Q4 2013 Update

Operating Results:

We report Sandalstone’s 4th Quarter and Full Year 2013 results to be records during the rental phase. Full year revenues increased 31% over 2012. The primary reason for this is the increased number of rental unit days. However this growth is abating as we only purchased two properties this year - both in the early part of the year. We stopped purchasing when our numbers couldn't be supported as asset prices increased above our (high) hurdle rate. This is a nice problem to have. This is reflected in the Quarterly numbers where we barely recorded a 1% gain. The gain is a positive surprise as we had two tenant turnovers in the Quarter. As a reflection of the strong rental market the Oakland vacancy was for 7 days and the Las Vegas one for 15 days. For the year we ended with 2.9% vacancy which is a good indicator of rental strength compared with our 6% historical average.

Another indication of rental strength is our ability to raise rents.  The best time for us to test this is when we have tenant turnover.  In Oakland we were able to raise rents 14.8% off the existing base.  We also used the opportunity to refresh the units - which after six years was due.  Thus, we can confirm that the SF Bay Rental market has been on fire as widely reported in the press (most of which include Google's buses).  Except for our Section 8 properties, we anticipate having operating leverage next year as we pass along price increases.  We are also going to explore value add short term options using services like AirBnB on one of our properties in the next year.  So that experiment will be interesting.  

In Las Vegas we had a two significant issues which put us at three for the year.  One involved tenant turnover.  The tenant despite having a non-smoke clause in her lease, smoked in the house.  We had to repaint the entire house and replace the carpet.  Unfortunately her deposit only covered a fraction of the cost.  The upside was that our crew was able to do the work in 7 days and we managed to get it rented out in the next 8 days.  So the work paid off in having a low vacancy.  The other issue was having to replace a heater/AC unit.  I suppose we will need to factor this in as most of our houses are about the same vintage.  The good news is that the unit is far more energy efficient and we are covered for the next 20 years with a warranty.  Despite these issues, the low overall vacancy and our conservative approach let us meet (and most likely exceed) our expectations.  There is some indication of our being able to raise prices heading into next year as the jobs numbers are improving.  Our forecaset is that as the overall Economy improves next year and that we should be able to raise prices in the second half of the year.  

Market Update 

We reference Case Shiller in each of our updates as we believe that index to be the best indicator of asset prices.   Las Vegas and SF were once again the Top Two markets in the nation registering annual gains of 27.1% and 24.6% respectively.   To put that in some perspective - based on Zillow which also tracks home specific housing prices with its ZEstimate - has our properties up over 35% from our fully capitalized basis (including repairs).  This would be on top of the income that has been distributed over the years.  We have had our earliest properties return their entire purchase cost.     

Having said that, the strategy for Sandalstone is to continue to hold.  This is where we are going to maximize what's best for our investors rather than some IRR number.  We may need to do some re-positioning for tax purposes as time goes on - however for now the strategy of patiently waiting, collecting rents, and ultimately letting the markets return to its long term growth rate remains our preferred approach.     


I'm going to repeat some of what I wrote last quarter as its still applicable and still worth reading again - with one additional sensitivity analysis.  Still no news to report on the Acquisition front.  As we have not been able to find deals of the type we focused on reducing debt and further strengthening the balance sheet.  Our revolving lines of credit remain fully open as we have paid back the amount that was used to fund purchases in our growth phase.  Our average interest cost as a percentage remains less than 4%.  This is the most sensitive item in our Free Cash Flow and we have worked diligently to minimize this expense while giving us flexibility.  

In thinking about real estate as it was taught to us, we recognize that real estate is cyclical.  In the single family sector the cyclicality has played out as expected (in hindsight of course).  We had a remarkably long and high upcycle which ended in 2007/8.  We are clearly out of the bottom by 2012 in just about every area of the nation.  Investing in the bottom is always the best time as the actual risk is relatively low (perceived risk high) and the returns both from a yield (high cap rate) and subsequent appreciation are the highest.

We spent a lot of time investigating multi-family acquisitions this year.  There was nothing that appealed to us.  Most of the sellers wanted (and received) offers with a 5% or so cap rate.  And these of course were in B and C neighborhoods.  By comparison when we started a decade earlier we were taught that 7 to 8% cap rate was the historical norm.  Just a bit of math to illustrate the sensitivity of this as it would seem this difference is trivial.  Say a Building has a NOI (net operating income) of $1M.  Using a 5% cap rate this building would be valued at $20M.  At an 8% cap rate this building is valued at $12.5M.  Even assuming a conservative leverage ratio of 65% - that means the entire equity position has been wiped out.  Of course the folks buying at these prices are assuming a few things that would help.  One is rent/income appreciation (a 3% appreciation in income for 7 years gets you $15.4M assuming 8% cap rate).  The other is that interest rates stay at these low levels.  

In the Bay Area rents though have gone up quite more than 3% in the past few years.  So using my math above and as a further test of sensitivity average rents would have to rise about 7.5% annually to compensate for a rise in cap rates.  In others words a $1,000/month rent would go to $1,659 or $2,000 rent would go to $3,318 for breakeven on asset value - IF cap rates go to 8%.  

If either of these two variables don't work out as forecast (rent increases or interest rates staying low) then there will be opportunities in this class.  If interest rates rise as multi-family loans come up for renewal (usually in 7 years) there will be distressed sellers who have been buying during the last few years (and who have used high amounts of leverage).  At that time people with strong balance sheets and the availability of financing will do extremely well (again).  We think there is prudence in waiting at this time.  

Clarameda Fund, LLC:

  • See commentary about Las Vegas.  We managed three adverse events this quarter including a perceived mold issue, a tenant turnover that had significant damage, and the replacing of a rooftop AC/Heater.  
  • Continued Partner distributions (every month for past 5 years and going...).  Anticipate subject to final approval to issue a Special Distribution based on 2013 results.
  • We end the year in a strong financial position.  Partners will get more 2013 analysis when we issue K1s next year (expect in March).  

In Summary,

As we celebrate our best year ever (during our rental phase), we are looking forward to next year where we anticipate continuing to manage the properities diligently.  We did well this past year with an overall vacancy of 2.9% and believe that is due in part (the part we can control) to our emphasis on keeping our properties in excellent shape.  Our forecast is that the Bay Area will remain hot as the number of companies with positive liquidity events continues to grow.  In Las Vegas the catalyst events including two new Strip casino projects get going in 2014 so we anticipate that the economy moves forward with those drivers.  The latest jobs reports confirm our forecasts of improved jobs, (in the Rental business - its JOBS, JOBS, JOBS).  

While we project our revenue growth to slow down if as anticipated we don't add new units - we are optimistic that our ability to raise rents (either through value added services such as AirBnB and simply thru price increases) will continue strong results.  We also project that this year will be the last one where we enjoy absurdly low interest rates - our adjustable rate mortgages re-set for 2014 at below 3%! - so we continue to pay down liabilities on our balance sheet.  

Finally, one more shout out to the Shorey House which became one of 145 City of Oakland Landmarks!      



Biren Talati
Managing Member
Sandalstone Group, LLC




CURRENT YIELD:  4.3%  Compare to Clarameda...



Bay Area Rents:

An article that doesn't also mention Google Buses 


Case Shiller:

WSJ:  Q3 Case Shiller - Top Two Markets: Vegas and SF   

This is an interesting Graph which shows cyclicality of the SF market using Case Shiller data

Las Vegas Unemployment:

NICE DROP IN UNEMPLOYMENT RATE - 8.6% vs 9.4% - perhaps seasonal - however part of downward trend