Beware of False Financials

I follow a number of Realtors on Instagram, Twitter, blogs, etc because sometimes oversharers enjoy friendly competition. However, most of these Realtors who dabble in multifamily properties couldn’t understand a financial model if it were spelled out on subway tiles.  One particular Instagrammer recently pointed to 3165 Cazador St., a “turnkey” duplex, claiming it earns $2,000 “monthly profit after expenses” on a $850,000 asking price with 25% down and a typical interest rate.  That would mean an 11% return on investment.  That’s damn good for not doing any renovations. The problem is, that’s also totally untrue.

The reality is, if we’re assuming her rental projections on the vacant units are accurate ($3200 and $2500) and the property needs zero work (this is never the case for multifamily deals), we’re only making 4-5% on our investment with about $800 monthly cash flow.  That’s actually still good for a Los Angeles investment property, but there are a lot of barriers to reaching that profit.

Here is what this agent is missing in describing a $2,000 monthly profit: property tax, insurance, water/sewer, trash, gardener, replacement reserves, pest control, and possibly exterior electric bill.  That’s not including a management fee and repairing deferred maintenance. While many agents have great aesthetic taste, know the owner’s family, or have sold millions in single family homes, understanding the financials of a multifamily real estate investment is key to understanding a good deal.  And not all properties are the same, so these financial models can’t be carbon copied from one deal to the next.

Moses Kagan, the broker at Adaptive Realty, has brought his finance background to the over forty properties he’s renovated in the last five years, and knows firsthand what max rents are in neighborhoods from East Hollywood to Highland Park because of the properties Adaptive manages.  The agents at Adaptive Realty, half of whom are Princeton graduates, fully understand the financial details of real estate beyond the picture that the flashy agent paints.  One of the first things we do with new clients is to go over spreadsheets for three properties in their target market to help them understand what the numbers really are.

Part of me wants to educate all Los Angeles real estate agents on the expenses involved in multifamily investment properties because then perhaps asking prices will come down on bad deals.  Until then, however, I hope you find a smart agent who tells you the truth about your investment property, or else you may find your expected returns quickly chopped in half upon taking ownership.

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Appraisals

As a buyer’s agent, it’s a beautiful thing when the bank’s appraisal comes in higher than the purchase price you negotiated. Appraisers are notoriously blind to rental income comps and gentrifying markets, so I make it my business to give appraisers as much information as they need to understand our purchase price.  I’ve never had an appraisal come in short and today I had one come in $25,000 above the purchase price.   In this business it’s important not to take anything for granted, and in the case of appraisals, you can’t trust that a bank will understand the value of real estate like you do.

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Need for Buying Speed

There’s one thing in common with all of the buyers who have gotten into contract with me: they were fully prepared to make an offer the day that the property came on the market.

What does “fully prepared” mean?  Simply, it means I have your pre-qualification letter (which you have gotten by qualifying through a lender) and your proof of funds (a screenshot of your bank statement), and you have your Docusign account set up so you can sign the offer I write for you.  Cash buyers clearly only need the latter two items prepared.

Many new buyers of Los Angeles income property naturally expect the process to be like buying a house: you go to the open house, maybe you have a private inspection, and if you still like it, you make an offer.  Investors think differently from that, and therefore you have to keep up with that mindset.

One major reason for the difference is that there are tenants living in the property.  If every interested person got to tour the property, tenants would have 40 people walking through their apartment.  We’re slightly more civil than that in real estate. Instead, once a buyer gets into contract, she can have her team of inspectors come through.  At least the seller knows that she is serious and not wasting the tenants’ and the listing agent’s time. It makes sense.

One reason why this works is because of your physical contingency period.  Typically, we do two inspections during this period, during which we can cancel the deal and get your full deposit back. And if there’s a serious problem with the property or with the numbers the listing agent gave us, we can ask for a price reduction or cancel.

Because of Adaptive Realty’s experience managing properties in the Los Angeles rental market, we do a very good job of estimating monthly expenses for each property I recommend to you, and based off of those numbers and the rents, we can make a fairly accurate estimate of your monthly profit. In investment property, that is one of your two bottom lines.

Your second bottom line comes from appreciation. While I can give my own predictions as to how properties in certain areas will appreciate, that will come from your own gut as much as mine.  That’s why driving by the property if you’re unfamiliar with the area can be a good idea.

I’ve written before that not all buyers are the same. So when I send listings to by clients, first I determine which clients are the right investors for the property. And if there’s more than one, you can be sure that the one who is ready to offer first will have the best shot at the property.

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Section 8 and Los Angeles Rent Control

section 8 and rent control

Many clients ask me if they can evict Section 8 tenants. Are they different from normal tenants under rent control law?  Yes and no; let me explain.

First, what’s a Section 8 tenant? “Section 8” is the common name for the Housing Choice Voucher program, funded by the U.S. Department of Housing and Urban Development. Basically, it provides substantial rental assistance for some low-income tenants. The craziest contract I’ve personally seen was a tenant paying $4 / month for a $1,040 unit.

When it comes to eviction, you have to separate the Section 8 contract from the Section 8 tenant.  You can cancel the Section 8 contract with 90 days notice, but the Section 8 tenant has the same rent control rights that anyone else does – and even more.  DO NOT cancel the Section 8 contract.  Once you do, the tenant is now only responsible to pay you the smaller portion of the rent that he was paying.

That said, Section 8 benefits you in one way. If you pay the tenant to relocate, that tenant can be assured that the amount of rent that he pays remains the same when he moves into a new, Section 8-approved unit. His Section 8 status moves with him. The tenant pays the same amount for the new place and the government pays the price hike.

The bottom line is that out of all the tenants you’ll want to relocate, Section 8 tenants have the most incentive to do it peacefully. They won’t pay more for a new place; they’ll simply get a hefty chunk of cash to deal with the annoying hassle of moving.

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Rent during REO sale

When a bank owns a property due to foreclosure, different rules apply.  Here’s one worth knowing:

Sometimes, banks won’t collect rent from tenants while they own an income property.  Sometimes they do; it depends what their priorities are.  When you enter escrow for an REO property, find out whether the bank has been collecting rents.  If they haven’t, you, the new buyer, can collect all past rent not paid by the current tenants.

Other than cash, what does that buy you?  Leverage.  If these tenants are low paying tenants, and your priority is to relocate them in a rent controlled building, the money they owe you in past rent is leverage in your negotiation to relocate them.  Imagine thinking you don’t have to pay rent for six months and then you find out you owe $4,000 in back rent.  If you don’t pay you can be evicted.  Would you rather scrounge up $4K or get paid $4K to move somewhere else?

Man, I know this sounds harsh and most tenants aren’t in the real estate business like you are.  But when you’re making the biggest financial decision of your life, it’s important to know all of the rules involved, and which of them may be on your side.

 

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A Unique Preliminary Inspection

duelWith income property, you, the buyer, often cannot inspect the subject building(s) before the seller accepts your offer. The reason is that people live there, and the owner doesn’t want to disturb her tenants with serious and non-serious buyers alike traipsing through their homes. Understandable.  You can read about this in my entry Subject to Inspection.

A good listing agent will schedule for us to see the interior of the property the same day or day after your offer is accepted, and before your earnest money deposit (EMD) is due. That way, he doesn’t have to open escrow and take the property off the market if, for some reason, you hate the interior and want to cancel escrow immediately.

Well, the listing agent I’m working with now has taken this idea one step further.  He’s asking his top two offers to do our preliminary interior inspection before our offer is even accepted.  This could be okay, but it isn’t preferable. My first concern with this preemptive inspection is that there may be something wrong with the interior that the seller is extra worried we’ll balk at. Secondly, having the two top buyers and the seller in one place is very strange (and a little tactless). Perhaps the listing agent hopes we’ll hold an auction at the property, bidding each other up?  Or maybe he’s just buying time, expecting another offer to come in higher and with more favorable terms while we’re checking for water damage.

While more than likely this is a good faith measure, this unique inspection feels a little Old West to me, and my buyer and I are bringing our figurative guns. Because the seller will be there, my buyer is bringing his EMD check, and I’m bringing our offer on good old-fashioned paper for the seller to sign. Oh, and a quill and ink bottle. Should be fun.

Read the UPDATE!

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