Area Apartment Values, Rents to Continue to Climb

Apartment dwellers will pay higher rents and the buildings they live in will continue to appreciate next year in Los Angeles and Orange counties, according to a new forecast.

Compared with this year, rents will rise an average of 6% in Los Angeles County to $843 and an average of 7.1% in Orange County to $1,060, according to a study by Palo Alto-based real estate brokerage Marcus & Millichap. Sale prices will rise 7% to an average of $61,000 per unit in Los Angeles County, and 7.1% to an average of $75,000 in Orange County, the forecast predicts.

The continuing climb in rents and apartment values reflects the ongoing economic recovery, which in many parts of the region is just now pushing rents and apartment prices near their pre-recession levels, said John Kerin, a senior vice president at Marcus & Millichap.

“We believe that in the next 12 to 24 months, the economy is going to remain strong, which means landlords will get rent increases, which means that values will go up,” Kerin said.

Apartment rents and sales prices are among the most-watched real estate indicators because apartment owners constitute one of the biggest groups of real estate investors, numbering in the tens of thousands in Los Angeles County alone, according to the Apartment Assn. of Southern California.

The investors range from mom-and-pop owners, who buy buildings for a few hundred thousand dollars, to pension funds and real estate investment trusts that pay tens of millions for large complexes. In between are a host of investment partnerships of all sizes.

The rental and sales figures in Marcus & Millichap’s forecast are averages for all apartment buildings with 40 units or more, but Kerin and other industry sources said the increases can vary substantially according to the age and location of buildings and whether they fall under rent control.

Average sales prices actually dropped in Orange County in 1999, compared with 1998, according to Hessam Nadji, director of research for Marcus & Millichap. Nadji explained that many large, high-priced complexes were sold during 1998, driving up the county’s average, whereas few, if any, such complexes were sold this year.

Rents rose most dramatically in the highest-priced neighborhoods of both counties from 1996 to 1998, but the rate of increase in upscale buildings should slow this year, Kerin said. By contrast, rents and sales prices for more modest buildings climbed faster this year than they did in 1996-98 and should continue to do so next year.

“Six months ago, we were getting rent increases of about 2%, and now we’re getting about 4%,” said John Gordon of Pasadena-based Fertig & Gordon, which manages approximately 1,000 apartments in the San Gabriel Valley.

Gordon, who describes the apartments as “blue-collar buildings,” said that segment of the market has only recently recovered sufficiently to allow greater rent increases. Most of his units rent for $500 to $800 a month and are one- and two-bedroom apartments.

During the recession, rents for apartments managed by Gordon’s company dropped to 10% below their 1990 peaks. “Next year, we will probably get back to those levels,” he said.

Investors trying to make sense of the apartment market should be aware of the gap between rents and values of blue-collar buildings and their luxury counterparts, cautioned Carl Reinhart, president of Irvine-based Peninsula Investment Real Estate.

“The market is very stratified,” he said, “so people looking at the average rent increases and price increases might develop some unrealistic expectations about the upside potential in these deals.”

A forecast from Westlake Village-based Hanes Investment Realty sounded a similar theme regarding the wide variations among apartment types.

Apartment buildings in Los Angeles County fall into at least five general classifications, according to the Hanes report: pre-1978 buildings under rent control; pre-1978 buildings exempt from rent control in cities outside of Los Angeles; post-1978 properties; buildings in need of substantial rehabilitation with or without rent control; and new high-end apartments.

Rents and values are more likely to rise in newer and better-maintained properties and those that are exempt from rent control, said Todd Schwartz, a senior associate at Hanes. Schwartz said apartment prices rose 16% to 30% this year in most of the San Fernando Valley markets tracked by Hanes, but the company expects values will rise less dramatically next year.

Thanks to rising prices, Schwartz said, “the Los Angeles apartment market is the best we have seen for sellers since the beginning of the real estate depression.”

Prices in many markets still remain below their late 1980s peaks and below the cost of building new apartments.

“Buildings are still selling for way below replacement costs,” Reinhart said. He cited a building that sold recently for $68,000 a unit but would cost $110,000 a unit to build anew if land was available.

Reinhart noted that the high costs of land and construction keep developers from building moderately priced apartments at a profit. Hence, most developers stick to luxury apartments where rents are $1,000 and up.

Just about the only types of apartments being built today are luxury projects and low- to moderate-income projects financed through federal or state subsidies, Marcus & Millichap’s Kerin said. Developers are building only about 5,000 apartments a year in Los Angeles County, compared with tens of thousands a year in the 1970s and 1980s, according to the Construction Industry Research Board.

Development sites are difficult to find even for those building luxury apartments, said Scott Davis, a vice president at Alexandria, Va.-based AvalonBay, a real estate investment trust specializing in apartments.

AvalonBay has rehabilitated 4,000 units in Southern California in the last two years but is having difficulty finding properties that fit its remodeling criteria. The company plans to build about 950 new units during the next several years at four sites it has under contract in L.A. County, Davis said.

Based on today’s land and construction costs, AvalonBay will need to charge rents of approximately $1,000 to $1,250 for one-bedroom apartments and $1,500 to $1,800 for two-bedroom units to make the projects profitable, Davis said.

Finding properties to rehabilitate is more difficult for REITs such as AvalonBay because they tend to favor larger properties, and relatively few large properties are available, said Marc Paul, a principal at Secured California Investments Inc. in West Los Angeles.

Paul said SCI, which forms partnerships to acquire apartment buildings, has turned to smaller buildings this year because it believes they offer greater potential for appreciation. “Most of the larger buildings have been gobbled up by smart, sophisticated operators who have already raised the rents as much as they can, but we can still buy a lot of 10-unit buildings from private owners who haven’t raised rents,” Paul said.

Paul said the company bought 15 small Westside L.A. properties this year after previously buying almost exclusively in the San Fernando Valley, where it owns 20 buildings.

“We’ve refocused our efforts on the Westside and the better parts of the Valley because we want to be where tenants can afford to pay the biggest rent increases,” Paul said. He said the upbeat outlook for the apartment market is a central reason SCI recently co-founded a new Re/Max commercial real estate brokerage office in West Los Angeles.

Marcus & Millichap’s Kerin said values generally have risen faster overall in Orange County than in L.A. County because Orange County has no rent control.

The landlord of a rent-controlled building might be limited to raising rents by a certain amount each year, for example, while the owner of a nearly identical building exempt from rent control might be able to raise rents by twice as much, he said. Under the Los Angeles city rent control ordinance, apartments built before October 1978 fall under rent control, whereas those built after that date are exempt.

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Apartment Supply and Demand

As rental units become more scarce, rents are approaching pre-recession levels in Los Angeles and Orange counties. Figures are averages for all apartments in buildings with 40 or more units.

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Los Angeles County

The vacancy rate is expected to drop 55% between 1994 and 2000 ...

... while rents are expected to rise 34% during the same period.

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Orange County

The vacancy rate is expected to drop 69% between 1994 and 2000 ...

... while rents are expected to rise 29% during the same period.

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Source: Marcus & Millichap