Published April 2001

Supply barriers help two investors turn a profit

I had known the seller for two years. She had bought the apartment complex about 15 years earlier from the original developer. My business partner and I had been managing it for her through our then-start-up property management company.

We liked the property. Mostly senior-aged tenants. Stable, good cash flow — definitely some upside in rents, we thought. When she approached us with the opportunity to buy, we jumped on it.

Over the next five years, we learned a great deal about investment real estate by making every mistake in the book. For us, though, an unexpected but fundamentally simple economic condition would bail us out in the end and turn the investment into a winner.

Soon after closing, we sent a letter to the tenants informing them of our planned rent increase the next month. It wasn’t received as we had expected. Half of the longtime tenants moved. They were almost all on fixed incomes, it turns out. Even though the market supported the rent we were asking, their particular incomes did not.

The carpets were 20 years old in some of the units that turned over. Then we discovered dry rot behind the tub walls when we started cleaning. We were upside down $15,000 in repair and maintenance costs before things settled down.

I remember the next lesson well. October 1992. The newspaper headlines read: “INTEREST RATES HIT 30-YEAR ALL-TIME LOW.”

Great news if you’re refinancing or applying for a purchase money loan, I thought. But we didn’t anticipate that our tenants — who now found buying a home affordable in the low-interest-rate climate — would move. The second half of the building emptied in the next six months.

It wasn’t over. The effect of low interest rates lasted longer than we anticipated. Rents in the market were flat. Tenants were buying homes in droves while rates remained low. Apartment owners everywhere were feeling the pain.

Once the market settled down and homebuyers reached a more natural balance with rentals, the apartment market started showing promise again.

It had been four rough years, but there were signs the economy overall was on a positive growth pattern.

With little or no development of new rental properties in the pipeline, investors, who were now bullish on purchasing apartment properties, began competing on price to acquire a position in the market. Rents kept rising, which fueled investor interest.

The Growth Management Act settled in about then, artificially restricting supply while demand kept growing.

Many developers simply couldn’t sustain themselves in the new growth-restrictive climate, sending another message to investors that to get into the game one had to buy existing product.

Cash flow on our complex was improving. Brokers began calling looking for listings.

We listed the property at a “high number,” and a buyer with time running out on his 1031 exchange bought it. After closing costs and payment of underlying debt, the investment proved an 18 percent average annual before-tax rate of return. The market bailed us out — and then some.

Real estate has a way of doing this, particularly in the Puget Sound region. Because of the unique barriers to entry here — some natural, some artificial — it takes time for the market to respond to demand. This creates value appreciation on existing product above that which investors would normally experience if supply barriers were not so high.

With water on one side, mountains on the other, only one major north/south freeway, salmon problems, the Growth Management Act and other factors, restrictions to supply here appear to be entrenched. Unless these supply barriers are lifted or softened, all signs point toward value appreciation in investment real estate anytime demand spikes up.

Tom Hoban is CEO of Coast Management Co., a property management company with offices in Everett, Bellevue, and Boise, Idaho. He can be reached by e-mail to tomhoban@coastmgt.com.

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