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.

Good reading on zoning and sprawl

Happy Monday!

Have recently read two great, short pieces on the effect of terrible zoning on cities, in general, and LA, in particular:

  1. David Leonhardt’s interview with Matthew Yglesias in the Times. Yglesias talks about how parking requirements and artificial limits on density conspire to drive up the cost of housing (and, thus, living) in attractive coastal cities where the best jobs are located; and
  2. Jeremy Rosenberg’s series, Laws Tthat Shaped LA, covers the 1908 zoning regulations that separated residential from industrial uses. This zoning regulation led to the banning of mixed-use buildings (retail or office on the first floor, apartments upstairs) that are so common and beloved in other cities, but that are very rare in LA.

I personally love the few walkable parts of LA, notably Larchmont, Sunset Junction, the part of Sunset that runs through Echo Park, and Downtown. We, as a city, need to make some changes to how we regulate land use to promote these kinds of dense, walkable neighborhoods.

Introduction to Los Angeles Zoning

Get it through your head: The land is important!

Too many buyers don’t understand that the land component of a property is potentially it’s most important aspect. Why? Well, buildings all fall down in the long run. But land is unchanging and often has potential.

What do I mean by potential? Well, in the absense of government regulations, you can always build a lot more structure on a given parcel of land. Buy a single family house, knock it down and building a fourplex. What stops you from doing that in LA? Zoning.

Zoning is a form of governmental regulation that determines what can be built, where.

LA’s zoning code is particularly terrible, since it was designed for a city of detached, single family homes, making it extremely difficult and expensive to develop apartments or condos, which are the kind of denser development the city desperately needs to combat sprawl and traffic. OK, lecture over.

For the purposes of the apartment investor, here’s what you need to know about the relevant types of LA zoning:

  • R1 – This is residential home zoning, but an apartment building in an R1 zone is allowed to continue to operate because it’s grandfathered in. In a way, it’s the best scenario, because you know no one can build any more apartments to compete with you.
  • R2 – Slightly denser than R1. You can building one dwelling unit per 2,500 sq ft of land. So if you have a 5,000 sq ft lot, you can build two units (provided you meet the other requirements)
  • RD1.5 – One unit per 1,500 sq ft of land
  • RD2 – One unit per 2,000 sq ft
  • R3 – This is where things get interesting. One unit per 800 sq ft
  • R4 – One unit per 400 sq ft
  • C1 – Commercial zoning; but can be treated as R3 if you want to build apartments or condos
  • C2-5; CM – Treated as R4
  • MR1 – M3 – Treated as R4

Why does all of this matter? Because a property’s value is to some extent determined by its potential. Say you’re looking at two otherwise identical single family homes on 6,000 sq ft lots in Echo Park:

  1. Property A is zoned R2. To find out how many units you could build there, divide 6,000 / 2,500 = 2 (the city always rounds down). So you could build two units.
  2. Property B is zoned R3. So divide 6,000 / 800 = 7 units.
Right now, apartment developers can afford to pay you  around $50,000 per unit for well-situated land to develop. So the land underneath Property B is worth $350,000 by itself (ignoring the value of the home). By this measure, Property A’s land value is obviously only $100,000.


So identical pieces of property can have vastly different values due to their zoning. And that’s why you pay attention to boring zoning codes.


Want more info? Here’s a Zoning Summary.

Legalese: I’m not an architect or a land-use attorney, so this is not architectural or legal advice.