John and Ryan discuss an upcoming renovation project in Livingston, New Jersey. The two debate potential exit strategies and play out various scenarios.
Ep. 3 - The Anatomy of a Deal in North Jersey - Transcript
Ben Shelley: [00:00:07] Welcome to the Brick by Brick Podcast where we take you from the ground up on all things real estate. I'm your host Ben Shelley. We are fortunate to have back with us today the partners of Liberty Hudson Ryan Goldfarb and John Errico. The focus of today's episode is a very common investors' question. How do I determine the highest and best use for my real estate investment. For this discussion the focus will be on the residential real estate market and we defer to our experts to learn their thought process on deal analysis, exit strategy, and everything in between. Ryan, why don't we start with you.
Ryan Goldfarb: [00:00:42] Well I guess I would I would classify it as falling into two two departments so to speak. There is the financial viability and you know from a financial perspective what is the highest and best use of a property. And then there's also the zoning component. So you know anything in midtown Manhattan or any any plot of land is going to support the absolute highest density you can build on it. You know the value that we're in the middle of Manhattan. Real estate is super valuable here. So just about any play you would attempt in a place like this is going to pencil out. The main constraint that you're working within are the zoning conditions provided by the New York City building apartment or the New York City Planning Board, zoning office. I don't know what the jurisdiction falls under exactly..
John Errico: [00:01:28] Probably many multiple...
Ryan Goldfarb: [00:01:30] Seven layers deep so high level, that's how I approach it. When we're talking about things in the residential context specifically in a more suburban setting the subset of opportunities or the subset of options is going to be a little bit more cut and dry than it would be in a place like Manhattan. If you're in the middle of a residential neighborhood you're gonna be building residential. It's probably going to be a single family. The question is whether knocking that down and building new is the play or keeping the existing footprint and renovating that is the play. Or, keeping the existing footprint and then adding onto it as the play. So this is a question that John and I have faced quite frequently in the past and the more we deal with these types of projects the better idea we'll have of what the right candidate for the right solution is.
John Errico: [00:02:24] I agree I think something that I think about when approaching this topic is what if money was not an option and that's not true because money is always limiting factor as well as time. But when considering the highest and best use for property I envision it saying well what if I had a billion dollars. What would I do in this one piece of property to make the most money off of it or to to add the most value to it? And that sometimes you can come up with creative answers that you might not have anticipated before and if you really become convinced of that you might be able to find a way to to raise that amount of money. I'm thinking of for example in Atlantic City. So I've done some investing in Atlantic City and I'm very bullish on Atlantic City for different reasons but a lot of plays in Atlantic City are really ground up redevelopment plays so ripping down existing buildings and rebuilding them. And that is very, very... It takes a lot of money to do that. It takes a lot of time to do that. But hypothetically the value to doing that on a property and selling it as something brand new could be very high. I think perhaps we could get into this topic by addressing a project that we have right now which is in Livingston northern New Jersey. Ryan, maybe you can set the field and we can talk about it.
Ryan Goldfarb: [00:03:41] So we're looking at or we're under contract on a single family house in Livingston. It's a split level home which is pretty common for the area. It's on a very quiet dead end street from an intangibles perspective it ticks every box. It's in a great school district. The block itself is pretty nice. And we're looking at an entry point based on our purchase price that makes a few different plays viable. So when we were looking at this deal we were contemplating a few different, a few different options.
John Errico: [00:04:15] I think just even as a baseline statement so this is a residential area. So building something other than a single family residential home as you said to your zoning issue is just, you can't do that at all.
Ryan Goldfarb: [00:04:25] More than, like, I think the max we could do is probably two and a half three stories.
John Errico: [00:04:30] Sorry yeah. So yeah, in terms of, yeah it's gonna be a single family home. It could be multiple stores but it's not going to be more density than that. And I think I'm not sure if we even really seriously consider this but the idea of doing ground up construction is just not going to be economically viable.
Ryan Goldfarb: [00:04:44] Yeah for that, for that size lot, I don't think we'd be adding enough square footage for it to make sense. And given the state of the existing structure, there weren't any compelling structural issues that would have made that more advantegeous.
John Errico: [00:04:58] We came to this conclusion by looking at other stuff in the neighborhood essentially.
John Errico: [00:05:02] So we we saw this house. You were familiar, you're more familiar with because you grew up essentially around the block and so we saw this house. We were familiar with what stuff generally sold for more or less in the neighborhood and so we said OK well this house could sell for this if maybe possibly it had X Y Z. And we sort of had a decision tree maybe wasn't as formal as that but we had a decision tree where we thought okay if we did x we could make this amount of money. If we did y we can make that amount of money. If we did whatever whatever whatever. So maybe it will be interesting to discuss what the decisions were that we kind of went down.
Ryan Goldfarb: [00:05:41] And on the way there. Something else that is always worth bearing in mind is what's on the block. You know as nice of a town as that may be there's a ceiling on value. So if zoning would permit a 3,500 square foot or 4,000 square foot monster to be built on a block where the average house is 2,000 square feet that may not be the right place for it. So it's always worth bearing in mind that you don't want to over improve your property and you don't want to be going above and beyond what that street will support or what that area will support. So from a very fundamental level I think that that ruled out some of the more extreme options like knocking it down and building something brand new.
John Errico: [00:06:22] Yeah I think from our perspective to it just super risky to have to try to sell the most expensive property in the neighborhood, which could have been an option with what we were doing. But I think there's an adage in real estate like the cheapest property in the neighborhood will always sell. Doesn't matter what the economic macroeconomic environment is. And I think that the most expensive property will always have a hard time selling even when things are great. So we didn't go with the most expensive kind of option.
Ryan Goldfarb: [00:06:50] Yeah right. So that was that was ruled out essentially from the beginning. So the two main options that we were considering at least once we saw the place and once we saw the current condition were option A going in renovating it with a similar floor plan in mind maybe modernizing some things maybe bumping...
John Errico: [00:07:09] So this is a three bedroom as it is now ranges on renovated it's a three bedroom two and a half bathroom property with a formal family room and even in what you'd call it...
Ryan Goldfarb: [00:07:20] A family room, a rec room, a den...
John Errico: [00:07:23] A den, a kitchen, and then like a living room, dining room esque area opening up until a fairly sized backyard with an attached garage.
Ryan Goldfarb: [00:07:32] And an unfinished basement
John Errico: [00:07:34] Unfinished basement, right.
Ryan Goldfarb: [00:07:35] So option A was to essentially keep that same floor plan in mind and just renovate it, update it, modernize it. Maybe contemplate a few changes like opening up the kitchen to the rest of the living space again to go for a more contemporary modern open style feel. But for the most part the footprint would stay the same and there wouldn't be any noticeable difference outside of the aesthetics of the property. Option B that we were considering was to add an addition above the current primary living area. So it's a split level home. If you're not familiar with that... The way to think about it is rather than a colonial or a cape where you have one floor with another floor mirroring it right on top, you have kind of like a half level between between floors. So you have the ground floor. Then you go up about a half a set of stairs to the main living area and then you go up another half a set of half a flight of stairs to get to the bedroom area. So for an addition, what we were proposing was to put up half, or a third, half staircase to go up to an additional half flight above that living room/dining room/kitchen area to put on a master bedroom and master bathroom. These houses were built in the early 1960s so they were built with a little bit different of -- a little different style. The master bedroom in those style houses are not significantly larger than the other bedrooms. There's no real fancy en suite with a walk in shower, soaking tub, anything like that. No double vanities. So the only way to to achieve that is to build it or to significantly alter the current landscape of the floor plan.
John Errico: [00:09:26] Our premise was as Ryan alluded to before this is a neighborhood of primarily families that have moved there probably for the school district or suburban living. It's not, in contrast to say, it's not you know, young urban professionals that are commuting every day to New York. It's not renters. I mean there are people who commute for work but it's not necessarily in a family in a family context. It's not renters it's not lower income housing per se. Generally, I would say, higher, upper middle class type of a neighborhood. So that alone would dictate you wouldn't ever make sense to say convert it to some massive two bedroom or something where each bedroom is humungous. But that might maybe appeal to a renter and it wouldn't make sense to convert it to like a seven bedroom property or something that might make sense for maybe a lower income area where density is more important. So we are sort of constricted of operating in the three bedroom or four bedroom type of realm which is what we think from the neighborhood appeals to families. You know, two bedrooms probably not enough. Anything more than four bedrooms is probably crazy, doesn't make any sense.
Ryan Goldfarb: [00:10:36] Right. So The main goal we had in mind was to build something that is going to be appealing to the average family looking for a newly renovated house in that area. So with the current floor plan we were looking at three bedrooms, two and a half baths, which would certainly work for some. But if you think about the average family who's buying in that area, again, on average, you're likely looking at parents, two children, maybe a golden retriever, and it's safe to assume that if you're looking for a family home, you may also want space for guests, for in-laws, for parents for cousins, whomever. So with a three bedroom layout you are constricted in the sense that if you have one child or if you have like the only one that's going to work and if you have one child or two children who are sharing a room, which at that price point is probably unrealistic. So that put the idea of the addition in play because we could get that fourth bedroom.
John Errico: [00:11:34] Right... And so to use kind of actual numbers the way that we thought about it is our kind of purchase price is $400,000. That's what we're going into it for. We had thought that the after renovated value or sort of the market value after we were done would change based on how many bedrooms we had, based on how it looked. So in a three two and a half scenario which is the current default scenario I think we get maybe what...
Ryan Goldfarb: [00:12:01] Frankly it's hard to comp that out because it's a fairly unusual, most people typically want that fourth...
John Errico: [00:12:08] Which is another issue.
Ryan Goldfarb: [00:12:09] Right. Right. So whatever the scenario or whatever the number would be it is most likely a discount to what the ideal scenario would be for.
John Errico: [00:12:18] So structure. Right. Would you just call it, say, we could get $650k or something. The logic that's going through our minds and we're looking at is OK we're we're in for $400k. And of that $400k gonna put a little bit of money down and we're going to borrow the rest which we're paying interest on. So every month that we hold the property we pay interest on it. The way that we are funding it is with a hard money loan. And that's quite high interest. Not credit card interest but not traditional mortgage interest so it's maybe in the realm of like 10%. So every month that we own the property we have to pay interest on that and then we might loan more than that because we need money to renovate the property. So we're paying interest on that every month or else paying taxes, insurance, utilities, general upkeep, you know making sure the lawn is cut and whatever else you have to, you know, snow removal, which is very expensive apparently. And so, so that's that we have to do that regardless of whatever we do with the property. The variable is how much does it cost to actually renovate it or expand on it. And that price difference quite substantially if it's, we're adding a floor or we're doing an extension in some capacity versus just doing an aesthetic renovation, which as Ryan was saying before was blowing out a wall, redoing the flooring, bathroom, kitchens, and then calling it a day. So the calculus is well if I put more money in to do the extension and then I make more money am I making even more money than I would have had I not done, done any of that at all. Say I'm gonna make $50,000 after I calculate all those carrying costs and also that the sale costs I guess I should mention too are substantial so there's broker fees, attorneys fees, transfer taxes, all sorts of stuff. After all that say if I'm making $50,000 by just doing aesthetic renovation and if I were to do an addition and have to spend $150,000 more but I'd still like to make $50,000 then I would never do that because that would take me six more months to do and I would just do the easier thing which is to do do the very cheap renovation.
Ryan Goldfarb: [00:14:14] Right. And anytime you add to the scope in one way or another you're complicating things. The notion of you know keep it simple stupid certainly applies to real estate and certainly applies to flipping. If you can get away with doing a cosmetic renovation not necessarily going cheap or not necessarily skimping on the scope but rather than getting too fancy with it you can, if you can make money doing that, that is typically going to be your safest play. To John's point that calculus is is applicable and is I would argue that's the right way to look at it. Something else to bear in mind as part of that is you're not just thinking about you know if you're looking at scenario A you're talking about putting one hundred thousand dollars in renovation costs to make fifty thousand dollar gross profit versus Option B of putting two hundred thousand dollars into it to make fifty thousand dollars gross profit - the difference there is not just in your hard renovation costs. The difference is also in your soft costs which would be your holding costs, i.e. taxes, insurance, snow removal, utilities, etc. as well as your financing costs which is your interest for that time period that you are holding a project.
John Errico: [00:15:26] And the opportunity cost of your time. Time is very valuable when you're doing the sorts of things you have to spend eight months on a project versus four months in a project that's four months that I have to at least devote some amount of mental energy and physical energy to do.
Ryan Goldfarb: [00:15:39] And from a qualitative standpoint there's also risk in whether your plans are going to get approved, and whether the exact scope that you have planned from day one is going to be approved, and whether they're going to be alterations required to the existing systems in the building.
John Errico: [00:15:53] And what is the market going to look like in eight months?
John Errico: [00:15:55] I may know what it's gonna look like in two or three months but eight months is a long time.
Ryan Goldfarb: [00:15:59] Especially when you're talking about a specific time of year. So right now where we're sitting here in November and if we close on this property in the next week or so and we go with a pretty simple - I don't wanna say no frills - but if we if we don't get too complex with the renovation having this on the market in let's say six months is quite realistic and I would argue is almost an excessively conservative estimate. But nonetheless that leaves us in the spring season getting towards summer which is by most accounts the best time to be selling a property. Whereas if we try to pop the top off, pursue an addition, and potentially pursue an extension of some sort, there's a lot more volatility on the timeline side of things that may push us out passed the summer to sell the project.
John Errico: [00:16:46] To kind of like contextualize it to the actual thing that we're we're talking about are doing.
[00:16:51] We had thought well for us maybe the addition is the only way to do it because there really aren't any properties in this neighborhood that have three bedrooms two and half bathrooms and we may just really have a hard time selling it at all if we did it. Doing the addition was something that we were hesitant about doing because we worried about the building department and whatever else so we were kind of hemming and hawing about what can we do what can we do and then you actually came up with I think a great idea which is now most likely going to be the winning idea which I'll let you describe but essentially to get both right to have add a bedroom but not have to do the addition.
[00:17:27] Right. So the thought here was what does the end buyer in this town want. And in my head It's four bedrooms, minimum two and a half bathrooms, ideally three full bathrooms. And in thinking about that we had been stuck on this idea of doing the addition which would have required obviously a more exhaustive scope from a plans and permitting standpoint. It would have required additional framing. It would have required potentially addressing some structural issues with the existing building.
John Errico: [00:17:58] A ten thousand dollars steel beam apparently...
Ryan Goldfarb: [00:18:00] Not necessarily things that are of immediate concern but things that could potentially be a concern if you're talking about adding additional load to the building. Because if you think about it these buildings were spec'd out and were framed out and designed with a specific purpose in mind and that was to to function as a split level home. So if you're adding another level on top you're talking about adding additional weight to a structure that was not intended to originally support that. So there is potential that something like that can have to be addressed in the future not to mention, you know, just the hard costs of doing that actual renovation that actual additions which would be the framing, the plumbing, the electrical, HVAC, so on and so forth. So in contemplating this I was thinking you know the angle is really to get four bedrooms. Are there any other ways we could do that? Given the existing structure and giving given the existing floor plan... And I was thinking you know for for a family of four, the three bedrooms upstairs is not necessarily a concern. The bedrooms are all pretty decent size, pretty decent sizes and there are two full bathrooms up there already. And then there's also the family room downstairs. I know something that's common is to have kind of a guest suite or at least a guest room. And I thought that something like that maybe more of like a flex room was something that would be of substantial value there. So what we proposed was to build out a closet within the family room on the first floor. A closet is typically a prerequisite to being able to list a room as a "bedroom" notwithstanding a few other requirements like minimum square footage and oftentimes a window. So that got us passed the hurdle of trying to get that fourth bedroom. The next thing was thinking about it from a functional standpoint which would be you know if you have three people living on the second floor and then you have guests saying over... It's great that they have a guest room but they have to go up two flights of stairs to use the shower or to use the bathroom.
John Errico: [00:20:03] So to contextualize at the half bathroom that we have right now that the half in the two and a half is right next to the family room.
[00:20:10] Right. So the remedy to that was the half bathroom that John just mentioned, that abuts the family room. And then on the other side of that is a laundry room. So the thought is to combine the laundry room and the half bath to achieve a full bathroom on that first floor. We may be able to relocate the washer/dryer on that first floor as well but more than likely we'll move that to the basement, which, to compensate for the fact that we're adding a bedroom on that first floor and kind of getting rid of some of the utility space or the family space in that family room, we're gonna be finishing the basement as kind of a playroom, rec room for kids again with this young family in mind. And the great part about that is even though it's a basement there are some windows down there. There is some light. It doesn't feel totally basement-y. And once it's finished and has lighting in it it certainly won't. And most kids are not 6 foot 5 like John so they're not going to have an issue with the lower ceiling height.
Ben Shelley: [00:21:15] So I know we're going to have to definitely do a part one and a part two because I think I'm on the rollercoaster ride of my life right now. I think for people who know me they can't even believe I've been silent for this long but that's how good these guys are. Now we've already got a little taste of what this will be but as a book into this segment can you tell us what is your optimal exit strategy.
[00:21:35] Yeah, from a financial standpoint our goal all along is to have the largest gross profit that we can, to make the most money that we can from the sale of the property. So Ryan's solution is is so great and so elegant because we get to essentially have a four bedroom, three bathroom property which is what we were anticipating we would have if we were to make an extension, b we don't have to actually do any structural work. And structural work as Ryan was alluding to this is very expensive. So we can have an additional bedroom that is within the footprint of the property do a mostly aesthetic renovation to the property and still sort of have all the advantages that we would have if we're to spend a lot of money. So essentially our after return amount like a four bedroom, three bathroom, we could sell in the...
Ryan Goldfarb: [00:22:27] High sixes...
John Errico: [00:22:27] Sure. So we can have that sort of exit while only putting in maybe, a hundred grand in renovation costs. We'll see.
Ryan Goldfarb: [00:22:36] Give or take.
John Errico: [00:22:37] Whereas I think to do in addition we're talking more in the realm of 200 grand. Yeah probably 175 hundred.
Ryan Goldfarb: [00:22:45] I would say two hundred as a starting point. Right. And part of the reason for that is everything that goes along with doing it it's not just the hard costs.
John Errico: [00:22:52] So if it all works out we will have saved if you will one hundred thousand dollars which is a substantial amount of money on a deal of this size.
Ryan Goldfarb: [00:22:58] About a hundred thousand dollars in about six months of time.
John Errico: [00:23:01] Yeah, and a lot of effort and sweat and concern and stress and etc.
Ben Shelley: [00:23:07] Well if you took notes throughout this episode you're gonna have at least the base tools to understand and execute a proper analysis of a deal that you're doing particularly in Livingston but in wider New Jersey residential market. And I appreciate how you guys took us through all the different scenarios blowing the top off versus a general rehab and whether or not you would you just sort of cosmetic lift versus maybe some more serious work. I know I appreciate this I know the listeners appreciate it and guys thank you for your time and your expertise as always.
Ben Shelley: [00:23:46] And thank you for listening to the Brick by Brick Podcast where we take you from the ground up on all things real estate. We will continue to bring you the best and brightest the real estate world has to offer as we leave no stone unturned in helping you, the everyday investor. Thanks for listening.