Walking away from a potential homerun

Just walked away from a really nice deal and I’m still in mourning.

Last week, we were offered the opportunity to buy a group of smaller buildings in a single portfolio, off market, through a broker with whom we’ve done business before.

The numbers looked good and even got a little better after inspection.

I was excited, because I was planning to use this portfolio as the cornerstone investment for the fund we’re going to start raising shortly.

However, during our diligence, we discovered an obscure issue which I feared might make it extremely difficult to refinance or sell one of the three properties.

This is an issue that not many people know to even look for (including, presumably, the seller). So, I think many in our position would have been tempted to move forward with the deal, rolling the dice that the issue would never emerge.

In fact, I was tempted. But, the more I spoke to experts and considered the issues, the more certain I became that this was a show-stopper for us. So, we walked away from what looked on the surface to be an opportunity to put out about $7MM at around a 7% unlevered yield… which is a homerun in LA in this part of the cycle.

And today, while I’m sad not to be doing the deal, I’m 100% at peace with the decision. Before everything else, our obligation is to look out for the best interests of the people who trust us with their precious capital.

A really scary roof deck

Came across a listing for a renovated building yesterday that made me very scared for the potential new owner.

To be clear, this was a nicely renovated building, with brand new systems, high-quality finishes, decent taste, etc.

And the rents were pretty good – around $2500 for 2 beds with no parking, which, for the neighborhood, is close to the maximum achievable.

So, what was wrong?

Well, to get those rents, the owners put in a roof deck.

Sounds harmless, right? Lots of buildings have them. And it wasn’t too hard – this is a classic center hallway, 1920s building, so there was already a stairway up to the roof and a door. So all the current owners had to do was put down some decking material, add some furniture and – BOOM – have a great amenity for tenants.

Here’s the problem:

  • Stick-and-stucco 1920s buildings are not designed to carry the weight of a real roof deck – the staircase and door are for emergency egress, not every day use
  • To put a real roof deck on, you need to dramatically upgrade the structure’s ability to carry weight, which probably means dropping steel columns down through the walls, all the way to the foundation, then upgrading the foundation
  • Then, you have to either replace the existing roof joists with thicker joists designed to carry real weight, or else build a new floor frame tied into the new steel columns (eg not resting on the existing structure)
  • In addition, you almost certainly need to upgrade the sheer value of the building (to prevent side-to-side swaying under the new weight), which means taking off the stucco, adding a plywood wrapper to the framing, then re-stuccoing
  • Finally, you need to have two means of egress from the roof (and those buildings were only designed with one)

I am 99.9% sure the owners of the building for sale did not do this, which means they have an unpermitted roof deck.

Why is that a problem?

If the Housing Department is doing a their job during SCEP inspections, they will flag the unpermitted roof deck and require the owner to return it to its previous use as a normal roof. The tenants, who are protected by rent control, will then be in a position to apply to the city for a reduction in rent, since they signed their leases under the assumption that the roof would be available to them. A $100 / month reduction across all the units in the building is real money… and would imperil the new owner’s ability to pay her mortgage.

More seriously, imagine the owner’s liability in the event someone (drunkenly?) falls off, or through, the roof deck. I guarantee the owner will not have disclosed the unpermitted nature of the deck to her insurance company, nor to her mortgage lender. If someone dies up there and it is discovered the deck was unpermitted, will the owner be covered by insurance? If there is a huge award and the owner can’t pay and the building goes into foreclosure, will the bank have a claim that the loan ought to be treated as recourse (eg hold the borrower personally liable for any losses on the loan), because of a material misrepresentation in the loan application?

Investing in multifamily real estate in Los Angeles is supposed to be relatively safe, which is why the returns are pretty low. For example, if you buy the building above, even without a mortgage, you’re looking at ~4% year if everything goes well. If you use a mortgage, it’s worse.

But, if you aren’t careful, you can end up in a situation where the upside (the 4%) is nowhere near high enough to compensate you for the downside risk (the chance of losing your downpayment, at a minimum, and possibly additional liability, depending on the insurance situation and whether a plaintiff can pierce your corporate veil).

This is a big-girl / big-boy game, and you really need to understand what kind of risk you’re taking on, even with something as (seemingly) trivial as a roof deck.

When liquidity dries up for supposedly liquid funds

When people invest with us, I always warn them not to expect their money back at any particular time.

Why? Because real estate is a fundamentally illiquid asset (eg it takes a long time to sell). As long as you’re not a forced seller, you’l probably do very well… but you can get killed if you need your money immediately.

Some mutual fund investors in the UK are apparently learning this lesson in a pretty painful manner today.

Per the Wall Street Journal [subscription required], five funds which invest in UK commercial property have suspended investor redemptions since the Brexit vote. That means investors can’t get their money out… which is supposed to be one of the virtues in investing in a publicly traded fund like this.

Why can’t they get their money out? Because the funds’ money is invested in real estate and you can’t easily liquidate properties to generate cash to fund redemptions. So, when large numbers of investors want to pull out, there’s no way for the funds to oblige.

Even worse: When the funds do manage to liquidate their portfolios, they will be doing so under duress, meaning bidders will know they are dealing with distressed sellers and will act accordingly.

It’s kind of amazing to me that these funds are allowed to exist, period. There’s just too much of a mismatch between the short-term nature of investment in publicly traded vehicles and the long-term nature of commercial real estate.

Anyway, word to the wise: If you’re going to put money into real estate, make sure it’s money you don’t need to see again at any particular time. Otherwise, you’re in for a world of hurt.

Why people pay high prices

Had someone yesterday email me asking why I think people are paying insane prices for Los Angeles apartment buildings.

By insane, I mean 15-19x annual rents. At those prices, there’s basically no cashflow; in fact, at the upper end of the range, it’s likely you’ll pay to own the asset each month (instead of the asset paying you!).

As I see it, there are three reasons why someone might be willing to pay such insane prices:

  1. She may intend to do something else with the property. For example, I just paid 18x for a property. But, since I plan to renovate, I don’t care much about the existing rents. Same goes for developers who rip down and replace older buildings;
  2. She may expect appreciation. Prices in LA have risen faster than inflation for decades. Some people might be fine with just breaking even on the cashflow and hoping for appreciation. I don’t like this strategy in a hot market (where prices are already at a cyclical high), but what do I know?; and
  3. She may be misinformed. Inexperienced buyers are easily duped by inexperienced / dishonest brokers who fail to price-in normal expenses, making bad deals appear reasonable.

What chutzpah!

Have been following a listing in Highland Park for a little while and wanted to share it with you all.*

It’s a decent-size deal in a good area at a somewhat reasonable price. So, what’s the big deal?

If you dig into the listing info, you will see that the building has an underground parking area, which is highly unusual for a building of this vintage in this area.

And if you check the permit record, you will (likely) come away convinced that the parking area was built entirely without permits.

Now, as many of you know, I did some un-permitted work early in my career, for which I paid dearly (so dearly that we never, ever do it now).

So I’ve been a cowboy. But I’ve never seen anyone cowboy in an underground garage… that is truly amazing. Undermining a building without the supervision of city engineers / inspectors is asking for major trouble in the event the thing collapses.

*Note: I’m not sharing the listing itself because I don’t want to cause trouble for the owner or listing broker, both of whom are honorable people, to my knowledge.