West Coast Apartment Investors Navigate Choppy Market & Regulatory Waters

It’s wave upon wave of challenges for West Coast apartment players as inflation and increased government regulation have followed the major capital market headwinds in testing investor strategy. The resulting reduced demand has caused multifamily cap rates to rise more in the last six months than they did over the prior 10 years, according to Jordan Carter, an EVP at the Portland, Oregon office of Kidder Mathews — the largest independent commercial real estate firm on the West Coast. Across the coast, similar stories are playing out.

“Interest rates are by far the 800-pound gorilla affecting transactions and the pricing of existing multifamily assets,” says Scott Rosenberg, SVP at the company’s El Segundo, California office.

David Nelson, Kidder Mathews Regional President of Brokerage for Northern California and Nevada, and Robin Ossenbeck, SVP in Los Angeles, both see property insurance rates as a substantial problem. Nelson notes that insurance costs become a sticking point for many transactions in certain markets, and Ossenbeck sees carriers shy away from buildings older than 1978.

LA’s Story

Los Angeles exhibits a mixed bag of multifamily market factors, including multiple regulatory influences. Rosenberg casts LA’s rent control measures as “a landlord antagonistic framework [that] has pushed more ‘would be active’ investors out of multifamily altogether, contributing to a chilling effect on demand.”

Despite subsidized low-income housing incentives shifting some investor and developer focus away from market-based product, Kidder Mathews Senior Associate David Evans reports that Downtown LA is experiencing a development boom while residential vacancies are increasing. This comes in an environment of increasing tension between state and local agencies regarding housing development issues such as accessory dwelling units (ADU).

“Los Angeles has significant overbuilding in the city limits especially in Koreatown, the westside, downtown, and Hollywood, with more units coming online this year than any year since the late 1980s,” Ossenbeck says. “This is causing increased concessions and vacancies with negative migration from the city.”

Investors must also cope with a ULA tax that imposes a new special transfer levy on residential and commercial real estate exceeding $5 million and has caused “a major slowdown in transactions,”, according to Eric Paulsen, Kidder Mathews Regional President of Brokerage for Southern California and Arizona Meanwhile, regional bank lenders in Southern California continue their retreat from the capital markets.

Balcony Views

As if multifamily owners weren’t already burdened enough, particularly in the LA area, the “balcony law” SB 721 will require them to inspect and, if necessary, repair balconies by 2025. Calling it not only expensive but “quite invasive,” Ossenbeck says replacing cantilever balconies in LA will run at least $50,000 per balcony.

“You may see an increased number of sales as owners choose to let the new buyer deal with the hassle,” says Paulsen. “And it will reduce the price investors are willing to pay if they have to do those retrofits. That’s a major issue if the exit price from their original underwriting is going to get lowered.”

“The balcony ordinance — along with new composting requirements, higher interest rates, and significant increases in insurance premiums adding to other operating expenses that have exploded since 2020 — will make replacing debt more challenging in 2024,” says Josh Luchs, EVP and Managing Director at Kidder Mathews’ San Fernando Valley office.

In Washington

While rent control continues to impact some areas in California, the Washington State prohibited rent control when they passed RCW 35.21.830 in 1981. In essence, landlords can raise rent as much as they want, as long as they comply with the appropriate notice period. While there have been multiple attempts to repeal this law, none have been successful.

However, challenges remain and should be monitored going forward. According to Kidder Mathews’ investment specialists Jay Bennett and Holly Yang in Bellevue, Washington, “Increased debt service costs continue to bring a headwind to multifamily markets. The Fed’s pause on interest rate hikes is welcomed, but we are in no way out of the woods yet. The uncertainty continues to bring pause to owners and buyers alike on when to pull the trigger.”

What’s Next?

High interest rates have apartment owners and investors keeping a close eye on maturing debt (or loans going adjustable rate) in the next 12 to 18 months. “Investors — both buyers and sellers — have been waiting for the Fed to start to reverse course and lower rates, and we should see that occur sometime in 2024,” says Nelson.

Evans points to February 2024 when LA residential price controls, which were frozen for almost four years, will allow a 4% rent increase. More so than rent control, Carter reports that Portland investors are watching local governments to see if they “put their money where their mouth is” regarding crime, homelessness, and graffiti problems.

Paulsen calls attention to “serious legislation” in the coming election year, including a tax ballot initiative that could help jeopardize Proposition 13, the 45-year-old California state amendment that keeps property taxes limited to 1% of assessed value.