Introduction to Los Angeles Zoning

Get it through your head: The land is important!

Too many buyers don’t understand that the land component of a property is potentially it’s most important aspect. Why? Well, buildings all fall down in the long run. But land is unchanging and often has potential.

What do I mean by potential? Well, in the absense of government regulations, you can always build a lot more structure on a given parcel of land. Buy a single family house, knock it down and building a fourplex. What stops you from doing that in LA? Zoning.

Zoning is a form of governmental regulation that determines what can be built, where.

LA’s zoning code is particularly terrible, since it was designed for a city of detached, single family homes, making it extremely difficult and expensive to develop apartments or condos, which are the kind of denser development the city desperately needs to combat sprawl and traffic. OK, lecture over.

For the purposes of the apartment investor, here’s what you need to know about the relevant types of LA zoning:

  • R1 – This is residential home zoning, but an apartment building in an R1 zone is allowed to continue to operate because it’s grandfathered in. In a way, it’s the best scenario, because you know no one can build any more apartments to compete with you.
  • R2 – Slightly denser than R1. You can building one dwelling unit per 2,500 sq ft of land. So if you have a 5,000 sq ft lot, you can build two units (provided you meet the other requirements)
  • RD1.5 – One unit per 1,500 sq ft of land
  • RD2 – One unit per 2,000 sq ft
  • R3 – This is where things get interesting. One unit per 800 sq ft
  • R4 – One unit per 400 sq ft
  • C1 – Commercial zoning; but can be treated as R3 if you want to build apartments or condos
  • C2-5; CM – Treated as R4
  • MR1 – M3 – Treated as R4

Why does all of this matter? Because a property’s value is to some extent determined by its potential. Say you’re looking at two otherwise identical single family homes on 6,000 sq ft lots in Echo Park:

  1. Property A is zoned R2. To find out how many units you could build there, divide 6,000 / 2,500 = 2 (the city always rounds down). So you could build two units.
  2. Property B is zoned R3. So divide 6,000 / 800 = 7 units.
Right now, apartment developers can afford to pay you  around $50,000 per unit for well-situated land to develop. So the land underneath Property B is worth $350,000 by itself (ignoring the value of the home). By this measure, Property A’s land value is obviously only $100,000.

 

So identical pieces of property can have vastly different values due to their zoning. And that’s why you pay attention to boring zoning codes.

 

Want more info? Here’s a Zoning Summary.

Legalese: I’m not an architect or a land-use attorney, so this is not architectural or legal advice.

Buying a single family home for investment purposes

Recently, I’ve had some people approach me about buying houses for investment purposes.

The concept is simple: There are loads of people out there who either can’t or won’t buy a house right now. They choose to rent (hopefully from me!) instead. But there are lots of people trying to sell their houses… both individual owners and also banks (which got them through foreclosure). So there is an opportunity for investors with cash and / or the ability to get mortgages to  step into the breach, buy unwanted houses, and rent them to appreciative renters.

Depending on the neighborhood, you can even find individual houses that, as rentals, not only cover the mortgage but also yield some cashflow. (That’s pretty much all the evidence you need that it’s time to buy real estate.)

Let’s do some math on a real, sample property in Echo Park to find out how the numbers work. Here are the facts about Property A:

  • Single family home
  • 2 bed / 1.75 bath, plus bonus studio
  • 860 sq ft home on 4,00 sq ft of land
  • Priced at $400k

Say you buy it for $380k as an investment property. Here’s how the deal works:

  • Put down 20% (banks require at least that much for an investment property these days), or $76k
  • Borrow $304k at 4.5% (interest rates are a little higher for investment properties) fixed for 30 years
  • Mortgage payment of $1,540 / month
  • Property taxes of ($380k x 1.25%) / 12 months = $396 / month
  • Add in $100 / month for gardener plus another $100 / month for insurance
  • Total costs of $1,540 + $396 + $100 + $100 = $2,136 / month
  • Rent the house out for $2,400 (you might do better, but let’s be conservative)
  • You’re netting $264 / month or $3,168 / year in cash
  • Plus, you’re reducing your loan balance by about $400 / month or $4,800 / year of your mortgage (this goes up gradually over time)
  • So your total return on your downpayment is ($3,168 + $4,800) / $76,000 = 10% in the first year

And that’s not all. You’ve got a fairly highly leveraged investment. If the property appreciates by 1% over the first year, the value of your equity will grow by an additional $3,800 (ignoring transaction costs involved in actually selling).

One caveat: As previously discussed here, it’s a little risky to depend so heavily on one tenant to make your mortgage payments. You need to be in a position financially where a month or two of vacancy won’t kill you… otherwise, buy a fourplex.

Interested in buying the property above or one like it? Have $75-100k in the bank and decent credit? Get in touch!

The numbers are in: South of the 101 is better than Silver Lake

On the numbers alone, buying income property south of the 101 beats buying in Silver Lake. There, we said it.

Before we get to the numbers, the area we’re talking about includes part of Westlake/Historic Filipino Town and the southern part of Echo Park. We’re going to call it…”South of the 101″.

Here’s a map:

Here’s the “by the numbers” comparison:

Highlights of our analysis:

  • Both the GRM and CAP rate tests get at the same idea, which is that you’re paying much less south of the 101 for each dollar of income
  • On a bulk basis, where you ignore the rents and focus on the price per sq ft and the price per unit, south of the 101 also wins… you’re paying roughly half of what you’d pay in Silver Lake
  • Finally, a note about rents, which aren’t captured in the above numbers: The rents are much lower south of the 101, in general. If you assume that there’s some kind of cap for what you can charge a normal, working tenant, it would appear that Silver Lake is a lot closer to that cap than South of the 101… so you might argue that there is more room for future rent increases to the south.

A possible explanation:

  • Silver Lake is, generally, an amazing place to live, while the area South of the 101 remains pretty rough, albeit with some nicer pockets
  • Most buyers these days are using FHA loans, which require that the buyer live on the property, at least for a while
  • Anecdotally, many of the buyers I talk to are simply unwilling to live south of the 101, at almost any price
  • So, non-resident buyers (investors) and those resident-buyers willing to tolerate a crappier neighborhood clean up to the south, because there’s so much less competition.

Interested in the Silver Lake numbers? Here they are.

Interest in exploring buying an income property, either north or south of the 101? Get in touch.

Fine print: 

We looked at properties listed as sold by the MLS between 3/11/11 and 3/12/12 in the area defined in the map above. There were 18 properties in the initial sample. We removed four properties which, for various reasons, would not have qualified for a mortgage, meaning that only a professional flipper could buy them. For the remaining properties, we estimated the rents for units which were delivered vacant at time of sale. We also estimated the cap rates based on an expense margin of 30% of rents.

The Silver Lake sample used for comparison was for the six months to 2/28/12, while the South of the 101 sample was for the 12 months to 3/12/12.

Properties south of the 101 are generally older, so the maintenance costs may be higher, a fact which we’re ignoring.

My brother and I own a property on Reno St in the area in question. So maybe I’m biased.

Based on information from the Association of REALTORS®/Multiple Listing as of 2/28/12 and /or other sources.  Display of MLS data is deemed reliable but is not guaranteed accurate by the MLS.   The Broker/Agent providing the information contained herein may or may not have been the Listing and/or Selling Agent.

Here’s the raw data: Income Prop Survey – South of the 101 – March 2012

Why you should get pre-approved for a loan

Say you decided to sell your building and I offered to buy it. Say I offered you the following deal: I’ll buy your building for $1MM, but first I want you to guarantee you won’t sell it to anyone else for the next 45 days while I get the money together.

You would be an idiot not to check if I had the ability to get the money before allowing me to tie up your property for 45 days, right?

Most sellers aren’t idiots. They want to know that the person who is offering to buy their property at a certain price has the wherewithal to do the deal. And that’s where the pre-approval letter comes in.

A pre-approval letter is a letter from a bank or loan broker attesting to the fact that you, the buyer, are capable of getting the loan necessary for you to close. Either implicitly or explicitly, the letter assures the seller that someone knowledgable about getting loans has looked at your credit score, your tax returns, your employment history, etc. and has determined that you will be able to get the loan you need. It’s not binding (neither you nor the seller can sue the bank if they don’t end up doing the loan), but it does provide some comfort.

Incidentally, the pre-approval process is great for buy-side brokers (like me), because it filters out serious buyers from bs artists. The process of getting pre-approved isn’t terrible, but it does require that you open your kimono for a lender or loan broker. Your willingness / ability to do so is my first indication that you are worth spending my time on.

So, when you call me about buying your first property, and I immediately refer you to a loan broker, don’t be surprised. It’s the best way for everyone to gauge just how serious you are about making a deal.

OK, I want to buy a building. What do I do first?

Call me. J/k. Sort of.

The first thing you need to do is take stock of your current position. Here is what you need to get started:

  • A decent credit score. FHA will loan down to a 580 score, but ideally you’d be north of 700.
  • A stable work history. The ideal loan applicant would have worked in the same job for 2+ years with stable or rising income which is reflected in his/her tax returns.
  • A bit of cash. Depending on where you want to buy, you’ll want at least $25,000 in the bank for a minimum of two months. FHA will allow you to get the money from someone as a gift, but you’ll be better off it’s been sitting in your account for two months before you even begin the loan process.

If you’re missing one or more of the above, don’t worry. Cash can cover up a lot of sins. If you can get together enough cash to put down 20-30% of the purchase price, you’re almost definitely going to be able to get a deal done, even with bad credit or a non-traditional employment history (though the terms of the loan won’t be optimal). If you do have all of the above, or if you have a bunch of cash, you’re ready to get started.

The next thing you need to do is determine what sort of property you’re looking for. For a first time buyer who fits the loan criteria, I strongly recommend an FHA mortgage, which means you’ll be limited to 2-4 units. My advice is to be open minded, but to favor 3-4 units over two. (If you already own property, or are going to be putting down 20-30%, go with more units, since you’re not getting the benefit of a high-leverage FHA loan anyway.)

Next, you want to determine where to look. All other things being equal, I recommend areas where the rents are increasing. Buying a building for a fair price with a fixed, 30 year mortgage in an area with increasing rents will turn your good investment into a home run without you having to do much. To find increasing rents, look for gentrifying areas (in LA, try Echo Park, Highland Park, etc.).

Finally, you want to find an experienced agent… hence my semi-joke above. I am sometimes guilty on this blog of making buying buildings seem easy. But you have to remember that buying a building with a mortgage is basically equivalent to doing a leveraged buy-out on a small business. Leverage (debt) magnifies outcomes. This means that, if you do a good deal, you do very well. But if you do a bad deal, you can do very badly. You wouldn’t do a leveraged buy-out without getting advice from someone who knows what they’re doing. Don’t make that mistake with an apartment building!

So find an agent you trust. Tell him/her what your resources are, what kind of building you’re looking for, and where. And listen very carefully to what he/she tells you. You’re probably 60-90 days away from buying your first cashflowing asset.