Moses Kagan on Real Estate

Right now:

• There is a ton of demand for apartments in LA; and
• There is a lot of capital seeking yield

This represents an opportunity for entrepreneurs, like Jon and me, to make money by partnering with the capital to provide housing.

Like most entrepreneurs in this space, we’re more or less agnostic about whether we service the demand by refurbishing older units or building new ones. If anything, we have a slight preference for building new, for ego reasons.

And yet our focus is almost entirely on refurbishing older buildings, which has the effect of driving up rents (because we’re taking low rent units and turning them into high rent units).

Why is our focus on these older units? Because the city makes building new ones so difficult and time consuming that the business is not really worth pursuing, unless you’re deploying capital at scale.

Think of entrepreneurial energy as water flowing downhill. You can let the water go where it wants to and just accept the consequences (in this case, refurbished apartments at higher rents). Or you can channel that water through a water-wheel on the way down (channeling energy into ground-up development)… the water still gets to the bottom of the hill, but in the meantime it’s done something socially useful.

So why are we doing the former, and not the later?

We just entered lease-up on a new building and the rents are coming in too high.

How on earth could I be concerned about rents coming in too high? Isn’t that a good thing for landlords?

Sort of, except that it means I’ve been missing out on deals that I could have been doing.

When we look at a deal, we’re trying to understand how much it will cost to buy and reposition and then what kind of cashflow we can expect thereafter.

The buy price is pretty obvious; it’s whatever we can negotiate with the seller. And the costs of repositioning are reasonably easy for us to estimate, since we’re constantly renovating buildings.

So, the variable that’s kind of unknown is the rents. We try to mitigate this with local knowledge; because we manage tons of similar buildings in the same neighborhoods, we generally have a pretty good sense for where we’ll end up.

But, particularly when it comes to new neighborhoods (for us!), we’re much less confident regarding our estimates. To combat this uncertainty, we opt for caution by using very conservative forecasts.

Which is fine, except when you blow those forecasts away (in this case, by like 20%) and then end up wishing you bought a lot more buildings!

Over the next few days, am going to spend a bunch of time revamping our standard lease.

Why would I do this boring job? Aren’t all leases pretty much the same?

The answer is, obviously, no way.

First, landlord-tenant law changes over time. As new laws are enacted and new court decisions come down, what is and is not allowed / enforceable in a lease changes. So, your lease needs to keep up.

Second, we are always running into new and interesting problems with tenants which we want to head off in the lease. Once enough of these little problems accumulate, it’s worth taking the time to revise the lease to deal with them.

Since college, where I regularly wrote 10-20 page papers in a day or two, my attention span has diminished. But I can force myself to do projects like this new lease, because I know it’s going to benefit our organization for years to come.

 

Attended a Princeton alumni event last night and got into an interesting conversation with a guy who is considering investing in a syndicated multifamily deal in Arizona. He asked me my thoughts.

Here’s what I told him: Focus on the operator, not the deal.

Why?

First, there’s no way an amateur is going to come to an educated opinion about a deal based on materials provided by the operator. You don’t know the market or the property. And the information you’re getting is provided by someone who wants you to do the deal. It’s not propaganda, but it’s not objective, either.

Second, separate from risk factors that no one can control (interest rates going crazy, the economy tanking, etc.), the operator is the one who is going to be holding all the cards. He’s the one who has chosen the property. He’s going to oversee whatever value-add is going to happen. He’s going to oversee the leverage. He’s going to set the asking rents. He’s going to police the management company. He’s going to pay himself fees (hopefully, only those set out in the operating agreement!). He’s going to choose when / how much to distribute back to the investors.

In short, when you’re in an illiquid real estate deal, the operator is king. So focus on what kind of king he will be.

How do you do this? Ask the following questions:

1. Has he done these kinds of deals before in this market? How have they worked out?
2. Is he putting in an amount of money that is material to him? (Remember that, early in an operator’s career, $50k can be a lot of money!)
3. Who else is investing? My biggest investor suggests the “were they invited to his wedding” test… if “yes”, that’s a good sign
4. Can you speak to other people who have invested in his deals? How do they feel about the results?

If you like the answers you get and you can live with losing your money (if it comes to that), then go ahead and invest. If not, run.

Had drinks with a friend who is an architect / developer last night.

We got to talking about a big piece of land he owns in Echo Park.

He is currently planning to develop it as a small lot subdivision and sell off the resulting homes.

I told him this may be a mistake, and here’s why:

If you believe in a neighborhood, why would you want to sell off land you own there? Instead, why not build apartments and collect rents which ought to increase as the neighborhood improves?

Otherwise, yeah, you’re making a lot of money on the sale (less the insane 50% tax you pay on for-sale development), but you’re letting someone else benefit from the upside.