Small (but Active) Investors Find a Home in Apartment Buildings

Perry Herwood bought his first apartment building in 1967 when he scraped together $2,000 for a down payment on a $21,000 duplex in Manhattan Beach.

Herwood, who at the time was a part-time college student earning $1.98 per hour at Douglas Aircraft in Santa Monica, now owns 14 buildings containing 112 units and has bought and sold numerous other properties throughout the years. He says taking the plunge into apartments is one of the best decisions he ever made.

Apartments have also been good to Jeff Joyce, a former IBM marketing representative who bought his first four-unit building in Burbank in 1968, retired at age 49 and now owns 76 units in Los Angeles and Sacramento.

Herwood and Joyce are proof that an investor need not have millions of dollars or be the chief executive of a real estate investment trust to invest in commercial real estate.

While the business pages of newspapers are brimming with stories of multimillion-dollar investments by REITs and other big spenders, apartments represent a segment of the commercial real estate market where small investors can still participate.

Granted, small investors can jump aboard the recovering real estate market by buying REIT shares or investing in mutual funds that invest in REITs, but apartments remain the commercial property of choice for those who want to own their investments directly and control their management.

“For those who have limited capital and who want to control their own destiny and be the primary investor, apartments are the logical choice,” said Harvey Green, an executive vice president with Marcus & Millichap Real Estate Investment Brokerage Co. in Encino.

Even REIT executive Mike Meyer, who says many investors are probably better off putting their money into REIT stock, concedes that direct investment in small apartment buildings can be profitable for those who are willing to be actively involved.

“Buying a small building and managing it is a good business for a hard-working soul, but it’s not the place for a passive investor,” said Meyer, chief executive of San Jose-based Bay Apartment Communities.

Buyers looking for small apartment complexes need not fear competition from REITs, because most REITs consider buildings only of 100 units or more, Meyer said.

Prices for apartment buildings have risen far beyond the $21,000 of Herwood’s original purchase or the $38,000 that Joyce paid in his first venture, but investors can still buy buildings with down payments of 10% to 20%.

That means they can get in for as little as $10,000 to $20,000 in some neighborhoods, far less than would be required for most other types of commercial property, said Barry Baker, a Grubb & Ellis Co. associate vice president who specializes in apartment buildings.

Apartments also are “something that most people can understand better than office or retail space,” Baker said, a point that virtually all of the real estate professionals emphasized.

“Apartments are more forgiving. Other types of property have more moving parts,” Green said. Office, retail and industrial space are more daunting because they usually involve bigger investments, more complicated leases, frequent negotiations with tenants and their lawyers or brokers, and various other pitfalls.

“When you lose a tenant in a 20-unit apartment building, you only lose one-twentieth of your cash flow,” Green said, “but you can lose one tenant in an office building and there goes 30% to 40% of your cash flow.”

The appeal of apartments for small investors is evident in ownership statistics. According to President Dan Faller of the Apartment Owners Assn. of Southern California, there are 100,000 landlords in Los Angeles County, each owning an average of 12 units.

Apartments took a beating during the last real estate slump, when rents dropped and vacancies climbed. But according to a survey by Faller’s association, rents are rising again and vacancies are declining.

For the survey years 1991 through 1996, average rents in Los Angeles County peaked at $649 per unit in 1991 and fell to their lowest point, $626 per unit, in 1995. In 1996, the latest year for which figures are available, they rose to $632 per unit. Vacancy rates have also recovered. From a high of 12% in 1993, they declined to less than 9% last year.

These trends are pushing up the prices paid for apartment buildings. John Kalmikov, a Grubb & Ellis senior vice president, said owners can finally look forward to some appreciation again after the dark days of the mid-1990s, when many owners lost buildings to foreclosure.

“Just in the last 18 months out here, buildings that were selling for $20,000 to $25,000 per unit have gone to $30,000 to $35,000 per unit,” said Kalmikov, who is based in Ontario.

Even with per-unit prices rising, buying an existing apartment building is still cheaper than building a new one, which experts consider a key factor in rating the market. Kalmikov said buying existing apartments is generally considered a sound investment if prices of existing properties are lower than the cost of new construction.

One of the simplest ways to get into the market is to buy and manage a small building such as a fourplex, which in Southern California might be priced from as little as $150,000 to hundreds of thousands of dollars.

According to real estate advisors, owners can expect an annual return of about 8% to 12% on such an investment. That means that a buyer who makes a $40,000 down payment on a $200,000 building could expect to make a profit of $3,200 to $4,800 per year after paying the mortgage and other expenses.

But that doesn’t take into account the potential profit on appreciation and the magic--but dangerous--possibilities of leverage.

Joyce, for example, sold his $38,000 Burbank fourplex for $475,000 in 1990. Herwood pointed out that once a building becomes plump with equity, an owner can borrow against it to buy additional apartment buildings at 10% to 20% down. This is the upside of leverage, a way of using a relatively small amount of money to control a relatively large amount of property.

On the other hand, many apartment owners who borrowed against their properties lost them through foreclosure.

Since then, quite a few investors have chosen to put their real estate dollars into shares of publicly traded REITs. Many prefer the liquidity of REIT shares, which can be bought and sold quickly in public markets. REIT shares and the stock market have also offered higher returns lately than direct ownership, but Herwood considers apartments a good investment despite those factors. In the long run, he said, real estate provides reliable returns and appreciates in value despite occasional slumps.

“It’s just that you get hurt to the max if your timing is off.”

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Apartment Life

Apartment buildings remain the commercial real estate of choice for small investors who want personal control of their assets. The market in Los Angeles County is moving in the right direction for owners, with rents rising and vacancy rates falling.

Average Monthly Rent

‘96: $632

Average Vacancy Rate

‘96: 8.9%

* No survey done in 1992

Source: Apartment Owners Assn. of Southern California