneurial profit” – the profit that an investor would demand for taking on the risk and spending the time necessary to buy and renovate the property. In our example, let’s just peg this at $200,000.

OK, now we’re ready to estimate the value of our building: Take the fully renovated value. Subtract the cost of the renovations. Subtract the cost of the money. Finally, subtract an “entrepreneurial profit”. That’s $2,160,000 – $500,000 – $25,000 – $200,000 = $1,435,000.

So the maximum valuation we can put on the un-renovated, screwed-up, POS building is $1.435MM. If you can buy it for less, you’re doing pretty well.

Tour our projects?

Quick question for you regular readers based here in Los Angeles:

Would you be interested in taking a guided tour of some of our projects?

In my mind, I’m envisioning looking at 1-3 of our projects in detail. We would discuss:

  • The forecast that led us to buy the property
  • The cost of relocating the tenants
  • The design choices we made
  • The construction process
  • How the project turned out financially

The idea behind the tour is to give you some insight into how a re-positioning project works from beginning to end.

If this is something you’d be interested in, pls shoot me an email at moses@betterdwellings.com and let me know what days / times are best for you. If we can get a group together, we’ll definitely go ahead.

Why would I sell real estate?

I often joke on this blog that you should never sell apartment buildings. The main reason is that the transaction costs of selling real estate are high (brokerage commission, transfer tax, etc.). Also, in CA, there’s a major benefit to holding on as your rents increase, because your NOI margin increases (see here for more details).

But, obviously, there are a few reasons that you might want to sell:

1. To return capital to investors: This is the reason I’m selling 1239 N. Westmoreland. Once you’ve added a bunch of value to a building, holding it for a long time just serves to drag the IRR down towards the new yield on rents. So there’s a point where it makes sense to sell and let someone else collect the yield.

2. To shift capital to a higher-upside property (using a 1031 exchange): You might find yourself owning a property in an area where the rents are stagnant. If debt is cheap and the market is good (like now), it can make sense to sell your property and do a 1031 exchange into another property in an area with more upside.

3. When your depreciation is used up (or has shrunk): The government allows you to deduct an amount equal to 1/27.5 of the initial value of the structure on a property each year from your taxes for 27.5 years (more info here). Once you’ve reached the end of that period, your asset is fully-depreciated (from a tax perspective) and you lose the tax shield that depreciation provides. At this point, it probably makes sense to 1031 into another income property, which re-starts the depreciation clock (on the new asset). Another flavor of this is the situation where the rents are increasing but the depreciation allowance isn’t (because it’s pegged to the original purchase price), meaning that depreciation is shielding less and less of your income from taxation.

Can you think of any other reasons to sell?