If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.
Continued from Part 20: She wrote down the call-back numbers on the handful of For Rent signs she saw. Then she pulled into a Trader Joe’s and stood in the longest line she could find, holding a small plastic jar of peanut butter cups. Lots of good conversations start over peanut butter cups. All you have to do is to turn around, show the label to the woman behind you and ask, “Have you tried these?” That almost always gets the ball rolling. If it doesn’t, just give her a cold look so she knows you are nobody to trifle with, then go to another line and try again. Your goal is to first start a conversation of any sort then to move it towards finding out why her family moved to the area and how long she’s been there.
Do this a dozen times and you’ll get a pretty good idea what the neighborhood attractions are. You don’t even have to buy 12 containers of peanut butter cups. Just put the jar down before you get to the cash register and go outside. Check your social media for a few minutes or so and go back in. If your peanut butter cups are still by the dark chocolate you can just snag them as you pass and again go to the back of the longest line: “Have you tried these?” A lot of these sorties can be done in a short time. The whole thing will take an hour or two, max.
Emily discovered that within her yellow borders were three elementary schools. They drew from different residential areas. The school rating guides ranked one school poorly and the other two schools much better. As you would expect, young families were eager to get their children into the better schools.
Emily believed that being serviced by a highly ranked public school would be something her tenants might be willing to pay for. She did a little research and then used another highlighter to run a pink border around the areas serviced by the two better schools.
Sure, Emily learned that people liked the local Saturday Farmer’s Market, but the biggest neighborhood draw was definitely the school system. Right then, she knew that (a) she must develop a property in one of the two higher rated schools, and (b) all of her comparables had to come from those school systems.
Now that Emily had almost a local’s grasp of the area and knew where she wanted to develop, it was simple enough to get MLS comps of recently sold (within the six months or so) two to 4 unit properties that were comparable to the property she hoped to develop. Those MLS comps gave her data on both (a) income and (b) market value. Both were important because Emily knew that a lender would consider both items when the time came to finance / refinance the property.
To Emily’s mind, three elements had to be present before she could allow herself to proceed. First, the project had to be legally permissible. She’d checked with the city, and it was.
Secondly, the project had to be financeable. Her mortgage broker assured her that the concept was lendable but, the broker said, the problems are in the details. How was Emily’s credit? Did she have liquid funds sufficient to close the purchase? Did she have reserves in case things at first didn’t go quite as well as she hoped? Will interest rates remain low enough to support the needed loan(s)? Financing, especially for high loan-to-value properties that aren’t even built yet, remains uncertain right up to the moment the loan is funded.
The loan broker made sure Emily recognized the financing risk. But she also emphasized that people succeed in developing small projects on borrowed money all the time. And if interest rates increase, it doesn’t mean the deal is dead. It could mean that the seller just has to recognize that his property is no longer worth what it used to be. After all, we all know that the higher the interest rate, the lower the property value. The seller’s choice then becomes one of reducing his price to accommodate the higher rates or not doing the deal at all and perhaps watching rates climb even higher. Construction loans have a lot of moving parts and each must be provided for. This requires flexibility from all the parties especially, Emily hoped, from the seller. If conditions changed but everybody still wanted to do the deal, compromises might continue right through to the last minute.
Then there were the costs of construction. This included not only “hard” costs for materials and labor but also the “soft” costs, the fees the city attaches to new construction. Emily separated the cost element into two boxes: (a) what the contractor charged, and (b) what the city demanded.
She decided to deal first with labor and materials. And that meant she had to make a decision on what she would most likely build.
She called one of the agents she’d been talking to and asked for a farm package of the area. She said she wanted one that showed (a) all residential properties; (b) their addresses, (c) age(s), (d) living areas, and (e) bedroom and bathroom counts.
Emily expected that with this data she could get a really good idea of how the market responded to older, well maintained properties. Her first task was to find the typical ages of the existing duplexes and triplexes. Construction dates shown in the farm package indicated most were built after WWI but before WWII.
There were more than a few larger apartment buildings and some condos that were built recently. Most of the SFRs were in the same age group as the duplexes and triplexes: between 80 and 100 years old. A drive-by showed that some were in better condition than others.
Now she refined her parameters. Ideally, she hoped to buy a properly zoned lot with a single poorly maintained house on it. Emily wanted to restore the original structure and then build a second house in back. She expected to wind up with two freestanding units. For the new unit to be compatible with the neighborhood, it would have to look pretty similar to the older house in front. This did not mean the living areas had to be the same, only that the architecture matched enough that from the outside they appeared to be built at about the same time.
As one would expect, older properties were smaller than people expected today and that was where Emily hoped to create her marketing edge.
She knew from her previous reading that Location was the most important characteristic in rental properties – good locations were where lots of high disposable income people lived.“Lots”, because that probably meant a shortage of available rentals. “High disposable income”, because that supported higher rents. Locations that had lots of residents with high disposable incomes were called archipelagos. From an investment perspective, they were like chains of islands rising above the more pedestrian neighborhoods that surround them. Emily’s target area was a modest archipelago with above average income, but certainly not as wealthy as those areas across town by the water. Rentals were available but never stayed on the market very long, indicating the area was not overbuilt.
The second thing Emily learned from her reading was that in addition to a good location which drew people to the area, the property itself had to offer something unique and desirable enough to draw people to that particular property.
For example, those buildings way over there by the water had . . . the water. People paid more rent for a unit that had a water view. If a unit was directly on the water, the only proper answer to the question “How much is the rent?” is . . . “How much you got?”
Other examples included hillside units that had a city or even a rooftop view. Rents tended to be higher than competing units with no views at all. Under certain conditions, downtown units close to public transportation, major job centers, or quality schools were other cases.
Emily knew that the market divided amenities into (a) external and (b) internal. An external amenity was something that occurred outside the property lines: water, views, etc. Those things are usually unchangeable by the property owner, benefit more than one property, and are usually associated with archipelagos. An internal amenity occurs inside the property lines, benefits only the host property, and can be changed by the owner. Buildings that have internal amenities superior to the competition are franchise buildings.
Emily reviewed in her head: archipelago amenities are external, benefit the entire area and draw people to the area. They are good. Franchise amenities are internal, benefit only the building they enhance, and draw people to that specific building. They are good. But the very best is to own a franchise building in an archipelago. Emily was already in a modest archipelago. She now resolved to turn whatever property she might buy or develop into a franchise building, if she could.
She returned to the farm package and looked for the living area of between-the-wars duplexes and triplexes. She found that most of them were one and two bedroom units. There were some “singles” with no bedroom at all. There were a few three bedroom units. None of the old units had more than a single bathroom. And she saw no units that were over 900 sq. ft.
Further research showed that the predominant monthly rent was $2.00 per square foot. So a 900 sq. ft. unit would generate about $1,800 a month (gross). The very rare three bedroom units were getting $2,500. Emily was surprised and excited at the $700 surcharge for a third bedroom. She decided that her best approach would be to buy an old house on a lot zoned for multiple units. Assumedly, the first unit would have to stay pretty much as it was, maybe PCDC (paint, clean, drape, and carpet) or something. But a newly constructed second unit of 1,400 sq. ft. or so, with three or four en-suite bedrooms, might generate enough rent to make the project feasible.
As always, google was her friend. She searched on-line for plans for mid-sized homes built between 1917 to1940 . Emily was really interested in three or four bedroom houses between 1,200 sq. ft. and 1,500 sq. ft. That was about the biggest she thought she could fit on one of the standard lots. She found a couple of sources but, as expected, the plans all had one bathroom, even the four bedroom houses. Four bedrooms sharing a single bathroom! Could you imagine that today?
Her marketing edge, her franchise would be en-suite bedrooms. Her units would be in splendid condition (the front one renovated, the back one new), but “condition” would not be her franchise element. Every landlord on the street could conceivably remodel his units, so condition was not a robust franchise item. But bedrooms and bathrooms certainly were: it would be really, really hard for other landlords to add bathrooms.
Emily’s googling found a couple of sites with copies of old house plans (http://www.antiquehome.org/House-Plans/1916-Sterling/Radcliffe.htm). Several of the plans showed homes that would fit right in with her area, and that’s what she wanted: compatibility with the neighborhood. She printed out details of a few of the four bedroom homes that interested her and arranged to meet Hiram. The following afternoon, Tuesday, she waited for him at the bakery. Black coffee and a small plate with two of his favorite cheese/guava Danishes were already on the table when Hiram walked in. He expected that Emily was going to ask for free advice. But at least this time she was willing to pay for the pastries and coffee.
A little small talk, then Emily put her printouts in front of Hiram. Her first question was simple: could he extend the depth of the house by 10 feet (on both floors) without too much trouble? If he said “no”, there would be no need for any other questions. If he thought it could be done without too much expense it would allow the four bedrooms on the second floor to each have their own bathroom. On the first floor, the additional space would allow for building a laundry room and a half-bath off the kitchen.
Hiram thought it could be done. “Happens all the time”, he said.
Emily then asked for a labor and materials bid. Labor costs were pretty standard: the cost to frame a four-cornered house of a given square footage was calculable. Hiram had the program on his home computer. Material costs, however, were highly variable. A fiberglass bathtub could be had for much less than a porcelain one. Plywood cabinets cost less than zebrawood. There were expensive windows and economical windows. Hiram did not expect her to have priced out all the materials, but he did want to know whether the overall quality was to be fair, average or good. Emily said, “Average”.
“Just to confirm, you’ll provide the complete plans but need me to modify them to add 10 feet to the depth of each floor, right? And the overall level of finish will be Average?”
“Yes”, she said. “And I’ll need a schedule of completion, broken down by stages.” When Hiram heard that, he started to have a little confidence his time wasn’t wasted, because that’s how lenders pay: a certain percentage of the agreed cost at the completion of each stage of the construction. Usually the lender pays 10% for the first nine stages, and doesn’t pay the last 10% until the lien period has expired. No lender wants to totally pay off the general contractor only to learn that the contractor never paid the subcontractors and the subs have a lien on the entire project.
Hiram folded the papers and put them in his notebook. He stood up and said, “I’ll call you the day after tomorrow”. He went back to work and she returned to her property search. An agent had left a text message about a lot and asked Emily to get back to her as soon as possible.
Hiram called as he promised, late Thursday afternoon, quoting a labor and materials price of $225,000. That did not include land or city fees. She thanked him and said she’d get back to him when she had a prospective lot.
Emily texted the agent, Trixie Dixie (#TrixieDixieSellsEverything), who called her immediately. She’d been working the expired listings and found one from 18 months ago that, she assured Emily, was exactly what she was looking for.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker – Commercial Loan Broker, BRE: 00957107, MLO: 249261. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can probably help. Find out how much loan the building will support. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Info@KlariseYahya.com.