Returns
While actual returns realized by investors will vary based on
holding period, future market price performance and other factors, our
investors generally target returns that are based on a reasonable
annual pre-tax cash-on-cash yield plus potential future price
appreciation.
The annual pre-tax cash-on-cash return is based on realized rental
rates
for the property after remodeling is complete. That is, the yield is
based on the all-in cost including purchase price, closing and
remodeling costs. We like to see going in pre-tax cash-on-cash returns
in the
range of 4-7% annually. (Remember that LA rents have generally
increased by 2-3% annually so yields tend to rise during the holding
period.) Higher going-in yields are is always better but we are willing
to
accept lower annual returns in exchange for buying properties in
superior neighborhoods that experience lower price volatility and have
a better outlook for future price appreciation.
These returns can be enhanced by using leverage in the form of a
mortgage loan. Lenders will typically provide a mortgage for 70-75% of
the purchase price.
In Los Angeles, we like to target name-brand neighborhoods like Cheviot
Hills
or Hancock Park. We also consider more middle-class neighborhoods like
Mar Vista, Culver City or Atwater Village but we require a higher yield
to compensate
for lower potential price appreciation. The combination of annual cash
yield plus price appreciation should generate an unlevered IRR of 11% -
15% over
the holding period.
Since the Los Angeles residential market peaked in 2006, we are now
five years into the cycle. Based on the last market cycle which occurred over
a ten-year period (as measured from the peak in 1990 until the market
regained that same price level in 2000), we currently don’t expect
substantial price appreciation for at least two to three more years.
Investors therefore need to buy properties with a sufficient current
yield to allow them to carry the property through the balance of the
cycle so they can reap potential price appreciation that won’t occur
until late in the cycle.