State of the market

I’ve only been doing this for five years or so. I jumped in in 2008, meaning that I’ve never seen a normal, healthy, strong real estate market in Southern CA.

I think I’m seeing one now, and I have to tell you: It’s not pretty for multifamily investors.

Go check out the apartment buildings listed on Loopnet and the MLS for your standard gentrifying areas (East Hollywood, Silver Lake, Echo Park, etc.). What you’ll find is, generally speaking, a collection of over-priced junk.

Why “junk”? Rents have gone up by something like 10% in those areas this year. Anyone who sells a building with rents doing that is either a professional with investors to pay out (like me!) or else has a truly crappy building that, for reasons of tenancies (rent control) or physical condition, is incapable of taking advantage of the run-up in rents.

Why “over-priced”? There are basically two ways to look at apartment buildings:

  • On an income basis: For simplicity’s sake, let’s take GRM (which looks at the relationship between total annual rent and purchase price). Paying more than 11x GRM for a building pretty much guarantees little or no cashflow. For the most part, you can’t touch anything in the areas I’ve mentioned for less than 12-13x. And there are plenty of deals being marketed at 15x+. There ought to be a warning label attached to deals like this, something like: “Warning: At this price, this building is a weapon of mass cashflow destruction”.
  • On a sq ft basis: Sometimes buildings don’t work on a GRM basis but they’re still reasonable because you’r getting the thing cheap on a per sq ft basis (bonus points if you realized this only happens when the rents are very low). I renovate buildings for a living. To take your standard PoS 1920s building and make it perfect, you’re looking at spending $50-70 / sq ft, easily. That means, to make a deal make sense, you’ve got to buy it for something like $200 / sq. But that’s not where most of these screwed-up buildings are priced right now… they’re at $250 / sq (and 15x GRM). If you buy something like that with the intent to renovate, you are very likely going to lose money.

So, where does that leave buyers?

Two choices:

  1. Pay retail for renovated projects.  For example: My 1947 Clinton St deal, which was fully renovated with good tenants, was priced at around $310 and 11.5x GRM. The guys who have it in escrow are getting a steal (assuming they close). If you’re going this route, make sure the quality of the renovations is high (hint: check for permits!).
  2. Roll up your sleeves and add some value. There are definitely deals out there where you can leg into a good cash-on-cash return if you’re willing to hustle. You just need to be well-capitalized and willing to take the risk of buying something with some hair on it (vacancy, physical issues, evictions in progress, city problems, etc.). If you’re going to take on something like this, you better be prepared to spend your time on it.

Bottom line: 12-18 months ago, you could make money by buying almost anything. Now you have to be smart and careful.