Property-Buying Firm Is Sold on Apartments

Buying nearly 50 houses as investments has convinced Marc Paul of one thing: Apartment buildings are a better way to make money.

“If you do everything perfect in buying a house and everything perfect in buying an apartment, you will almost certainly make out better in the apartment deal,” said Paul, who spent 17 years as a residential real estate broker before he and partner Robert Robotti started buying homes as investments in 1994.

Their company, Secured California Investments Inc. in West Los Angeles, has since switched almost exclusively to investing in apartments.

Paul says comparing houses to apartments is a timely exercise in Southern California because rising home prices, the widely touted real estate recovery and a desire to diversify out of the stock market are tempting many individual investors to look for ways to invest in real property.

Of course, homes and apartments are just some of the options. Shopping centers, office buildings, industrial properties and real estate investment trusts are some of the others.

But Paul and other real estate professionals say that beginning property investors most often choose houses or apartments.

“It’s very easy for someone who has owned a house to understand apartments, which is why people coming into the market for the first time tend to gravitate more toward houses and apartments than shopping centers or small office buildings,” said Katherine Bergh, a Grubb & Ellis broker in the San Fernando Valley who specializes in apartment buildings.

Most investors don’t make any profit on homes until they sell them, Bergh said, but even small apartment buildings can generate a cash flow. Since owners must pay mortgages and such upkeep costs as insurance, gardening and pool maintenance, homes are often a cash drain.

“A lot of the people I know who bought homes as investments are disgruntled with them because they’re not making a cash flow,” Bergh said.

Paul said he learned the advantages of apartments over homes through trial and error.

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From 1994 through 1996, he and Robotti bought dozens of houses, primarily foreclosed properties they snagged at rock-bottom prices. Many had been damaged by the Northridge earthquake.

Paul and Robotti would refurbish the homes, put them back on the market and sell them.

They made money, but Paul said the homes required much more time and effort--and generated many more headaches--than the apartments he and Robotti began buying in 1996. Since then, they’ve sold all but 12 of the homes and acquired 27 apartment buildings totaling 800 units in a portfolio valued at about $35 million.

Paul emphasizes that he is not anti-house. He recently added another one to his portfolio, and he says many people will continue to profit by investing in individual homes. He even says homes are rising in value faster than apartments are, especially in higher-priced neighborhoods.

“We’re just saying that in our experience, apartments are so much easier and more profitable that we rarely buy a house now,” he said.

According to Paul, one of the key differences between investing in homes and investing in apartments is that houses usually represent a cash drain or at best a break-even proposition until the investor sells, while apartments generate revenue even while being remodeled.

He explained that inexperienced investors typically buy “fixer-upper” houses and underestimate the cost and time it takes to remodel them.

“If you buy a house and put $50,000 into it, you’re almost guaranteed to get $50,000 or more out of it when you sell it,” he said. But the house usually must remain vacant during the remodeling, meaning the landlord is paying the mortgage and other expenses.

“Those holding costs are hard to recapture. You can easily lose 60 to 90 days waiting on permits or inspections,” Paul said. “I’ve had brokers tell me I could get $10,000 more for a house just by redoing the kitchen, and they think they’re really smart. But they don’t realize that it will probably cost more like $17,000 to do that kitchen, plus the four months of time the house is vacant during remodeling.”

In contrast, apartment buildings usually bring in money even when they’re not fully occupied.

“Even if you buy an apartment [complex] that is 10% vacant, it is still 90% occupied while you’re remodeling the vacant units, so you’re still generating income,” Paul said.

He said homes usually generate a profit only when they are sold, but apartments produce profit three different ways for the investor:

* Through cash flow that exceeds the cost of the mortgage and other expenses.

* Through appreciation.

* Through rent increases, which boost the value of the building.

Although apartment rents have remained relatively flat in Los Angeles County, even during much of the real estate recovery, they have started to climb recently. Paul said that since the selling prices of apartment buildings are typically calculated as a multiple of rents, any increase in rent means a corresponding increase in property value.

According to a recent Grubb & Ellis study, apartment buildings in Los Angeles County in 1997 sold for about 5.75 times the annual rent generated by the building. This figure is known as the gross rent multiplier. A gross rent multiplier of 5.75 means that a $25 rent increase on a 15-unit apartment building would theoretically raise the selling price of the building by $25,875 (15 units, multiplied by $25 multiplied by 12 months, multiplied by the gross rent multiplier of 5.75).

But apartments are not foolproof investments, Paul acknowledges. He offers some important caveats for investors, regardless of whether they’re buying homes or apartments.

“It’s very important to stay close to home so you can watch the property,” he said. “Every time I’ve not done well on a deal, it’s been one that was too far away for me to keep my eye on it.”

Another tip: Have an on-site manager if you can afford it.

“An on-site manager can deflect 90% of the problems that would come to you,” Paul said, noting that this is another area in which apartments generally represent fewer headaches than houses.

“If you own a house, the tenant will call you for every little problem. We own 800 apartment units and 12 houses, and I have more hassles from the 12 houses than I do from the 800 apartment units.”

Despite the widely publicized apartment-buying binge of REITs, Paul and Bergh both say that private investors still account for many if not most of their transactions, especially the smaller deals.

Many of these investors prefer to own real estate directly, or at least more directly than they would by buying REIT stocks, they say.

Even syndicators--individuals or companies who specialize in finding apartment properties for sale and then forming investment partnerships to buy and manage them--are still around today, even though they fell out of favor after federal tax reform in 1986 eliminated some of their advantages.

The syndicator typically acts as general partner in buying and managing the building, with investors acting as limited partners who receive cash disbursements on a quarterly basis.

The limited partners exercise much less control over their properties than those who buy apartment buildings directly, but they do have some control over the fate of the building because they vote on major decisions such as whether to sell the property or roll it into a REIT.

A syndicate ordinarily forms a separate partnership for each property it buys, said Paul Allen, whose Laguna Hills-based Allen Properties owns about $35 million worth of apartment buildings through 34 partnerships formed since the company was established in 1978.

Allen said he and his brother Frank both invest in each of the partnerships and serve as general partners in each deal as well as property managers for the buildings. Investors are limited partners who typically sink from $10,000 to $100,000 into the partnership, in return receiving cash distributions that run about 7% to 10% of their investment, Allen said.

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Limited partnerships offer tax advantages because a portion of the property can be depreciated, Allen said, but “one downside is the lack of liquidity.” That’s one reason his company is looking into the possibility of rolling its portfolio into a REIT.

Paul’s firm focuses on deals too small to interest REITs but too large for mom-and-pop investors. Bergh, who markets buildings from eight units up to several hundred units in size, said most buyers for buildings under 100 units are still private investors.

Most of the sellers are private investors too, Bergh said. Many of the private owners have been wanting to sell for some time because they are getting older and want to take their profits while prices are up.

Many of the sellers bought buildings in the 1960s or ‘70s but missed out on the hot market in the ‘80s, then held on to the buildings through the ‘90s because they couldn’t get the price they wanted, she said.

“In many ways, it’s like the 1980s again. It’s a frenzy. There’s too much capital chasing too few deals,” Bergh said. “I have more buyers than I can keep track of.”

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Apartment Market Trends

Apartment submarkets in Southern California, first quarter of 1998:

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Avg. price Total Rank Submarket per unit transactions 1 South Orange County $84,619 6 2 Westside 84,395 26 3 West Hollywood 83,704 3 4 Ventura Boulevard Corridor 78,572 9 5 Glendale/Burbank/Pasadena 66,054 15 6 North Orange County 63,482 4 7 Central Orange County 62,500 8 8 West San Gabriel Valley 57,681 4 9 Mid-Wilshire 50,774 11 10 Upland/Ranch Cucamonga 47,692 1 11 Redlands/Loma Linda 46,543 1 12 East San Gabriel Valley 42,268 2 13 Temecula/Murrieta 41,071 1 14 Long Beach/Lakewood 40,385 1 15 Hollywood 38,177 11 16 Central Riverside 37,500 1 17 West San Fernando Valley 37,292 10 18 Coachella Valley 36,721 5 19 Van Nuys/North Hollywood 32,404 22 20 Northeast San Fernando Valley 31,914 4 21 Ontario/Montclair 31,782 2 22 Downtown Los Angeles 29,973 10 23 Mid-Cities 29,661 2 24 Fontana/Colton 28,614 2 25 Los Angeles Corridor 27,667 2 26 Riverside 25,108 8 27 Corona/Norco 22,258 1 28 South Bay North 20,536 1 29 San Bernardino 18,578 6

Sales vol., Rank in millions 1 $35.2 2 26.9 3 3.3 4 29.6 5 19.3 6 34.3 7 14.7 8 8.3 9 10.5 10 12.4 11 8.8 12 8.2 13 2.3 14 1.1 15 16.0 16 3.6 17 19.6 18 10.0 19 26.4 20 5.1 21 5.5 22 28.9 23 1.8 24 2.6 25 1.7 26 21.5 27 0.7 28 0.6 29 5.7

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Source: Marcus & Millichap