Rocket Ride Over for Luxury Rents

By BOB HOWARD

June 5, 2001 12 AM PT

SPECIAL TO THE TIMES

The economic slowdown and the demise of scores of Internet companies have trimmed a little off the top of the apartment market, reducing the rate at which rents are increasing in luxury buildings in Southern California and lowering rents in some parts of Northern California.

The slowing of rent growth is noteworthy, observers say, because it marks the first time in three or four years that landlords haven’t been able to count on double-digit rent increases. The change is also one of the first signs that the cooling economy is affecting the rental housing market, but experts say the shift is limited to top-tier properties and has not affected low- and moderate-priced apartments.

“For the last four years, we were getting [annual rent] increases of 10% to 15%. Now it’s 3% to 10%,” said Paul Jennings, chief executive of West Los Angeles-based PCS Development Inc., which owns 2,000 apartment units on the Westside and in the San Fernando Valley, about 1,500 of them luxury units.

PCS has upped its marketing budget by about 25% over the last four months to attract new tenants, Jennings said. The vacancy rate in his luxury units is only about 3%, he said, but the flow of prospective renters has slowed noticeably in recent months.

What’s happening at PCS’ apartment buildings is occurring throughout the luxury market, said Harvey Green, Encino-based president of brokerage Marcus & Millichap, which specializes in investment properties.

Rent surveys for the first quarter of this year by Marcus & Millichap and by other sources didn’t reflect the slowdown in the luxury segment because most of those studies are averages of all classes of properties, Green said. However, a recent study by his firm of luxury rentals shows that the rate of rent growth has begun to slow in Southern California.

“Rents are still moving up,” Green said, “but some owners are beginning to [make] some concessions, and there is a slowing of the increase in rents.”

Vacancy Signs Are Staying Up Longer

The Marcus & Millichap study projects that upper-end rents will grow by an average of only 2% in Los Angeles County in the second quarter, compared with rent growth of 3.8% in the second quarter last year. Orange County rents are expected to rise by 1.5% in the second quarter, compared with growth of 5% in the same period last year.

Some of the most dramatic changes in the study are the rent decreases in parts of Northern California, said Hessam Nadji, a managing director at Marcus & Millichap. In the second quarter last year, rents jumped by 13.7% in San Francisco. They are projected to drop by 5% in the second quarter this year. In San Jose, rents climbed by 18.1% in the second quarter last year but are forecast to slide by 8% in the second quarter this year.

Anecdotal evidence of the softening is mounting too. “There are Beverly Hills complexes where a vacancy sign would never stay up for more than a weekend,” said Hooman Ghaffari, a Grubb & Ellis broker who specializes in apartment sales. “Now you see signs that stay out there for a month.”

No hard and fast rules define “luxury” apartments, but luxury apartments typically are about 20% larger than most and have far more amenities, ranging from grander swimming pools and entertainment rooms to finer finishes inside the units, valet parking and doormen. At PCS, one-bedroom apartment rents range from $1,300 to $2,000 and two-bedrooms from $1,600 to $3,000. Other luxury buildings in Southern California command $4,000 to $5,000 monthly and in some cases even more.

Jennings attributes the softening in the luxury market to a number of factors. They include the demise of Internet companies in Westside communities where a large proportion of the luxury units are located, lingering effects of the threatened strikes by Hollywood writers and actors, the general economic slowdown, the stock market’s decline and apprehension among prospective tenants about California’s electrical power crisis.

“We know that some of our [former] tenants moved in with other people to try to save money,” Jennings said, “and we know that some of our tenants moved out because their Internet companies went out of business.”

Even though the supply of apartments in Los Angeles falls short of demand and even though many housing experts lament the lack of new apartment construction, Jennings said, there has been an increase in construction of luxury units on the Westside that has contributed to the softening of that particular market.

Meanwhile, there is still such a shortage of low- and moderate-priced apartments that the middle of the apartment market hasn’t suffered, market observers say.

“We haven’t seen any effect at all on our rents or our vacancies as a result of the economic slowing,” said John Gordon of Fertig & Gordon in Pasadena, which manages 1,100 low- and moderate-priced apartment units in eastern Los Angeles County. Most of these apartments rent for $500 to $600 for one- and two-bedroom units, Gordon said, with a few in the $700 range.

Low Tenant Turnover at Lower End of Market

Fertig & Gordon is continuing to raise rents about 5% per year for existing tenants and to boost the rent by about 10% on any unit that becomes vacant. Only about 2% to 3% of the company’s apartments are vacant, the lowest vacancy rate Gordon has seen in 20 years. Tenant turnover is also the lowest he can recall.

“In effect, it’s full occupancy,” Gordon said. “‘Our units are only vacant long enough to clean and paint them. As soon as they’re ready to rent, someone is ready to move in.”

The difference between the luxury market and lower end of the apartment spectrum is not surprising, said Stephen D. Cauley, associate director of the UCLA Real Estate Center, who tracks the Southern California apartment market.

“I would expect the dot-com bust to be reflected in high-income apartments and houses,” Cauley said, “but I would not expect the effect to be nearly as pronounced--if at all--in the middle-income bracket.”

The demand for low- and moderate-priced apartments continues to grow as the region’s population increases, while construction of such apartments is limited.

“Unless we have a rip-roaring recession, there is going to be a continuing increase in demand for moderate-income apartments,” Cauley said.

The softening of the luxury market, however slight, has important implications for investors, according to both Grubb & Ellis’ Ghaffari and Marcus & Millichap’s Green.

Buyers should be more conservative in estimating future rent increases in apartment complexes they acquire, and they should expect lower returns, Ghaffari said. He is preparing to sell about 2,000 apartment units, 1,000 of them in the luxury class, on behalf of institutional investors who believe “the market here doesn’t quite have the glow it once did.”

“Many of the smart investors believe the market is at its peak or has just passed it,” Ghaffari said. “They don’t believe property values will rise as fast as they have in the past few years.”

Lower Growth on the Upper End

Formerly rocketing rent growth has slowed at top-tier apartments throughout California, and rents have actually declined in some luxury markets.

San Francisco

Change in second quarter 2000: +13.7%

Projected change in second quarter 2001: -5%

Oakland

Change in second quarter 2000: +11.7

Projected change in second quarter 2001: 0% (No change)

San Jose

Change in second quarter 2000: +18.1%

Projected change in second quarter 2001: -8%

Los Angeles County