Economic Outlook for Apartment Buildings in Santa Monica: Supply and Demand
By Rosario Perry, Esq.

The Number One reoccurring question for apartment building owners is “How good is my investment?” This question arises time and time again as owners are asking themselves, “Should I keep my Santa Monica apartment building or sell it?” Another way to put the question is “Have I had enough problems, should I give up and move on to another city or another type of investment?”

The three criteria (or goals) for a good investment are: (1) security (2) appreciation in value of the investment; and, (3) rate of return on the invested money (cash on cash). Let’s analyze these three goals.

First, there is security. Clearly, a Santa Monica Apartment Building (hereinafter “SMAB”) is secure in many important ways. No one is going to steal your investment from you. You have title insurance to protect your ownership interest, you have liability and fire insurance to protect against loss and lawsuits, and you have the ability to drive by your investment each and every day to see that it is there, and that it is being well maintained. All too often people invest in far away real estate sites, different types of real estate, or stocks and bonds because the apparent rate of return is higher or the management is less demanding. We have seen what has happened to those unlucky enough to have gotten into a Ponzi investment scheme (such as Bernie Madeoff’s). Clearly safety is the primary consideration for any investor, and owning a local income producing property can’t get much safer.

Second, there is appreciation in value. Traditionally SMAB have had good, strong, long term appreciation in value. What gives an apartment building its value is primarily the income from the property. Income is generated from residential rents, which in turn are primarily controlled by supply and demand. Supply and demand means, how many apartment units are available for rent and how many prospective tenants are there who want to rent these units. In a normal market the scarcity of units in Santa Monica has driven rental rates for apartment upwards. Ever since January 1, 1999 a vacancy allows an owner to raise the rent and change the amenities on that vacancy without restriction. This of course has generated large increases in the gross rental income of the buildings, and has increased net profit. The 2007 Rent Control Board study has shown that the average rents have increased 8% to 9% per year on vacancies from January 1999 through December 2007. Therefore, there is an historically strong rental demand which supports continuing appreciation in value.

Third, there is return on invested money. This return is greatly influenced by gross rents. Today, many good brokers will present SMAB for sale by calculating what interest rate the buyer will obtain on the buyer’s invested cash. Remember that not all buildings are purchased for all cash. Most SMAB are purchased with a mortgage. The normal evaluation of a building is the Net Operating Income approach (“NOI”) but this figure is based upon a 100% cash payment for the building. Thus the NOI skews the actual Cash on Cash return of the buyer’ invested down payment. What is more important than NOI is what you will obtain as a return on your cash down payment after considering the cost of the mortgage you can obtain. This of course requires the buyer to figure out how much of a mortgage the buyer can qualify for (obtain or wishes to obtain). The interest rate figure is called “cash on cash” and has been the most accurate and measured way to analyze an investment for the specific buyer.

What we wish to concentrate on in this article concerns the second factor in our investment formula, appreciation in value. The primary factor within the Second Factor is of course supply and demand. Supply and demand is a two part equation. First there is “supply” and all the social, economic, and political forces considerations which interrelate in helping or hindering new and existing rental housing in our city. The Second is “demand” which is controlled by different social, economic, and political forces.

SUPPLY
One would think that if there is a demand for more housing in SM, that more housing would be built in SM. That presumption ignores SMRR (Santa Monica For Renters Rights political party). We all know who SMRR is, but for those that are new to the party, SMRR is a political party founded in approximately 1978 upon a platform of renters’ rights and strong rent control laws and no growth policies. SMRR has dominated and controlled SM politics and the SM City Council since 1980. SMRR’s theory is that to preserve rent control in SM, there has to be an end to demolition of existing apartment buildings in the city. When existing apartment buildings are demolished, SMRR voters and supporters are evicted and moved out of the city. SMRR loses votes. If SMRR loses too many voters, SMRR will lose their absolute control over city politics. Thus throughout the years, SMRR has gradually but consistently changed all the laws to inhibit the demolition of existing apartment buildings. The primary way SMRR has achieved its goals is to reduce the density for new construction. Thus if an owner were lucky enough to be able to obtain an empty lot to build upon, the number of units that an owner could build on a lot is about 1/3rd of the number of units which could have been built in 1977. This tremendous reduction in the number of units that can be built, of course, discourages (and in many instances stops) an owner from demolishing an existing building to build a new building. For many years, the work around for this reduction in density was the construction of condominiums instead of apartments. This of course increased the loss of rental units, and increased the demand for rental units, since rental units were replaced with ownership units. SMRR even though creating this reduction in rental housing, disclaimed any responsibility for it, and pointed to the losses in rental housing as additional grounds to support even stricter rent control regulation. Something in the character of George Orwell’s Animal Farm.

SMRR wasn’t content on down zoning alone. SMRR brought in bureaucrats to work in the Building and Safety department of the city. Pedantic-ism at its worst. This new breed of bureaucrat were (and still are) extremely disruptive to the normal building cycle. Their attitude is to impede, obstruct, complicate, and stop any and all residential building within the city. They make obtaining a permit an ordeal. They make the actual construction process a nightmare. And they make finalizing a building after it is done, a lawsuit. For instance, the city goes so far as to send out different building inspectors from time to time, on the same project, who each contradict the last inspectors change directives. Inspector one comes to the job site and tells the owner to install 1” braces each 10 feet in the floor. Inspector two then comes out after the work is done, and says it should be 2” thick braces not 1” think. Inspector 2 then orders the owner to remove the 1” and replace with the 2” braces. Inspector three then comes out when the work has been redone, and states the braces should be 3” and to remove the 2” and replace with the 3” braces. The owner can either file appeals, which will delay the project for months and months, or simply comply with all the silliness. In either way, the owner is behind time, spends more money on the project than budgeted, and sours on building within the City. This has lead to Santa Monica obtaining the reputation in the county as the worst city to build in. Many contractors will not build in Santa Monica at all, and may contractors who do build within the city surcharge an additional 30% over what they would charge for a similar building in another city. This is what we call the one-two punch. First, reduction in density, then when the construction finally does start, unreasonable inspection and delay.

Decreased Supply
It is no mystery then that there are not many owners building new apartment buildings within our city. What about existing apartment buildings? Are they being reduced in number? Well in 1979 (just prior to rent control coming to SM) there were approximately 34,000 rental residential units. Today there are about 26,500 to 27,278 residential rental units registered with the Board. But the existence of these units does not mean they are available for rent (and that they are part of the rental pool). There are a number of apartment buildings that are either being Ellised (under Gov. Code 7060 et.seq.) and converted into family homes or extended family compounds, or converted without the Ellising into family homes and compounds. Thus while these units might be technically registered with Rent Control they are not part of the residential rental stock. The Rent Control Board issues an Ellis report each year. The report issued in 2008 shows what the use of a property has been put to after being Ellised. Based on the report, we can see that since 1986, 30% of all Ellised properties are developed into new condominiums and 40% are being used for family compounds. The total number of units Ellised since Ellis came into law in 1986 has been approximately 2,000. Thus there has been a consistent loss of rental units, (which is in effect, a negative supply). This loss of supply increases rents.

Another important factor which increases rents is the number of rental units that have obtained at least one Costa Hawkins increase to market rent. Based on the Board study as of December 31, 2007, there have been only 14,672 units which have gotten one market rate increase since January 1, 1999, and 12,606 units which have NOT gotten a rent increase at all. Thus approximately 54% of the rented units in SM building have gotten one increase to market, but 46% of the units have historically low rents from a time period where there was no vacancy decontrol. When buying a building, one should not only look at the gross rental income, but at each units rent as well. What is the probability that the tenant in the unit with historically low rents will be leaving? What will the rent be after a vacancy is created? What is the time frame as to when the historically low rents will be going to market? This will dramatically increase gross rental income in the future. If a proposed building has half of its units at historically low rents and thus the building’s gross income can be increased by 50% upon vacancy of these units, that building must be looked at much differently than if the building had no historically low rents at all.

What we have been seeing historically is that the number and thus the percentage of units obtaining their first market rate rental increase in each year, has decreased for each year since 1999. The numbers are as follows: in 1999 there were 3,899 units obtaining market rate increase for the first time; in 2000 there were 2,462 units for the first time; in 2001 there were 2083 units for the first time for the first time; in 2002 there were 1,665 units for the first time; in 2003 there were 1,386 units for the first time; in 2004 there were 1,131 units for the first time; in 2005 there were 893 for the first time; in 2006 there were 670 units for the first time; and in 2007 there were 483 units for the first time. The Board has not published their figures for the year 2008. However, as the historically low rent tenant population ages, the facts will be that many of these remaining tenants (who make up the 46% of the rental market) will be giving up residency for one reason or another. In other words, while the March to Market Rents has been slowed from year to year, there may be a spike in units turned over in the near future. Think about this, of the approximate 14,672 units which have not gone to market rent, many of these tenants have lived there since before 1979. It has been almost 30 years since 1979. A further study needs to be done as to the actual age of the historically low rent tenants, but it can be safely assumed that at least a third (say 5,000) of the remaining 14,672 units will be turned over in the next 5 or so years.

Governmental Interference with Supply
Our final factor is governmental interference with the supply of new residential units. With all the talk about global warming, water shortages and old fashion conservation, it is no surprise that the state and federal government have passed numerous laws which burden new construction. There are additional requirements for extended studies and reports for larger residential projects, which delay construction by years, and in some cases which defeat the projects altogether. Many proposed projects have been turned down because local residents’ opposition to increased density and traffic (a political decision which the state courts do not overturn).

The federal courts have gotten into the picture as well. Los Angeles’ ability to obtain state water from the Sacramento Delta has been greatly restricted because (as the Federal Court has found) taking too much water from the Delta endangers a fish called the “smelt.” Has anyone ever eaten a smelt? State courts are requiring more detailed studies about water usage and housing construction. S.B. 610 and S.B. 221 (passed in 2001) require “water assessments” for all new large housing projects. The future of the water sources must be analyzed. This is so much mumbo jumbo, however, these studies requirements delay or defeat projects. S.B. 221 (Gov. Code 66455.3 and 66473.7) require the local agency to obtain from the water district written guarantees that there will be enough water for a proposed project for the next 20 years. (Is that with or without global warming we may ask?). Then comes California State law S. B. 375 (2008) which attempts to limit greenhouse gas emissions by requiring (among other things) a study of what effect large housing projects will have on production of gas emissions. Of course this law requires a cooperation between local, regional, and state bureaucracies, in the review and planning stages. Multi state bodies must prepare and adopt criteria to achieve these goals. It appears that communities will be restricted in building based upon the current amount of traffic they have. This seems counter productive for housing needs. The statute wants “smart growth” whatever that means. However, it is clear that the State expects its population to grow from 29 million (as of 1990) to 45 million (as of 2020) to 60 million (as of 2050). The goal of this state law is to reduce the rate of emissions per person to the same rate as that of a citizen living in Columbia, South America. That is low indeed. What this means of course is that all new housing construction is going to be negatively impacted while these legislatively imposed studies and organizational meetings take place (and thereafter, when they get adopted as well). Not only must an owner go before the local planning commission to get approval for the project, now regional and state agencies will have to be consulted and convinced that the proposed project meets all sorts of vague criteria. Well, the handwriting is on the wall. Population growth is expanding, housing production is decreasing on all levels (state, regional, and local). There will be more and more people chasing fewer and fewer rental units, especially in cities such as Santa Monica. Supply is going down, and demand is going up.

DEMAND SIDE
With apologies to President Reagan, demand-side economics works in Santa Monica as well as anywhere in the State. Santa Monica, with its wonderfully funded grade schools, and overly funded police and fire departments, libraries, parks, and its fine restaurants, clothing stores, coffee shops, Montana separation of rich and poor, all strike a fabulous balance for all. Most importantly is safety. The city of Los Angeles is being hammered financially, whereas the city of Santa Monica needs to burn 10 tons of Fifty-Dollar bills per week (or they do, whether they need to or not). Where the City of Los Angeles is pulling hundreds of police officers from West Los Angeles area, to move to the downtown and East Los Angeles areas (because they cannot afford to hire more new officers) Santa Monica has no need to do so. Santa Monica is seen (as it is) the safe city. The city where people can walk the streets without fear of shootings. This means more and more Los Angeles residents want to move to Santa Monica. These long term trends will continue to add to the demand side of the equation, pushing rents in Santa Monica higher than rents for comparable buildings in West Los Angeles and surrounding areas.

Conclusion
Well, we took a lot of paper to state the obvious. Santa Monica apartment buildings are safe investments, which also have strong long term economic appreciation. We think you should seriously reconsider any urge to sell. Overall, the factors that drive SMRR to limit production of new housing create an artificial shortage of rental housing, and that shortage should last for many years to come. Seen in this light, SMRR is the HP strongest economic supporter. If the HP tried to conspire to stop production of new housing, there would be no end to the bad press and government investigations. When SMRR and the City Council do it, it’s just good government. Our hats off to SMRR– may they keep the supply low and demand high forever. In future articles, we want to share with you the various factors and laws you should look at in attempting to place a value on a proposed apartment building. Many times a building will justify a larger purchase price than one would think, for the long term rewards it promises. Knowing these factors as well as the negative factors that can exist, will hopefully help you decide what to pay for an apartment building and at what price to sell an apartment building.