This post first appeared in: Cirios Trends – Special Edition: The Year Ahead
While most of the positive press in 2010 surrounded the single family home market, perhaps no segment fared as well last year as apartments. Investors piled into multi-family properties for a host of reasons, which leaves the sector at a critical crossroads for 2011.
First, a quick tour of last year’s data. According to Integra Realty Resources 2011 IRR-Viewpoint, the multi-family sector is typically the first to turn around after a recession, and 2010 was no different. Integra saw 81% of US markets recover or begin an expansionary phase, compared to just 9% in 2009. Vacancy rates dropped dramatically, a finding echoed by REIS: Nationwide vacancies dropped to 7.1% in Q3 of last year.
A major factor pushing down vacancies was a snap back from the massive demographic upheaval of the Great Recession. According to Marcus and Millichap, between 2005-2009, the number of 18-34 year-olds living at home increased by 2.2 million, the highest level recorded in the past 25 years. Since this demographic is the highest population of renters, vacancies skyrocketed as the economy soured.
But vacancies started dwindling as the economy slowly got back on track. Call it pent-up demand to move out of mom’s basement: As young adults began to find jobs (or became more hopeful they would do so soon), they moved into their own places in droves. Further, the housing market’s dramatic collapse coupled with tightening mortgage guidelines is forcing many young people to delay the home buying decision for more clarity in the market’s future.
Meanwhile, falling vacancies and an influx of investor cash pushed down capitalization rates to levels not seen since before the crash. During the early stages of the downturn, investors raised huge pools of cash to buy up distressed commercial properties as banks foreclosed on troubled borrowers and pushed the buildings out to market. But as Washington encouraged lenders to extend loans and modify terms, the flood of distressed properties never came.
Marcus and Millichap noted that the pendulum has swung full circle, and that 2010 exhibited a flight to quality trend, as investors focused on geographic markets with strong liquidity characteristics and resilient economies. New York City, Washington DC and San Francisco have been the beneficiaries of investor money seeking high quality, cash flowing assets. Cap rates, as a result, have compressed, leading some observes to wonder if the apartment market has gotten ahead of itself.
Here in San Francisco, there has been a marked change in the rental market just in the past six months. Gone are the days where tenants could negotiate a lower rent or get a couple months free. Back are the days where multiple applicants are common and the most pro-active prospects show up with deposit checks and completed applications in hand. Rents have risen in kind, as employers like Twitter, Salesforce.com, Zynga, Trulia and others are doing their part to repair the battered Bay Area employment market.
A second trend, which has been noted both nationwide and locally, is the divergence between high end and mid-low end buildings. Just last week, the popular economic blog Calculated Risk noted “the apartment market has bifurcated. Upper half of apartments are improving, regardless of geography. Lower half are struggling.” This echoes Marcus and Millichap’s view that there is a flight to quality ongoing.
So where are the opportunities, if big players are snatching up all the “high quality” properties and banks are delaying the flushing of distressed assets onto the market? The answer, in our view, lies somewhere in between.
As anyone who has spent considerable time as a renter can tell you, landlord quality varies widely, if not wildly. Often, owners of small buildings (duplexes, triplexes, etc) can offer high touch, personal service, resulting in a good tenant experience. On the other end of the spectrum, large institutional landlords may be impersonal, but generally their service adheres to a reasonably acceptable level of quality. Meanwhile, there is a middle band of properties that lie somewhere beyond the scope of the small-time landlord but below the radar of the institutional owner. Typically in the 5-30 unit range, these buildings are often older, landlords less pro-active and amenities lacking. Low rents can be found, but tenants likely have to settle for outdated kitchens, old appliances and fairly mediocre living conditions.
This is particularly true here in the Bay Area, where large numbers of such buildings were constructed during the 1950s and ‘60s. Many of these properties have been owned by the same individual, family or small investment collective for decades and haven’t been updated since Reagan was President, or before.
Rents are low, systems are out of date and the properties in general are in need of some love. The opportunity exists for savvy buyers to come in, make smart improvements, raise rents, lower operating costs and dramatically increase the value of the property. Couple this straightforward, time-tested investment strategy with downtown redevelopments ongoing in cities like San Mateo, San Carlos, Redwood City and Sunnyvale and you have a recipe for opportunity.
Of course, such properties are scarce and sellers often unwilling to bring prices down to where it makes sense for an investor. Which begs the question, where are the real sellers and will they finally come out of the woodwork in 2011?