Experts predict next real estate boom will be apartment units.

Experts predict next real estate boom will be apartment units

Los Angeles will be the nation's top investment market for apartment buildings over the next five years because of this area's soaring demand for affordable housing and slumping returns from the overbuilt office market, according to a new study by accounting firm Ernst & Young.

With fewer and fewer Angelenos able to afford their own homes, demand for apartment housing is booming and will continue to rise over the next five years, the study concluded. That demand will fuel higher rental rates which, in turn, will translate to healthier investment returns for apartment owners.

Los Angeles rents rose, on average, 3.1 percent last year, down from an average annual increase of 5.4 percent between 1987 and 1989.

While last year's rental rise was down from previous years and was less than many other top U.S. apartment markets, Los Angeles rents remain significantly higher than those of most other markets. And that condition is expected to persist for the next five years. (See chart, page 65)

"One-bedroom apartments are renting for $550 to $750, or more, on the Westside," said Marty Shelton, an apartment sales agent at Coldwell Banker Commercial Real Estate Services. "(That is) pretty darn good when you consider the same units are renting for $300 to $450 in Phoenix, Denver and Salt Lake City."

The relatively high Los Angeles rents are translating to healthy cash flows for apartment owners, and that is driving the price of city apartment buildings to new highs.

"Buildings that would have sold for $40,000 a unit five years ago are now selling for $60,000 a unit," Shelton said. "And they'll be selling for $70,000 to $80,000 five years from now."

The average price paid for a Los Angeles apartment building has soared in recent years. Last year, the average sale price rose more than three times as much as the average Los Angeles rent.

Much of that rapid appreciation is being fueled by the entrance of major institutional and foreign investors into the apartment market.

"In the past, foreign and institutional investors had restricted their real estate investments to commercial office buildings or retail centers; they saw the apartment market as far too risky," explained Rick Bobrow, Ernst & Young's western region director of real estate.

Apartments are generally more risky because their rental rolls are less stable than office tenant rolls. But that higher risk is usually at least partially offset by higher yields.

Institutional investors traditionally opted for the safer, lower-yielding office buildings.

But the recent overbuilding of office markets across the country has increased the risk and lowered yields on office projects which, in turn, has increased the relative attractiveness of apartment investment, Bobrow explained.

Shuwa Investments Corp., for example, announced this month that it will begin developing apartments in the United States, and that its first apartment project will be a "high-quality complex" on Wilshire Boulevard in West Los Angeles.

The Japan-based company had previously restricted its U.S. real estate investments to trophy commercial properties, such as the 3.5 million-square-foot Arco Plaza in downtown Los Angeles.

Most foreign and institutional investors are choosing to buy or build large (100 units or more), luxury apartment complexes on the Westside, such as Shuwa's, because those projects are generally perceived as less risky, said Coldwell Banker's Shelton.

"We've identified about 800 (apartment) buildings in Los Angeles County that have 100 units or more, and we're keying on those," he said. "When pension funds or other institutional investors come to us, we want to be able to identify those properties quickly because we know that's what they're looking for."

Institutional investors are willing to accept lower returns on their investments than typical apartment buyers, Shelton said, as long as they can get large buildings in prime locations.

"They're willing to pay `cap rates' of 6.5 to 7.5 (percent) versus the typical cap rate of 8.5 to 9 (percent)," he said.

A "cap rate," or capitalization rate, is an indication of return on investment. It is computed by dividing a property's net annual operating income by its purchase price. For example, a $1 million property providing an annual income stream of $80,000 would have a cap rate of 8 percent.

While large apartment complexes on the Westside may be the preferred investment for institutional investors and those in search of prestigious addresses, the best apartment buys are further east, Shelton pointed out.

"The best areas for (apartment) investment are Hollywood, Mid-Wilshire, Koreatown and the Westlake district," he said. "Those areas have the most turnover and the best value. Their purchase prices are keyed to economics, rather than mere prestige.

"If you're the kind of guy who wants to go for a Saturday drive with your friends, point out the window and say, `That's my building,' they buy in Westwood," Shelton continued. "But if you want to make a buck, go buy down around the Ambassador Hotel."

Another healthy local apartment market can be found in the Long Beach area, according to a study released just this month by Marcus & Millichap Real Estate Investment Brokerage Co.

The number of Long Beach apartment transactions increased by 29 percent over the past year, and the average per-unit purchase price increased from $63,108 to $68,686, the report stated.

Purchase prices for apartments in the Los Angeles area are expected to continue rising, too, because construction of new apartments is slowing.

The number of new apartment units approved for construction last year was down 26.4 percent from the previous year.

Industry sources attributed this decline in apartment construction to the growing slow-growth sentiment and environmental concerns in Los Angeles. [Tabular Data Omitted]