How you get them to believe a $1MM building is now worth $2MM

When I re-position a building, the numbers often look something like this: I buy the building for $1MM, spend $500k on renovating it, and then ask a lender or buyer to believe that the building is now worth $2MM, based on the rents I am achieving from the new tenants.

Now, obviously, the lender or buyer is going to have some questions, the most important of which is: “How do you expect me to believe that this building you just bought for $1MM is suddenly worth $2MM?!”

The answer to this question is that the new valuation is justified by applying a market cap rate to the new net operating income or a market gross rent multiple to the new rents. (For more information about how this work, please click here.) So the new valuation is entirely dependent on the new rents.

The goal is to be in a position to demonstrate the true profitability of the building to a lender or potential acquirer. You do this by sending them the actual profit and loss statements (P&Ls) generated by your accounting software, often called the “actual P&Ls” or “actuals” (as opposed to “pro forma P&Ls”, which are estimates of profitability).

Why are actuals important? You’re not going to believe this, but there have been occasions where people in the real estate business have fudged those new rents. They’ve signed leases with higher rents and then kicked the tenants back cash under the table to reduce the effective rents. Or they’ve got their friends to move in and sign leases at high rents, knowing that the owner won’t evict them for non-payment. Or the owner is successful is tricking people into signing leases but the tenants break their leases and move out after living in the building for a short time because it’s not worth the money.

So, lenders and buyers are justifiably nervous about accepting the new rent roll as gospel. Instead, they want to be able to look at your actuals and see the money flowing in from the rents and out to cover the expenses for a reasonable period of time, usually 3-12 months, depending upon the lender or buyer. The more months of P&Ls you can show, the more apt they are to believe you.

Inspection Day and Closing Day

Busy day today, so I thought I’d keep it kind of brief and just give you a run-down of what I’m up to:

1. Am helping clients with inspections on a beautiful 1920s fourplex they’re thinking of buying Boyle Heights using an FHA loan. We’ve been at this one once before, but one of the tenants wasn’t home and the landlord refused to open the unit without the tenant being there. So now we have to go again… not that sweet. But it’s a nice deal and I’m hopeful it works out. Will let you all know what happens in a subsequent post.

2. Closing day! My partner, Jon Criss, and I have partnered with some investors to buy and renovate a five unit building in Echo Park. We close today, after which I take over management. We’ve already planned the renovations (which are going to be amazing), so the next few weeks are going to be about striking the deal for the contracting (which my partner will probably do) and then waiting for the existing tenants to move out so we can get started. It’s kind of a small project for us, but one which we hope will lead to many more in the future.

Wish me luck!

 

LA’s crazy Metro system

Want to see something really insane? Check out the location of the Gold Line Extension stop at Pico / Aliso (the little red “A” on the map below):

Can you figure out why I hate the placement of this station?

Here’s a hint: Look at the use of the land on the north side of 1st St., stretching to the east. See how it’s playing fields? Look to the west… it’s a huge LAUSD school.

Who the hell wants to walk by 1/4 mile of playing fields or school buildings to get to the metro? Imagine doing that walk at night… it would be absolutely terrifying.

As developers, we’re always looking to find cool, little, walkable neighborhoods where you can create distinctive places to live. In some ways, the western part of Boyle Heights fits the bill. It’s really close to downtown, has a metro stop that takes you right into the Arts District in two seconds, and has some relatively cheap buildings you could potentially buy and turn around.

Sadly, whoever chose the location of this Metro stop pretty much guaranteed that no one would be able to do anything interesting around it. Just a text-book case of bad transit planning.

Grandfathered zoning in LA

What does “grandfathered zoning” mean with respect to apartment buildings? To understand that, you first need to understand that zoning in Los Angeles has generally become stricter over time.

For a long time, there wasn’t any zoning. You could just buy a few single family homes, rip them down, and put up an apartment building. If you drive around the streets to the south of Sunset in Silver Lake, you will see some rather large buildings on streets which are otherwise full of single family homes. These are examples of buildings built before zoning.

Over time, homeowners in the city forced the government to impose some restrictions on building apartment buildings in single family areas. Now, much of the city is zoned R1 or R2, zones which generally make building apartments impossible. But what about those old apartment buildings standing in what are now R1 or R2 zones?

Well, it would have been an unconstitutional taking for the city to rip the buildings down without fairly compensating the owners. And buying out all those apartment building owners would have been ruinously expensive. So the city just left those buildings alone.

That is the meaning of “grandfathered in”. Because they’ve been in those zones since before zoning existed (or, at least, before it got strict), those buildings are allowed to stay. In fact, an owner of one of these buildings can generally get what is called a “re-build” letter from the city, which gives him the right to re-build the building if it falls or burns down, even though the zoning wouldn’t allow the owner to build the same building on the lot if it hadn’t existed in the first place.

But no one can build another apartment building on those streets. And that’s why those buildings are valuable. Because they will never have any more competition for renters than they do right now.

When a deal goes bad

If you make enough deals, eventually one goes sour. Here’s one that went sour on me…

We were looking into developing some small-lot sub-division homes in Silver Lake. We found a lady selling a house on a properly-zoned ¬†piece of land. We contacted her next door neighbor, whose duplex wasn’t for sale, and convinced him to take godfather offer for his property. By joining the two parcels, it looked like we could develop 14 small homes on the two parcels, enough to make it worthwhile to buy them.

Once we got both properties under contract, we jumped into the due diligence. We spent a lot of money on soil testing and bringing in an architect to figure out how to lay out the homes on the land. We got some bad news: Because of the slope and some other factors, we could only build 12 homes, not 14.

Once we lost two of the 14 units, the deal stopped making sense. We were within our contingency period, so we went back to the sellers, told them the deal didn’t work for us anymore, and signed escrow cancellation instructions. The first lady was fine; she signed the cancellation instructions and we got our deposit back.

Property owner number two was different. He refused to sign the cancellation instructions. Without them, we couldn’t get our money back from escrow. He had a two-bit lawyer write me a letter alleging that we had cancelled the deal for illegitimate reasons and that he therefore deserved to be able to keep our deposit (which was around $20,000).

I was enraged. I called all the lawyers I work with and explained the situation. They were unanimous in telling me two things:

  1. I was right, and
  2. I should just negotiate a settlement and move on
We ended up going to mediation, as called for in the standard real estate purchase agreement. They put you in separate rooms while a retired judge beats on you to accept a settlement. He tries to undermine your confidence by getting you to imagine what would happen if you actually went to arbitration and the other guy won.

Now, I knew the other guy would lose in arbitration. We were CLEARLY without our rights to cancel the deal. And he was acting totally in bad faith by refusing to sign the cancellation instructions. But my time is valuable (and, because he’s an under-employed jerk, his isn’t), so I wasn’t inclined to fight it out, even though I knew I would win. We settled. I seethed as this guy walked away with some of my (and my investors’) money.

What did I learn? A few things:

  1. I should have fought that guy through to arbitration. It wouldn’t have made economic sense. But sometimes you need to act on principal, even when it hurts you in the short term. I won’t make that mistake again;
  2. Some people are jerks. (This one I already knew but sometimes manage to forget); and
  3. Make sure, if you’re planning to buy for potential development, to include a clause in the contract specifically giving you the right to cancel unilaterally during the contingency period if you determine that the parcel is unfit for the development you had in mind. (Not that this would have helped much with this seller, but it’s good housekeeping, anyway).

I know you’re supposed to let these kinds of things go to avoid spending your life embittered. And, mostly, I have. But I’m not above fantasizing, when I drive up Hyperion sometimes, about something bad happening to the guy who owns the duplex on the left.