Apartment Landlords’ Strategy: Buy, Renovate and Increase Rents

Owners of many large Southern California apartment complexes are on a remodeling spree, improving their properties--and raising rents--in an investment strategy that depends on a growing economy.

Thanks to the growing demand for apartments and a lack of sites for new construction, investors say they can spend thousands of dollars per unit in renovations to create complexes that are almost like new for substantially less than the cost of building from scratch. And thanks to the region’s continuing economic recovery and population growth, they can hike rents and thereby quickly boost the value of their properties.

Average rents in Southern California may rise as much as 12% this year, according to one analyst.

The buy-and-renovate strategy represents a marked change from earlier years in the 1990s, when investors bought foreclosed properties at bargain prices and generally spent a minimum on improvements, counting instead on the nascent real estate recovery for slow appreciation, said Jerry Fink, managing director of Irvine-based Bascom Group.

What’s changed, Fink said, is that landlords can now raise rents with confidence that they can keep their buildings filled--unlike conditions a few years ago, when owners hesitated to raise rents for fear of losing tenants.

Bascom’s strategy is to buy complexes in need of maintenance, spend $5,000 to $15,000 per unit to renovate them, operate them more efficiently, and raise the rents to increase returns, said Fink, whose company owns 18 Southern California complexes totaling 2,500 units.

For example, Bascom paid $93,000 per unit for a Redondo Beach apartment complex, where it is spending $10,000 a unit in renovations. Fink figures the building will be worth as much as $150,000 per unit after the renovations and subsequent rent increases. In Pico Rivera, the company paid $41,000 per unit for a 146-unit building and is spending $10,000 per unit on renovations. That’s still much cheaper than building a new complex, which would cost about $110,000 a unit.

In Orange County, Bascom Group renovated Bascom Square, a 104-unit complex at 222 N. Muller St. in Anaheim, formerly known as Casa 222. Fink said his company paid $4.1 million for the property about 18 months ago and has spent $6,000 per unit in renovations. Bascom raised rents an average of $157, or about 26.4%, after the renovations. Fink estimates the building is now worth about $7 million.

Fink pointed out, however, that those pursuing this “buy-and-renovate” strategy are mainly well-financed investment groups buying larger apartment buildings--generally 100 units or more. Bascom Group buys its buildings in partnership with investment funds backed by pension funds and life insurance companies.

Fink said most smaller investors, by contrast, aren’t able to raise the money for substantial renovations. “There are some banks that will lend money to smaller investors for building improvements, but the deal usually has to be worth at least $1 million before the banks are interested,” Fink said.

Owners of buildings with less than 100 units are generally enacting modest rent hikes and experiencing modest increases in their property values, according to Jim Joseph, owner of Grisham-Joseph Century 21 in Whittier and a specialist in apartment sales.

“Rents are everything in the apartment market,” Joseph said. “They are what drives values.”

Joseph explained that rents are crucial because most buyers and sellers of apartments determine prices by multiplying the building’s total annual rent by a figure known as the gross rent multiplier. If a building generates $1 million in yearly rent and the currently accepted gross rent multiplier is seven, for example, the building is worth $7 million.

Apartment prices in the range Joseph specializes in--buildings of five to 150 units--are rising slowly and steadily despite what may seem to be dramatic rent increases.

“For most of the last decade, landlords really didn’t see any rent increases at all,” he said. He explained that rents remained flat or rose only slightly in most parts of Southern California, even though inflation drove up expenses.

“Expenses have been rising by about 4% a year, and if you multiply that by 10 years it’s a 40% rise in expenses, but rents haven’t come anywhere near matching that increase,” Joseph said. “To tenants, it may look like landlords are going hog wild with increases, but many landlords are just playing catch-up.”

Most of Joseph’s clients, he said, have only recently felt confident enough about the apartment market to raise rents.

“A few years ago, most of my clients were throwing in free microwaves and two or three months of free rent,” Joseph said. “Now we’re seeing rent increases on vacating units, waiting lists and some landlords who are even bold enough to enact across-the-board increases.”

Rents rose 5% to 7% in Southern California last year and will rise another 8% to 12% this year, according to Craig M. Silvers, a senior analyst for Sutro & Co. in Los Angeles. Apartments are now “a very good bargain relative to single-family homes” because home prices have been rising faster than apartment rents, he said.

Silvers, Joseph and Fink all said they expect apartment sales prices will at least directly correspond to and probably exceed rent increases. In other words, a 10% rent increase should lead to at least a 10% increase in a building’s value.

Prices can increase faster than rents, Fink explained, because gross rent multipliers tend to rise when investors’ confidence is high. Buyers who are willing to pay six times a building’s annual rent this year might be willing to pay seven times the rent next year.

While rents and values are rising at those rates for some larger, prime apartment properties, Joseph pointed out that most of the apartments in Southern California are smaller properties and their prices are rising much more slowly.

“In the marketplace where I work, we’ve seen 5% to 7% annual appreciation on average,” Joseph said. These relatively modest gains have created what he calls a “huge gap between the perceptions of buyers and sellers.” He said sellers read about the big price increases on premium properties and expect to command the same prices for their more modest properties, while buyers still hope to find bargains like the foreclosed properties that were readily available a few years ago.

Joseph added that apartment values have been held down for the last few years as investors turned to potentially more lucrative options. “We’ve been competing with the stock market,” he said.

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Apartment Rents Rise

Landlords in most U.S. markets expect to charge their tenants more in the months ahead. In Southern California, apartment rents rose 5% to 7% last year and will climb another 8% to 12% this year, according to one analyst. Apartment values may rise even faster.

Average monthly rent

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Apartment market 1997 1998 1999 Atlanta $740 $750 $750 Austin, TX 626 655 668 Boston 1,050 1,155 1,247 Charlotte, NC 624 646 691 Chicago 930 960 980 Columbus, OH 510 530 548 Dallas 604 648 675 Denver 636 666 686 Detroit 618 631 663 Fort Lauderdale 760 775 798 Fort Worth 529 566 588 Houston 499 528 541 Kansas City, MO 538 562 590 Las Vegas 645 665 678 Los Angeles 660 700 725 San Fernando Valley 750 779 790 L.A. Westside 853 910 940 L.A. South Bay 629 664 700 Miami 700 712 733 Minneapolis 627 652 684 National avg. 710 750 775 New York 1,490 1,600 1,760 Newark, NJ 751 750 752 Oakland 900 960 1,000 Orange County 860 920 930 Orlando 603 636 650 Philadelphia 668 688 718 Phoenix 580 603 628 Portland, OR 635 653 660 Riverside 592 614 638 Sacramento 605 635 665 Salt Lake City 675 700 731 San Diego 685 715 750 San Francisco 1,295 1,415 San Jose 1,199 1,300 1,326 Seattle 635 685 705 St. Louis, MO 450 470 485 Tampa 618 637 650 Washington 820 850 880

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Apartment market 1997 1998 1999 Atlanta $36,000 $48,000 $46,000 Austin, TX 36,083 46,000 27,700 Boston 67,134 75,190 82,709 Charlotte, NC 50,396 55,867 59,500 Chicago 40,900 41,100 41,100 Columbus, OH 43,400 44,268 45,600 Dallas 26,143 28,200 27,500 Denver 37,417 41,900 46,000 Detroit 37,290 39,670 41,650 Fort Lauderdale, FL 46,000 48,000 49,440 Fort Worth 24,527 24,767 25,500 Houston 25,000 26,500 27,028 Kansas City, MO 41,000 41,700 50,000 Las Vegas 50,500 50,750 55,000 Los Angeles 55,198 60,219 63,500 San Fernando Valley 39,286 40,857 42,491 L.A. Westside 87,954 93,794 98,000 L.A. South Bay 52,506 55,801 58,530 Miami 45,423 47,000 48,000 Minneapolis 47,000 48,000 65,400 National avg. 42,000 45,700 48,874 New York 73,000 81,753 89,900 Newark, NJ 21,950 22,000 22,050 Oakland 63,500 67,000 70,000 Orange County 60,616 65,197 67,158 Orlando 36,604 40,299 42,871 Philadelphia 52,000 53,533 55,375 Phoenix 30,186 34,310 36,025 Portland, OR 44,700 45,647 46,500 Riverside 35,500 35,400 37,000 Sacramento 38,800 43,000 45,000 Salt Lake City 42,500 44,700 46,500 San Diego 47,992 50,724 52,700 San Francisco 82,779 88,717 93,000 San Jose 88,649 98,000 104,000 Seattle 64,139 67,300 St. Louis, MO 29,000 31,500 51,200 Tampa 32,160 40,983 43,656 Washington 38,644 44,306 50,730

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Source: Marcus & Millichap