Feature
by Jim Forbes
As I sit here, the NASDAQ composite Index has dropped below 1,700 for the first time since October 1998, at barely 30 percent of its former high. San Francisco rents are tumbling with it.
My survey of median rents for market rate two-bedroom apartments indicates a serious decline since a peak of $3000 per month in October 2000. In the rental ads that appeared in the April 1 issue of the San Francisco Chronicle, the median rents were $2400, a 20 percent drop over the last six months or a loss of $100 per month. Since April 1998 when the median rent was $2000, there has been a rather bland increase of 20 percent, or less than 7 percent each year, if we strip away our recent roller coaster ride. We may discover that today’s rents will decline to the level they were when NASDAQ was last at 1,700.
If we compare our rents to inflation since April 1998, rents could go down an additional 7 percent and still be abreast of the cost of living increase since that time. This flattening of the rental market is not altogether unhealthy given how high rents were just a half year ago. Several times in the past this same phenomena has occurred when the market has needed a breather.
What does the market of the 1980s and 1990s, compared to this past year’s trends, indicate about the future? An analysis of the recessions of 1992-1994 reveals some interesting similarities as well as a few differences. First, rents in 1993 basically had been flat for six years without any double-digit market rate rent increases. This time the figure is not much above what it was only three years ago; although in each of these years there was an annual increase of 20 percent. The rent increases that preceded the 1987-1993 (9, 13, and 15 percent) flat period were more modest. Our more recent boom obviously reached a higher level than the one that last preceded a recession.
A similarity, though, can be found if we go back a little further in our rental history. Prior to the period of flat rent that began in 1986, rent had doubled in the seven years from 1979 to 1986. To contrast 1991 with 1998, the two-bedroom rent increased from $1,000 to $2,000. The same holds true for 1998 when a slowing down period began. What followed in 2000 was not typical and we should not include it in our calculations and comparisons. Consequently, we may assume further softening followed by three years of flatness ahead.
Another aspect of the prior recession could replay itself in the form of optimism. Rent hikes, starting in 1988 and spilling into 1990, had long since stopped but sale prices for apartment buildings continued their heavenly ascent. The reasons for this included the pressures of Hong Kong flight money as well as a case of selective denial in which we failed to accept the fact that rents were not going up anytime soon.
This ignorant optimism seems to be at play once again. Although certain sectors of real estate sales have slowed, there is still an upward spiral in bidding on apartment houses. To find a closing at less than $200 per square foot anywhere in the city is a challenge. This lunacy threshold used to be $100 per square foot as those of you who paid close attention in the late 1980s and early 1990s may remember.
A doubling of this cost value would make sense because rents and the cost of construction have doubled. However, many of the buildings bought or refinanced in the period from 1988 to 1990 were then lost to the lenders or sold for loan value a few years later when expenses (energy and scavenger) were not skyrocketing as they are today.
This time, investors may remember those good buys of the mid-1990s and repeat the earlier cycle. For those who bought, they will want more; for those who did not buy, they will want a piece of the real estate action this time. These decisions probably will generate demand that will keep prices over-inflated vis-à-vis rental value.
Look out and beware, however, for prices may repeat the decline evident in the 1990s, and perhaps worsen further. Lenders will run for cover, cash will once again be king and, if PG&E is still around, gas and electric rates may have as much to do with future vacancies in the Tenderloin as the lack of rental demand. Some of you may recall the Tenderloin in 1993 with studios available for $375 per month (today, parking costs that much). There were plenty of people who wanted to rent apartments but few had the jobs and the income to cover the rent. Up until five months ago, our unemployment rate was at the same level as our vacancy rate both were less than two percent. Now the vacancy rate is over two percent although it feels like five percent. According to federal estimates, the Bay Area's unemployment rate soon will match the nationwide March figure of 4.3 percent. In the beginning of the 1990s, unemployment was at 4.3 percent although San Francisco's rate hurdled into the high six percent range for the next few years after that.
Telecommunication stocks are a good example of how brutal the investment market can be when the economy dives downward. AT&T, as venerable a company as there once was, now trades at less than it did in 1997. Remember, San Francisco's apartment market could do the same. If we compare the rental market to Motorola, it could be worse. Motorola, a company with products everywhere and revenues over $30 billion, closed the day I wrote this article at their lowest level since 1993. Its market capitalization, including stock splits, is less than one times gross just as it is with Lucent and other companies. Imagine being able to buy a building for the price of the rent roll. In the recession of the 1990s, New York and other places experienced similar real estate downturns. It could happen here in our real estate market.
If San Francisco is the AT&T of rental markets, then rents are headed backwards another 33 percent. If we are Motorola, forget about it. Give your buildings back to the bank, because rents will be down 60 percent from today's rates. If our market imitates a Cisco or a Sun Microsystems market, then it is back three spaces to 1998, and rents decline another 18 percent. You know, in 1998 I was already screaming that rents were too high but I would eagerly accept 1998 values now. I sense we are headed that way.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the SF 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.