Moses Kagan on Real Estate

How would you like to be in a business where the law dictates that your biggest expense grows more slowly than your revenue? That’s what happens for owners of rent controlled apartment buildings with under-market tenants in Los Angeles.

Here’s how:

As an apartment building owner, your biggest operating expense every year is the property tax bill. For example: In 2010, for my first apartment building (a 16 unit building near Silverlake in LA – read about it here), out of operating expenses of around $62,000, property tax came to around $14,000 (22% of total expenses). The next largest individual expense lines were utilities, at around $12,000 (this building has one gas meter and I pay it- ouch) and general repairs, at around $7,000. Nothing else was more than $4,000.

Ah, but what about rents? Under Los Angeles’ rent control (called the Rent Stabilization Ordinance), annual rent increases for rent-controlled buildings (anything built before mid 1978) are limited to between 3-8%, with the actual number determined by a committee each year.

Imagine you buy a small building for $350,000. Maybe you have four one bedroom units that could rent for $1,000 on the open market, but you have tenants paying $700 and they have the right to stay forever. Bummer, right?

Not necessarily — check the numbers: In year one, your property taxes are 1.25% x $350,000 = $4,375. Let’s assume your other expenses are around $7,400 (I’ll explain this assumption in a later post). Your total expenses (before mortgage payments) are therefore $11,775.

Your rents are $700 x 4 units x 12 months = $33,600.

So your net profit (again, before mortgage) is $33,600 in rent – $11,775 in expenses = $21,825. Not bad.

Now, let’s zoom ahead 10 years. We’ll make the following assumptions: Property taxes grow by 2% per year (by law!). Rents grow by the minimum legal amount in Los Angeles (3%). Other expenses also grow by 3%.

Here’s what your profit and loss statement looks like now: Rents have risen to $45,155. Property tax is up to $5,333. Other expenses are now $9,945. So your operating profit before paying your mortgage is now $29,877. That’s around $8,000 more per year in your bank account!

And here’s the best part: This building is a piece of cake to own. It’s like a savings bond with upside. Your tenants NEVER move out, because their rents have remained at least 30% below market the entire time.You just collect the rent, make sure the place is in decent shape, pay the bills, and collect your profits every year.

In the unlikely event a tenant moves out, you throw a party and raise the rent by $300 per month, adding an additional $3,600 to your annual profit.

It’s amazing how that 1% difference in growth rate of rents and property taxes makes so much difference to your bottom line. For that, you can thank Prop 13.

If you live and work in California and you don’t own real estate, you’re getting screwed. Let me explain:

California residents, furious about rapidly increasing property taxes in the 1970’s, passed Proposition 13 in 1978. The law does the following:

• Causes real estate to be assessed for tax purposes at the time of purchase
• Limits property tax to roughly 1.25% of the original purchase price
• Limits tax increases to roughly 2% per year

Here’s an example of how the law works in practice: Let’s say you bought a beach house in Malibu in 1979 for $250,000. Your taxes that first year were 1.25% of $250,000, or $3,125 per year. After 32 years, your taxes are now $5,889 per year. Seems like a big jump, right?

Wrong. $5,889 is 1.25% of $471,000, so the state is implying that your beach house in Malibu is worth $471,000. Now, we all know that your beach house is worth A LOT more than that — maybe $5 or $10 MILLION. But because of Prop 13, the state can’t re-assess the beach house to its real value until you sell it.

Most states get most of their tax revenue from property taxes. When property values go up, they simply re-assess the owners and collect more money. But, because California can’t raise taxes by more than 2% per year unless there’s a sale, it needs to get money some other way. And that’s how you get screwed.

The main sources of additional revenue for California are sales tax, income tax, gasoline tax, and various fees (for example, for registering your car). When expenses go up by more than 2% per year, California has no choice but to raise non-property taxes to make up the difference.

So, if you don’t own property but do have a job and buy things, you’re subsidizing government for those of us who do own property. Don’t feel like subsidizing everyone else with your tax dollars? Start thinking about owning property.

 

I’m a real estate guy. It’s in my blood. My great grandfather, Morris, owned apartment blocks in the Bronx and a building in Manhattan. My grandfather, Leonard, owned commercial and multifamily in Rockland County, NY and was also a broker. My parents own several small apartment buildings in upstate NY.

I grew up answering calls from prospective tenants and shoveling out buildings on snow days. My first memory of a hard day’s work is of pulling weeds at 1 Washington Place in Troy, NY, a building my parents still own.

In 2007, I moved back to the States from London, where I did my graduate work at LSE and worked in investment banking, to start a real estate business. After checking out the insane relationship between (high) prices and (low) rents on every smaller apartment building on the market, my brother and I found a developer, Felix, who had gotten into trouble renovating a 16-unit building. The building was almost finished. Best of all, unlike most older buildings, it had no long-term tenants paying below market rents.

Felix had to sell. We saw the opportunity to buy a distressed asset at a pretty great price. After a painful sale process, we closed in April of 2008. I was excited for about five minutes. Then reality set in.

I’ll never forget the moment I realized we were now the owners of a not-quite-finished apartment building with no tenants and a big mortgage payment to make. It was terrifying. But we finished the building and filled it with tenants. We never missed a payment. If growing up a Kagan was our introduction to the apartment business, this was like freshman year of college, and I felt pretty good about passing.

Through this blog, I hope to share my what I’ve learned from buying and managing that first building and the twelve other ones I’ve bought or sold since. I’ll tell the story of how we came to own more than 100 apartments in LA within the next few years. I’ll share the ins-and-outs of LA rent control, dealing with tenants, how to spot a deal, the pitfalls of renovating, how to re-finance, etc. In short, I’m going to use this as the place to download all I’ve learned about the apartment business.

I look forward to sparking a conversation with those of you who already own or manage apartment buildings and those of you considering getting into the business.