27 Dec 2023

Decoding Commercial Real Estate

Category: Apartments, Multifamily Tags: los angeles

A Landlord’s Guide to Understanding the LA Multifamily Market

In the dynamic and ever-evolving multifamily landscape of Los Angeles’ commercial real estate market, understanding the intricacies can be both challenging and overwhelming for landlords. It’s not merely about owning property and collecting rent; it’s about knowing the trends, understanding the implications of demographic and economic shifts, identifying potential risks, and capitalizing on emerging opportunities. This is where this guide comes in, offering an essential toolkit for landlords seeking to thrive in this complex market. It sheds light on the market’s complexities, offering practical advice on how to navigate its many challenges, helping you maximize your property’s potential and generate remarkable returns.

Introduction

The LA Commercial Real Estate Landscape

Los Angeles is one of the l argest and most dynamic commercial real estate markets in the United States. The metro area has a population of over 13 million residents.

Key factors shaping the LA commercial real estate landscape include:

Strong population growth over the past decade drives demand for residential and retail space. LA County’s population increased by over 300,000 residents from 2010-2020, and by over 58,000 residents between 2020-2023.
A diversified economy spanning entertainment, technology, healthcare, logistics, and other key sectors provides a stable tenant base across office and industrial spaces.
High costs of living and housing shortages place pressure on residential rents and multifamily investment. The average apartment rent in LA County as of Q3 2023 is $2,742 per month.
Major infrastructure investments like the LAX airport modernization support the region’s role as a national and international hub.
Restrictive zoning and regulations that constrain new development, especially multifamily housing. Only 22% of LA residential land allows for multifamily housing.

Understanding Market Dynamics | Multifamily by the Numbers

Supply

Source: CoStar Group

Units Under Construction (past 12 months): 21,932 (2.2% of inventory)
Units Delivered (past 12 months): 11,588
Approximately 95% of the net units added in the past decade were in higher-end Class A communities, and the current construction pipeline is also predominantly focused on Class A projects.

Current Quarter	Units	Vacancy Rate
Class A	146,705	9.2%
Class B	220,484	4.5%
Class C	648,253	3.9%

Demand

Source: CoStar Group

The current vacancy rate is 4.9%, a 1% increase since last year.
Every submarket in L.A. County witnessed an increase in vacant units.
The median rent for a vacant unit has turned slightly negative in the Inland Empire, Orange County, and Ventura County, dropping by less than 2% in April from the previous year.
The decrease in apartment demand has led to property managers offering more concessions, with 23% of properties providing concessions over the summer of 2023.

Decoding Real Estate Cycles & Market Trends

On the heels of the COVID-19 pandemic, the commercial real estate market has seen both a bull and bear market. The economy experienced a sharp decline in March 2020, then quickly rebounded to reach new highs by mid-2022. But by 2023, the U.S. saw record inflation, causing concerns among investors and policymakers. In 2023, employment remains strong but there’s overarching fear and hesitation of a recession, conflicting views of market dynamics, record-high inflation (which has started to come down), and higher-than-average interest rates over the course of the last few years that have impacted commercial real estate.

Supply chain disruptions caused by global shutdowns sprouted a deep supply and demand imbalance while government aid rapidly increased consumer spending. Inflation reached a record high of 9.1 percent in June 2022.

Real estate is often one of the hardest hit asset types during a recession as property values decrease and debt becomes more expensive. Being a cyclical market, the effects of a recession can take months of fully come to fruition in the industry.

A recession’s effect on residential real estate is straightforward; incomes fall, and homeowners get behind in mortgage payments and, in turn, try to sell or go into foreclosure. Commercial real estate is more complex as values are reflected by net operating income (NOI). If tenants stop paying due to a lack of business or occupancy rises, NOI decreases, pushing property value down. In addition, capital becomes more expensive, and lenders become more selective. The tightening of lending standards and increased costs can make it difficult for commercial real estate developers and investors to obtain the financing needed to plant capital.

In the last major downturn from 2008-2011, The Los Angeles metro office vacancies surged from 10.4% to 17.8% while industrial vacancies went from 3.8% to 8.1%. Multifamily fundamentals held up better than other sectors. While Los Angeles remains vulnerable to recessions, its diversified job base and strong population growth could make this cycle less severe than past downturns. Proactive landlords will want to stress test their assets and strengthen their balance sheets to weather any storms ahead.

A Market With Challenges & Opportunities For Landlords

After years of growth, Los Angeles County’s population declined in 2021-2022, due in part to outbound migration. However, there are still opportunities for landlords in the area, driven by demand from key industries such as entertainment/media, tech, and healthcare. Los Angeles has over 128,000 people employed in digital media, and the city is a central hub for film and television production. The tech sector is also growing rapidly in Los Angeles, with companies like Google, Amazon, and Microsoft expanding their operations there.

Senior housing demand is also rising, as the population ages. The 65+ cohort in Los Angeles is expected to grow 45% from 2010 to 2030. This is driving the development of new senior housing communities, both independent living and assisted living. Residential demand is being boosted by international immigration and domestic migration from high-cost metros. Los Angeles is desirable for living due to its climate, job market, and cultural attractions. However, the city is also very expensive, and many people are struggling to afford housing. Logistics demand is surging with the expansion of e-commerce and the Ports of Los Angeles/Long Beach. Over 235 million square feet of industrial space was absorbed from 2012-2021.

Careful tracking of demographic and economic trends allows landlords to pinpoint emerging opportunities and risks across metro Los Angeles.

Property Types & Their Investment Potential

Class A

Vacancy Rate: 8.9%
Asking Rent Average: $3,220
Delivered Units: 521
Under Construction Units: 19,532

Class B

Vacancy Rate: 4.6%
Asking Rent Average: $2,335
Delivered Units: 32
Under Construction: 3,534

Class C

Vacancy Rate: 4.1%
Asking rent Average: $1,730
Delivered Units: 0
Under Construction Units: 494

1920’s Brick Buildings

Insurance costs for these properties are increasing.

Studios have been more valuable and increasing.

Value-Add

Value-add deals remain attractive if bought at the right basis, taking advantage of discounted Class B/C properties in need of light renovation. There is also an opportunity in converting office and retail sites to residential uses.

Overall, Class B/C multifamily and value-add deals appear the most compelling investments given Class A oversupply concerns.

Rent Control vs. Non-Rent Controlled

Rent regulation policies have evolved with the intention to create more affordable housing options and simultaneously protect tenants who live on a fixed or low-income, such as the elderly. Rent control is a law implemented by the government in which they control and regulate the amount a landlord can charge a tenant for rental housing. This policy prevents landlords from overcharging rent and protects tenants from eviction without just cause, such as late payments. It’s been proven that rental prices are rising faster than wages for moderate income jobs in the U.S. Rent control enables these families and the elderly who live on fixed incomes to live free of the concern from unexpected rent hikes.

Many believe that because rent control policies enforce rent ceilings and affect investor profit, it discourages new investments in rental housing. With rent ceilings instated in the policy plan, investors have less to spend on repairs, which can lead to housing deterioration, decrease in value, and neglected maintenance.

Local Zoning Laws & Their Implications

In Los Angeles, zoning restrictions have become a significant contributing factor to the affordability challenge in the city. These laws can impose limitations on the use of a property, making it difficult for developers to fully leverage their investments.

Height and density restrictions are another aspect of zoning laws that further compound the issue. These limitations can hinder the development of large, high-rise buildings in certain areas, limiting the development of multifamily apartments. Further, a recent study revealed that a significant 78% of residential land in the greater Los Angeles area is designated exclusively for the development of single-family houses. Such restrictions make it challenging to meet the growing housing demand, exacerbating the affordability crisis in the market.

The most high-profile of the city’s ballot measures, United to House L.A., also known as the “Mansion Tax” passed. Its aim is to fund affordable housing programs for tenants at risk of homelessness and slap a tax on high-priced real estate sales (4% to 5.5% tax on property transfers over $5M-$10M). The current city transfer tax on a $5 million asset is $22,500. The new measure creates an additional tax of $200,000. To put this into perspective, for a $10 million asset, the previous transfer tax of $45,000 will be inflated by an astounding $550,000 due to the new policy. Based on current property assessments, roughly 18,100 buildings could be impacted by Measure ULA.

Financial Analysis

ROI & Cap Rates

The 12-month sales volume for Los Angeles is $5.8 billion, lower than the historical average of $6.5 billion for multifamily assets. Further, the average transaction prices in the Los Angeles market have declined from a peak in Q2 2022, dropping from over $380,000 per unit to $316,815 per unit in Q4 2023. Some sellers are still holding out for the higher prices seen in early 2022, while buyers are anticipating a 10 to 20 percent discount compared to early 2022 pricing, due to the rise in debt costs. The recent implementation of additional transfer taxes has also put downward pressure on transaction volumes and asset values.

Average Cap Rate: 4.6%
Average Sale Price: $5,477,295
Vacancy At Sale: 6.4%
Time Since Sale: 6.1 Months

The Impact of Technology

How to Maximize NOI

Proptech tools can help LA landlords enhance NOI through:

Leasing automation to digitize paperwork and cut staff overhead
Revenue management systems to optimize rent pricing in real-time
Smart building sensors to track HVAC, lighting usage and identify energy savings
Remote property inspections via drones or video to reduce maintenance costs
AI chatbots to handle tenant queries and cut call volume

While proptech adoption remains low, landlords who embrace technology early can gain a competitive edge in maximizing their net cash flow.

Effective Leasing Strategies For Maximum Returns

To optimize leasing in today’s market, landlords should:

Lean on concessions like 1-2 months free rent to keep units filled
Offer flexible lease terms like 6-9 months to attract renters wary of long commitments
Update online listings frequently and highlight upgraded amenities to stand out
Incentivize current residents to refer their networks through referral bonus programs
Deploy dynamic pricing tools to target price-conscious renters in real time
Build strong social media and online reputation to reach digitally savvy renters

The days of simply putting out a ‘For Rent’ sign are long gone. Landlords now need nimble, tech-enabled marketing to attract qualified residents.

Regulations to Know For LA Multifamily

AB 1482: The passage of the California Tenant Protection Act of 2019 introduced rent control measures and placed limitations on rent increases for certain properties. This legislation aimed to enhance tenant protections and stabilize rental rates in the city.
SB 9: The permits the conversion of existing single-family homes into duplexes, potentially allowing up to four homes on parcels that currently have only one. It also allows single-family parcels to be subdivided into two lots, and a new two-unit building can be constructed on the newly formed lot.
ADU LAWS: Accessory Dwelling Unit laws have been revised and relaxed in California to encourage the development of accessory dwelling units, also known as granny flats or in-law units. These laws make it easier for owners to construct and rent out ADUs.
RENT CONTROL ORDINANCES: The Los Angeles County Rent Stabilization and Tenant Protections Ordinance (RSTPO) is a local law enacted to regulate rental properties and provide tenant stability. The ordinance limits annual rent increases, tying them to the Consumer Price Index (CPI) to ensure they are reasonable and in line with economic trends. The LA County Rent Stabilization Ordinance (RSO) also limits rent increases and provides eviction protections for most residential rental units in unincorporated areas. Rental units under the City of LA RSO have a rent freeze until January 31, 2024.
AB 309: The proposed bill establishes the California Housing Authority, a public entity focused on developing “social housing.” Social housing, which would be funded by the government, aims to provide housing for residents across all income levels.
SB 4: This bill proposes a $10 billion housing bond with a goal of funding affordable and supportive housing, including $5.25 billion for the Multifamily Housing Program, $1.75 billion for supportive housing, $1.5 billion for rental housing preservation, and more.
SB 440: The bill allows multiple local governments to form a regional housing authority. Its main objectives include raising and managing funds, as well as providing technical support, to facilitate affordable housing development at a regional level.
SB 555: This bill would establish The Stable Affordable Housing Act of 2023, which aims to develop social housing using a combination
of acquisition and new production strategies. The bill sets a target of adding 1.2 million units of social housing over the next ten years and 600,000 units within the next five years. Among these, at least 200,000 units are aimed at being affordable for extremely low- and low-income households.
SB 567: This bill, also known as the Homelessness Prevention Act, enhances housing stability for a larger number of renter households. The bill closes loopholes that have led to widespread abuse of no-fault just causes for eviction. It also broadens the scope of protected tenants and sets a more reasonable cap on allowable rent increases.
HB 1236: Washington state law that limits the grounds for eviction and protects tenants from being evicted without just cause.
ELLIS ACT: California law that allows landlords to evict tenants in order to take the units off the market for the purpose of moving in themselves, a close family member, or to rehabilitate the building.

Sustainability & Green Building Practices

To reduce their carbon footprint, leading LA landlords are:

Installing EV charging stations, solar panels, and other eco-upgrades
Seeking LEED/CalGreen certification for newly constructed properties
Upgrading HVAC and lighting systems to boost energy efficiency
Using sustainable materials like low-VOC paints and recycled content carpets
Adding green amenities like resident gardens, bike storage, and recycling areas

Sustainability investments can help attract eco-conscious residents while also reducing operating expenses over the long run.

Preparing for the Future of Los Angeles’s CRE Market

Looking ahead, LA Landlords should prepare for:

Slowing rent growth and elevated vacancies as new supply is absorbed
Value-add and lower-tier assets outperforming Class A product
Ongoing tenant migration to more affordable submarkets
Rising operating costs squeezing NOI if a recession hits
Select opportunities in converting obsolete retail and office sites
Demographic tailwinds from international migration and Echo Boomers

While economic uncertainty persists, LA’s strong population growth and resilient job market should buffer against major declines if a downturn hits. Savvy investors will remain disciplined, targeting deals with clear value-creation upside.