In this episode of The Acquirer’s Podcast Tobias chats with Moses Kagan, Co-Founder & Partner at Adaptive Realty, a company that buys, renovates and manages apartment buildings in Los Angeles. During the interview Moses provided some great insights into:
- Invest In Real Estate Like A Smart Family Would Own Real Estate
- Successfully Invest In Hyperlocal Real Estate Using One Simple Equation
- Here’s Why You Should Forget About Rent Growth Forecasts
- The Key To Successful Real Estate Investing – Don’t Use Debt!
- Generating Liquidity Out Of Real Estate Investments
- How To Survive In Real Estate Investing When The Market Bottoms
- Scaling A Real Estate Business
- Vertical Integration Gains Lead To Outsized Returns
- As Long As You’re Not A Forced Seller, You’re Going To Do Fine
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Full Transcript
Tobias Carlisle:
When you’re ready, let’s get going.
Moses Kagan:
Yeah.
Tobias Carlisle:
Hi, I’m Tobias Carlisle. This is the Acquirers Podcast. My very special guest today is Moses Kagan. He’s a co-founder and a partner at Adaptive Realty. They’ve got some really interesting approaches to buying, developing, holding real estate. He’s based in Los Angeles along with me. I’ll be talking to him right after this.
Speaker 3:
Tobias Carlisle is the founder and principal of Acquires Funds, the regulatory reasons, he will not discuss any of the Acquires Funds on this podcast. All opinions expressed by podcast participants are solely their own, and do not reflect the opinions of Acquires Funds or affiliates. For more information, visit acquiresfunds.com.
Tobias Carlisle:
Hi Moses. How are you?
Moses Kagan:
I’m really well, thank you. How are you?
Tobias Carlisle:
Very well. Thanks too. I’ve been following you along on Twitter, which is how I discovered you. I agree with your philosophy of investment matches my own really closely. So I just wanted to sort of talk about how you implement that in real estate when, this podcast in my own interests mostly, equity listed on the stock market. So let’s start with what is Adaptive and why did you form it?
Invest In Real Estate Like A Smart Family Would Own Real Estate
Moses Kagan:
Sure. So, Adaptive is a real estate private equity firm. A tiny one in the grand scheme of things. Our business is that we buy, renovate and manage, apartment buildings in Los Angeles. The kind of assets that we target are what I would call sub institutional scale, which means, typically kind of under 10 million total capitalization between buying and renovating the buildings. And, a number of things probably set us apart from other real estate, private equity shops. But I think the most important one, and maybe the reason that we’re talking today is that we are effectively permanent holders of real estate. So, we can get more into what that means. But basically we’re not flipping stuff. We’re buying, fixing it up and refinancing it and just holding it, definitely.
Tobias Carlisle:
So how do you achieve that? How do you become a permanent holder?
Moses Kagan:
Well, I mean, and I guess there’s a couple of parts to that question. One is like, how do you arrive at that strategy sort of philosophically? And then the other part of it is how do you convince other people to come along with you? Maybe, let’s unpack it and start with the philosophical part first-
Tobias Carlisle:
Please.
Moses Kagan:
… and then go, [inaudible 00:02:31]. Okay. So, I guess maybe the first thing to say is that the state… Let’s kind of describe what a standard real estate private equity firm does that, you raise money. If you’re big, you raise money from pension funds and endowments and everything. You buy some real estate, you spend a couple of years adding value to it, fixing it up, raising the rents, and then you sell it as quickly as you can. Because what you’re trying to do in that scenario is maximizing IRR and the way you maximize IRR is, you use as much debt as you possibly can, and you flip the thing as quickly as you can.
Tobias Carlisle:
Right.
Moses Kagan:
And it works out really well for the sponsor, the guy who’s putting the deal together because, of course he or she gets to crystallize their promoted interest, the 30%, 25%, 20%, whatever it is that the promoter is getting for putting the deal together. He gets that as soon as he sells the asset. So that’s the thought process and the incentive structure that normal real estate, private equity firms operate under. So what’s the problem with that? Why are we inclined to do things differently than others?
Moses Kagan:
I think the answer to that is, first of all, we want to look at the investor base and when you’re Blackstone and you’re raising from a bunch of pension funds and endowments, who don’t pay taxes. Maximizing pretax IRR, is obviously the smart thing to do. There’s no question, right? But if you’re raising money from taxpayers, like high net worth and family offices, tax is really important. And it takes a huge whack out of your profits. So that’s the first thing to say. Another thing to say is like, I’m a big believer in the illiquidity premium. I mean the concept makes sense to me that you ought to be rewarded by the market for buying assets that you can’t quickly liquidate. So real estate is like a perfect example of an illiquid asset, right? You can’t trade in and out of it easily.
Moses Kagan:
In fact, you incur transaction costs. Like in Los Angeles, I probably would underwrite like a seven to 8% on a transaction cost whack, every time you sell something. So if you’re going in and out of things, you’re basically, you should be getting your own liquidity premium, but you’re paying this transfer tax effectively. I mean it’s literally attacked, but also all kinds of other brokerage costs and escrow title, and all these other costs associated with going in and out. And so that has the effect of sort of counteracting the illiquidity premium that you should be getting. Okay? So there’s the tax consequences, then there’s the consequences of the transaction cost. So, philosophically, looking at that, I look at that and I say, “Well wait a second, I mean, if you own asset assets in a really good market,” I mean, what I’m about to say I don’t think applies to some tertiary market somewhere.
Moses Kagan:
I’m not going to pick on anyone, but where there’s not a lot of population, or job growth. So what I’m saying now is specifically for really good markets that have big, diverse economies with lots of people, and lots of action.
Tobias Carlisle:
Is that LA or is that cities within LA, or how do you think about that?
Moses Kagan:
I mean, it’s certainly for LA, I would say the entire LA Metro probably fits into this description, but so does San Francisco. So does New York. I mean, obviously, in the midst of this pandemic that we’re in, that’s some of the effect that I’m talking about, kind of slows down a little bit, but as we’ll see a little later in the conversation, even in the midst of this, rents and leasing and everything are holding up incredibly well, because people fundamentally want to be where opportunity is.
Moses Kagan:
And LA is one of the places where there’s a lot of opportunity. So if you own a high quality asset, in an area where there is a lot of economic dynamism, your rent and particularly if there’s supply constraints, because it’s hard to build there. Your rents and therefore values are going to tend to grow at a rate that exceeds inflation. Okay? And it’s really important that you think about it in real terms and not nominal terms. Because you can see rent growth in lots of markets, but obviously if it’s trailing inflation or whatever, it’s not real growth. If you’re in a market like that, why are you selling? What families do when they own really good assets in a market like that, is they hold onto it and over time they refinance, and they pull capital out, and maybe they redeploy, they buy something else, but they don’t sell.
Moses Kagan:
And so philosophically when we were sort of starting adaptive and thinking about what we wanted to offer prospective partners. The thought process was very much like, look, we want to create a firm that allows limited partners to own real estate with us, the way that a smart family would own real estate. And that was the Genesis of the kind of the philosophy of the permit hold.
***
The Key To Successful Real Estate Investing – Don’t Use Debt!
Tobias Carlisle:
So, if the family itself wants to move in or out of the real estate and you’re the controlling partner.
Moses Kagan:
Sure.
Tobias Carlisle:
How do they achieve some liquidity?
Moses Kagan:
Yeah, let’s talk about that. I guess, because, and that that kind of dovetails with the second part of what I was saying, which is like, so philosophical you want to be a longterm holder. How do you get investors?
Tobias Carlisle:
Mechanically, practically, how do you implement that?
Moses Kagan:
So, I guess the first thing to say about the way we do deals, it’s very different from a standard real estate private equity firm is, we do not use any debt on the way into these deals. So we always buy all cash. And there are some huge benefits to doing that. Because we can close quickly and because there’s certainty, we don’t have an appraiser, or a bank, or whatever causing problems. When I say, “We’re going to pay $3 million, or $500, or whatever for this asset,” we can pay it. There’s no other gating factor. So we buy all cash. We frequently, and this is going to drive some people crazy when they hear this, we frequently fund the renovations of the buildings in cash too. Sometimes we’ll use low leverage bridge loans.
Moses Kagan:
Maybe like 30% of the total cost of the project, not more. And if you, I mean, that may sound sort of normal to public markets investors, but if you ask, someone who does real estate deals, whether they would be cool with using 30% leverage on a project, they would look at you like you’re out of your mind, right?
Tobias Carlisle:
It’s not enough.
Moses Kagan:
Yeah, no, exactly. It is, there are bridge lending firms out there. I’m talking to someone about, buying distressed loans right now, who as a standard practice, we’re loaning people 75 to 80% of the total cost of the project. But that is a normal thing that people were doing. And as you can imagine, right now, a lot of those loans are not, let’s say performing well.
Tobias Carlisle:
And then that’s why you don’t do it.
Moses Kagan:
Yeah, well, there’s a number of reasons, but the main thing is, yeah, if you own real estate, if you want a good asset in a good market, okay? There’s not that much that can go wrong, as long as you manage it semi-intelligently and you don’t use a lot of debt. If you’ll use a lot of debt you… It’s just like using a lot of margin stock, in stock broking. If you use a lot of debt, then when you have economic calamities, like the kind we’re going through right now and your rents come down, you cannot service your debt and then you become a forced seller into a market where you do not want for sale. And that’s the risk in dealing with real estate in good locations.
As Long As You’re Not A Forced Seller, You’re Going To Do Fine
Moses Kagan:
Again, this doesn’t apply to some random place, but if you’re in a great market, if you’re in LA or San Francisco, as long as you’re not a forced seller, you’re probably going to do fine. There’s a question of, did you buy the right thing at the right price and do you manage it better or worse? And there’s all those things of course a matter of time. But fundamentally, as long as you can buy and not be forced to sell at the wrong time, you’re probably going to be okay. Anyway, sorry for the kind of the detour there. So we buy all cash, we use very small either no debt to fund the renovations, or small amounts of debt. When the property is done, we retenant it. And at that point we will go to the bank and say, “Hey look, Mr. Banker, here’s the new rent roll, here’s the new proforma net operating income, the new unlevered cashflow that the property will throw off. Please value this according to market comps and give us a reasonable loan, against this asset that we own.”
Moses Kagan:
And depending on how well we’ve done our job, in other words, how much value we’ve created. One way to think about this is like one plus one equals three. I know it sounds weird. The building is worth when we’re done with it, considerably more than the total amount that we have invested in it. I’ve read this a million times in books along the way and until I did this the first time, I was like, does this really work like this? But it really does. You can buy a building for a million and put a million into it, and have a bank come and tell you it’s worth 3 million. And that’s just because the appraisal is done on the cashflow.
Moses Kagan:
And if you’ve done a good job of renovating the building in a way that raises rents, then you can get the building valued, at a price that has a value, that has nothing to do with the amount that you put into to creating the building. And then in that scenario, ordinarily what people do is sell, right? Okay, I mean, I put 2,000,000,000 and it’s worth 2.8 or whatever the number is. I’m just going to sell it and we’re going to take our money. Okay. What we do is we say, “Hey, look, Mr. Banker, the building’s worth whatever it is.” 3,000,000,000 would be ridiculous. We’ve had a 50% uplift before, but that’s, would be extraordinarily rare. We’re likely, you’re like in a 30%, 40% uplift is what would be a great deal?
Moses Kagan:
And you just say, “Hey look, can I get alone for 65% of the value, maybe 70% of the value of this asset.” And the bank takes a look at the numbers and they look at their interest rate that they’re loaning at and what they’re comfortable with and they typically get pretty comfortable that they’ll loan you 65% of that new appraised value. Well, it just so happens that 65% of the new higher value allows you to pull out, almost all of the capital that you’ve put into the deal. In many cases we’ve been able to pull all of the capital out. And what we do once we’ve pulled the capital out is distribute that back to the investors. And that’s what’s called a debt finance distribution and subject to a whole bunch of limits, and console your CPA and tax attorney, all that stuff before you take what I’m about to say to heart.
Moses Kagan:
Subject to all these limits. That is a tax free distribution. We put all this money and buy, fix up the building. We get this loan and we basically get, somewhere between 80 and 100% of the capital back out. We hand it to the investors tax-free. Okay? Thereafter, asking the investors to hold the asset permanently, is not so painful. What you’ve done by giving them their money back, is dramatically reduced the opportunity cost of holding that thing. It’s not like they have all their capital tied up in this asset and you’re asking them to hold it forever. You’re saying, “Hey, you got 85% of your money back, or whatever it is.” And by the way, we’re earning a very high levered return on the small sleever of equity that we’ve left in the deal. So you feel good about what you’ve left in the deal, but meanwhile you have the rest of the money back and you can either give it back to us and we go buy another building, or you put it in stock market, or do whatever else you want with it.
***
Generating Liquidity Out Of Real Estate Investments
Moses Kagan:
So mechanically, yes, we are asking investors to ride with us for a very long time. But your question was how do they get liquidity? The answer is they get the liquidity pretty quickly, because they get back almost all of their money, but then give or take 18 months, or something like that of buying the building.
Tobias Carlisle:
So how are you making that assessment? How are you, working out approximately what you think you can get the valuation to where you can get the rents? Why is it available to buy at this sort of lower price? Is it that kind of idea? So in a public markets, you’d be trying to buy an asset, or trying to buy it an equity on its assets and then you’re trying to sell it basically on its income or not so as the case may be in your case, but is that the idea or how are you making those assessments?
Moses Kagan:
Yeah, the way that we think about it, is not primarily in terms of the value, when we’re done. And the reason is, I don’t know what the value is going to be, I can’t. I don’t know what interest rates are going to be like, I don’t know what the market for properties is going to be like 18 months from now, or whatever, after we finished the project. So what I’m doing is thinking about unlevered yield. It’s a little bit of an idiosyncratic way of talking about it. A lot of people in real estate use the term cap rate. Cap rate is basically just, you divide the cash, ignore the mortgage, ignore any kind of debt financing. You just take the cashflow from the rents minus the operating expenses and then you divide it by the total cost of the project, or the price to buy the building, or so.
Moses Kagan:
And you get a percent yield and normal for the market, until three weeks ago, or whatever, in LA maybe it was a four and a half or 5% yield. So if you bought a building with a million dollars, you would sort of be expecting to get 45,000, 50,000 in net operating income. So that’s how the market kind of works. What we try to do, is we are looking for projects, where the proforma unlevered yield, exceeds the interest rate at which we can borrow on the project, by at least 200 basis points and ideally 250 basis points. So let’s just… Maybe we can unpack that one a little bit cause it’s a little complicated.
Tobias Carlisle:
Yeah.
Moses Kagan:
Okay. So, why are we doing that? Well, when you borrow on multifamily asset, Los Angeles, there’s a 30 year amortization period on the loan. So the cost till you have the money, because you have to amortize the loan. It’s not an interest only loan. I think maybe the way a lot of corporate loans are, generally speaking, you have to amortize the loan. So 4% interest rate loan, it feels to you like it’s more like a six. Does that make sense?
Tobias Carlisle:
Yeah. Absolutely.
Moses Kagan:
It’s because you’re amortizing the loan. So the reason we think about things in terms of trying to get to an unlevered yield, which is a 200 to 250 basis points premium, over the interest rate at which we expect to be able to borrow is, because that will give us positive leverage once we refinance. Note, that puts us into a situation where even though the loan is amortizing and therefore costs more than the interest rate, when we borrow, that the yield on whatever equity remains in the deal, will be higher the more that we borrow, as opposed to lower. Does that make sense?
Tobias Carlisle:
Right. Yeah.
Moses Kagan:
It could be positive leverage. Okay? So, there’s a bunch of uncertainty there too. Who knows what interest rates are going to be like in 18 months. You can’t, this isn’t an exact science. But the most important thing from our perspective is, in extremists, we want our LPs to be able to feel comfortable, owning the property unlevered. Okay? This is like real estate heresy. People are like, what do you mean own a property unlevered? You’re a crazy person. We started in the business, in 2008, nine, when literally you could not get loans sometimes. A bank could be like, we don’t care, we’re not lending. And actually today, like right now, even banks that I have long relationships with, I’ve got a ton of loans with, they’re like, well man, we’ll quote you a month from now. We like the asset, we know you guys.
Moses Kagan:
There are times including the moment right now, where the debt markets basically stop functioning or at least stop functioning normally. And so in extremists, we love to be able to tell LPs, “Hey, you know what, we can’t borrow right now.” Sucks, we couldn’t control the debt markets, because I can’t tell the banks to loan me money. Doesn’t matter what the tenure’s doing. We have a six and a half unlevered return right now. Six and a half percent unlevered return on the capital investment deal. Sucks for me as the promoter.
Moses Kagan:
And I’ll explain why in a second. But like from the LPs perspective, Hey, you own a good asset and an improving neighborhood in Los Angeles and you’re earning a six and a half, you can kind of live with that for six months, or a year, or a couple years if you have to. Again, it’s not good for me because I get the way that these things are structured. I really don’t start to participate in the profits, until the investors get back all of their money and kind of a preferred return on it, for the time that I had it. So it’s very bad for me not to return capital. It delays by years, when I’m going to get to start to see cashflow from that building. But from the investor’s perspective, it’s like, look, our downside is that we ended up at a six or a six and a half or something unlevered and, our money’s tied up there for as long as it takes the debt market to reopen.
Moses Kagan:
And again, maybe that’s six months, or a few months, or who knows. But that’s not a disaster. What’s a disaster is if you have an 80% LTV, or loan-to-cost construction loan, and the rents have come down, and the debt market’s closed, and your loan is coming due. And you’re a forced seller because you can’t refinance and you can’t sell, and you can’t service the debt. That’s a disaster. With our stuff, it’s like the debt market, seizing up is bad for me, but it’s tolerable from our LPs perspective.
***
Scaling A Real Estate Business
Tobias Carlisle:
And so from their perspective, it’s good till you’re heavily incentivized to get the capital back out, because that’s how you get paid. So you’re paid on the return on the equity that remains and once they’ve got debt?
Moses Kagan:
No, The way it works is, and this is a very standard real estate private equity structure. Things have got many sponsors have kind of got to these increasingly baroque structures over the last three, four or five years because LPs were so thirsty for yield, they were willing to tolerate sponsors doing a lot of stuff that I would regard as maybe arguably a little shady. We have always been really plain vanilla, with respect to the structuring. And the structure is basically like, look, you give us your money, we accrue some preferred return on it. Typically it’s been somewhere between five and 8% simple interest depending on which deal, and which fund and everything. We accrue that, we can’t pay at in the beginning because there’s no cashflow from the building.
Moses Kagan:
We’ve ripped it to shreds, we’ll talk about that I imagine in a little while, there is no cashflow on these buildings while we’re doing the renovations. So there’s no cash to pay. So we accrue that pref, for a year and a half it takes to finish the project. And then so the order of the distributions. So there are going to be distributions from refinancing and then there’s distributions from just the operating cashflow, from collecting the rents and paying the expenses and the mortgage, and you got some cash, you can give it to the investors. The order of the distributions is first to retire a crude pref, then to return capital. And then once you’ve zeroed out all the capital, typically the investors will get 70% of whatever remains and we get 30%.
Moses Kagan:
So if you think about it a while, it’s a little, it’s kind of like the investors are loaning us money and seven or 8% or whatever it is. Almost like a credit card. And in exchange for doing that, once we’ve paid them back, both the principal and the interest, they own 70% of the building. They get this kicker, which is they own 70% of the building. And for us, we get a little bit of a fee, a onetime fee, but basically what we’re doing it forwards, because once this whole thing works out, four or five, six years from now, we’ll own 30% of the building.
Tobias Carlisle:
Right. Do you continue to manage the building at that point?
Moses Kagan:
Yeah, so we’re fairly vertically integrated, so we have internal property management organization. We didn’t want to do that, when we started, I went out to try to find some other property management companies, to hopefully manage for us. And the first that happened was, those management companies laughed at me when I told them what rents I needed to get. They were just like, you can’t get those rents. And I was like, I know you can get these rents, these units are amazing. We did such a good job renovating them and the location is much cooler than you think it is. We can get these rents. And they said, “No.” Okay, so we had to do the leasing. And then, over the course of last like 10 years of doing this, I have had occasion, a couple of times for various reasons, to hire other property management companies. And the quality of the service that the tenants were getting and more importantly, the quality of the financial record keeping, left a lot to be desired.
Moses Kagan:
And so from my perspective, if I’m going to take millions, and millions, and millions of dollars from LPs, I can’t turn around and hand that asset, their asset that we bought with their money, to some property management company whose execution and record keeping I don’t trust. So for a really long time, we ran the property management as a loss making business. So we were making money on our deal fees. We were waiting for our three, four, or five years, or whatever, to get into our ownership state. And meanwhile, my partner and I were subsidizing the management of the building, we were are taking our deal fees and using it to pay salaries for the people to manage the building. Because the property management company was subscale.
Tobias Carlisle:
Yeah. That’s what I was going to say, it’s a scale business, right?
Moses Kagan:
Yeah, exactly. So it took us until… And we have, all units get very premium rents, we run, it’s a high end property management company. But it took us until approximately 400 units under management, until the management started breaking even. So that was probably five years, six years into Adaptive’s history, where my partner and I would just like every month and we were kind of broke, for at least particularly the beginning chunk of that. And we were literally taking our deal fees and using it to subsidize property management on behalf of rich people. It was not a great feeling. But we’re at 650 units now, so when it crossed 400 units, it started to be a profitable thing and we’re very happy to own it now because, the property management revenue, covers the expense associated with the entire platform.
Moses Kagan:
So we have 11 employees, four of them are direct property management people. And then we’ve got accountants and we’ve got construction oversight people, and I’ve got an acquisitions guy who works with me. The property management revenue covers all of those people’s salaries, and the rent, and insurance and everything. So it provides sort of a level of stability to the platform where, if we don’t do a deal for a year, I mean it’s not good for me personally. I would prefer to have money as opposed to not, but we’re not hostage to the market. We don’t have to do deals if we don’t want to do them, because of that property management revenue.
***
Vertical Integration Gains Lead To Outsized Returns
Tobias Carlisle:
So, I read in your brochure that you’re vertically integrated. And I know that your partner, he’s a contractor, in addition to being a, I think a real estate agent for California, I saw?
Moses Kagan:
Yeah, he got-
Tobias Carlisle:
So, what does that vertical integration mean in that context?
Moses Kagan:
… So, there are a lot of different ways to do real estate private equity. One way of doing it is to be a guy, or a couple of guys in an office and you look all over the place, you find deals and then you go, there are like JV equity platforms you can go to. So you get the deal under contract, you go pitch it to Carlisle, or any one of a number of, there’s an infinite number of these JV equity platforms, that invest money on behalf of pension funds and endowments, and high net worth and everything. And that capital is very expensive but you can get it, if you have a good institutional quality, yeah, you can get it. So you don’t have to have any relationship with your LPs, you can just go out on the market, and you can outsource the general contracting you. And you can hire an owner’s rep to oversee the general contractor. And then you can hire a property management firm to do the leasing and the management. And you can actually outsource all of your accounting to their fund accounting companies that just do that.
Moses Kagan:
So that would be a totally non-integrated company. We are the opposite of that. We are first of all, we’re not looking all over the world for assets. We believe very strongly that there are enormous advantages and we can talk about them, to being extremely focused on the areas, on specific neighborhoods. Second, the kind of contractors that we hired to get the construction pricing that we get, they’re not institutional quality contractors. Because the institutional quality contractors cost twice as much and we’re so focused on the numbers.
Moses Kagan:
So, we’re dealing with imperfect contractors. We’re leasing, buildings where… Literally when we lease of a building, it’s not just like, oh, what should we charge for a two bedroom? It’s like, we walk into each of the apartments and differentially price them based on, the light coming into that unit and then, how much private outdoor space this unit has. It’s all about these, there’s no such thing in our business like someone having a 50% better thing, it’s a game of inches. And what you need to do, or what we to do, to generate the kind of returns that we’ve generated, is to crank each dial up 10%. Be 10% better at acquiring and that’s why we buy all cash, be 10% better at design and my partner lays out by hand, with a pen and white out, what each of the units is going to be. Be 10% or whatever cheaper on the construction by hiring contractors who are maybe imperfect but with whom you have long-term relationships.
Moses Kagan:
Do the leasing a little bit better. Each of these things independently, it’s just a small advantage, but the agglomeration, the accumulation of a bunch of small advantages is what gives us, what I would like to think is sort of super normal returns.
***
Invest In Hyperlocal Real Estate Using One Simple Equation
Tobias Carlisle:
Right. Just to return to you, let’s talk about the neighborhoods. You describe it in your brochure as being hyperlocal. So what does that mean and how do you achieve that practically?
Moses Kagan:
Yeah, so, a couple of things to say about that. The first thing is we’re like, as I said before, “We’re super quantitative,” so we’re constantly running a very simple equation on very many deals, or every day. And the equation is basically just unlevered yield. So forecast annual rents, minus forecast, annual operating expenses, divided by the cost of buying and renovating the building. And as I said, “We’re looking for that number to be approximately 200, 250 basis points higher than the interest rate at which we think we can borrow on the asset.” So that’s the equation. Super simple. We build the simplest models in the history of the world. Sometimes people ask me of… We’ve had investors, particularly these JV equity guys, we’ve talked to them, we don’t do business with them really, but they come to us sometimes and sometimes we talk about deals.
Moses Kagan:
And they’re like, can you send me your model? And I send them this one page, super simple model. We don’t do 10 year forward projections. Because who knows what rents are going to be 10 years, how would I now? Anyway, people look at our models and they’re like, what do you got? This is too simple, but, anyway, this works for us. So, we’re constantly running properties through that model every day. I mean, obviously most of the time we can just look at it right away and say, “It doesn’t work.” But there are enough surprising outcomes that we do have to model a bunch of stuff every day. You asked about the neighborhoods. And so the question is like, what are the inputs into that very simple model? Right?
Moses Kagan:
The model is simple, but the key is the quality of the inputs, right? And so the inputs are, well, you know what price you can buy the building for. That’s out there, the guys marketing the property, that broker comes, tells you the prices. You have to estimate what it’s going to cost, you have to figure out, what are you going to do with this thing. And we do crazy stuff to buildings. What are you going to do to it? Which is a creative process, it’s like junior architecture stuff. What is it going to cost to do that, to the building? What are the rents going to be? And one of the operating expenses is going to be? That’s it. Those are the inputs, right? Because we are doing construction all the time, we know what the construction price is going to be.
Moses Kagan:
In fact, when we tore a building before buying it, we bring the contractors who have done 40 projects for us in the past, and we make them quote, so we know… We can hold them to those quotes more or less if we, as long as we don’t change what we’re going to do the building subsequently. So we know what it’s going to cost to do the thing we want to do. And it’s not just like, oh, $1,00 a square foot or $50 a square foot or whatever. It’s not some simple back of the envelope thing. It’s like we get quotes from the plumber about what it’s going to cost to do the plumbing. Okay? And because we’re kind of getting, we’re signing construction contracts all the time, I’m renovating 10 buildings right now. I have two projects that are in bidding right now.
Moses Kagan:
I know what construction costs for these kinds of projects. And so that’s the information that’s getting fed into those simple models. What are the operating expenses? Well, we’ve been doing this for like 10 years and so we can just look back at what it actually costs to run this buildings. And by the way, we do full gut renovations generally where, we’re replacing the plumbing and the electric and everything. And so, you can be tempted in the initial years to underwrite very low operating expenses because, obviously you’re going to have fewer problems with a brand new building than you would with an older one. But now that you’re starting to sort of own these things for 10 years, you start to kind of have, you can’t fool yourself about what it actually costs to run the thing.
Moses Kagan:
So we kind of try to look back and say, “The operating expenses can be lower in the initial years and then they’re going to kind of rise in the out years. And so we need to take more of a normalized view about what this is going to look like, in the initial 10 years of ownership or something.” And then crucially, and this is, now we’re getting to your neighborhood thing. Because the construction prices in the operating sense don’t change, doesn’t matter if I’m doing a deal in Compton or if I’m doing it in Beverly Hills, it’s going to be the same. What matters is the rents. And you can easily, fool yourself into doing a dumb deal, by missing on your rent projections, by even 200 bucks a door. Because the way that these things work is, 200 bucks times X number of units, times 12 months. It can swing the value of the cashflow and therefore the value of the yield, and the value, and an enormous amount.
Moses Kagan:
And so what we’re doing is, we have a portfolio of 650 similarly renovated buildings in probably six neighborhoods, seven neighborhoods. So I personally set all of the asking rents. When a unit becomes vacant, I’m the one who decides what we’re going to charge for it. And I’m the one who approves all the tenants. So I know, minute to minute, literally, I woke up this morning to tenant applications, I know what people are and are not willing to pay for our kind of two bedrooms in these different neighborhoods. And so, when a property comes up for sale in a neighborhood that in which we are currently doing business. I know what the purchase price is, I know what the construction prices, I know what the OPICS is, and I damn well better know what the rents are, because I’m leasing similarly renovated two bedrooms around the corner and a few blocks away, and whatever all the time. Okay? So, in on the existing neighborhoods, we already do business, we have this incredible informational advantage. Right?
Moses Kagan:
And we exploit it. Okay. The problem is how do you go into a new neighborhood where you don’t have the same level of information about the rents. Because then you’re guessing a little bit. And so what we end up doing is we’re constantly looking across the LA Metro area. I mean, I run numbers on neighborhoods, I’ve run numbers on hundreds of deals in neighborhoods where we’ve never done deals, right? Because what I’m looking for is, I’m looking for deals where I can not sandbag the projected rents. I’m not putting them so low that it’s a hurdle that I can step over. But I want to be really confident that I could hit those rents when I’m done with the renovation. So in a neighborhood where we don’t do a lot of business, what I’m doing is being extra conservative on my projections.
Moses Kagan:
And what that’s going to do, is it’s going to cause a threshold, for doing a deal in a new neighborhood to be higher than the threshold for doing on an existing neighborhood. And so what that means is, we can look at a neighborhood for years and we can’t do anything there. When we find a deal that works, then we’ll find one that’s great. It’s such a good deal that even despite the more conservative underwriting, it makes sense to do it. We buy that deal. Then, once we’re operating that building and we have some more certainty regarding the rents, then we very frequently find other deals in the same neighborhood that work. Like, Oh, okay, you can get this for a two bedroom. Okay, this deal over here works now. So it’s been the slow process of sort of buying into a neighborhood then expanding there, then finding ideal, another neighbor and expanding there. And so it’s very, quantitatively driven I guess you would say.
Tobias Carlisle:
And what neighborhoods are you in, in Los Angeles now?
Moses Kagan:
Mostly on the East side. And some kind of, like West Adams, like Mid-City, West Adams areas. But honestly, I mean, I would do deals on the moon if they made sense. It’s not… and we miss-
Tobias Carlisle:
It’s not so much the location, it’s how well you know it.
Moses Kagan:
… Yeah, well, it’s right. I mean, it’s what is… Because given that construction pricing and operating expenses are basically flat across all these different neighborhoods, the only variables that matter are what are the purchase prices and what kind of brands can you underwrite? That’s it, there’s no like that.. But the balance between those two things is constantly changing. And so I’ll give you an example of a neighborhood where I would love to buy more stuff, but I can’t right now. So we went into Highland Park, I think we did our first deal in Highland Park, which is a neighborhood in Northeast LA. Awesome neighborhood. Everyone who’s in New York right now and wondering where they should move, should move to Highland Park. I mean, let’s hope all the retail survives because it’s super walkable and just awesome, enough density to be… Interesting small apartment buildings, but also lots of single family homes, walkable retail. So dope.
Moses Kagan:
We did our first deal there, I think in 2013. And we actually did it as a fee project where we didn’t… This was back in the old days, we couldn’t even raise enough money for the scale of the opportunity. So, we did a lot of deals where we didn’t even have an ownership state. We just got, fees for doing it. So we did this deal, 16 unit building and we were underwriting 1350, for two bedrooms there. And by the time they leased it up, we leased the whole building up in two weeks at 1650. And it was like, oh! And then I bought everything that wasn’t nailed down there. I went around and this luckily, we were at that point able to raise a bit more money. And so we were able to actually an ownership stake. We now have 100’s of units in Highland Park.
Moses Kagan:
And the rents have continued to rise, and those deals are done incredibly. Okay? I can’t buy stuff at Highland Park. Every once in a while, I’ll pick off a small deal because I have, relationship with a broker or whatever. But that era of being able to just run around and buy everything that’s over, and it’s been over for probably like three years or something. So what I’m saying is that, the reason it’s over is because they started printing, articles in the LA Times about how cool Highland Park was.
Tobias Carlisle:
Curbed LA.
Moses Kagan:
Yeah, curbed. And I was stupid, early in my career. I used to jump up and down and tell people of this.
Tobias Carlisle:
Tell people about it.
Moses Kagan:
Oh, yeah. Such an idiot. I got incredibly stupid stories about dumb stuff I did like that. But yeah, so the rents have been climbing there, but it’s just the purchase prices went crazy. And so that the equation’s at whack and we can’t buy stuff there. And then there were other examples of neighborhoods that I’m not going to name where, they were… the equation was in balance and we bought a bunch of stuff. And then the equation went out of balance and we couldn’t, but then the rents kind of came back up, and then we could again, and then we started buying more there. So it’s all about, just constantly feeding back the information that we’re getting from the existing management portfolio. back through this equation that we’re using to underwrite new deals. And then constantly seeing, okay, can we make this work? No, but what about over here? And that’s the process.
***
Here’s Why You Should Forget About Rent Growth Forecasts
Tobias Carlisle:
Yeah. That’s super interesting. Just going back to your brochure, one of the things that I found most interesting, you’ve got this page where you say, “These are the things we ignore.” And the first thing that you ignore, is the rent growth forecast, which I completely understand that because that’s something that I try to do too, basically ignore growth, cause I think it’s much harder to predict than, super hard to underwrite. I’ll take you through them or if you can do it from memory, but you start with the no growth forecast. So you’re looking at that on the yield basis as you buy it.
Moses Kagan:
Yeah. Let me, let me just jump in there and maybe you can say the things that I’ll respond to it.
Tobias Carlisle:
Yeah. Let’s do that.
Moses Kagan:
Yeah. So, here’s the thing about rent growth. Okay. If you look at, a crowdfunding real estate site, or basically any pitch from a sponsor, what you’re going to see is, tenure projections. This is like standard in the business and they’re going to say, “We’re going to buy this building, we’re going to do whatever to it.” Here’s what the rents are going to be, here’s how they’re going to grow over 10 years. And then we’re going to sell the building, usually at some multiple, it’s higher than what we bought it for. Leave that aside for a minute.
Tobias Carlisle:
Then you DCF it back and until you get really high.
Moses Kagan:
Yeah, exactly. And by the way, we’re going to grow rent at a very reasonable 3% a year compounding. And we’re going to grow expenses at a very reasonable 2% a year. It doesn’t sound that crazy. Okay? Almost any deal. If you grow rents faster than expenses over 10 years and you use a bunch of debt, and by the way, you would then forecast a multiple that is higher than what you paid for the building. The numbers are going to look good. It’s obvious that they’re going to look good. And so you can do that and talk yourself into doing a lot of stupid stuff. Meanwhile, the following things I know to be true about Los Angeles rents, over the last X number of decades, they have grown faster than inflation. Okay, like Los Angeles 100 years ago was a dusty town with unpaved roads. Rents have been growing crazier.
Moses Kagan:
But I also know that at any particular year, specifically like this one, rents can go down and they can go down by like… I came into the business right before the last one of this, and rents came down like 15, 20%. And then what they did is they grew very quickly thereafter. And if you look at the long-term trend line, it’s still, the growth has been great. But if you condition your deals on steady linear 3% rent growth, you may very likely find yourself to be wrong and to talk yourself into doing something you shouldn’t have done. So what we try to say is, look, let’s get comfortable with the rents where they are now, if they run fantastic, they may come down, that that may happen. And therefore we’re going to keep the leverage down. So that doesn’t kill us, if that happens and they may run, and if they run break, I’m not going to turn down high rents.
Moses Kagan:
I love high rents. I’m very happy for the [inaudible 00:45:26], but I don’t want to allow future forecast about rent to talk me into doing dumb stuff. Now, let me just say, as a kind of a comment here, if I had known over the last 10 years, if I had been able to accurately predict the future, right? Over the last 10 years, rents basically did run. And actually it turns out that the smartest thing to do was to buy the biggest buildings you could, not give a shit about the entry price, and use as much debt as you possibly could. And then exit to some nitwit, three years down the road, that worked really well. Okay.
Moses Kagan:
But one of the things, and this is sort of a Howard Mark’s thing, and maybe he got off somewhere else. But, I really love the concept of there having been different possible worlds that we could live in. We lived in one world where this pandemic happened now, for the five years ago, or eight years ago, or whatever, but there are a lot of different worlds. And we don’t know which one in advance that we’re going to get. And so my way of thinking about things is to prepare for a bad scenario and then look, obviously if you get a good scenario that’s a fantastic thing. But anyway, that’s a long way of explaining why we don’t forecast brands cause they’re unknowable in the timeframes that we’re talking about.
Tobias Carlisle:
Yeah. I completely understand that. I think it’s the same thing has happened in the public equity markets. If you’d been more aggressive and been prepared to pay more for some of these faster growing companies, that’s paid very well. Historically that hasn’t been the best way to do it because, many times you run into some obstacles along the way that prevents you from kind of cashing in the chips at the end. And being a little bit more conservative, and kind of getting the growth for free, or if it materializes getting it without kind of relying on it has been a better strategy. So, yeah, I like that approach. So the others, probably it’s all part of the same piece, but you say, we’ve talked about, you don’t like debt, you prefer all cash. You don’t think about the exit price and then you don’t calculate an IRR.
Moses Kagan:
Yeah. Well, let’s talk about the exit price. So, standard real estate, private equity model, and okay, you’ve got the tenure projections and you’re going to exit at a certain price, right? You’re going to plug in a cap rate. You’re going to say, “Oh, I bought at a five cap and 10 years from now, I’m going to solidify that.” A lot of times people like I buy at a five cap, but for reasons that I can’t explain to you, I’m going to be able to sell up it at a four cap, or whatever.
Tobias Carlisle:
Which is a 10% improvement, from-
Moses Kagan:
Yeah, exactly. You just take, and you divide the forecast, the net operating income 10 years from now, divide by that four cap and that’s your value. And then you can work backwards from there and figure out what your IRR is. For better or worse, I am personally uncomfortable with promising investors, things that I’m not pretty damn sure that I know to be true. And so back in 2012 and ’13, it was possible to buy a building under an underwriting exit, where you could see a buyer buying from you, two years, three years later. At a price that would make sense for that buyer and you as the seller would do well. And the buyer would be buying at a price, which was reasonable. Okay? Since about 2015, 2016, in my opinion, there has been no way to underwrite an exit, at a price which a smart buyer would buy. Now, of course, there are lots of dumb buyers and you can do well, by selling to dumb buyers. Whenever I want to sell something, I want to find them buyers too.
Moses Kagan:
But, because I have always thought, I would just look at this stuff and it’s, now I can’t, I don’t know who the guy is. Who’s going to buy a four cap building and he’s going to borrow at four. And so, because his loan is amortizing, it’s really a six and he’s getting next. So he’s plunking down a bunch of money, to get a 2% return. I don’t know who that buyer is and apparently they’re out there, but because I have not been willing to… I wouldn’t do that. So I’m not going to sit there and tell my investors that I’m certain that I’m going to find some idiot to do that. So I just, I personally, I’m temperamentally unsuited, to a model where I need to tell them that I’m going to sell it at some price, at some time in future.
Moses Kagan:
I mean, by the way, the cap rates are totally dependent on where interest rates are. So if you’re telling someone you’re going to exit in four or five, six, 10 years, whatever, at a specific cap rate, implicit in that is a forecast about interest rates. And it’s like, if you can forecast interest rates five, six, seven, 10 years from now, go be an interest rate trader. You’ll make a lot more money being an interest rate trader, than you can messing around real estate. Anyway, so I have not been willing to underwrite those exit prices and therefore I cannot quote IRS because the IRS are obviously dependent on the exit price. And this has dramatically retarded our fundraising over time. Because investors are conditioned to be like, Oh, I’m looking from mid-teens IRR, I’m looking for a [inaudible 00:51:07] IRR.
Tobias Carlisle:
… Me too.
Moses Kagan:
Yeah. No kidding, everyone, yeah. That’d be awesome. Right? And they’re like, what are your IRR, I’m like, I’m not going to tell you, I don’t know, how would I know? I have no way to tell you what my… What I can tell you is, we’re going to do a deal where the unlevered yield is going to be six, or six and a half, or seven. And it’s going to be in a market where people are buying four and a half. So there’s definitely value creation. And you should probably be okay with holding that thing unlevered. And then what we’re going to do is, assuming the debt markets cooperate, we’re going to put a bunch of debt on there, at a reasonable amount and get you the vast majority of your money back. And then we’re going to hold the thing and good things are going to happen because over a sufficiently long time horizon, we’re very confident that the rents will rise faster than inflation.
Moses Kagan:
And if you own a good asset in a good area with a reasonable capital structure. And you manage it appropriately, you’re going to do well, how well? And that wait, in what timeframes, I can’t predict. And therefore I regard it as intellectually dishonest to promise that to anyone.
Tobias Carlisle:
Yeah. It’s an interesting hack to think about, the eventual purchaser of the building being, yourself down the road to think about, what would you buy this building for down the road. And try and make that fit your own model. And then that probably tempers your expectations a little bit.
Moses Kagan:
My partner, he used to try to strangle me. I mean, I’m kind of metaphorically, but sometimes close to him really, because it really has impacted our ability to raise money. It’d be so much easier to say, “Oh, we’re going to do a blog IRR.” And this is like the standard, that’s what people are used to. It’s a normal thing. And so our unwillingness to act like that, has really slowed down the growth of our business. But I only know how to do this, the way that I do it. And it’s like, I didn’t learn… We didn’t work anywhere else. Neither my partner nor I ever worked in other real estate business. So we didn’t have people showing us how to do things. So everything from the model we use to the way we deal with contractors, to the way we organize our leasing and management, it’s all been two, reasonably bright people, confronted with a question, a problem or whatever.
Moses Kagan:
And just trying to do what seems smart. And then to the extent that it worked, kept doing it. And to the extent that it didn’t work trying something else, but we didn’t import a way of doing something from somewhere else. We just figured out what seemed to make sense to us. And this is where we’ve landed. You don’t feel better, for better or worse.
***
How To Survive In Real Estate Investing When The Market Bottoms
Tobias Carlisle:
So how did you get started?
Moses Kagan:
It’s a little bit interesting question. So, my parents had always owned, really small buildings, in Troy, New York where I’m from. Maybe a total of a maximum of 10 units, maybe at various points. Self-managed, I love my parents they’re supersmart, they gave me amazing advantages. They are not financially sophisticated people, they’re just not. They don’t think in terms of lever. In Troy, for a long time, you can basically get a building for free if you’re willing to pay the property taxes. I mean, really, Troy is like the king industrial, it’s actually come back somewhat since then, but it was just pretty awful when I was growing up there. And so they’d get a building basically for free, but they were good at running it.
Moses Kagan:
So we actually did things cashflow really well. The returns were actually pretty good. Anyways, so I grew up, shoveling those buildings out when it snowed and taking messages from perspective tenants, when we’d have a vacant unit, they would advertise it in a newspaper. And then we’d get calls. And my mother used to threaten to kill me if I didn’t write down the person’s name and phone number, because that was going to be an apartment that would stay vacant. And it was a big deal to us, if that happened. So there was always a little bit of that in our family. So, in 2007, my brother and I were in LA, we got the kind of bug that I think everyone got about buying a house, right? And then we were like, well, we’re going to buy a duplex.
Moses Kagan:
The two of us are going to live, one in each unit. We start looking at the numbers, totally naive. The numbers were obviously insane. We were not experts, it was just like, this is ridiculous. It was obviously better to rent one of those two units than to buy the whole building, because the market was insane. My brother happened to cross a guy, who had bought a derelict 16 year old building and renovated it, and then one out of money, right at the end, before he could lease it up. And this is in late 2007, early 2008, with help from our parents, we bought that building. And finished the renovations and leased it up. And then that was before the market tanked. So in some ways it was the worst time to buy something.
Moses Kagan:
But what was interesting about it, there’s a number of interesting things about that experience we can go into if you want. But what was, I think that the biggest learnings from that experience were rents can go down by 15 to 20%, but if you’ve only levered to 65 LTV, you can survive that. It’s not pleasant. You may have no cashflow for a few months there right at the absolute bottom, it might get pretty ugly, but, you can survive. And so, that whole experience kind of, A, it was obviously our, that was kind of like a high school for us in this business. And subsequently we went through college and graduate school. But fundamentally it was like, look, you can buy a deal. You can do a reasonably smart deal at a terrible time. And as long as you don’t use, insane amounts of debt, it’s going to work out okay. And that has sort of conditioned our thinking, all the way along.
Tobias Carlisle:
Yeah. That’s super interesting. I think we’re coming up on time, Moses, if folks want to get in contact with you, what’s the best way of doing that?
Moses Kagan:
Yeah. So, I have a blog that, well I used to write it every day. It’s called Kagan’s blog. So K-A-G-A-N-S-B-L-O-G.com.
Tobias Carlisle:
I’ll link it up in the show notes.
Moses Kagan:
Yeah. So if you Google my name, you’ll find Kagan blogs, the first thing that comes up, you can join my mailing list there. And I’m also on Twitter, @moseskagan. I’m like a big real estate nerd, you probably can tell.
Tobias Carlisle:
Yeah. Great follow on Twitter, endorse it.
Moses Kagan:
I appreciate that, you too. So, I love talking about this stuff, so I’m in touch with tons of people and honestly, I’m just being totally transparent. We’ve met through the blog and then through Twitter and this kind of stuff, we met, very many of the people who became LPs of ours. That’s kind of like mainly my motivation for doing this stuff. But I’m in touch with, at this point, probably 100’s of young people who are trying to do their first deal or whatever, and I’m not going to, it’s not like I’m going to spend 20 hours with each of those people, but I’m always happy to look at a deal or look at a deck, or talk through a thorny problem. Cause obviously, I was there myself, not that long ago. And I didn’t really have a mentor in the business. So I like to kind of do that as a way of giving back.
Tobias Carlisle:
Yeah, that’s great. Thank you very much. Moses Kagan from Adaptive Realty,
Moses Kagan:
Thanks, again.
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