Rental Buildings Expected to Produce Moderate Gains

Southern California’s sizzling apartment sales pace will cool to lukewarm next year as part of an anticipated slowdown in the nation’s economy. But apartment buildings will still appreciate in value and deliver a steady cash flow as the region’s housing shortage and the lack of new apartment construction translate into fuller buildings and higher rents.

These are some of the conclusions from recent forecasts for the apartment market, which draws one of the broadest investor bases of any segment of the commercial real estate industry. Ownership of apartments is spread among more than 100,000 individual landlords in Los Angeles County alone, each of them owning an average of 12 units, according to the Apartment Owners Assn. of Southern California.

Selling prices for apartment buildings have risen to an average of $60,219 per unit in Los Angeles County this year, up nearly 9% from $55,247 in 1997, according to a report from real estate investment brokerage Marcus & Millichap. The same report said the average price has risen 9.7% to $61,480 this year in Orange County, where one complex sold for $145,000 per unit, a record for the county.

For 1999, however, industry sources expect more moderate gains. Marcus & Millichap forecasts a 6% increase in prices in Los Angeles County and a 4% increase in Orange County as the nation’s economy cools.

While those increases pale in comparison with the hefty returns many investors have realized in the stock market, it isn’t appreciation alone that continues to draw buyers to apartments.

“The market is still cash-flow driven. It’s not as appreciation driven as it was in the 1980s,” said Todd Schwartz, a senior associate with Hanes Investment Realty Inc., a Westlake Village firm that specializes in apartments.

Hanes President H. Bruce Hanes, in fact, sees a potential slowdown in the sales of apartment buildings next year because of the emphasis on cash flow rather than appreciation.

“For the first time in many years, many of the owners have fully occupied buildings. That means if they are long-term investors, they may be less inclined to sell because the property is finally making a good cash flow for them,” Hanes said.

Vacancy Rates Expected to Drop

Landlords have fuller buildings in part because apartment construction continues to fall short of meeting growing housing demand in Southern California, according to Harvey Green, chief operating officer of Marcus & Millichap. He cited figures from the Los Angeles County Economic Development Corp. showing that the number of housing units in the county grew by only 83,500 units while the population grew by 623,000 between 1990 and 1997.

And relatively few of the new housing units are apartments, even though multifamily construction has increased slightly in L.A. and Orange counties in the last two years after dwindling during most of the 1990s.

The number of new multifamily permits now numbers between 4,000 and 5,000 issued each year in both counties, according to the Construction Industry Research Board in Burbank. According to CIRB figures, the number of permits issued for multifamily housing (including apartments, condominiums and townhouses) peaked at nearly 53,000 in Los Angeles County in 1986. The peak year in Orange County was 1969, when nearly 20,000 multifamily permits were issued.

Thanks to the lack of new apartment construction and the region’s growing population, average vacancy rates are expected to drop by 1.5% to below 6.5% in Los Angeles County and to less than 2% in Orange County by the end of 1999, according to the Marcus & Millichap report. As a result, rents--now averaging $679 monthly in Los Angeles County and $920 in Orange County for a one-bedroom apartment--are expected to continue rising in both counties.

Green, who is to be a panelist at an apartment industry outlook conference Monday at the Century Plaza Hotel in Century City, said another factor continuing to contribute to the demand for apartments is the high cost of single-family homes in both counties.

Added Tom Booher, a senior vice president at San Francisco-based TRI Capital Corp. and a scheduled panelist at Monday’s event sponsored by the Real Estate Conference Group: “When you look at the demographic numbers for the state of California, you can see that there is going to continue to be an incredible demand for housing--and particularly rental housing--because so many people are priced out of the home-buying market.”

Booher said TRI sees “a strong demand in 1999 for apartment financing and refinancing generally.”

Others forecast a similar stability in the market.

Dan Faller, president of the Apartment Owners Assn. of Southern California, said the group expects the market to remain stable, provided the expected national economic slowdown is as mild as economists predict. A report from Merrill Lynch & Co. says the L.A. apartment market “should perform at least as well as, if not better than, those in the rest of the country.” Merrill Lynch says Southern California is expected to perform better in large part because there is so much demand and so little new construction of apartments.

Apartment broker Hanes agrees with these assessments, but his outlook has a twist: He says L.A.’s rent-control regulations might hold prices artificially low next year.

“For the first time in 10 years, rent control could be a factor dragging down the market,” Hanes said.

Hanes explained that rents ultimately determine the price of apartment buildings because investors buy on the basis of how much cash flow a building is expected to generate. While landlords can improve cash flow to some extent through more efficient operations, they generally must count on rent increases to add to their bottom line.

Broker Sees Plenty of Buyers in the Wings

Hanes said rent control hasn’t affected selling prices for many years because many landlords wouldn’t have been able to raise rents during most of the 1990s anyway. Vacancy rates were relatively high until about a year ago. But now, Hanes said, there is pressure on rents to move up higher than permitted by rent control.

Rent controls apply only to the 60% of the city’s apartments for which occupancy permits were issued before Oct. 1, 1978, the date L.A.’s rent control law went into effect. While older buildings in general would be expected to sell for lower prices than newer construction, Hanes said the price gap could begin to grow artificially wide next year if the scenario he described comes to pass.

Nonetheless, he sees plenty of buyers in the wings, even for rent-controlled buildings, because the apartment market attracts investors who are willing to buy a rent-controlled complex, earn a steady cash flow by operating very efficiently, and raise rents gradually over time.

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APARTMENT PRICES RISE

Steady cash flow from Southern California apartments is attracting investors, who expect to raise rents as the housing market tightens. Shown are average per-unit prices from 1997 to the present.

Los Angeles County

1997: $55,247

1998: $ 60,219

1999 projection: $63,832

*

Orange County

1997: $56,051

1998: $61,480

1999 projection: 63,939

*

Inland Empire

1997: $35,000

1998: $35,400

1999 projection: $37,524

Source: Comps Inc., Marcus & Millchap Research Services