This article was posted on Saturday, Feb 01, 2020

Many of the same barriers to entry that are used to choose promising stocks can also be applied to help select auspicious apartment buildings. The elements are the same-but-different in the way that middle C is the same note whether played on the oboe or the cello, but the sound is not the same.  The advantage to the buyer/owner is that buildings with appropriate barriers to entry are uneconomical to duplicate. That limits direct competition. As a simple example, consider that years ago, when land was cheap, a developer could build a few units on a large site and still have a satisfactory cash flow. That was then. Now is now and now, not many people would buy a 42 unit site and limit their improvements to six units. It would be economically disastrous.

High barrier to entry buildings often (not always, but often) benefit from (a) higher rents; (b) shorter vacancies; (c) expensive purchase prices, and (d) high resale prices.

The rents are higher because (example) there are no other three bedroom units available in this well regarded school district, and the prospective tenant has two boys, three girls, and one whose pronouns are pending. 

Vacancies are shorter because a family that needs two bedrooms can rent a three-bedroom and be quite pleased, but the reverse is not true. If you need three bedrooms, you need three bedrooms.

Purchase prices are higher because the capitalized value of the property’s (higher) net operating income is greater, and the NOI is a fundamental determinant of value. The subsequent resale price would be higher for the same reason.

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Intangibles:  Some cities have pre-war (built before 1939) buildings with architectural details not often found in post-war buildings. The rooms and hallways are larger, ceilings higher, wainscoting and crown moldings more prevalent, and wooden floors, often in a herringbone or parquet pattern, are common. These features draw a special sort of (usually) desirable tenant. As an example, the Drake hotel (now the 432 Park Avenue condominiums) was known to host silent film actress Lillian Gish, Frank Sinatra, Muhammad Ali, Judy Garland, and Jimi Hendrix. A series of guests like these, over time, create a brand image not inconsistent with patents or copyrights. There’s a reason product managers seek well-known people to be their spokesmen.

Economies of Scale:  Larger apartment buildings often have a smaller expense ratio than the five-unit building down the street largely because the denominator is greater. Management costs are supported by (example) 100 apartment units rather than five. The larger building can support a full time maintenance crew at (example) $15 / man-hour rather than piecing repairs out at (example) a $50 arrival fee plus $78 / hour (including driving time). One large roof is usually cheaper to replace than 20 dinky ones.

Switching Costs:  Moving from an apartment in a small amenity-free building to another similar building across town is a mere trifle. People are seen doing this every weekend: the rent-a-truck parked in the red zone, loading doors open and boxes stacked on the verge. People move for the flimsiest of reasons:  “I’ve been here too long and just want a change”, Sheila explains, or “The guy that just moved into the apartment downstairs smokes and the reek floats into my unit and makes my sweaters smell bad”, or perhaps “My dog has the same birthday as her dog.”

Moving from a larger project with multiple amenities means giving up the amenities. The larger building has two pools (one lap-pool for the adults and one kiddy-pool), a barbeque patio, a concierge that will accept her Amazon packages, and a gym that almost nobody uses. The barbeque area was Sheila’s favorite. That’s where she would plan her weekend ambushes. On Sundays she’d make a barbeque and have an ice chest of chilled craft beers on the table while she cooked chicken or something. Any guy that wandered over was met with “The beers are cold, the chicken is almost done, but my sister and her boyfriend just called to say they won’t be coming. All this food will just go to waste!” She’s met a lot of guys while trolling thusly.  

That’s the kind of amenity-rich complex Sheila likes. If she moves, she’ll miss those Sundays. Some of them were fruitful.

Network Effects:  Network effects, from the real estate perspective, are reflected in high WalkScores. To put this into perspective, consider for a moment a place that does not benefit from the network effect: Bieber, CA (pop 120 or 312, depending on whom you believe. Old Uncle Winesap used to rent a room in Bieber, above where the Elk’s Lodge used to be. He was a cautious man with various medical issues and had to limit his excitement, but Bieber (population 216, taking the average) was too dull even for him and he soon moved. He never thought of it as a lack of network effects, he just knew that he would rather go back to his first wife than stomach the boredom anymore. Anything”, Uncle Winesap thought, “even going back with Ellen, would be better than this!”

Had Uncle Winesap found lodgings in one of the amenity-rich projects built by Avalon Bay (NYSE: AVB) or Equity Residential (NYSE: EQR), he would probably not wished to leave. Both companies locate their assets where the commercial demographics are superior (e.g., a market area with more people, more money, and more things to do).  While boredom in Bieber was inevitable, in an AVB or EQR building, boredom is a choice. 

The network effect, as applied in real estate, is also a type of branding. Once a person has experienced an amenitized apartment project run by service professionals, it’s really hard for him to settle for something less. Just as a hungry person will eat in a strange McDonald’s without a second thought, it is not unusual for a person leaving an Avalon Bay community in Boston to have pre-leased an Avalon Bay unit, sight unseen, across the country in San Francisco.

Rent enhancing amenities are often on-site, but do not have to be. A building could certainly benefit high WalkScores, but it can also benefit from a doggy-bath sink in the laundry room.

Limited Market:  This is best considered in the context of scarcity. Three-bedroom units within a highly ranked school system are likely to have materially higher rents than two-bedrooms in a meh! school district. Items of scarcity are defined as beneficia that are rare to the area but that speak to certain people. 

Not all scarce items are equally important. Some are relatively easy to acquire. Being easy to acquire, they are not all that important. Think of a parking lot large enough for 16 cars, but striped for 11. Easy peasy. 

The important scarce items are the ones most difficult to change. These are frequently (but not always) related to things outside the building site, simply because the owner has no control over property that is not his. As we’ve discussed, some of these might be a high walk score (see, access to a great school system, a nearby public dog park, convenience to major employers and / or public transportation, proximity to hospitals, walking distance to college or university, or low traffic street. These are all important off-site amenities that might motivate a tenant to pay a little higher rent or to stay a little longer.

Separately from the site, there is also the improvement itself. What desirable thing does the building offer that is hard to find in the local market? It might be three-bedroom units, or a separate dining room, a fireplace (even if artificial), northern light, garages, or upscale finishes (wood floors rather than laminate, etc.),  opening windows for natural ventilation, a balcony or patio suitable for company, or even soundproofed units. Each of these items (and more will occur to the reader) might not be common to the area and would be a reason for the right tenant to lease that particular unit.

If it’s true that units with desirable site or improvement characteristics can reasonably expect to generate excess income (two forms of excess income are: higher than normal rents or fewer / shorter vacancies), then a property with two or more pleasing but rare features might be expected to do even better. It’s synergism. When two or more desirata are simultaneously present, well, that can really embiggenate rents. 

When reflecting on the best way to market certain units, consider some random difficulties a prospective renter may have. If she’s elderly and no longer drives, would units close to public transportation be desirable, maybe even desirable enough to pay extra for? How about a couple with a boy and a girl in elementary school? A three bedroom apartment in a great school district means the parents don’t have to budget for two private school tuitions. It’s not just couples with children that might be attracted to a three-bedroom unit. What about three college girls that don’t want to live on campus anymore? Or nurses from the nearby hospital working different shifts? Is it reasonable to suggest that a hipster might want to live in a high WalkScore community? A watercolorist, even an amateur photographer may appreciate a unit that faces north for the muted light created. 

It has been a long time since it’s been necessary to actually market apartment units. Often, they’ve sort of rented themselves with minimal management effort. At the same time values of apartment buildings have increased faster than their income justified. In an effort to rationalize the higher prices, rents have recently pushed towards the aspirational. Consequently, units that used to fill quickly now linger vacant, sometimes for several months. In those cases it might be appropriate to root around and discover what there is about the building or its location that’s rare and consider the sort of tenant might find that trait desirable. With a few covetable features and a little marketing – emphasis on marketing – units can rent so quickly, and be vacant so seldom, that an owner might begin to think that apartments are still the simple business they used to be.

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].