SROs: A new, old idea

I read a TON about business, in general, and real estate, in particular. So it’s fairly rare for me to come across an idea that’s genuinely new to me. But I came across one last night, during a conversation with a much more experienced owner-operator, that I’d like to share.

We were discussing the housing affordability crisis currently affecting cities across the country, and particularly on the West Coast.

The usual suspects came up: Zoning, construction pricing, stricter building codes, etc.

But he had another take: That cities ought to be allowing the construction of SROs (single-resident occupancy hotels).

SROs are cheap to build, because the residents share communal kitchens and bathrooms, and generally don’t get parking. Because they cram a lot of people into a relatively cheap structure, they can generate a good yield, even with very low rents.

SROs flourished in LA and other cities during most of the 19th and early 20th Centuries. Young, unmarried men, in particular, used to congregate in SROs while they worked to find their footings in adult life.

However, during the 20th Century, cities adopted more stringent zoning codes aimed at increasing property values and banned construction of SROs, either explicitly or through things like minimum dwelling size restrictions, parking requirements, etc.

In doing so, city governments wiped out a whole stratum of cheap housing that was ideal for single people, thereby forcing those people to double- and triple-up in conventional apartments, pushing the price of those units up as well. From a housing affordability perspective, this wasn’t so smart.

Now, you could argue that the birth and growth of the co-living model is sort of a rebirth of SROs. However, it seems to me that the co-living companies target the more affluent end of the single-renter demographic, by bundling in expensive services and space (like group dinners, communal living rooms, etc.), which drive up the monthly rent.

Perhaps what is needed, as my fellow owner / operator pointed out, are new SROs, or co-living facilities stripped way down to allow for the lowest possible monthly rent.

Why I oppose Prop 10

Want to add my voice to those urging people to vote against Prop 10.

Oh, you say, what a surprise! A real estate guy who dislikes rent control! Shocking!

But, honestly, we’ve learned how to make money for ourselves and our investors under rent control. The more buildings that are subject to rent control, the more opportunity there will be for us.

It’s not just that there will be more buildings to buy. Rent control “locks up” units, because people who are paying under market rents very rarely move by choice. The more units locked up by rent control, the fewer units available at any one time in the spot market, where rents are actually determined.

So, since demand isn’t going to decrease by a commensurate amount (and, in fact, is likely to keep rising), expanding rent control means rents for those few units that become vacant will increase. That’s good for us, too.

If Prop 10 is likely to benefit me, why do I oppose it?

It’s terrible public policy, because it favors the status quo over the future. Why?

Say you’re a company looking to expand in Los Angeles. Because rent control focuses the intense demand for new units on a tiny sliver of the total apartment stock and, therefore, pushes asking rents to the moon, you have to pay your new hires extremely high wages in order for them to be able to live in the city. That means you’ll hire fewer people, decide not to expand, or expand elsewhere.

Or, suppose you’re a kid who has grown up in LA. You finish highschool or college and want to find a place here. Bad news: You can’t afford to live here, because you’re competing with higher-paid people for that same tiny sliver of the apartment stock that’s available.

If we want a growing, thriving city, we need policies that favor growth and dynamism, not ones that lock in place the way things are now.

Help support more housing along the Expo Line

Am writing today with a request: That you click the link below and add your name to the long list of people and organizations in favor of adding more housing along the Expo Line in LA.

Here’s the link.

Regular readers know that LA’s housing crisis is basically the result of terrible land-use planning. We have plenty of land to build enough housing to meet the demand… but we stupidly reserve vast swathes of it for single family homes.

The results are predictable: High housing prices, sprawl, and lower property taxes per square mile, resulting in less revenue to maintain infrastructure like roads and water pipes.

Fortunately, there is a solution: Mass transit (to take cars off the road), coupled with much higher allowable housing densities near transit stops (to increase housing supply).

The two are mutually reinforcing:

  1. Each new line / stop makes the whole system exponentially more useful for everyone who lives and works close enough to stations to use it; and
  2. The more people who live and work close to stations, the more riders there will be, raising revenue and demand for yet more investment

In short, we can create a virtuous cycle that helps to solve our housing crisis.

The problem? We still have a bunch of hold-outs who are trying every trick in the book to block changes to the zoning code that would allow for more density. And so Abundant Housing LA, a group dedicated to addressing these issues, is asking for our help in pressuring these hold-outs to allow for more housing to be built where it will do the most good – right near the stations of the new Expo Line.

Won’t you join in?

Let’s behave ourselves

Have been stewing over the behavior of a few of our competitors, who skirt city law in order to drive up the returns they earn on deals.

All businesses are subject to some level of government regulation. For a variety of reasons, including the fact that the assets are immovable, the ownership of rental housing is probably the most heavily regulated of all.

Many owners and developers hate and fear this regulation. And they’re not crazy. Anyone who has spent time winding her way through the Kafkaesque maze of rules where LAHCID and LADBS overlap can be forgiven for getting emotional.

But we need to remember that our business exists at the sufferance of the public and their elected representatives. The regulatory environment can always get worse, particularly if bad actors cut corners and take advantage of people.

So, we need to conduct our business in a fair and above-board manner and comply with the existing regulations, while patiently making our case to the relevant decision-makers.

Cities will always need clean, safe, well-maintained rental housing. So, as long as the suppliers conduct ourselves in a reasonable manner, cities will continue to have an interest in allowing us to make a reasonable return on our investments.

How increasing replacement costs imply a widening investment moat

Experienced real estate investors know to keep an eye on replacement cost when considering rehab deals.

The idea is to try to ensure your property will have a cost advantage vs. its neighbors.

The thought process is pretty simple: When considering doing a project, you want to look at what it would cost a competitor to buy a lot nearby and build a building from scratch to compete with you. You want to try to ensure that your all-in cost, on a per square foot basis, will be lower than your competitor.

Here’s an example of the calculation:

  1. Assume you’re looking at a 10,000 sq ft, 10 unit building you want to buy and rehab
  2. Say you’ll be all in for $3,500,000, which equates to $350 / sq ft
  3. Assume further that the lot next door is zoned for, say, five units, and similar lots have sold for $1,000,000 (eg $200,000 / unit of land)
  4. Assume that building a 5,000 sq ft, 5 unit building ground up on that lot would cost $300 / sq ft, or $1,500,000

To come in and compete with you, someone would need to spend $2,500,000 ($1,000,000 for the lot, then $1,500,000 to build). So, for his 5,000 sq ft building, he would be all-in for $2,500,000 / 5,000 = $500 / sq ft.

To carry the calculation to its conclusion:

  1. Assume you can each get $3,000 / month for your units ($36,000 / unit / year) and that expenses will equal $10,000 / unit / year, implying net operating income per unit of $36,000-$10,000 = $26,000
  2. On your 10 unit building, you have invested $3,500,000 to get $26,000 x 10 = $260,000 of net operating income, or a yield of $260,000 / $3,500,000 = 7.4% (awesome!)
  3. Your competitor would be looking at investing $2,500,000 to get $26,000 x 5 = $130,000, or a yield of 5.2% (a terrible outcome)


Obviously, the higher the cost to compete with you goes, the lower the yield a competitor can expect. And the lower the yield he can expect, the less likely he is to come in and compete with you.  Less supply means more pricing power for existing suppliers, implying higher rents and, therefore, net operating income and free cashflow.

What we have here is a naturally-occurring investment moat (for more on the concept, you go read Warren Buffett), one which works to protect and enhance your return over time.

Want to end by sharing a few implications of the above:

  1. If the city wants the market to supply more apartments, it desperately needs to reduce the cost of doing so. Most of the conversation in this area lately has been about up-zoning, which in theory ought to reduce the per unit cost of land. Much more attention needs to be paid to construction costs, which, after all, make up a much large portion of the total cost of building ground up.
  2. As construction costs have gone through the roof over the past few years, the moat protecting existing owners has widened.