Converting Garages to ADU's to create massive value

0:00And there's a lot of people that won't won't touch you know, Southern California just because they're they're looking for different things. The cash flow is certainly a lot harder to squeeze in in Southern California than it is in in the markets you touched on. But what what attracted me to this market was a few things. Number one is it is it's been a constant over the last decade plus that there's not enough affordable housing in San Diego. They're just not the the the cost to own versus the cost to rent is the is are it's probably the biggest gap of any city in the country.

0:40It's more it's about over $3,000 a month difference to own in San Diego versus rent. And that is a huge huge gap. So what does that do? It keeps tremendous amount of pressure on the rental market. The vacancies are extremely low and it is it is hard to find affordable housing. So that's number number one is that you have a very strong rental market because of that. Number two, San Diego geographically is constrained. It is if you look at it on a map it's actually like an island.

1:15You have Mexico immediately to the south. You have the Pacific Ocean to the west. You have Camp Pendleton to the north. And you have a mountain range that runs from Mexico up through San Diego County P up through LA, you know, and and beyond. And it's really not developed. You can't develop on those those mountain range ranges. And so what you have is a a geographical island that that that San Diego is is is sitting in in which which prevents massive expansion.

1:48You know, some of the expansion we see in markets like Houston or Dallas, you know, even even Phoenix has expanded like crazy. But in San Diego, we really can't do that. You can't just say, "Okay, we're going to expand here. We're expand there." The land doesn't exist anymore. M and so because of that again there's not there's not a massive release relief button that the city can push to create housing. And so when they created this ADU law in and passed in 19 and went into effect in 2020 that allowed you convert ex existing multif family apartments that had addition that had existing square footage that's convertible basically something that's surrounded by three three walls you could convert

2:36That into additional units. And in San Diego, the the city of San Diego went from roughly 300,000 people in the 1940s to now, you know, there's 3.6 million people in San Diego County. Wow. So, so rapid growth and during that time of growth, 60s,7s, 80s, the mandate was to have parking and ensure that there was enough parking for these apartments. And these apartments that were being built were 5 to 40 units. That makes up about 90% of the market in San Diego and their requirement was to have garages.

3:12Well, as time has moved on, the garages have morphed into storage and junk. They're not really parking cars, they're just parking people's junk. And in many cases, we found this out after the fact, but in many cases, the apartments, the garages are being leased by somebody that doesn't even live at the property. Somebody down the street is leasing it for 100 bucks, 50 bucks rather than getting a storage unit, you know, that that's 700, 800 bucks. And so that is really what these garages have in them.

3:46And so the city, I think, knew that. And when the state passed, this is a state law that was passed allowing you to to convert for every existing for every four existing units you have, you can add one additional unit to the property as long as it you're not adding there's many different ADU laws. Okay. The one we're taking advantage of is is the multif family one where we're not adding additional square footage to the property. We're just changing that square footage. Which really means converting garages. Like I mentioned, you could do laundry rooms, you could do, you know, if there's storage rooms outside of a garage, you can convert things like that.

4:22So, you're not we're not adding additional square footage. We're just changing what the existing square footage is. And so, when that law was passed in the state, we were like, "Oh, this is this is great. You know, we can we can certainly take advantage. There's over 8,000 properties, multif family properties in San Diego that that fall under this this criteria, which is an incredible amount." and and then in November of 2020, the city of San Diego said, "That's not enough housing. We have all these garages. We're making it unlimited.

4:54You can do unlimited conversions as long as it fits the the code." And so, for an example, we bought a five unit building that had seven garages and we converted those seven garages for a total of 12. And so, we have a 12 12 unit apartment. If that was anywhere else in California besides the city of San Diego, we would have only been able to add one one more unit. So, we would have went from five to six because of the state law. But the San Diego code is so aggressive because they want they want this affordable housing that they they they made it unlimited.

5:29And so that has been those you you put all those reasons together along with the fact that San Diego is an extremely diverse economy. It used to be 100% based on government, you know, military. That's really how the city grew, but now it is a very diverse economy. The government's still a big part of it. There's a ton of veteran or excuse me, there's a ton of active duty bases. Military personnel is is up and down the city. But you also have a a there is no driving sector that's more than about 15% of the overall economy.

6:05So, it's very diverse. It's actually become San Diego has become like the biotech capital of the US. We've seen a ton ton of biotech spun up here especially since co you know so that that biotech industry has boomed bringing a lot of jobs to San Diego. And so all those factors when you combine them all to me it make it made San Diego very very attractive. And because of the cost is so expensive, if you add just one unit to a building, you're you're significantly impacting that value.

6:38If you add 10 units to a building, well, you know, now you're you're you're have a good opportunity. If it costs, you know, $100,000 to add and the post construction value is 300,000. You know, it's a nice delta there. And so when we looked at this and said, okay, this is this makes a lot of sense. We do we do know it's California, so things are going to be hard. It will not be easy. You know, the government made it sound easy, but reality is everything but that. But we have been able to get things done.

7:09But the the the biggest thing, Kirby, is that we we knew that in 2020 when COVID hit, you know, we expected some kind of down decline of commercial real estate. Mhm. And of course, immediately afterwards, we were exactly wrong. Everything took off, right? Because the cost of of borrowing money was incredibly cheap. Just having housing was was was super valuable and and basically construction was halted.

7:41There was nothing being done. So, rents across America shot up, values across America shot up. And and everybody's like, "Oh, this is great." You know, we're making all this money in real estate. And you cannot lose in commercial real estate from 2020 to 2022. Then all of a sudden it's up. We have a problem. Interest inflation is is through the roof. We need to to curb that. So let's put on you know, let's bring these interest rates up to combat the inflation.

8:12And so we weren't right about the timing of when the market would would would go go down, but it did happen. And so our our plan was in a mark in a down market, if we're able to add units to a building and we're able to improve the existing units, that should be enough to carry us through a a you know, a a real estate recession. And so the the the thought is always protect the downside, you know, protect the downside.

8:48Always be project the downside and protect it and you know that's for me I was a defensive coach Kirby so you know playing the defense is is is comes naturally and you know that's what we look to do our strategy was a defensive strategy to buy real estate in a time where we thought it it would it would go down and figure out how to how to withstain down market and so that's really those factors all led me to say, "Yep, let's let's do San Diego." Yeah.

9:23Wow. Longwinded answer to your simple question, Kirby. No, that's super interesting. And I there's typically a lot of factors that play into it. So, I appreciate you kind of breaking that down, and it makes a lot of sense. And one thing I was thinking about as you're describing that too is, you know, there's been a lot of talk about these self-driving cars and how, you know, in the next decade or so there there's already cities with plenty of self-driving cars that'll pick you up when you call it Uber or whatever their the name of the company is with the self-driving cars. But a lot of people are saying eventually people just won't need cars because, you know, anywhere you want to go, it's just on demand a self-driving car takes you there.

10:00So, why would you park a car in your garage all that time that you're not using it? So, it could lead to way less cars on the road, way less need for garages. And so you guys are kind of ahead of the ball game here converting these garages because that could very well be the case. Yeah, I think Yeah, plus and minus being ahead is is good and bad, you know. Yeah. If if if we were at that point right now, then then the values would be even greater. Yeah. Because then the next buyer is going to say, "Oh, why do I need I don't need these group.

10:32I don't need these parking. I'm not worried about the parking ratio. You know, we're getting rid of cars." And that did factor into our decision-m process. You know, number one, at San Diego, people are like our strategy. I probably wouldn't be as aggressive if if I was doing this in, you know, Philadelphia or or Boston, you know, because then in the wintertime, you know, people are not wanting to walk to work and, you know, the parking factor is a huge decision maker and but in San Diego, you know, the weather's great all year round.

11:06You know, maybe I have to walk a block and a half to get to my car, but I'm I'm willing to do that because I'm living in San Diego. Yeah. And the other thing we're seeing, a lot of the folks that that will rent our our conversions, a lot of them don't even have a car, you know, they're they're either biking to work, they're walking, they're taking Uber, you know, and I think what you're saying is is kind of the next step is that that many people will just stop having their car or if they have it, they'll drop them off and go go park on its own, you know, and go find a place to park without having the owner worry about it.

11:39So, I do believe that that is coming. How quickly I don't know but I think that that will enable our strategy to keep keep moving forward and I think when we start seeing that more and more people will will jump on board. You'll probably see in you know people jump into the industry when that happens. Yeah, absolutely. That makes sense. Can can you kind of walk me through maybe a recent deal or a typical deal on, you know, the numbers of what it what it costs you to buy something like this?

12:09And then it's really interesting, you know, to think about that conversion like you know, converting a garage like what does that cost to do that and you know your your timeline and then what does that do to the value? Like maybe that five unit that you turned eight of the garage spaces into eight more units. What did that look like in terms of numbers? Yeah. So, that one we we bought for right around I think it was around 1.1 million. So, a very a very cheap buy in San Diego.

12:43You know, we we got we got five units for that price. Which was a good buy. And then the cost to do the units is about 100,000 each is what it's worked out to be. A little bit less, but with with the construction costs, everything rose over, you know, 2020, 21, 22, we're sitting right now about 100,000 each. So, the way we structured that specific deal is we took a bank loan with pretty low leverage.

13:16So, around a 50 50 to 60% leverage on the purchase. And then we we raised the equity to do the construction. So we brought the the investors brought money for the down payment and then brought money for the construction of the garages. So like I said it's about 100,000 each. And upon you know what you got to go through is you go through permitting. So everything's done you know above board.

13:48You go through the city you submit your plans. The permitting took way longer than we had hoped. Shocking. Yeah. The second plan too for the property. So not only did we do the permitting for the units, but we also planned on renovating existing units. Okay. So the rents were probably, $1,100, $1,200 a month, which was well below market. Yeah. So we renovated all five of the units. We ended up getting around $2,000 a month for each of those in rent. So, we pretty much doubled the rental income right there.

14:22And then the permitting took about, you know, 10 or excuse me, about 12 months. Now we're we're about 6 months of permitting on in today's world. Back then it was a little newer and it was taking forever. Took about 12 months of permitting. Took another probably 12 months of construction. Again, because they inspect, it's bureaucracy California. They inspect every step of the way and makes construction much longer than it needs to be. More expensive as well. And so fast forward about by month I think month 26 27 28 we we started leasing the units.

15:01They leased for these were all we built all studios. So we built seven studio apartments. Very tiny. They're like 200 square feet. Oh wow. Extremely small. But it's it's how you can keep the the cost down for the tenant. And so that there those rents were right around 1,400 to,500. And so we, you know, we significantly incre increase the income that the property was making by by adding those additional units by in renovating existing units.

15:34And so in commercial real estate, everything's driven by NOI, net operating income. So the money that the property brings in and that's how they're valued. So what we did was because we when we finished this the market was kind of dead. This was middle or towards spring of last year. So the sales market in the commercial real estate world has was almost came to a screeching halt to the second half of of 2024.

16:05Everybody's kind of hit the pause button wanted to see what's going to happen to interest rates. Want to see what's going to happen in the elections. Want to see if happen local elections, local laws that had been put up for vote. And so we said, "Okay, well, we created all this value. We don't want to sell at a at a time that's not ideal." And so we we said, "All right, let's refinance." And we end up refinancing into a a Freddy small balance loan, which is a governmentbacked loan, which is how you can get your best rates that way.

16:37We refinanced in we closed in September with a interest rate of 5.7%. So that we kind of we timed it we got lucky we timed it right kind of when there was a little dip in interest rates last last September. Got the 5.7 we were distributed you know I'd say probably a million dollars back. They valued the they valued the property at I think 2.9 million. So, we went from buying it at 1.1, now we're valued at at at 2.9 and you know, investors were distributed most of their initial investment back.

17:14They still we still own the property. We're still slightly positive cash flow every month right now. And we'll wait to sell, you know, for the right time and that could be that could be now. The market's definitely there's been more and more activity right now than we've seen probably over the last two years. I expect that to continue to build and we'll see what happens. But you know, we've created a lot of equity. We're in a really good position and a great way to take advantage of it, you know, and that's just one way you can slice this Kirby.

17:46There's a lot of different ways and we've done multiple ways. This is one way to do it and it helps to to have folks that know what they're doing to give you advice and and and walk you along the steps that you have. The one thing I say, Kirby, is always try to have options, right? Like anything in life, you'd like to have options. You don't want to be boxed into a corner. Sometimes that's inevitable, but if you can have options, it is certainly allows you to make the best decisions for for your projects and your properties. Oh.