A New Lease on Apartment Life?

By BOB HOWARD

April 28, 1998 12 AM PT

SPECIAL TO THE TIMES

Apartment owner Phil Dunford nudged the rents up on two of his small Anaheim complexes recently, something he hasn’t been able to do for most of the 1990s. Being able to raise those rents was a sign that apartments remain the promising investment Dunford has long believed them to be--even when property values were plummeting a few years ago.

Even so, Dunford and others familiar with apartment ownership are offering some words of caution to would-be investors.

Although rents are rising and buyers are paying higher prices for apartment buildings, they say, investing in apartments is not the ticket to riches that some brokers and news reports might suggest it is.

Industry experts agree that the apartment market has improved dramatically in the last year or two, and they still see a substantial upside because rents and property prices remain below their pre-crash peaks.

But that very improvement may be creating unrealistic expectations on the part of investors buying and selling apartment buildings.

“Investors are betting on future cash flow instead of what the buildings return at today’s rents, especially here in Orange County,” said Joe Berkson, a broker with Marcus & Millichap in Newport Beach.

There’s nothing inherently wrong with that, Berkson said, as long as the expectations of future rents and appreciation remain in line with reality.

“The improvement in the market in the last year or two is remarkable, but we have a problem in today’s market because of all the hype about how values are going up,” Berkson said.

He said many owners are either holding their properties off the market in the hope that values will climb even further, or listing properties at prices that are far too high.

“If seller expectations remain unrealistic because of the frenzy that’s been created by us brokers and the media, we could see the number of transactions slow down considerably during the remainder of the year,” Berkson said.

Although rents and values are both rising, Berkson questions whether they will rise fast enough to justify the frenzy that seems to be gripping the market. He said investors buying apartments are settling for much smaller cash flows than they would have just a year or two ago, when buyers “wouldn’t look at a property unless it was going to return 10 to 15% on their investment.”

The frenzy is fueled in part by zealous brokers who encourage sellers to ask for unrealistically high prices and by news reports of record-breaking sales, Berkson said. An example was the October sale of the 714-unit Villa Martinique in Costa Mesa for $73.5 million, or nearly $103,000 a unit, a record per-unit price for Orange County.

But Raymond Maggi, a vice president at the Apartment Assn. of Orange County and the owner of more than 750 units, said he recently sold one of his buildings in Stanton at a loss.

Maggi said he sold the building for $2.8 million, compared with the $3.4 million he paid for it in 1987. He wanted to raise cash to invest in an office building, he said, and he fared well on the deal because of tax considerations, but otherwise he would have waited three or four years to sell.

“I didn’t want to wait until the prices come back up because I don’t think we’ll see 1987 prices again in this century,” he said.

The difference between Maggi’s sale and the record-setting Costa Mesa deal illustrates the difficulty of describing the apartment market in general terms. Rents are generally higher and the market tighter in southern Orange County than in the northern part, he said, so higher sales prices may be justified in upscale markets where well-heeled renters will gladly pay top dollar.

But the situation is different in what many call the “economy market,” where property values are rising less dramatically and a few dollars a month can make a big difference to the typical tenant.

The market is yet another story in Los Angeles County. Executives at the Apartment Owners Assn. of Southern California say the L.A. market has recovered, but they don’t speak about it in the superlatives often assigned to Orange County.

“The feeling is that things are slowly getting better,” said Dan Faller, president of the association, who said one of the brightest signs is that most sales of apartment buildings now are ordinary transactions as opposed to the foreclosure sales that were dragging down prices a few years ago. Jim Rodriguez, a vice president at the association, said another sign of steady improvement is that landlords no longer need to lure tenants with periods of free rent. That’s good news for investors, Maggi said, because such giveaways can greatly reduce the cash flow generated by a building.

“For most of the ‘90s, I would have thought I’d died and gone to heaven if my rents would have just kept up with” the consumer price index, Maggi said. “Average rents didn’t actually go down, but landlords were giving away so much free rent that the effect was the same as if they had lowered rents.”

Maggi said free rent was so common that some tenants made a habit of moving every few months to take advantage of it.

“People would get a free month’s rent, stay three months, then rent a U-Haul and buy pizza and beer for a few of their friends to help them move,” he said. Maggi figures this was very profitable for such tenants, considering that they got about $750 in free rent every time they moved but probably paid no more than $150 for the pizza, beer and truck rental. The practice became so widespread that he modified his leases to nullify the free rent for those who moved too soon.

Maggi said landlords resort to free rent in a soft market because they are loath to lower rents. Generally, he said, the market begins softening when the vacancy rate reaches 6% to 7%.

Today’s vacancy rate in Orange County is about 5.5%, according to Maggi, who described that figure as “great” compared with 1990-94 but added that it pales in comparison with the 1% vacancy rate of 1973, when he entered the business.

“The market is about where it should be today,” he said. “If the vacancy gets too low, tenants don’t have enough choices. But if it gets too high, it eats into the landlords’ profits.”

Landlords were still playing catch-up in 1997 despite the improvement in the apartment market, according to Pam Wooldridge, president of Rancho Santa Margarita-based Research Network Ltd.

An annual survey by her firm showed the average rent for all units in Orange County was $846 in 1997, up from $702 in 1985.

But the 1997 figure lagged far behind what it would have been if landlords had been able to raise rents to keep pace with the consumer price index during those years. With the index’s increases, the 1997 figure would have been $1,053 instead of $846. Apartment owners consider that lost income and hope to recover some of it with rent increases that are expected to continue as long as the market remains robust.

But raising rents can be tough, even in an improving market. Apartment owner Dunford said he lost two prospective tenants recently when he raised rents to $660 from $635 on a two-bedroom apartment in one of the eight small buildings he owns in Orange County. The would-be renters told him they were going to an apartment renting for $600 a month, even though it wasn’t as nice as his building.

Dunford said the anecdote illustrates that price is still extremely important to a big part of the population, something investors need to keep in mind in figuring how much they can afford to pay for an apartment building.

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Apartment Conundrum

Apartment vacancies have been declining in Southern California while property values have risen. Not all landlords have been able to raise rents, however, and investors who count on being able to do so soon are taking a gamble, market observers say.

Orange County Sales

Average price per 16-to-36-unit apartment building, in millions:

1993: $1.0

1994: $1.1

1995: $1.1

1996: $0.9

1997:: $1.1

Area Vacancy Rates

Westside- 1996: 6.5%

1997: 4.5%

Hollywood- 1996: 7.0

1997: 5.8