Adding Square Footage and ADUs With Derek Harms #676

Derek Harms blog

Aaron Norris is joined this week by Derek Harms today. Over the next couple of months, Aaron is going to try to go area by area and talk to some trusted voices in the market. Derek happens to be the president of the North San Diego Real Estate Investors Club, or NSDREI. He is a Compass agent and a real estate investor down in the San Diego market. 

Episode Highlights

  • What was happening in the market last year that made everyone nervous?
  • Does he believe we should be cautious in 2020 when it comes to timelines and big projects?
  • What new regulations are being required for ground-up construction projects, including ADUs?
  • How much is he willing to do when it comes to adding square footage?
  • What are some big property errors he has seen that we need to avoid this year?
  • Where are the deals in San Diego coming from in terms of sourcing?
  • Will Compass be launching an iBuyer program?

Episode Notes

A year ago, Derek was a part of The Norris Group’s attempt to bring in some more expertise into their training portal. He helped build out the chapter on adding square footage. They are going to cover a lot of ground in this show because he is all over the place with some cool stuff. They began by talking about the strategy of adding square footage. Last year, he and Kimberly Nelson had really dug into a lot of high-end stuff and said they were taking a little bit of a step back because the market was a little murky. What’s interesting is last year, San Diego attendees at SDCIA, where The Norris Group launched their annual talk, were so stressed out because the market seemed to really be shifting. Aaron wondered what happened with the market last year?

Derek said everyone thought last year was it. It was the beginning of Q3 in 2018. We had seen interest rates go up, and that affected home sales and pricing in San Diego County. Everyone he knew in the space had trouble flipping their houses in that particular time. He knows for a fact he got nailed on a couple, and he had other friends who got nailed on so many more. That interest rate that went up almost a full point created this sense of carefulness and caution with buyers. Derek wasn’t even getting showings, and it was just a completely different market vibe then they were getting 4 years prior. There had been a couple of little bits over the past five years where similar things had happened, but this one lasted through Q4. At the beginning of 2019 after the holidays, in January and February, things started to pick back up again. It was a little bit of a scary time, and it makes you really think twice about how the affordability is affecting everything. If rates went up one point, despite them being so historically epically low, yet it has that much effect on the buying here. That’s what happened, and it was real. If you had too many high-priced, high leverage projects and you were going on market at that time, you got hurt.

Aaron said it’s like market amnesia with interest rates. Nobody remembers anything higher than a 10, probably higher than a six, especially new buyers. For everybody entering the market now, it’s been so long that they just think this is normal. Derek tries to put this at the forefront of his mind. He’s 34 and a millennial, so his advanced career and the whole time that he has actually been in this business for the last 10 years, he has been part of a lower interest rate environment. He is in this space and does a lot of research, and he is friends with Aaron and a lot of other people in town who watches this carefully and can show the history and the cycles of where this has been. He always tries to remember that., and he lets clients and investors and friends know about it as well. A lot of times you’ll get a buyer who might mention a quarter-point on an interest rate or something, and you just have to bring him back down to earth a little bit and remind them that a 30-year amortizing loan at approximately a 4% rate, even if it’s a quarter-point higher than it was last month, is still ridiculous. If you can afford that payment for now and moving forward in your life, pull the trigger.

Aaron has had this conversation a lot since he does a lot of market timing, and they have their newest talk Turmoil coming up. They just tell people it could go up or it could go down, but they don’t like some things happening. Their main goal is to talk to people about their portfolios, especially with rentals or the kind of strategies that they’re doing. If you’re doing multimillion-dollar deals along the coast, that’s going to take a year because of how much construction you’re doing. If you get stuck, there are some investors up in the San Jose area that have experienced the same thing. Oddly enough, their peak median price happened in 2018, and they’ve never made it back. They’re off hundreds of thousands of dollars.

Derek works with high-end things, so what’s a hundred thousand dollars on a high-end rehab? Derek said if you’re in that space in the Bay Area, you’re talking four to 10 million. If that’s the case, a couple hundred grand isn’t as big of a deal as it is for someone in San Diego working with a $1.5 to $2.5 million dollar space. That’s a big deal.

A year ago, Derek was backing off some of the really heinous rehabs, the ground-up kind of things. Aaron wondered if he has stuck with this. He said he has stuck with that almost exclusively. He has shied away from larger projects almost exclusively with respect to one project they have right now, which is a fire burned house. It’s probably a one point four million dollar house, and they picked it up for $570,000. There’s enough room on this to go ahead and take the risk. A lot of people listening to this are going to say one point four million is not that high end in California. In San Diego, that’s first-time buyer material.

When you look at the overall numbers and see how many properties trade above one point three million, it’s drastically lower than anything in the median price space. However, your buying is still limited. Your buyers are more educated and more discerning and techier. This is probably their second, third or fourth house, and you have all of the permitting and environmental issues, and HOA issues. There are all these layers that add to the risk, and you really better have that number of profitability for you to go in and take the risk. Sometimes you get a home run, but if you get nailed on one like this, then it’s really going to hurt.

Aaron asked Derek if he sees 2020 as being very much the same with being cautious when it comes to timelines and big projects. He said he does. He recently talked to one of his friends here in town. They probably do a lot of volume, probably 50-60 deals a year. They are really good at the higher end stuff. He works with La Jolla projects, and they have one project in escrow on the resale side for over $5 million. They had a good conversation about this exact strategy, and they’re shying away from almost all big projects and basically giving it a three-strikes rule where if you look at a median-priced house and it has three negatives, they won’t do the deal. In this case, even on these higher-end deals, if it has one negative, whether it’s a power line, a busy street, on a slope below grade or anything like that, they walk. They’re seeing the same things, and it goes back to all the factors discussed at the event last year regarding any square footage. There’s so much risk and unknowns with the city and with oversight and project management and municipalities. It just adds all these layers on to where if it’s not an absolute home run and there aren’t any of the major red flags, then it’s just not worth it.

Aaron thinks that is a smart bet in 2020. He has been hearing that across the board. The Norris Group gets to speak to all these clubs throughout the state and can get a sense from the Inland Empire and Sacramento versus some of the coastal regions. It’s interesting how different it can be depending on the market. One of the things he is concerned about right now is in October, 18 bills got pushed through. You have accessory dwelling with a timeline that went from 120 days that cities and counties have to push the projects through to now 60. If they’re part of an existing primary and adding it on, you have 60 days. If it’s a brand new construction, that could take a year. Depending on where you’re at, it has to go through the standard process. Aaron said that legislation didn’t come with any extra dollars for the economic development departments and planning departments forced to push those through.

Aaron asked Derek if he is worried about timelines when it comes to people adding square footage and construction. He said absolutely. That timeline is number one, especially when you’re talking about adding new construction and any of these higher-end properties because the timeline is everything. This includes your carrying costs. What if this is the top of the market cycle and you’re three months into planning and not anywhere close to a building permit, and we end up having a market event. Timing is everything when it comes to this. There are projects right now he is seeing where he is seeing guys shell out $25 grand a month in carrying costs, which include four to five million dollar projects in the La Jolla area where you better know what you’re doing and you better have a solid market with the disposition of that asset. That is major, and it goes even deeper.

The timing has so many layers. The cities are so understaffed, and a lot of cities in the San Diego area are closed on Fridays or closed every other Friday. It just adds to the length of all your submittals, and municipalities are extremely slow. Water districts are now required to regulate water usage. On any new construction in San Diego that is ground-up, you have to submit a landscaping plan first and show your stormwater and water usage before you can even get into a building plan. They want to know what’s going to happen with the water usage and and stormwater. It just adds all these extra layers. Derek got this tip from Leo Clark. There’s just so much solar now as a requirement on ground-up construction. That’s the case even for ground-up ADUs.

Aaron said for SDCIA, they’re working on the February event for ADUs, and Senator Wieckowski is going to be there. Greg Nickless from the Housing and Community Development Department will also be there. They also went to the head guy in the state for energy efficiency. If it’s ground-up, a city can grant you a waiver if there’s too much shade or there are a few different variables. However, Aaron said he would assume the worst and just be happy if you don’t have to have it. Unfortunately, ADUs are required to have solar. Nobody likes surprise solar projects as those are not cheap. Derek said he would much rather just know so he can budget it into the underwriting before pulling the trigger on anything.

Going back to the timeline, there’s more. For instance, they have a project right now in Escondido that they submitted a couple of months ago. With these, they’ve been having to go through a third party plan checker because the city is too impacted. Now they have to play like a telephone game between the third party, which in this case is a company called Esgil. It’s first them, then the city, then the architect, Derek Harms’ company. It’s like this merry go round that undoubtedly adds time to the project, although he doesn’t know how much exactly. Each day that goes by, it’s hundreds of dollars of carrying costs every day.

The Norris Group does hard money loans for new construction, and he said it would actually benefit them if they just did loans up front. But, they actually require that the land be owned free and clear and the permits and plans done before they fund. That’s actually to benefit of the borrower because a lot of people, especially if they’re new, just don’t understand. You could be in planning and permitting for a year before you ever get to break ground, and then you’re just paying interest on a loan where you’re not even being able to use the money. That is not cool, especially if you’re talking about the million dollar properties. You’re talking huge carrying costs.

You have to be very careful, even when it comes to general financial planning. It’s like if you have this expensive house in a rich neighborhood and the market does turn and you have to hang on to this asset, you’re not even going to be able to come close to treading water. This is something now where you have to look at it and say, “OK, well, what do we do? Do we stop paying and let this go to foreclosure?” “Are we going to be able to just put money into this every month. What are we going to do?” “Can we Airbnb it potentially?” If you don’t have good answers to all those questions, there’s so much risk involved with that. If you have a median priced home, six hundred fifty thousand dollars in a very central neighborhood here in San Diego, you’re going to have someone, a family, who would be willing to rent that, and you can at least tread water for a while. You may not cover all your costs, but you will get close and at least not get smoked. There’s so little inventory right now. Year over year, we’re down significantly, and it puts you at such low interest rates. It’s like you have a line out the door still in San Diego if you have that asset and it’s priced appropriately and updated properly. At least it’s somewhat safer.

Aaron followed up on the topic on adding square footage by asking him if he is willing to rearrange the internal or guts of the house. He said it really comes down to the way he looks at every deal now. He asks himself how they can get through the quickest and have a faster velocity of our their money. They then look at it both inside and outside. Usually, the answer they come back with is to reconfigure. They then decide what they can do under the existing rules. If there is an unpermitted edition that’s already there, he would much rather deal with that than having to break ground on anything new. They are doing a lot of reconfiguration. They almost reconfigure every property, whether or not it’s a massive 4000 square foot home or just a 700 square foot home, one of which they just recently sold. It’s reconfigured, and it’s by far the better play if you can do it. When underwriting these larger deals, everyone he knows that’s doing it well is first starting by looking through the lens of not going through the city. They figure out how they can get it solved and turn a profit and move on. Going through the full blown permitting process and plans for the engineering is usually the last option.

Aaron asked what would be the top three things to avoid in 2020 when looking at features to add or things to be aware of. This includes errors on properties that he is seeing people get burned on pretty bad. He said one thing he has seen people get burned on is drainage issues. The stormwater requirements in San Diego are very strict, and they may be throughout the state. You have to have a very good plan. Sometimes those are water retention basins, and sometimes it’s just a bunch of grating. Sometimes it’s a combination of all the above. It wasn’t really this strict until recently. It caught a lot of people off guard who didn’t have their nose to the ground every single day. He has seen people bite off more than they can chew in the higher end space. It means you’re seeing a lot of people who are relatively new investors who are buying properties that were maybe just a little too over their head in terms of the scope of work and all that is needed. When it comes to these things being discussed, you don’t really know about it until you get into it unless you’ve done a few or you have a mentor who’s done them or you have just been plugged into a network that has a lot of information that can help you through this. Other than that, nothing else really comes to mind.

NSDREI just had their Christmas party where they had a panel of flippers. They had a panel of three extremely high-level experts very much like householders. They’re similar but different. One was almost a house flipper only. The other was more of a developer/creative zoning play guy, and he works with opportunity zones. The other was a myriad of everything going into house swapping and rentals. They have done apartment buildings amongst other things. Between them all, there’s probably a couple thousand deals in San Diego that not have been done. It was just a very, very high-level panel.

Aaron asked where the deals are coming from right now in the San Diego market as far as sourcing them. Derek said whenever he asks anybody this same question about where they find their deals, it almost strictly came down to one term, and that was relationships. He knew all three of the guys on the panel personally, and he knew how a lot of them ran their business. Their businesses are very much centered among relationships, whether that’s real estate agents, whether that’s other investors, or whether that’s other people out there who know the ground or wholesale or the title company. Sometimes hard money lenders get word of a deal that the borrower can complete. Most all of the good deals I know are coming through relationships. A lot of them are doing direct marketing to sellers and homeowners, and he is seeing that work. He is even doing some himself. What they are seeing is there is a pretty good return right now on the text message campaign because the cost is so low and the media is instant. A person is going to check their phone immediately and see a text message rather than send out a piece of mail and get a reply days later, and it just sits on their coffee table and then they call you back, etc.. That’s actually a message. Campaigns are interesting. Direct mail still works, but at the end of the day, relationships are the way to go. Derek said looking at the board of properties right now, almost all of them came from relationships.

At the moment, Zillow is the only one buying out in the San Diego market. There are a lot of real estate brands that are going to open up California, possibly Keller Williams and the Realogy brands. Aaron asked if his company Compass will be lau