Feature
by Jim Forbes
I think we’re facing an economic slowdown of sufficient proportions to rub the glow off the Bay Area real estate market with prices going down, not up. All those speculative purchases in the year 2000, and perhaps during 1999, appear unwise if not downright reckless. Yes, the bubble is bursting as I write this and you read this.
Crashing Market Rents
Applying a quick rental survey update as of February 25, I found
that the median asking rental rates for two bedrooms dropped almost
as fast as the NASDAQ composite on which our economy is so dependent.
From a peak last October, tenant seekers who use the Sunday Chronicle
to advertise their wares dropped their ambitions 8.3% in January
and another 8.3% in February. Depending on one’s perspective,
16.67% is either not much (since we are still up 19% since last
spring) or it is a whole bunch because on a desired 20% down deal,
it could mean you have already lost most of your equity.
The silver lining of rent control is that we rarely need to put 20% down and, if we did, it probably would not be based totally on market rents. Therefore, a 16% decline in market rents may mean an 8% decline in a property’s short-term potential income (this assumes really low rents have little probability of being increased since those tenants have few options but to stay put).
For example, a typical San Francisco apartment complex has no more than 30% of its units at or close to market rate at any one time. Thus, based on a constant multiplier, the 16 2/3% drop in market rents would mean only a 5% drop in value for that building. Five percent is not a number of concern although alone it could cause pain if figured on a 20% down payment — i.e., it would be 25% of the cash investment — an every day loss in the stock market but not a common one in real estate.
The multiplier usually does not remain constant. A seller always wants more for a building even when rents are far below potential. Thus, a building with 50% upside may sell at 13 times the gross income while one that is 20% below market rents might sell for an 11 GRM. The effect of this is magnified by more than the change in the value of the apartments at market rate. For example, assume a building has ten units with a gross income of $150,000 and nearly half that revenue comes from three units paying $2,000 per month. At the time of purchase, the gross potential income was $240,000 per year, a 60% upside over the actual rent.
Suddenly, in the current market, those $2,000 apartments are now worth $1,650, amounting to an annual drop of $12,600 in rent if all three tenants move out immediately or the units are renegotiated to market rate. In addition, this drop computes as a $42,000 a year drop in building market rent potential (16.67 percent times $2,000 a month per unit). Instead of a 60% upside, there is a 32% upside. This reduction in existing gross income can be multiplied at least once if not more. For discussion purposes, let’s say the market discounts the deal from 12 times gross to eleven. The value of the building dropped $150,000, from a previous $1,800,000 to $1,650,000, a drop of 8.3%, or about half the drop in market rents. If the discount were twice the gross, then the loss in value would be equal to the decline in market rents, or 16.67%.
If rents were to fall back to April 2000 levels, a strong possibility given our high-tech based economy, then the numbers get scary especially for those who bought between June and December of 2000 when market rents were highest. For instance, if someone purchased a building in October, rents at last April’s level would mean a 30% drop since close of escrow. Using the same GRM discount as in the example above, this translates as a market value loss of 15% or two times the gross. The buyer’s equity quickly becomes history, at least until the next recovery.
The PG&E Factor
I would expect by now everyone has felt the shocking pain of recent
PG&E gas bills. For us, it is eating away at our cash flow at
the same rate as a 5-6% vacancy factor. We might have operated our
buildings earlier at 35% expense ratio but now it is at 40%. Natural
gas prices in the Bay Area are the highest in the country. Why?
Suppliers think we can afford the increase (just as we do at the
gas pumps) because of the high rents we receive and the high value
of our real estate. Those in charge of energy understand the laws
of supply and demand whether it applies to our homes or our cars
and we, the consumers, have limited control over our demand.
The problem has been brewing since the summer when natural gas-fired power plants consumed the gas reserves for winter use. PG&E, as our local utility, suffers from an infrastructure that fails to bring us better natural gas prices and provides narrow pipelines that restrict storage capacity. The utility has no incentive to invest in improvements since it can charge customers the full amount. PG&E buys on the spot market without the benefit of long-term contracts that its brethren Southern California Gas has and, as a result, customers are paying nearly three times as much. Although prices have come down somewhat, they are still double what they were last summer and probably they will remain unchanged for the foreseeable future. The impact of these prices on property values of master-metered and steam-heated buildings is extremely significant.
If we apply a capitalization rate of 7% (that is divide a building’s net operating income before debt service by 7%), the value of a $1,000 per month increase in gas prices results in a $171,000 decline in property value. For a typical steam-heated 40-unit building, the drop in value could be double this amount, or as much as 5-10% of it’s previous value. I do not see much improvement until or unless we get a local utility company with the resources to buy and store sufficient natural gas to achieve the best price on the market. I would not be surprised if the Board of Realtors starts requiring special disclosure for buildings served by PG&E as it does for lead-based paint or asbestos.
What is the net result of these words of gloom? There will be a 13%-25% decline in property values, especially for larger buildings with steam heat, and rental rates will reflect a declining market. Ouch! To this financial decline, add the recent loss of capital improvement passthroughs and the potential for operating and maintenance limitations, and an uglier housing scene will be apparent in San Francisco.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the San Francisco Apartment Magazine. Jim Forbes is president of Urban Properties, a real estate investment and brokerage firm. He is a SFAA board member and the publisher of SF Property Report. He can be reached at 415-922-8998 or at his Web site at propnews.com © Copyright 2001.