Fewer Sales, Higher Prices Show Hot Apartment Market

Investors continued to pour money into Southern California apartment buildings in 1998, but the number of building sales declined from 1997 and is likely to drop further this year despite strong demand from prospective buyers.

At the same time, buyers paid higher prices for apartment buildings as prices per unit--one of the industry’s most telling yardsticks--rose dramatically and are expected to continue rising.

Those are among the conclusions experts are drawing from year-end statistics that show how thoroughly and quickly the region’s apartment market has recovered in the last few years.

“It has shifted from a buyer’s market to a seller’s market like . . . whoosh!” said Marc Paul, a principal at West Los Angeles-based Secured California Investments, a buyer of apartment buildings in joint ventures with other investors.

Paul said that as recently as 18 months ago, buyers could find foreclosed properties at rock-bottom prices, but in 1998 the market turned clearly in favor of sellers.

“Buyers weren’t necessarily trying to get steals or even great deals, they were just trying to make sure they didn’t overpay,” he said.

The reasons for the shift to a seller’s market include rising demand for housing because of Southern California’s growing population, a shortage of supply caused by the lack of new apartment construction and a healthy economy that has enabled landlords to raise rents--which ultimately determine the value of an apartment building.

These factors have produced what David Casper and Bruce Furniss, two senior VPs at Grubb & Ellis, describe as a shortage of inventory that shows no signs of abating.

The number of apartment sales in Los Angeles County declined from slightly more than 2,000 in 1997 to just under 1,800 in 1998, according to Casper and Furniss, authors of an apartment industry newsletter. Transactions declined from 330 to 259 in Orange County and 450 to 422 in the Inland Empire.

While the 1998 figures are preliminary and may change slightly, Casper and Furniss say the trend is clear: Fewer apartment buildings are being sold because fewer owners want to part with their properties. That is in sharp contrast with the market of several years ago, when banks scrambled to dispose of repossessed buildings and buyers snapped up properties at huge discounts.

According to Furniss, owners are holding on to their properties for several reasons. Among them:

* They depend on the apartment building for a steady cash flow and view it as an investment they can control, compared with stocks and many other investments.

* They would face substantial capital-gains taxes if they sold.

* They believe they can realize an even greater return in the future because they expect property values to continue climbing.

In addition, Furniss said, “today’s owner is likely to be a local person who lives within an hour of the property and probably has owned it for some time. Most of the owners who came in during the opportunistic cycle a few years ago have sold out, so the buyers now are intermediate and long-term holders.”

An analysis of 1998 apartment sales showed the average price per unit rose from $45,747 to $54,167 in Los Angeles County--an increase of 19%. Per-unit prices rose by 15.5% in Orange County and 17% in the Inland Empire. Per-unit prices are considered a more significant indicator than average sale prices because a higher average may simply indicate that larger buildings were sold.

As prices have risen, the Grubb & Ellis brokers said, buyers have had to accept lower rates of return on their investments because rents, although rising, haven’t risen fast enough to produce the high returns of several years ago. Back then, buyers expected annual cash flows equal to 10% or more of their buildings’ purchase prices. Today’s buyers are settling for returns of 7.5% or 8%.

On the other hand, Casper pointed out, the actual dollar value of the returns has remained steady or increased slightly in many cases because the investor is receiving a lower percentage of a higher number. For example, a buyer might have paid $1 million for a building several years ago and realized a 10% cash flow, or $100,000, before expenses. That same building might sell for $1.4 million today and generate a 7.5% cash flow, or $105,000.

These are very general trends reflecting the overall improvement in all segments of the apartment market, according to Casper. Price increases, sales volume, return on investment and appreciation in property values can differ significantly, depending on the quality, age, size, location and condition of a building as well as other factors.

In general, however, most of the action in Los Angeles County’s apartment market continues to be in smaller buildings, Casper said.

“Unquestionably, for all subregions, the smaller deals are driving the market both in terms of dollar volume and number of sales.”

According to Casper’s analysis, properties selling for less than $500,000 accounted for 709 deals, or 43.1% of the transactions last year in Los Angeles County, while sales in the $500,000 to $1.5-million range accounted for 43.9% of the transactions.

Those two categories combined accounted for nearly half of the dollar volume of sales; if transactions in the $1.5-million to $5-million range are added, the three categories combine for more than 97% of the transactions and 72% of the dollar volume.

In Orange County, by contrast, larger deals produced most of the dollar volume in 1998, 67.4% of the $725-million total. Smaller deals accounted for the largest number of transactions, 49% of the 259 sales.

Furniss said more large deals occurred in Orange County because more large apartment complexes have been built there in recent years and the county has more land on which to build than Los Angeles County.

Even with the construction of a few large complexes in Orange County, however, Furniss and Casper say Southern California is falling woefully short of building the new apartments the region needs for its swelling population.

The problem is compounded by aging buildings that are due to be replaced soon, they said.

“Given that over 641,000 units [in Los Angeles County] are a minimum of 18 years of age and 225,000 units are more than 28 years old, a strong argument can be made for replacement development, which is unrelated to construction needed to satisfy normal growth,” they said in their recent newsletter.

Casper said L.A. County will continue to suffer from a ‘tremendous imbalance” between supply and demand caused by population growth and a lack of new building because of high land and construction costs.

“The big story, the long-term story, is the disparity between supply and demand. Only about 5,000 new units are in the pipeline over the next 24 months, and yet the need, according to our analysis, is for 60,000 rental units over the next four or five years in L.A. County,” Casper said.