Value through Design

The maturation of e-commerce has created a significant opportunity to save on materials acquisition costs and create value through cost-effective design.   Whether its door handlesets; faucets and other trim products; cabinet pulls; or other items, elegantly designed products can now be sourced online at fraction of the cost that they are available in local upscale stores or through home designers.

Contractor Inflation

Most homeowners rely on their contractor or a home designer to help them select appliances, finish materials and hardware.  Either of these choices can result in excessive costs.  Contractors tend to be very busy and they don’t like to shop around.  They also add a contractor’s mark up to all labor and materials (usually 10-15%).  But that’s not the big problem.  Contractors often rely on a network of suppliers that cater to contractors.  These companies deliver directly to the job site, provide favorable credit terms, etc., all of which make them the contractor’s best friend.  But not yours.  They pay for all that service by charging very high prices (which you the client actually pay via the contractor).   That basic white American Standard bathtub might cost might cost $250 from and they provide free shipping.  The local plumbing supply store charges $600 and your contractor marks that price up so it’s almost triple the price you could be paying.  Sometimes your contractor will put in an ‘allowance’ for certain items such as carpet.  If the allowance looks high, the contractor will tell you that they will only pass on the actual cost to you if the allowance is too high.  That’s great in theory but what’s the use if they are still going to buy the item from an overpriced vendor?  I can’t remember ever getting back money on an allowance.  I expect to be going to an Ice Capades show in hell before a contractor ever writes me a check.

Designer Inflation

The problem with designers buying/recommending materials is similar – they rely on a network of high-convenience, overpriced suppliers.  Most designers take a markup on items they purchase as well.  Often they will tell you that you should buy from a certain supplier because they get a ‘designers discount’ of 10%.  That sounds good but if you are charged twice the price you could be paying elsewhere prior to the application of the 10% discount, the math is not very favorable for you.

Door Knobs & Cabinet Pulls

Door knobs provide a good illustration of potential savings because there are many doors in a house so there is a multiplier effect applied to your per item acquisition cost.  I remodeled my house a couple of years ago and my wife selected some very nice Emtek Basel Brass Modern Passage Leversets.

Calculating Intrinsic Value

Calculating intrinsic value is a fundamental requirement of value investing in the securities market.  If the market value of a company is not sufficiently below its intrinsic value, then a margin of safety won’t exist which is required for a worthy value investment candidate.

This concept can be translated into the real estate market.  We would define it as the property’s value based on prevailing cap rates using the stabilized net operating income (NOI) adjusted for prevailing market rents after your expected remodeling investment.  This assumes that you are able to re-lease units that have been remodeled at market rates.

Most properties that sell for less than their intrinsic value are distressed either by their current ownership or their physical condition, or both.  Generally the industry refers to foreclosure properties as ‘distressed’ because banks are not long-term owners and tend to be motivated sellers.  They won’t hold a property for years but instead will discount it to whatever level is required to sell the property within a few months.  These properties tend to sell at a discount to other similar properties that are listed for sale by owner-occupants in the market area.  Too many bank-owned properties in a given market area will drag down overall market prices over time.

Properties can also be physically distressed by deferred maintenance, functional obsolescence (tiny closets, no master bath, etc.) or poor (or dated) design choices in finish materials, features and appliances.  The best opportunities tend to be properties where the basic systems (roofing, plumbing, HVAC, electrical, foundation) are updated but design choices and finishes are poor.  It’s always best to spend remodeling dollars on items that are visible to potential tenants and buyers and will create value either by commanding a higher rental rate or purchase price.

In practice, we look for the highest rental rates in a market area. After inspecting the property, we develop a remodeling budget including the ‘have to repairs’ on major systems and the ‘value add’ cosmetic changes that build value through good design choices in finish materials, features and appliances.  We develop a projected basis (acquisition price + acquisition costs + remodeling costs) and then project cash-on-cash returns based on the increased rental rates.

Ideally we will see annual cash-on-cash returns of at least 4-6% during the holding period with an IRR of 8% – 10% including the sale proceeds.

In addition to calculating intrinsic value, we also like to look at several current property metrics to determine if we are getting a good deal including: price per unit, price per square foot and sale price.  Is this sale price near the low end in the market area? While these metrics don’t determine if the property investment is a good one, it’s reassuring to see that your prospective acquisition is being done at the low end of current market values.

Distressed Property: California Dreamin’

Distressed properties have traditionally been found primarily in marginal areas that experienced sharp declines in market value amid economic decline.  However, in the deep industry recession of 2007-12, even high-quality Los Angeles neighborhoods  experienced substantial foreclosure volumes.  While foreclosures are now relatively rare, there are always some opportunities in this market segment.

Foreclosure Background and Timeline

California is a ‘deed of trust’ state which means that the property deed is held by a third-party trustee not the lender or homeowner.  Generally all foreclosures are non-judicial as lenders foreclose on the deed through a Trustee’s Sale rather than going to court.  In LA county, these sales are literally held on the district courthouse steps in Norwalk or Pomona.

The start of the process begins with the filing of a Notice of Default (NOD) when a homeowner is late on their mortgage payment (traditionally done if payment is more than 30 days late).  The homeowner then has 90 days to cure the default by making all late payments and associated fees.  After the 90 day period expires, the lender files a Notice of Trustee Sale (NOS) giving at least 20 days notice prior to sale of the property at auction.

The property will be sold at auction to either an investor making a cash bid above the lender-set opening bid (with no opportunity for property inspection) or the lender will bid an amount equal to the Unpaid Principal Balance (UPB) of the mortgage plus penalties, fees, etc.  Since that amount is owed to the lender, they have no out-of-pocket cost to acquire the property.

If the lender purchases the property at auction, it is referred to as ‘bank-owned’ or ‘real estate owned’ (REO).   Banks generally assign properties to a third-party asset management company that handles the eviction (if necessary); ‘trash out’ and any required repairs; and assigns the property to an REO specialist real estate agent that will list it for sale and coordinate the property sale with the asset manager.

To recap, the market characterizes distressed properties at one of three stages:

  • Pre-Foreclosure:  the property owner is up to 90 days late on their mortgage payment and a Notice of Default (NOD) has been filed.
  • Auction:  the property owner is more than 90 days late on their mortgage payment and a Notice of Trustee’s Sale (NOTS) has been filed.   The borrower can catch up on payments and pay penalties due at any time prior to the auction.
  • Bank-Owned or REO:  ownership of the property has now been transferred to the bank (or an investor) and it will be sold by a real estate agent in the future.

Most foreclosure investors buy properties at the trustee’s sale or when the property gets listed for sale in the local MLS.  In Los Angeles County, there are many active foreclosure investors and bidding is highly competitive at auction and for MLS-listed REO properties.

Investment Strategies

There are different acquisition strategies that are applicable at each stage of the foreclosure process.

Stage: Pre-foreclosure

During the pre-foreclosure stage, purchase offers can be made to the homeowner as a ‘short sale’.   That is, the sale price is less than the unpaid principal balance (UPB) and therefore requires approval by the lender (s) as well as the homeowner.   Because of the multi-step approval process, a short sale can take a long time to consummate, often a minimum of 45 days and frequently more like 90 days or more.   A short sale allows the borrower to get out from under the mortgage loan(s) but the amount of forgiven debt creates a tax liability.  While a short sale has a less deleterious effect on a borrower’s credit rating than a foreclosure, it is still a significant negative.

Stage: Auction

Buying a property at the Trustee’s Sale has several challenges.  It is an all cash purchase, literally requiring bidders to attend the auction with cashier’s checks.  There is no property inspection allowed so property purchases are true ‘as-is’ transactions.  Once the property is purchased, the former owner still needs to be evicted which can take 3-4 months.  Finally, auctions are frequently rescheduled either because the homeowner is pursuing a short sale or declares bankruptcy.   This means that acquisition visibility is very limited because a target property auction can be cancelled or rescheduled 3-4 times over a multi-month period.  Buying at auction requires a discount to market value of at least 15-20% in order to compensate for the associated risks.

Stage: Bank-owned (REO)

The blind spot for most investors occurs during the period after the lender has acquired a property at auction and before it is listed for sale on the MLS.  Banks don’t publicly identify which asset management company has responsibility for a specific property and asset management companies don’t identify which real estate agent in their network has been assigned responsibility for listing and sale of the property.  This doesn’t occur until a sign goes up in the front yard and the listing goes active in the MLS.

One strategy is to build relationships with asset managers and local REO agents who will let you know when an REO property is going to be listed for sale.  Ideally you should have the listing agent write the offer for you.  By having the listing agent write the purchase offer, they have the opportunity to retain 100% of the real estate commission rather than split it with a buyer’s agent.  In the industry this is referred to as ‘double-ending’ the transaction.  It’s perfectly legal as long as both buyer and seller provide written authorization.

This provides a powerful incentive to the listing agent to promote your offer and convince the asset manager to accept your offer.  Mathematically, another investor would have to offer twice the price for the listing agent to make the same money as they would by double-ending the deal with our offer.

To a certain extent, this has become standard practice in Los Angeles as competition for REO properties has intensified.  Investors need to be disciplined and prepared to lose multiple property bidding wars before they land the right opportunity at the right price.

Long Term Perspective

Real estate in Southern California is cyclical.  The current down cycle we are currently experiencing is by no means the first.  If you bought residential real estate at the prior market peak in June 1990, you would likely have been underwater until February 2000 when the market finally regained its peak index value of a decade earlier (source:  S&P Case Shiller LA metro index).  From peak to trough the market declined about 27% during that period before regaining its prior level.

If you bought during the 2005-2007 period, you’re probably still underwater and will be for a while yet.  The S&P Case Shiller Index for Los Angeles hit a peak in September 2006 and has declined by 38% since then.

However, even if you bought at the earlier peak in June 1990 and remained invested, your property today would have appreciated 70% even after this most recent large price decline which began in 2006.  If you had bought in 1995 and sold in 2005 your gains would have been much greater.

Of equal importance is the fact that you would have enjoyed rental income throughout that period.  The keys to success are a long-term perspective; a financial capability to ride through the cycles; and an acquisition price that produces a solid ongoing annual cash flow yield from the property’s rental income.  Long-term appreciation is what turns a good real estate investment into a great one.  However, it can’t turn a bad investment into a good one.  If you buy a property with weak cash flow at the top of the market, don’t depend on the market to bail you out.

You also have to believe in Los Angeles: the lifestyle, the weather, nearby beaches, deserts and mountains, the Hollywood glitz, etc.  If you think that what makes LA unique and attractive now, will continue in the future then real estate can be a good long-term investment for you.

Lastly remember that while general market conditions are influential on your real estate investment results, choosing the right property and neighborhood are even more so.  Valuation is based on a multiple of operating income. A highly desirable property in a highly desirable neighborhood will allow you to grow your operating income by raising rents at a rate that exceeds market-level growth.