Successfully Invest In Hyperlocal Real Estate Using One Simple Equation

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During his recent interview with Tobias, Moses Kagan, Co-Founder & Partner at Adaptive Realty discussed Successfully Investing In Hyperlocal Real Estate Using One Simple Equation. Here’s an excerpt from the interview:

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.

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