The math behind what we do

At this point in the cycle, when we consider a new deal, we spend a lot of time thinking about leverage.

Mainly, we’re looking at how our pro forma unlevered yield (eg the cap rate we’re trying to hit post renovation) compares to the projected interest rate on the refinance we’ll do at that point.

I know this is a little boring, but stay with me!

Let’s look at three scenarios, all $5MM all-in deals.

Scenario 1: 7% unlevered yield

  • Invest $5MM
  • Hit 7% unlevered, so $350k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $7.8MM (divide $350k by 4.5%)
  • Borrow 65% LTV at 4.5%
  • That’s a $5.1MM loan, with annual debt service of $309k
  • So, we’ve got all the money invested back out of the deal and we’re earning $350k-309k = $41k / year
  • Levered yield of $41k / $0 = Infinity!

Scenario 2: 6.25% unlevered yield

  • Invest $5MM
  • Hit 6.25% unlevered, so $313k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $7.0MM (divide $313k by 4.5%)
  • Try to borrow 65% LTV at 4.5%, but can’t, because the NOI won’t exceed the debt service by enough to make the banks (or us!) comfortable
  • Instead, borrow $4.3MM (61% LTV), with debt service of $260k
  • Leave $5MM-$4.3MM = $700k in the deal
  • Receive free cashflow 0f $313k-260k = $53k
  • Levered yield of $53k / $700k = 7.6%

Scenario 3: 5.75% unlevered yield

  • Invest $5MM
  • Limp into a 5.75% unlevered, so $288k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $6.4MM
  • Borrow $3.95MM (ouch), with debt service of $239k
  • Leave $5MM-$3.95MM = $1.05MM in the deal
  • Receive free cashflow 0f $288k-239k = $49k
  • Levered yield of $49k / $1.05MM = 4.7%

As you can see, in Scenarios 1 & 2, the more you borrow, the better the deal gets. That’s because the unlevered yield exceeds the cost of the debt (which is the total debt service divided by the loan amount). In Scenario 3, because the cost of the debt exceeds the unlevered yield, the more you borrow, the worse the deal gets.

The above is, in a nutshell, why our business exists. We get paid to deliver unlevered yields that are in excess of the cost of the debt, allowing investors to benefit from leverage, rather than get killed by it.

Anatomy of a homerun

Thought I’d share numbers for a deal we just stabilized.

Not going to share the address, because I don’t want to tip anyone off re neighborhoods, etc.

Anyway, here goes:

  • Acquired in Spring 2015
  • Stabilized approx. 13 months later
  • All in for ~$2.37MM
  • Stabilized rent roll of $262k
  • Implied GRM of 9x (!)
  • Forecast NOI of $190k
  • Implied unlevered yield of 8% (!)

We’re about to begin the refinancing process and I expect we’ll be able to pull the vast majority of the capital back out without saddling the property with more debt than it can handle, even in a downturn.

When we did this deal, I knew it was going to be good. But the combination of Jon’s design, some good leasing, and luck with the rental market turned a good deal into a bona fide home-run.

Some mildly annoying numbers

Just finishing a 4plex in a really cool, up-and-coming neighborhood that we renovated on behalf of an outside investor.

Was reviewing the original pro forma and revising in light of what I believe the rents will be… and got an annoying surprise.

Based on the original pro forma, this was not a deal that we could afford to do with our investor money. The numbers were not quite there.

But, now, with the new rents, I think our client is going to be looking at:

  • All-in around $1.33MM, of which $600k was a loan and $733k was cash
  • $ / sq ft of $312
  • Rent roll of $127k
  • NOI of $90k
  • Unlevered yield of ~6.8%
  • Estimated valuation of ~$1.6MM

Our client used a loan on acquisition, so I think his current, levered yield is around 7.8% / year. When he refinances based on the new valuation, he’ll pay off his existing loan, pull out $560k and be earning 14% on the $175k that remains in the deal.

Why is this annoying? Because I wish I had done this deal for myself!!!

A minor epiphany about valuations for larger buildings

Just had a minor epiphany while walking over to the office from breakfast that I thought I’d share with you.

It’s kind of embarrassing, in a “slap-myself-in-the-head-for-not-recognizing-this-earlier” kind of way, but I’m all about honesty on this blog, so here goes…

Regular readers know I spend a lot of time thinking about the components of value. What I mean by this is, basically, what are we actually buying when we buy a building?

I was stewing over just this question when an MLS alert showed up on my phone for a large building in Hollywood. As I usually do, I did a quick calculation of the asking price per square foot to see if there was any chance I’d be interested.

The number came back at around $400 / sq ft, which is an absolutely ludicrous price for a rent control building unless the rents are high and the cap rate is good (fat chance, in this market). This in keeping with my general observation that larger buildings in LA tend to trade at higher prices.

I’ve always explained the higher prices for larger buildings by telling myself that institutional and quasi-institutional capital is willing to accept lower yields, and therefore pay higher prices.

But another explanation just hit me: Large buildings are often on larger plots of land. And price per square foot, my favorite valuation metric, ignores land value (the “square feet” in question are square feet of structure, not land).

So, here’s my new understanding: For large buildings on large plots of land, particularly where the building is not developed to maximum current density, I need to dig deeper to determine if the land component is sufficiently valuable to justify a higher price per square foot.

Silver Lake rents and operating margins

Spent some time this morning looking at rents in Silver Lake.

When we started in this business back in 2008, a really nice 1 bed in Silver Lake was around $1500. Today, a similar apartment goes for $2200-2300.

That’s an increase of ~50% in eight years… or around 5-5.5% / year (inclusive of compounding).

But that’s understating the impact for a (non-rent controlled) building owner. Why? Operating leverage.

As an owner of an apartment building, your largest costs are your mortgage (which is a finance cost, as opposed to an operating cost, but let’s not be pedantic) and your property tax. Assuming you have a fixed mortgage, those payments are flat. And your property tax is limited to a 2% annual increase by Prop 13 (otherwise known as CA’s gift to landlords).

Your only variable cost (eg linked directly to revenue) is property management (usually pegged at 5% of rents or thereabouts). The rest of your costs, like gardening and water / sewer, go up, but are the same regardless of what rent the tenants are paying.

The result of the above is that increases in rent disproportionately fall to the bottom line, increasing your margin.

In concrete terms: Say you bought a 4plex in 2008 for $720k cash, which was 10x the $72k rent roll ($1500 / month x 4 apartments x 12 months). Expenses were probably $25k, leaving $47k in NOI (you bought a 6.5% cap!). Assuming your rents are up to $2250, your numbers are now: $108k rent roll, probably $32k in expenses, or $76k in NOI.

That increase in NOI, from $47k to $76k, is ~61%… more than the 50% rents have increased. Not bad, right?