Learning from Larry

On Thursday, Larry R., one of the Kagansblog regulars, taught me a ton about South LA real estate.

Larry’s an LA native who grew up on 111th St, which is a hell of a lot farther south than I’ve been in the city (besides going to the airport). Because he grew up down there and because his parents owned some rental property, he’s not at all afraid of investing. So we drove down looking for deals.

We toured interesting neighborhoods, talked business, ate burn-your-mouth-spicy BBQ at Phillips at 43rd and Leimert, and got propositioned for donations by a Black Muslim brother selling beam pies. It was awesome!
I learned first hand, from Larry, how much money you can make by investing in South LA. It’s often said that you make most of your money in real estate “on the buy”. What this means is, if you buy assets cheaply enough, it’s hard not to make money, even if you’re not great at the other aspects of the game. And boy can you buy stuff cheaply down there. There are honest-to-goodness 10% caps sitting around for anyone with cash and guts to buy.
Now, managing those kinds of properties can be tough. The neighborhoods can be dicey (though it’s important to recognize they’re not all the same at all – the area in the 40’s around Leimert Park is very different from the area around 85th St, for example), the properties can be in rough shape, and obviously you’re dealing with a different tenant base than you would be in NE LA. But Larry’s comfortable with the environment, knows how to renovate cheaply, and has a great system for picking tenants who pay the rent and don’t cause trouble.
I know Larry’s going to read this, so this is my opportunity to say a big, public “Thanks!” for educating me.
Do you know of an undiscovered neighborhood with great deals? Do you have a system for investing that works for you? I would love to learn from you, and I’m sure our fellow real estate enthusiasts would, too. Clue us in in the comments section, or send me an email at moses@betterdwellings.com!

Who to bring with you to an inspection

Once you get a property under contract, the clock starts on your physical inspection period (also called the “due diligence” or “contingency” period). This is the period, usually 10-14 days, during which you check the physical condition of the property. But most buyers aren’t experts in looking at all of the systems (foundation, roof, electric, plumbing, etc.) that make up a structure.

So the question is: Who can help you figure out if the structure you’re planning to buy is in good shape?

As a buyer of property, I have developed a team of people I bring to each inspection. They are:

  • A general inspector. I like to use LaRocca, because they create these very detailed 40 page PDFs that tell you every little thing that’s wrong with the structure, down to which light switches don’t work;
  • A foundation guy: My guy, Jose, has done a bunch of foundation work for me. He knows what’s really serious and what is just a “nice to have”.
  • A plumber: I bring in Andre to check the whole plumbing system and also to scope the sewer line with a video camera. This is something plumbers usually charge for, but Andre does it for my clients for free, because I funnel him so much business
  • A general contractor: My general, Gali, is an electrician by training. He looks at the overall condition of the property, the roof, and the electrical system. He’s renovated about 65 units in older buildings for me over the past 3-4 years. We’ve been to war together and I know Gali’s going to give me and my clients honest answers about what to worry about and what to let slide.

Each of these team-members produces a report detailing issues with the property and, in the case of all but LaRocca, a bid for fixing them. These documents serve as the basis for any negotiation with the seller about reducing the price of the property to compensate for work the buyer will need to perform after he buys it.

If you buy a property without bringing this kind of team along with you to inspect it, you deserve whatever problems result. And if your broker doesn’t demand that you bring in this kind of team, you’re working with the wrong broker.

Frank McCourt did nothing wrong

Think of the Dodgers like an investment property.

McCourt bought the property in 2004 from a bad owner (Fox) and dramatically increased the revenue.

As revenue increased, the value of the property increased (cash-generative assets are valued at some multiple of the cashflow they generate; increase the cash, increase the value). The increase in value created equity for McCourt, his compensation for taking the risk of buying the property and for managing it well.

He re-financed the property to withdraw cash for his family. The banks were willing to lend because the new, higher cashflow of the property could support higher debt service payments, and because the new, higher value of the property gave the banks increased security (if he hadn’t paid the debt, the banks presumably had the team as collateral.)

Finally, McCourt sold the property. Like any other owner, he conducted an auction and chose the highest bidder.

The amount bid was enough to pay back the debt and leave enough money to pay a big divorce settlement and leave around $1bn for McCourt.

Everything else about this story, from the bad PR around the McCourts’ divorce, to the moralizing about how he “stole” the money, to the “redemption” meme around Magic Johnson buying the team, is window-dressing designed to sell newspapers.

You may not like McCourt, but he’s just a guy who made a highly levered bet and had it pay off. He’s no different from the average couple who bought a home with a mortgage and got rich when the property market went up, like everone who bought a home in Southern California between probably 1850 and 2003.

Avoid problems with the Los Angeles Housing Department

Pro tip: You don’t want to buy a building, only to find yourself in the middle of a war with the Los Angeles Housing Department (LAHD).

Under the standard California real estate sale contract between seller and buyer, the seller has a duty to disclose any on-going issues that may effect the value of the property, including any problems with regulatory agencies like LAHD. However, it is downright stupid to entrust yourself to the seller’s sense of honor or propriety in this regard.

Fortunately, LAHD does provide an online system for checking if there are problems with the building. Unfortunately, they make it kind of a pain in the ass to find.

So here’s how to do it:

  • Go to http://lahd.lacity.org/
  • Click on “Code Enforcement” on the left side of the page
  • Click on “Prop Info / Complaints” in the gray window that opens on the left side of the page
  • Click “Property Profile”
  • In the boxes that appear: Type the street number and name of the street (exclude any directions, like “North” or “N.” and also the type of street like “Ave.” or “Dr.”
  • Click on the address of the property

At this point, you’ll get a list of complaints, violatons, etc. Understand that almost all rental properties have had violations before, so you shouldn’t be scared off. But here’s what to look for:

  • All complaints should include the words “Complaint closed” or “All violations resolved date”. If they don’t, they’re still open and you could be entering a world of pain;
  • If you see the word “REAP”, proceed with extreme caution – this is a serious city program that you want to avoid unless you really know what you’re doing;
  • If you see lots of complaints, you need to be aware of two potential issues, neither good: (i) the building could have a lot of deferred maintenance issues that will require you to spend money fixing, or (ii) there are one or more tenants who delight in causing trouble for the owner by calling in bogus complaints;

The city being the city, there is no guarantee that the list you see on the website is comprehensive. There could be complaints that have been made that have not yet made it into the system. But checking online is a good place to start and I highly recommend doing so BEFORE removing your contingencies on a property.

How leverage (debt) magnifies outcomes

You heard me say in numerous pieces that leverage (debt) magnifies outcomes. What do I mean by that?

Well, let’s examine two identical fourplexes with different capitalization structures. First, here are the operating details:

  • Acquired for $600,000
  • Annual rents of $60,000
  • Assume costs of 35% or $21,000
  • Annual Net operating income (rents minus expenses but not including mortgage payments) of $39,000 / year
The only difference between the fourplexes is the capitalization (how their owners paid for them):
Owner A:
  • Owner A bought all cash / no debt
  • Put down $600,000
  • Now collects $39,000 / year before taxes (6.5% return on cash)
Owner B:
  • Owner B put down 5% ($30,000), borrowed the rest
  • Mortgage of $570,000 fixed for 30 years at 4.5%
  • Monthly mortgage payments of $2,888, or annual payment of $34,656
  • Owner B collects $39,000 – $34,656 = $4,344 / year, a return on cash of $4,344 / $30,000 = 14% cash-on-cash
  • Plus the owner retires $7,634 worth of mortgage debt in the first year (this increases over time)
  • So Owner B gets $4,344 + $7,634 = $11,978 on his investment of $30,000, equating to an overall return of 40%(!!)

Right away, you can see one of the benefits of leverage: The Owner B is getting a 40% return on his money, while the owner in Cap A is only getting 6.5%. So, assuming nothing changes or goes wrong, Owner B is getting a better deal than Owner A.

Scenario 1: The Market Goes Up

Now, let’s look at what happens if the market goes up 20%:

  • Owner A’s property is now worth $600k x 20% = $120k more. Obviously, he’s made 20% on his money.
  • Owner A’s property is also worth $120k more. But he only invested $30k. So his $30k is now worth $150k, an increase of 500%.
So the leverage has magnified the outcome of the market improving for Owner B.

Scenario 2: Rents Drop

But let’s also take a look at what happens in the event the economy turns sour and rents decline by 15%:

  • Owner A is not great, but ok. His rents are down from $60k to $51,000. His expenses are still at $21,000, so he’s netting $30k. He still owns the building and he can hang on to it until the economy comes back around.
  • Owner B is in trouble. His rents are down to $51k as well, so his NOI has fallend from $39,000 to $30,000 (just like Owner A). But he has to make annual mortgage payments of $34,656. Uh oh… Owner B can’t pay his mortgage and defaults (unless he has other money to make up the difference). His initial $30k is gone. Clearly, all that leverage made a bad situation much worse.
So, again, the leverage has magnified the outcome of the rental market tanking for Owner B.

(Incidentally: Can Scenario 2 happen? You bet. It happened to me at Reno St., which we bought in 2008. We were getting $1,200 for 1 beds and $1,000 for studios. At the depths of the 2008-9 recession, we were getting $1,000 for 1 beds and $850 for studios. What saved us is that we had put down 30% on the building. So while it lost value, it never stopped paying the mortgage and cash-flowing.)

So why FHA?

Given the above, why do I generally advise my clients to use FHA mortgages to put as little as 5% down on apartment buildings? Well, I’m looking at context. Here’s my reasoning:

  • Prices are low right now and will increase over time. We just went through a major market crash, so you have to expect that prices will recover, if not immediately, then over the medium term. The larger the asset you buy, the more you’ll benefit (and leverage lets you buy a bigger asset than if you had to use all cash.)
  • Interest rates are cheap. If you’re ever going to borrow to buy an asset, now’s a pretty cheap time to do it.
  • The economy is generally improving and expected to continue improving. Demand for apartments is very strongly linked to employment. More jobs = higher rents, assuming supply stays flat.
  • Not much new supply. Very few new apartment projects broke-ground over the last few years, so there is little new supply coming on line for the next few year.
Smart investors make aggressive bets when they believe the odds strongly favor them. Right now, I think the odds favor increasing rents and property values. So the more you buy, and the more highly-levered you are, the better I think you’ll do. Could I be wrong? Absolutely. But I’m long real estate with leverage in my own life, too. So, if you follow my advice, we’re riding this particular train together.