Don’t walk into a rent control trap

Here’s a dangerous trap set for an unsuspecting buyer of an apartment building by a broker:

“Live in one unit and have additional income or use this 2800 s.f. structure as a single family residence.”

Let’s say you want to choose the later option. Can you? Absolutely not. At least, not without paying between $20,000-40,000 in additional cash to the existing tenants, going through some major legal hassles, and permanently impairing the value of the property. But the broker never mentions that in his listing (which I’m not linking to to avoid causing trouble for the other broker and me.)

Why can’t the new buyer do whatever he wants with his property? The 1978 Los Angeles Rent Stabilization Ordinance, otherwise known as rent control.

Over the years, rent control has become a big hairy gorilla of a law with all kinds of special exceptions and exemptions and with a major city department (LAHD) whose main purpose for existing is enforcement.

The good news is, you don’t need to understand all of it. But here’s a little primer for you. As always, caveat emptor (and broker).

  1. Rent control applies to properties in Los Angeles with two or more units built prior to 1978. This means that single family homes and anything built after 1978 are excluded from LA rent control. Note that the property above is a multi-unit building built well before 1978 and therefore is covered.
  2. Vacant units may be rented at whatever a new tenant will pay. There are some exceptions having to do with how the unit became vacant, but, basically, if a tenant moves out, you can try to rent the unit for whatever price you want.
  3. Once a tenant moves in, you can only raise the rent by an amount determined by the city each year. By law, this will be between 3-8% (recently, it’s been 3%). If you don’t raise the rent in one year, you can’t go back and raise it retroactively – you either use your annual increase or you lose it.
  4. Can’t evict a tenant unless he fails to pay rent. There are some exceptions to this rule, but, almost always, if they pay rent on-time, they stay. In the case of the building above, to turn the thing into a single family dwelling, you’d have to use the Ellis Act and would end up paying the existing tenants tens of thousands of dollars to leave, plus never be able to rent out the apartments ever again (which would permanently decrease its value).

When I explain these rules to people, their first inclination is to try to figure out ways around the Ordinance. And, to be honest, there are still a few tiny loopholes. But the loopholes disappear or get narrower every year. So, unless you’re a pro, don’t waste your time: if the tenant is there, he’s almost definitely staying.

One more thing: Rent control isn’t all bad. I have my problems with it, there’s no doubt. But you have to remember that 1. It does help some pretty poor people avoid being homeless (albeit in possibly the least efficient manner possible), and 2. It creates arbitrage opportunities for smart investors who buy rent-controlled properties, pay tenants to move out, rehab the buildings and increase the rents.

Imagine Your Building Burned to the Ground

When I look at a new building to buy, I almost always start by imagining it burned to the ground. Am I some kind of psycho?

No, I’m not (at, least, not that I know of). I imagine my building in ruins because it helps me focus on the most important aspect of any property: the land.

Particularly in cities, over the long term, land always increases in value. Why? Because the population grows every year but the amount of land doesn’t. So the demand for land increases but the supply is constant. I got a C+ in my college economics class, but even I know that increasing demand plus limited supply equals increasing prices.

You can always repair or replace a structure that is falling apart. But there is nothing you can do about a small or badly positioned parcel. And, on the other hand, it’s really hard to screw up a deal where the land is good – someone will always want to buy it from you.

So, when you’re looking at a property, imagine the building burned all the way to the ground. Think: Would I want to own this piece of land? What does the topography and the local zoning allow me to build on this land? Is the neighborhood in which this land is situated getting better or worse?

The best apartment deal isn’t necessarily the one with the absolute highest cap rate. Often, it’s the one with the reasonable cap rate plus the upside associated with an absolutely killer piece of land.

The Best Money I’ve Ever Spent

Out of the $500,000 we spent rehabbing my latest apartment building (here are some pics), the most important thing we bought cost $300. 

What was it? Advice.

We called in a great designer to pick colors for us. It took her 20 minutes of going through paint samples until she hit on the perfect combination of colors to tie together the whole building.

I get so mad when I see a beautiful old building savaged by some handyman who chose a color scheme based on whatever was on-sale at Home Depot. Those buildings call out to me… “Buy me,” they say. Because I know that I can paint them, add a bit of landscaping, remove some horrible window bars, and suddenly what used to be a depressing apartment building turns into a community good tenants would be proud to call home.

Sometimes this business isn’t rocket-science – you just need the right advice.

 

Median Silver Lake 2 Bed-Apartment Blows Past $2,100 / Month

Renters and Landlords know that the Silver Lake rental market is hot… but they might not know how hot.

 

The median asking rent for a 2 bedroom, 1 bath apartment in Silver Lake in January was $2,195 per month.

 

Other interesting conclusions from the survey:
  • Would you pay $250 per month for a bathroom in Silver Lake? Median asking rents for 2 bed / 2 bath apartments came in at $2,445.
  • Looking for a family apartment? 3 bed / 1 bath units came in at $2,725. Adding another bathroom gets you all the way up to $3,000. At least they all come with parking at those prices.
  • Studios are in very short supply. In late January, we could find only 3 real studios in Silver Lake proper, and they were asking between $900-1,100.
  • Median asking rents for 1 bed / 1 bath apartments came in at $1,400. That figure jumps to $1,450 if you want parking included.

What does all of this mean…

…for Silver Lake landlords: If you haven’t raised your rents this year, you should. Remember: Apartment buildings in Silver Lake are worth around 120x the monthly rent. So each $100 of rent increase increases the value of your building by $12,000

… for renters in Silver Lake: If you have decent credit, it’s time to consider buying. With mortgage rates below 4% and federal FHA loans available for up to 96.5% of the purchase price, you can buy a 2 bed / 1 bath home for about what it costs to rent one.

Where do these numbers come from? We reviewed all of the bona fide, Silver Lake apartment rental listings on Craigslist at the end of the last full week in January. Here’s the raw data: Silverlake Rent Survey – Jan 2012 – Final.

 

Income Property Teardown: 822 Sanborn in Silver Lake

Welcome to the “Teardown”, a series where I’ll take apart an income property listing and analyze it for the whole world to see. As always, all figures are estimates which you should not rely upon.

Today’s subject is 822 Sanborn, Los Angeles, CA, 90029, listed by Keith Cox of Keller Williams, Beverly Hills. Here’s a link to the MLS listing.

Key information
What: 4-plex built in 1923
Where: 822 Sanborn, 1/2 mile from Sunset Junction
List Price: $599,000
Unit mix: four one bed / one bath units, approx. 900 sq. ft. each
Building size: 3,780 sq. ft.
Lot size: 7,492 sq. ft.
Zoning: R3
Rent roll:

  • Unit 1: $658
  • Unit 2: $1,095
  • Unit 3: $1,153
  • Unit 4: $935

Buy/sell/hold: Strong buy.

The details
Here’s what I see when I look at this property: Low risk now, major potential upside later. Let’s drill into the numbers.

First, the present: This property is really close to Sunset Junction, the heart of Silver Lake’s ongoing gentrification. It’s generating $3,841 per month in rent, or $46,000 per year. At the list price, that’s $599,000 / $46,000 = 13x gross rent multiple. That seems high (remember, 10x is kind of normal right now), but you need to look a little closer to understand what’s going on.

The rents are low because of LA rent control. A large, renovated one bed, one bath unit in this part of Silver Lake can rent for $1,400-1,500 per month, depending on the quality of the renovations. So all of the tenants are paying between 15% and 60% below market. This is the upside of LA rent control: Tenants paying under market aren’t going anywhere. It’s actually not bad, because you can be assured you’ll get your rent every month.

How about the expenses? On a building like this, I would expect the expenses, including property taxes but not including mortgage payments, to come in around 25% of rents. That works out to $3,841 x 25% = $960 per month in expenses.

Deducting the expense estimates from the rents, I estimate there will be $2,880 per month in net operating income to cover the mortgage and/or put money in your pocket. Incidentally, that’s $2,880 x 12 = $34,560 in annual NOI. To get the CAP rate (for an explanation of CAP rate, go here), you can divide $34,560 / $599,000 = 5.8%. Another way of looking at this is that, if you invested $599,000 in cash, you would receive $34,560 per year in profits, or 5.8% per year.

The numbers above assume you buy this property as an investment, but that’s not what I’d recommend. Instead, I love this as an owner-occupier property, and here’s why: You can use your owner-occupier rights to displace one of the tenants, move in yourself, and this thing will cash-flow, even with only 10% down.

To displace the tenant, you’ll have to pay roughly $10,000-19,000, depending on how long the person has lived there, how old they are, whether they have kids, etc. Under LA rent control and because all units are the same, you’d have to bump the person who moved in most recently, which I assume is the tenant paying $1,153. So you get the property in escrow, issue your notice, pay your $10,000 in cash, wait your 60 days, and move in.

You use an FHA mortgage to buy, put down 10% of the purchase price, and borrow the rest at a very low interest rate, fixed, for 30 years. Assuming $599,000 x 10% = $59,900 down and a $539,100 mortgage at 4.5%, your monthly payment is $2,731, plus a bit of private mortgage insurance (PMI).

Your monthly outgoings are $960 in expenses plus $2,731 in mortgage plus $200 in PMI, or $3,891. But you’re very confident of bringing in $2,688 from the remaining units (and this will go up by 3% per year under LA rent control). So you’re only paying $1,150 per month to live in a unit that would fetch $1,400 or more on the open market. That means you’re “profiting” at least $250 / month, or $3,000 per year, on an investment of $59,900 down plus $10,000 for relocation = $69,900. That’s an annual return of $3,000 profit / $69,900 investment = 4.3%. But wait (as Billy Mays used to say), there’s more.

Remember I said this is a high upside deal? That upside comes from two things: Rent increases and development potential. First, the rents: If any of your tenants moves out, BOOM, you raise the rent to market, instantly adding hundreds of dollars per month to your rents and, therefore, your profits. Second, development: This is a nearly 7,500 sq. ft. lot zoned R3, which means you can potentially build 9 condos here. You’re probably not going to be the one who develops it… but the guy who buys it from you might be, and they can pay as much as $100,000 per potential unit for land like this. (I’ll let you do the math on this last piece.)

Conclusion

822 Sanborn is the kind of deal you search for. You get a very stable, easy to manage apartment building in a rapidly gentrifying area to live in now. The rents increase every year by 3%, which adds up quickly. With any luck, one or more of your rent-controlled tenants moves out and you raise the rent by a lot more than that. Maybe you own this building for 30 years and end up with a cash-cow that supports you in retirement. Or, maybe, in the future, you sell to a developer at a very large profit.

Interested in discussing 822 Sanborn or other income properties? Give me a call at 310 994 0001 or email me at moses@betterdwellings.com.