The multifamily sector of real estate, especially in Los Angeles, has experienced a sharp increase in prices over the last couple of years, primarily due to the demand from new investors and lower inventory. Many of these new investors have been first time investors looking for alternative investments outside of the volatile stock market. Some are just tired of not having any significant return from having their money in either the bank or in bonds. As new investors, many have not planned for some potentially significant pitfalls from investing in multifamily.
1. Rent Controlled Apartment Buildings
One of the major pitfalls of investing in Los Angeles multifamily is of course rent control. With the majority of the apartment buildings in Los Angeles falling under rent control, most investors do have a general understanding of what they might expect. For instance, they are unable to raise rents or unable to renew a rental agreement after the lease expiration. They also have to deal with biannual inspections and, of course, government mandated maximum rent increases. Unfortunately, many investors do not consider the possible long term effects of rent control.
2. Cost of Water
One of the biggest issues I see on the horizon is the cost of water. With almost every municipality issuing water rate increases, this will dramatically affect the bottom line of multifamily investors. The anticipated increase for every household is expected to be between $30-$50/month, not including any common area watering needs. The majority of buildings are on a master meter system. With this system, most landlords pay for 100% of the water costs. The cost to sub-meter each unit in a building can be as high as $2,500 per unit, as well as a monthly cost to monitor and send out invoices. Due to current rent control laws, this cost cannot be passed along to a tenant, nor can any increase in the water rates. This will have a tremendous negative impact in the bottom line of any investment.
3. Earthquake Retrofitting
Another issue is mandatory earthquake retrofitting. The city of Los Angeles recently passed a law about how much a landlord can recoup for mandatory retrofitting, and many other municipalities are considering similar laws. Earthquake retrofitting can cost upwards of $130,000 for wood frame, “soft story” buildings, and millions of dollars for concrete buildings. Landlords have up to 7 years to complete the mandatory retrofitting and all of the costs are supposed to be shared up to 50% by the tenants. In reality, the maximum percentage is almost never attained, because a landlord can only recoup these costs by raising the rent a maximum of $38 per month for a 10 year period. Also, this rent increase would go towards offsetting any interest on a loan a landlord would need to get to pay for the retrofitting.
4. Long-Term Expenses
A pitfall that seems obvious, but still a big mistake made by many new investors, is not preparing or anticipating for major capital expenditures or replacements. When reviewing expenses, many new investors do not take into account the costs they will occur later in the investment's life, such as the cost to repaint the exterior or the cost to replace a roof. Most seasoned investors try to take this into account by putting a replacement reserve as part of their expenses. This is typically anywhere from 3-5% of the gross income, depending on the amount of units, age of the structure, and age of the major components.
When you take a step back and look at the multifamily market for investing in Los Angeles, and take into account water rate increases, earthquake retrofitting, capital repairs and caps on rent for rent control apartments, many first time investors who made their investments expecting a return actually find themselves in a money pit. What I would advise any investor looking at investing commercial real estate is to not only look at the current investment, but also anticipate its needs for the future. Also, if you are looking to invest in multifamily as an alternative to the stock market, or interest income from the bank, take a look at other alternative investments, such as retail, office buildings, industrial, and single tenant NNN properties. Many of these asset classes have higher returns and potentially less risk.