June 2023
Firstly, Justin and Chris review SB 9, an act that was passed in efforts to improve housing supply issues and affordability in California. This act allows homeowners to create up to four homes on an existing parcel. Therefore, real estate investors can turn a lot that is large enough into multiple rental units. Justin recommends investors who are considering this option to look into properties with detached garages since they allow more flexibility when building and adding units. He also urges investors to do their research on zoning rules, which can be specific to different municipalities.
Furthermore, Justin says the increase in interest rates will affect multi-family home construction projects as developers try to obtain loans. Regional banks are generally more open to creative financing than big banks, so if more clients continue to leave regional banks, there will be less access to borrowing for real estate developers. Therefore, Justin and Chris agree this will increase opportunities in private real estate lending.
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Ep. 37 How Time Diminishes the Value of Money
Ep. 38 Maximizing Investment Opportunities in Growth & Income
Hello, everybody, and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm your host, Chris Galeski. And here to join me is Justin Mitchell with Real World Asset Group. Justin has 15 years of investing in real estate. More on the lending side. But there's a number of ways that real estate investing has changed, transpired over the years now that we've had a need for affordable living.
So we're here to talk to Justin about some interesting ways to invest in real estate kind of going forward and some things that he's seen. Justin, thank you for joining us.
Thanks for having me on.
So we were talking, I don't know, a little over a month or two ago as I've been kind of going looking at homes in different places and a number of these homes. What I've noticed, these are older neighborhoods out here in Los Angeles, Woodland Hills, Calabasas area. Some of the neighborhoods have older homes, maybe smaller. A lot of large, lot sized, smaller home.
And a couple of them have had these ADUs that have been built on them or turned into an office or an extra space. And I was talking to you about how cool those were and you were sharing with me a little bit about SB 9, a law that was passed in 2021, and I was fascinated by that.
So tell us a little bit about SB 9.
Yeah, so SB 9 was passed in 2021 by Governor Newsom for reasons for housing, shortage of housing supply and affordability. And I think it's great for the state. I think it's a much needed initiative. And I've seen some parts of our local neighborhoods starting to change. It really depends on area and the affordability of that market. The neighborhood, you know, we live in a very nice affluent pocket over here.
Right. And some of these pockets don't make sense. HOAs, I think, won't allow some of that. And really, it's about the lot coverage and how much lot square footage you have in order to build some of these ADUs. In some cases, you know what's traditionally called as a granny flat ADU, and now with SB 9 you can build a junior and a detached ADU, giving you three units on one lot.
And in some cases you can split the lot if it's large enough to create two separate dwelling units, you can even create up to four units, a two on one parcel and two on the other.
So if you're lots large enough and you're a real estate investor and so you find an opportunity and your lot is large enough, you could have a single family home and turn it into five different rentals from the home being one of them to a couple other ADUs. And then you split the lot and add a couple more.
Yeah, and that becomes an attractive investment play from the sense that not only are you building value, it's value add construction, but you're also having smaller units that you can rent out, create more cash flow for the investors, but also more affordable living. Is that the gist of it?
Right. And it really comes down to unit economics again, construction. What does the lot look like? Because you want to add access points for each of these units where it's not everybody going into one singular access point. Right. You want to make it so like you can go around the back or, you know, in a corner lot, which is nice, and it gives a little bit more of a desirable, I guess, flavor for that for the development needs.
So how did you get introduced to SB 9 and this framework or excited about the potential to invest in real estate?
Yeah. So the last 15 years I've spent in the credit markets lending to fixed operators. I started with a company called Genesis Capital where we were actually selling REOs for the banks to the investors, and we said, Well, why don't we start off another arm and lend to these developers buying from the trustee sales? And it was a wildly successful business.
And in doing so, when you are the financial at the forefront of the financial market and lending to these guys, you get to understand everyone's strategy. And we were lending more to borderline institutional grade investors by that what I mean is guys that are flipping or girls flipping 12 to 50 homes a year and also building, you know, new construction.
Your strategy was similar to some of our private real estate lending strategies where you're lending money to professional real estate, real estate professionals that know what they're doing, correct.
And developer means, you know, developing multifamily, developing single family, built to rent communities, which are very large, single family build to rent communities. And so you get to understand everyone's strategy. How do they pick up off market properties, how do they source their deals and you get to understand this new SB 9 measure was introduced by a couple of our bigger borrowers down in San Diego, and we thought sort of financing some of these and started getting comfortable with them.
And, you know, when you really understand the model of it, you're like, this is a great deal. This is wonderful. There are some challenges, I think, though, with the planning. Cities are, you know, tough to work with, especially if you if you're going to split the lot. And that's always a big challenge and you know it and it really boils down to is the municipality, the state passed the overarching governing law and then they gave all the cities to a certain amount of time to develop, you know, regulations and kind of make their rules around.
For permitting and all that.
Yeah. And I think another thing that, check your municipality codes because while one city might allow for non unoccupied investments, another city might say has to be owner occupied for you in order to do these junior and senior.
So that's what I was going to ask is how much of this are you seeing? Are professional real estate developers adding these additional units to be able to rent out and generate income versus the people that own these properties? And they say, you know what, I've got very cheap mortgage on my place, you know, two and a half percent 30 year fixed rate mortgage.
My property's grown a lot in value. I can't really move, but I'd like a little bit extra income, an easy way for me to do that efficiently is maybe add a couple accessory dwelling units or ADUs on my property, rent them out to other people and then I'm generating some more income. So again, how much of it is institutional real estate professionals versus, you know, single family people?
I would say that's primarily owner occupied right now, those who are maybe a millennial moving back into the house, maybe they can rent out the back for them and they're close to their family or a retiree that wants additional income where they can build one ADU. You know, if they need more income, maybe they build two, right, they build a junior and a senior, in some cases they can go to four or five.
It just gets a bit more complex the more units you add on the institutional side. I think it's it's interesting because I think it's a little too small for the bigger institutional players. But I do see it from investors, real estate investors who are large in size, just not institutional. Right. But they're adding, you know, dozens to the portfolio every year.
And I'm sure they like add as many as they can, given, you know, the desirable returns that it produces.
It's fascinating. One interesting scenario that you played out for me was the difference between having a single family home on a large lot with an attached garage versus a single family home on a large lot with a detached garage. Walk me through the difference in the number of units or what you can do there.
Yeah. So if you had a detached garage, you could add a second story to it, right? And you can convert the garage into a separate unit. Right. And then on the whereas if it was attached, you can convert the garage and then add a second ADU in the back or third ADU in the back. So it primarily from what I’ve seen from investors is if you can find a house as a detached garage, it's a bonus just because of the bigger space you can add.
Typically a detached garage on a parcel means that the parcel’s a little bit bigger right. And I think it's a bit more desirable.
Got it. So when you're looking at going and taking advantage of these opportunities, in an ideal world, you're looking for a larger lot with a detached garage versus one that's attached because it allows you to have an extra rental for more income.
Right. And you can do more with it with existing lots. Right. And also you have a path where you can drive into that unit or you're parked there typically or an RV path, which is great, big wide side walks and you can park, you can build a driveway to the back unit, which is great. And a corner lot to me is kind of the most desirable because you can park this way, you can send a driver that way or put it this way.
Got it. Now, not to get controversial because there's some people that are going to like this bill and there's some people that aren't. Right. For people that, you know, live in these neighborhoods. Ventura County, Los Angeles, Inland Empire, San Diego. And this has been passed. How do you think it really affects them down the road?
It's a great question. I'm challenged with this because I live in a community where this kind of fits the bill. It's a little too expensive for investors to come into my community. So I've seen it done with one house in my neighborhood that that woman is retired. She wants some extra income. So she built three units.
Her son moved into the back and then the third is being rented out for additional income. But an investor typically wouldn't come in because the pricing of the house is a little too expensive for it to make sense. But I do it will change these neighborhoods, you know, into more of a I would say, multifamily in some cases.
Right. And I think that's the challenge. And as an investor, I see it as being the great thing where we add supply, we add affordability. But as a homeowner, you know, you're adding a different element to the neighborhood, right, where these are all positive things. But again, you move into specific areas for certain reasons and now it may be changing to more of a multifamily neighborhood.
So. Well, I think one of the, and correct me if I'm wrong, but it's my understanding that some of the moves towards these ADUs is because it's a lot quicker to get things plans pushed through the permits as opposed to tearing something down, turning it into multifamily and building a 4-8 unit building that way. And it's cheaper now that interest rates have gone up.
Access to borrowing is a little bit more difficult supply. You know, supply chain issues or expenses there. So these ADUs pencil out to be a lot cheaper and a lot more affordable to build than tearing something down and building a multifamily.
Converting your garage versus building a 800 square foot detached home is very much more affordable than in doing a new construction project. Right. And there you go. You have two units right away, I would say with the rising interest rates. I think that's another reason why we probably haven't seen as much institutional demand or development with these areas.
But as things kind of balance out, we may see that kind of pick up a little bit.
Got it. And then speaking of rising interest rates, I know that you've got years of experience in terms of doing real estate lending, making sure that you're loaning at the right loan to value to protect yourself and investors. How do you think the increase in interest rates is affected either will affect real estate values, single family homes, or even the lending cycle today?
Yeah, you would have thought that by now you would have saw a little bit more price correction right in the market given the rates. But it's been resilient. I think more so in the stronger municipalities metro areas. But I do think it's going to greatly affect multifamily right, because a lot of these projects that are started maybe in the last year or two that are finishing construction, construction loans maturing, they need to get taken out by regional banks.
And that's another issue, right? Are these regional banks going to be lending as much in the coming years and where the interest rates are, the interest rates favorable to the project, and most cases, I would assume not. And they're going to have to come up with more equity and potentially maybe just have to walk away from the project.
But there's a lot of great developers out there and this isn’t their first rodeo and they'll figure it out.
Yeah, it is interesting how this is all kind of coming to a head not to pick on the banking issues that we've had over the last month, but these smaller and medium sized regional banks, they're known for more creative financing than the big banks and if clients of those banks choose to leave them and go to the larger ones, there's maybe less availability of or access to borrowing from small and medium sized banks to do a number of different types of, you know, investment strategies, whether it's real estate or businesses.
So do you think that will help grow the private real estate lending side of the world?
I believe so. I think it's, yes, I do think it's going to be a great it should be great growth for these private credit guys. Yeah, I think the challenge is going to come down to is there going to be deal flow with the rise in rates, new projects are going to be stalled or potentially people waiting on the sidelines waiting for rates to come down?
That makes sense. Pricing really hasn't come down. I think we're starting to see some movement on cap rates where the sellers are coming to terms with, okay, this is reality and I need to now sell it at a cheaper price to move this thing. And I think we haven't really seen that happen just yet and we're starting to see it.
But I think the end of Q4. Q4, we're going to start to see some big movement and as we get into 2024 as well. And so I think there's a lot of money out there and these guys are well capitalized, but we'll see where the banks land.
I'm hearing a couple of different sides in terms of, you know, prices need to come down and then, you know, people that have lots of money waiting to deploy it once prices do come down. So it seems like we still have a little bit of a supply and demand imbalance, meaning there's just not enough supply to meet the demand of money that's currently out there for prices to come down too much.
And I'm still I'm still hearing from my contacts that pricing is in single family right now, 17 plus offers on a new home. So that's price, right? Right. And San Diego is on fire right now and it just blows your mind. Yeah, I guess the lack of supplies is really giving another layer of strength to this market. And until there's enough for selling, I don't think we're going to see a reduction in pricing.
Okay. Well, thank you for joining us. And just to kind of recap it, Justin, so for people that want to better understand how SB 9 affects them, this is something that was pushed out by Newsom in the state, but each municipality has different rules or regulations around zoning or whether it needs to be non owner occupied or actually owner occupied to build out that ADU.
So where do people go to get information if they want to, if they're looking to buy in a neighborhood and they want to be in a neighborhood that allows for this or doesn't allow for this, or if they live in a neighborhood and maybe want to add.
Yeah, I would just look at their local city's website and or even visit the local city and talk to the city planners and ask them some questions. There's some great resources online, but if you want to, if you're more in-person, walk in the city and just pick up their super resourceful and always willing to educate the local folks.
Great. Well, Justin, thank you so much for joining us today. Love your perspective and you kind of sharing some insights on some of the challenges that we're facing with, you know, supply issues for housing, but also what could potentially happen with real estate now that rates have come up and other unique or creative ways that people can invest in real estate besides building, you know, giant multifamily apartments all over the place.
Thanks for having me.
Yeah.
Disclosure:
Information presented herein is for discussion and illustrative purposes only. The views and opinions expressed by the speakers are as of the date of the recording and are subject to change. These views are not intended as a recommendation to buy or sell any securities, and should not be relied on as financial, tax or legal advice. You should consult with your financial, legal, and tax professionals before implementing any transactions and/or strategies concerning your finances.
