Ten
by Jim Forbes
With an extensive supply of vacant apartments to watch over, the ebb and flow of the rental market is more obvious to me than ever. Actually, the term “ebb and flow” sounds too organized, indicating there is some logic to the market. There is no logic to this market. The factors that influence tenant demand these days seem as fickle as the causes for stock price changes in our once dear stock market.
While holidays, school years and weather have always played a part in the frequency of our showings, today there are no indicators that point to when phone inquiries, a surge of showings or even an actual exchange of keys for money will occur. The usual end-of-the-month flurry proves to be hit and miss, for few move-outs are actually that worried about where they will live next.
Earlier we were looking upward in an effort to figure out where the ceiling to the market was, but now our view is downward to the floor. The floor feels like mush—not so much like oatmeal but lumpy Cream of Wheat. We’re in a big ‘ole citywide bowl full of Cream of Wheat. For a while it’s firm and resembles a crust of crystallized sugar, then plop! Suddenly there is nothing underfoot. Then a week goes by, and our traction through the mush takes hold and we make our way back to the top. Sure enough, we get there and discover some giant has also been eating the cereal, for the top of the mush is not as high as it was before we had sunk knee deep in the stuff. We can still see over the edge of the bowl, but the margin is less. Only because the giant keeps adding some milk (read lower interest rates), do we stay with our head peering over the edge. Yet this is dangerous, because the milk has no real substance and makes the cereal (read market) mushier.
My survey of two-bedroom rents seems to bear out this mush analogy, for the median advertised two-bedroom rent is down or flat for the sixth quarter in a row. More startling is that the survey number for March 31, 2002, has fallen back to where it was four years ago. The fact it has retreated so much when my own two bedrooms have not done so, makes me question my source—the Sunday ads in the San Francisco Chronicle. With the addition of Craig’s List and other online marketing services, I think the less desirable units and less tech-savvy landlords are the ones using the Chronicle, pushing down the median number. For sure, it is consistent with the feeling of mush.
I can’t complain about the lower rents. I like all kinds of cereal. The year 1998 concluded with a four-year upward surge resulting in rents doubling. Since a doubling every ten years would still put us ahead of inflation by over half, I would not be surprised if rents stay flat for another two years or more. We would still be ahead. In other words, today’s rents are lower than last year’s and the year before, but they are still on a curve far in excess of inflation and other investment alternatives. Although you may struggle to find someone to love one kind of unit—possibly with carpet or less San Francisco-style charm—you will find tenants willing to pay as much today, as a year ago for apartments with Victoriana, crown moldings or ceramic tile. Basically, with a little extra work, everything balances out.
Sales Prices
From a sales standpoint, this steady but inconsistent rental demand
is keeping the value of San Francisco apartment buildings sky high.
Due to a 20-30 percent drop in market rents, gross rent multiples
(GRMs) for buildings for sale have never been so high. For example,
twelve and thirteen times gross rents may seem like a justifiable
number in Pacific Heights or the Marina when rents are climbing
and substantial upside exists. Although these figures continue to
be the norm in all the good neighborhoods, they don’t really
make sense, even carried out over the next five years.
Ten years may be more like it. If history is any sort of guide, every time we’ve had a steep run up in rents, it has been followed by an equal or greater number of cooling-off years. The latest run up in rents, ignoring the brief period in 1998 to catch our breath, extended from 1993 to 2000. Most likely rents will not rise again until at least 2004; and, if not for the recent 25 percent drop, it possibly may be even later given the magnitude of the climb.
Therefore, a building bought today will generate zero cash flow or growth until the conclusion of 2004. Then, if all goes well, rents will begin an upward trend in early 2005. Possibly in 2007 or 2008, with an active turnover rate of approximately 20 percent per year, the new rents will be roughly one-eighth the original purchase price, and thus profitable with a normal 25 percent down payment.
If an Internal Rate of Return (IRR) analysis is used—something few San Francisco buyers even know how to calculate, let alone use in their decision-making process—the buyer of a thirteen-times gross San Francisco apartment building will be deeply in the hole for no less than three years. The buyer will be lucky to achieve even an 8 percent IRR if he were to sell immediately after the first couple of years achieving 20 percent turnover at higher rents. All this assumes the seller could still get 13 times the rents needed.
Such a scenario is doubtful because trends in buying behavior tend to change slowly. If rents stay flat for a number of years, GRMs will fall and hit a low sometime after rents have started to rise again. Only by waiting until a heating-up market is red hot again will the seller be able to justify that earlier peak-market buy.
Stock Market Exodus
Many experts have been attributing the recent run up in prices for
home and apartment buildings to an exodus of cash from the stock
market, which has stayed basically flat since its collapse more
than a year ago. This is contrary to what happened during the departed
bubble period. Then, it was the inflated values of corporate shares
that fueled the rise in real estate prices in all sectors. Assuming
this is the normal course of things, the depressed indices should
be taking some of the wind out of our real estate sails as well.
I tend to believe the experts on this one. If we are to believe economic news, the NASDAQ especially should be much higher than it is; probably in the range of 2,500 due to the way corporate shares tend to lead earnings in the tech field. However, if you take away demand from the average Joe, who, instead of investing in stocks, is chasing a three-bedroom house or duplex, you may see the stock market struggle to gain firm footing.
This upward pressure on real estate cannot last. Investing in real estate does little to help the economy. It produces few jobs and is highly illiquid, despite the best efforts of those annoying online lenders that keep sending me e-mails. With interest rates currently low, owning real estate is more attractive than ever.
Investing in real estate is one step away from gold as a haven for safety rather than growth, which is what the economy needs. We run the risk of mirroring the mistakes of Western Europe where real estate prices and unemployment are sky high. Also, as international instability poses risk for investors, more conservative investments will continue to be attractive at least for the near term.
In the long term, I believe in the creative spirit of Californians,
and San Franciscans especially. I don’t doubt that sometime
in the next ten years we will come up with another economic boom
of one kind or another that will produce jobs, raise income levels
and propel us out of the rental mush, all at the same time.
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 publisher of SF Property Report. He may be reached at propnews.com. © Copyright 2002.