How do apartment buildings increase in value? And how can you benefit?

When you put a bunch of money and time into an asset, you want it to increase in value. Obviously.

So you might ask: How does an apartment building increase in value?

Remember: An apartment building investment made correctly should cashflow to you every month, so you make money as you go along. But an increase in value is the icing. Here’s how it can work:

  1. Rents go up as your building or the neighborhood improves. All things being equal, higher rents equal higher profits. So if you pay $1.43MM for $100,000 in profit (a 7 cap) and the profit goes to $120,000, even without any change to the prevailing cap rates, your property should now be worth $120,000 / .07 = $1.71MM.
  2. More people want to own in the neighborhood, driving prices up and (therefore) cap rates down. Say you buy the 7 cap for $1.43MM. Say the rents and, therefore, the profits don’t change. If the prices are bid up such that the prevailing neighborhood cap rate falls from 7 to 6, your property went from being worth $1.43MM to $100,000 / .06 = $1.67MM.
  3. The combo platter. The best outcome is, of course, the rents go up and the cap rates come down. If your profit goes to $120,000 and cap rates fall to 6, the property you bought for $1.43MM is now worth $2.0MM.

There are two ways to take advantage of increases in value:

  1. Sell. Maybe you sell, do a 1031 exchange, take your profits tax free, and invest them in another building in a part of town that’s cheaper but improving. But I don’t recommend it, since you can…
  2. Re-finance. The amount of debt you have on a building is fixed or trending downward, depending upon the type of loan. So any increase in the building’s value accrues to you, the owner, in the form of equity. More equity means you can borrow more. Say you bought that original $1.43MM building with a loan of $1.07MM and a downpayment of $360,000. Now say it’s worth $2.0MM. You can go re-finance for 75% of the value, or $1.5MM. You pay off the original loan of $1.07MM and pocket the remaining $430,000 tax free AND keep your building. Booyah.

 

Legalese: I’m not a lawyer or an accountant and this is not tax advice. 

 

What can go wrong with an apartment building

Anyone who tells you that any investment is risk free is full of ish. People thought government bonds in Europe were risk free and look where that got them.

In order to make sure you don’t think I am full of ish, here’s a list of the things I can imagine going wrong with an apartment building investment in LA, in no particular order:

  1. Earthquake. Earthquake insurance is very expensive, so most owners choose not to get it. While older buildings have all lived through earthquakes, you never know when a big one could hit and cause damage you have trouble paying for;
  2. City inspection nightmares. Owning a building exposes to all the bureaucratic BS Los Angeles Housing Department can throw at you. Mostly, it’s fine. But you can find yourself in messy situations with them… which is when you should call Tom Nitti;
  3. Rents go backwards. This happened on our Reno deal. When we bought, rent for a one bed was $1,200 and for a studio $1,000. Then the economy went in the tank and we went as low as $950 for a one bed and $850 for a studio (I think). If you’re highly leveraged, this can cause you problems!
  4. Unforeseen repair / maintenance issues. We recently had to shell out $6,000 for a boiler that broke. It’s tough to negotiate a low price with the boiler company when 16 tenants have no hot water and are calling you about it.
  5. Your interest rate jumps. Not a problem for standard, fixed 30 year loans on 2-4 unit buildings. But on bigger ones, you might come to the end of your rate-lock period (after 3-, 5- or 7 years), only to find that loans are a lot more expensive than they were before.
  6. Bad tenants. Sometimes bad apples slip through. They cause trouble or don’t pay rent and it takes you a few months to get rid of them.
  7. The market tanks. Maybe you bought at a 6 cap and now the market is a 7 cap. As long as you don’t have to sell, no problem. But if you do, you’re taking a loss.
  8. Can’t sell quickly. If you have a stock you want to sell, you can always find a buyer quickly. Not so for an apartment building. Even at a fire-sale price, it takes a minimum of 2-3 weeks to sell; much more if you want a fair price.
  9. Crime. I had an idiot break into one of my buildings a few months ago. No harm was done, but he scared the sh*t out of my tenants, a few of whom broke their leases and moved out.

Unless you’re as dumb as the guy who broke into my building, you know that there’s no such thing as reward without risk. Owning a building is really owning a small business, and businesses sometimes have problems. That’s life.

But the reward is you get a 8-12% return on your money, instead of the 0.0034% you’re getting from a bank right now. And, as a landlord, you learn a hell of a lot about the world and about yourself along the way.

Rules of Thumb for Los Angeles Apartment Buildings

Get this through your head: Every apartment building is different. Even literally identical buildings differ because they are by definition located on different pieces of land.

That being said, there are some simple rules of thumb for quickly coming to grips with the numbers behind a building:

  1. Cap rates in Los Angeles currently range from less than 4% (for very large, institutional grade properties) all the way to 10%+ for challenged properties in terrible neighborhoods. In Northeast LA (Silver Lake, Echo Park, etc.), you’re looking at 6-7.5%.
  2. For 5-20 unit buildings, a good estimate of expenses (including property tax but not including any mortgage payments) is 35-40% of the total rent.
  3. For 3-4 unit buildings, figure expenses at 25-30% of the total rent.
  4. In Los Angeles, you can estimate what your annual property taxes will be after you buy the building by multiplying the price by 0.0125 (1.25%).
  5. For 5+ unit buildings, lenders are currently willing to loan you 70-75% of the cost of a new building (meaning you need to put down 25-30%), so long as the debt-service coverage ratio is more than 1.25. (To find the DSCR, divide the anual net operating income by the proposed total annual debt payments. If the ratio is 1.25 or higher, the bank will loan).
  6. Interest rates for 5+ unit apartment buildings are between 4-5%, depending on the length of the loan.

Did I miss any? Let me know in the comments.

Is Echo Park 24% better than Highland Park?

Landlords must think so. After all…

A 1 bed / 1 bath apartment in Echo Park rents for $1,150, compared to $925 in Highland Park. That means EP comes in 24% higher, even though in Highland Park you almost always get parking and in EP, you almost never do.

Here are the other highlights of our survey:

  • Median asking rent for a 1 bed / 1 bath apartment in Echo Park was $1,150 (and these were mostly without parking)
  • Median asking rent for a studio was $1,050 (and there were only 5 on the market)
  • Median asking rent for a 2 bed / 1 bath was right around $2350 (though this was based on just 4 units)

Two more things worth noting:

  1. The total number of apartments available in Echo Park was 24. That’s an incredibly low number for a neighborhood with such a strong brand.
  2. A lot of the units we saw were in fairly rough shape. I’m kind of surprised that EP landlords haven’t spent the money to upgrade their units… because I know you can do A LOT better on the rents there if you do!

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 – February 2012.

Open Challenge to East Hollywood Landlords

Guess what we get for one bedrooms with no parking on Westmoreland in East Hollywood. Give up?

$1,500 / month.

Here is an ad for the 2 bedroom unit that we have on the market now. We’re asking $2,000 and we’ll definitely get it. [Edit: We got it.]

On a per square foot basis, those rents rival anything landlords get in West Hollywood. How is this possible?

Two things are going on, one any owner can control and one that’s just dumb luck:

1. We have amazing units. We gutted the building when we bought it and completely turned the apartments into little homes that people are proud to live in. A lot of that is just good design; it’s not like we spent a ton of money on high-end appliances or designer tiles. Here’s an example:

2. Location. East Hollywood is very close to Sunset Junction, which is one of the coolest, most walkable parts of LA. It’s not rocket science. Given a choice, most young people with money to spend on rent want to live near enough to bars and restaurants and cafes that they can have a great life without getting DUIs. Here’s where we are relative to Sunset Junction:

 

So here’s my challenge to my fellow landlords on Westmoreland and all over East Hollywood: Why aren’t you getting the same rents we are? Why not spend a bit of money on your buildings and turn them into the kind of places people actually want to live.

Make them more like this:

 

And less like this: