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LOS ANGELES-Sales prices for apartment buildings in Los Angeles will begin to flatten or decline by the end of this year as rising interest rates push cap rates higher, according to a financial analysis by two apartment brokers. Dave Casper and Karoline Sauls of Hendricks & Partners, who specialize in the L.A. market, tell GlobeSt.com that they expect cap rates to rise by approximately 50 basis points in response to interest rates that will be nearly a full percentage point higher at the end of this year than they were at the end of 2005.

With cap rates at record lows and with current interest rates already puting the squeeze on cash flow from apartment deals, Sauls and Casper say, the cost of borrowing money will exceed current cap rates by approximately 60 basis points by the end of the year. Even with the solid rent growth that they expect in Los Angeles, they say that prices will need to flatten or come down to compensate for the difference.

“What we’re saying is that the market indicators, if they follow logic, suggest that a change is coming to the market,” Sauls tells GlobeSt.com. “We’re not saying that prices have dropped or that we’re in the middle of a major connection, but we’re saying that there will need to be a correction.”

The Casper and Sauls analysis foresees cap rates rising to about 5.85% overall in Los Angeles by the end of the year, which would be up from approximately 5.35% at the end of 2005. Rates are expected to shift the same 50 basis points in the higher-priced submarkets like Hollywood, Koreatown and the Westside, moving up to 5.25% from 4.75%.

Since buyers drive the market, Casper points out, sellers will need to change their expectations in order to attract buyers, who simply will not be able to pay today’s cap rates in an environment of higher interest rates.

Casper explains the projected decline in values: “With cap rates moving up 50 basis points by the end of the year, a property would suffer a 4.1% loss in value, even with 6% rent growth from day one,” he says. The 4.1% loss in value is a conservative calculation, Casper says, because, “Nobody gets 6% from day one.”

Sauls notes that some of the more sophisticated apartment owners are already making moves in anticipation of the cap rate shift and subsequent expected decline in values. “They tell us that they are going to cull out the properties that they had planned to sell over the next three years and that they are going to put them on the market now,” Sauls says. “Their thinking is that the price they can get now is higher than anything they are likely to get for a while.”

Smaller, mom-and-pop investors are less aware of the market shift and have not yet realized that buyers “are going to be reevaluating how they underwrite their purchases,” Sauls says. She and Casper are advising these smaller investors that if their plans call for selling any time in the next couple of years, their properties are likely to command higher prices sooner rather than later.

The financial analysis by Casper and Sauls is “pretty conservative,” Casper says. “It doesn’t hit the argument as hard as it potentially could,” Casper tells GlobeSt.com. “But even in our conservative analysis, the 6% annual rent growth that we’ve been getting in Los Angeles would not be enough to compensate for the cap rate shift that we’re envisioning,” he says.

Casper and Sauls are being conservative in their outlook partly because there are a number of mitigating factors in the L.A. market. “There is so much positive buzz going on about Los Angeles that it may temper some of the price adjustments that we are talking about,” Sauls says.

Casper also makes the point that the cap rate shift is likely to have less impact on the class A properties that the big institutional investors acquire in unleveraged deals. On the other hand, he says that institutional players who have been relying on two- to three-year LIBOR-based acquisition and rehab debt, “have definitely pulled out of the market.”

Casper adds, “We have talked to a number of smaller owners in the 20-unit to 100-unit range that are no longer hunting in this market because they can’t get the cash flows they need, especially on properties under rent control.” He and Sauls already see properties remaining on the market longer than they previously did, with some listings expiring and some sellers beginning to reduce prices.

The two Hendricks & Partners brokers say they’re not trying to present a gloomy view of the L.A. multifamily market. Apartments here still represent a good investment, they say, and they are especially optimistic about submarkets like West L.A., Hollywood and Koreatown. Nonetheless, they foresee a slowing in the flow of deals unless prices adjust to the coming new realities of the market.

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