On Friday, had a funny discussion with our largest investor regarding the value of parking spaces.
His joke was that, when I’ve got loads of parking, I tell him how valuable parking is, and when I’m under-parked, I start talking about Uber.
I’m not admitting that’s true, but I did tell him that I think that, over the long term, parking is over-valued. He agreed.
And here’s where we’re both coming from: As we’ve discussed here before, we’re 5-15 years from having networks of autonomous cars available through aps like Uber.
The most recent issue of Mother Jones has a wonderful article exploring the implications of this shift for society, in general, and urban planning, in particular. It’s a great read.
Today, we’re closing on a little fourplex deal in a neighborhood we really like.
It’s a roughly $1.1MM all-in project, way too small on its own to be worth our time.
However, it’s near a bunch of other stuff we’re renovating, it’s a simple project (no reconfiguration of the units), and we like the area enough to expect to outperform our pro forma rents.
So, we’re going to tuck it into the portfolio and move on to the next ones… two larger deals we have in escrow now.
For all you brokers reading this: We’re still very, very acquisitive for the right kind of product (beat up, low price per sq ft) in improving neighborhoods. We’re happy to have you rep us on the buy side if you’d like. And we’re dream buyers – cash, as-is, no screwing around.
We’ve now reached the point in the cycle where brokers describe their over-priced apartment deals as “condo conversion opportunities”.
Why would a broker do this? Well, if your client demands a price so high that no buyer could actually achieve any kind of yield on their investment, you don’t really have many options.
But, in all seriousness, what does the re-emergence of “condo conversion” as a strategy tell us about the current state of the market?
To answer this question, you first need to think about where we’ve been since 2008 or so. With interest rates at zero, capital has been chasing yields. Apartment buildings are reliable income generators, so capital has flowed into apartment buildings, raising prices and reducing returns.
But two factors are converging to change this state of affairs:
1. There’s only so high prices for cashflowing assets can go. Once you hit the point where the price is so high that the yield is negative, it’s pretty hard to convince even the stupidest buyer that he should go forward with an acquisition.
2. There is no limit to the insanity of single family home buyers in LA. Residential real estate in LA is totally, 100% detached from any fundamentals. No one thinks about what kind of rental yield they could get by renting the house or condo out. No one considers what it would cost to build the same house or condo across the street. Instead, they just convince themselves to pay a bit more than whatever the last sucker paid for a comparable house.
Given the above, it’s no wonder we’re seeing the re-emergence of the condo conversion as a marketing plan: If the price for your apartment building can’t go any higher, just transmute it into residential real estate and float away from the dreary world of actual returns into the beautiful fairy-tale of wanna-be stars living the dream.
As we seek to deploy our current pool of capital at a time of generally high prices, we are running up against the issue of replacement cost.
Here’s the problem: As a repositioner, you don’t really want to be in the position of spending more to buy and renovate a building than it would cost to build the same building from scratch.
The reasons are pretty obvious:
- All things being equal, you’d obviously prefer to have a brand-new, non-rent control building over an older (albeit totally-renovated) rent control building; and
- If someone can buy the property next door and construct an identical, brand-new, non-rent control building for less than you’re all-in for, then they should always be willing to under-price you on rents, assuming you’re both targeting the same yield.
Why is this coming up now?
It’s harder and harder to get our raw material (eg unrenovated buildings) at reasonable prices, because the market is hot. To compensate for the high prices, from a yield perspective, we can use the tricks we have developed over time to achieve high rents. But those tricks cost money, which drives up our all-in cost.
So, because I generally refuse to be all-in for materially more than replacement, we’re passing on some deals which have yields which would otherwise make them marginal “go’s”.
A lot of people are wondering whether it’s already too late in the cycle to buy.
After all, prices have bounced back up off the floor of 2009-10. For context: I sold a bunch of totally renovated buildings in 2011-12 for 10-10.5x the rents. I would get 11x all day right now, and possibly more. (Ouch!)
So, is it too late?
Syd Leibovitch, the president of Rodeo Realty, doesn’t think so. His prediction is that prices will double from the lows… implying there’s plenty of room to run.
Now, I love Syd. He’s a sweet guy and he’s brokered more deals than I probably ever will. (In fact, before I set up the brokerage part of Adaptive, I considered signing on at Rodeo… before remembering that I don’t play well with others!) But I always get a little nervous when I hear brokers predicting price increases. It’s a little too potentially self-serving.
But let me give you another data point: I’ve bought five apartment buildings over the past 3-4 months for our funds, several more for fee-for-service clients, and am making offers for myself now.
Why am I so bullish on the market?
First, let me acknowledge that I don’t have a crystal ball. Anyone who tells you they are certain which direction prices are going to go is a fraud. There’s just no way to know.
Here’s what I do know:
- I don’t pay high prices. The buildings we have bought were all cheap on either a price per square foot or GRM basis, or both. I can’t predict the future, but I know if I buy for less than replacement cost and/or at a price which allows me to lock in a good return from the cashflow (with increases to come), then I don’t really care that much about where the market goes…
- …because I don’t use a lot of leverage. If you don’t over-lever, then there’s no way you’re ever going to be forced to sell. If you’re never going to be forced to sell, then you can always wait out bad markets.
- Rents are rising. There is a lot of demand for quality apartments in good areas. We put a 2 bed / 1 bath in Echo Park on the market for $1850 and had 40 inquires within 24 hours. I think this demand is likely to increase as the economy improves and jobs come back. More demand in supply-constrained in-fill markets (like Los Angeles, generally, and Echo Park, specifically) leads to rapidly rising rents.
- There is a long-term trend away from the suburbs and towards city centers. Long commutes are among the largest contributors to unhappiness. Cities have culture, entertainment, exchange of ideas and, most importantly, good jobs. Over time, I just can’t imagine prices in the 2nd largest city in America not increasing faster than inflation, because living in the middle of a vibrant city is a good life decision for most people.
- Interest rates are incredibly low. Sure, they’re not as low as they were six months ago, but they’re really low by historical standards. If you lock in a 4.5% loan for 30 years right now, I can’t see how you will look back and wish you hadn’t done it.
So, there you have it… a slightly scattered, but fairly emphatic defense of buying now. If you buy my logic and want to get serious about buying a good apartment building, get in touch.