The 2-4 World
by Robert Link
Editor’s Note: This month, the San Francisco Apartment Magazine welcomes real-estate agent Robert Link to the pages of the publication. Robert will be writing a quarterly column covering the sales, trends and analysis of 2-4 unit apartment buildings in San Francisco.
We have all heard of Cat 5, the high bandwidth cable used to transmit Internet access at the DSL level. Developers have been incorporating it into new construction for years now. But have you heard of Cat 3? It is the hottest property category in San Francisco. Category 3 refers to the San Francisco Association of Realtors property classification for 2-4 unit buildings. It has performed extremely well in 2004 for a number of reasons rooted in the proliferation of tenancy-in-common ownership. Tenancy-in-common ownership, or TIC, has become a popular vehicle for the real estate and housing industry, for it creates opportunities for prospective homebuyers and small developers alike.
Homebuyers who may have been priced out of the market for condominiums or single-family homes can turn to TICs (defined as an undivided interest in a property with the right of occupancy to a specific unit). The pricing of TICs has generally been 10 to 15% below that of a comparable unit that has already run through the condo- conversion process, thus creating an opportunity for a homebuyer to create additional equity if he/she has the heart and patience to complete the condo-conversion process—one that can last anywhere from 30 months upward, depending on the property type. San Francisco’s condominium-conversion laws both prohibit conversion of buildings with more than six units and cap the total number of units in conversion, in any given year, to 200. This creates an added value potential to any building of six units or under that is reflected in the sales data. In this premier edition of my new column, my two objectives are to illustrate the sales trends for two-, three- and four-unit buildings over the first three quarters of 2004 and to offer an analysis of how the ever-changing legal environment coming from city hall affects properties in this category (see Chart A).
From Chart A, we can extrapolate a few truths. One, the sharp change in volume over the first two quarters of 2004 shows that there is a definite seasonality to home buying. The months of April through September have historically been the months of the year with the largest sales volume. Two factors for the slowing of the market are, first, the opening of the school year after the summer recess and, second, the winter holiday season and the start of the New Year.
The unique attraction toward duplexes is their exemption from the condo-conversion process lottery, provided that the following requirements are met. Both units must be owner occupied for a period of one year to qualify for the exemption. Each owner must hold at least a 25% interest during this occupancy period. If these qualifications are met, the owners may commence the condo-conversion application process that can take an additional 15 to 24 months to process, presuming there are no major code violations discovered in the required review by the Department of Building Inspection that would lead to an extended abatement project.
This exemption was once generally known only by real estate agents and the savviest of investors. Today, this is no longer the best-kept secret in town. In 2004, many duplex offerings were received by the marketplace with multiple offers that eventually pushed the differential between list prices and sales prices to 35.7% in the third quarter (see Chart B on page 56). The average price per square foot trended gradually upward throughout the first three quarters of the year.
Last month, Supervisor Daly proposed an amendment to the planning code that would have eliminated the lottery exemption for owner-occupied two-unit buildings and would have required them to enter the condo-conversion lottery.
His proposal would also have revamped the lottery to give preference to property owners with clean eviction records. An accord was struck, when Supervisor Michela Alioto-Pier’s amendments were agreed upon in a 9-0 vote in favor. Now, only those two-unit buildings in which the owners gained possession through the eviction (OMI or Ellis) of a disabled, elderly or catastrophically ill tenant will be required to enter the lottery. The amendment took effect November 16 and is not retroactive.
Another amendment defines disabled as someone with a mental or physical disability that substantially impairs a life activity. This nonspecific terms open to legal interpretation and will surely be a topic of heated debate in the near future. The outcome of this new law is yet to be seen, but I cautiously predict that the following may happen. There will be segmenting of the market between duplexes delivered vacant and those that are tenant occupied. Buyers will pay a premium for 100% vacancy to avoid the pitfalls of performing a tenant eviction.
Second, the buyout prices for tenant-occupied units will increase, although to quantify this trend is almost impossible for most agreements are made between attorneys and their principals (please note: under San Francisco’s Rent Ordinance, to buy out a tenant is strictly forbidden, and owners who seek to undertake such an action could face severe penalties).
For three-unit buildings, this year, average prices escalated sharply between the first and second quarters, increasing from $1,154,440 to $1,272,937 (see Chart C on page 56), which represented a 9.3% increase. Prices continued to rise from the second to the third quarter but at the more moderate pace of 4.3%. From my perspective as a real estate agent, I observed increased interest/demand for triplexes from buyers’ groups that found the duplex market too competitive. Most duplex offerings, as illustrated in Chart B, were warmly met with multiple offers substantially over the asking price throughout much of the year. It stands to reason that buying a triplex, with owners occupying two of the three units and having the third unit as potential mortgage relief, is a viable ownership solution. The path to conversion is longer, but most buyers in this category are more concerned with getting their foot in the door.
With three units, the condo-conversion process becomes slightly more challenging in regard to the city’s requirements. The fast-track conversion opportunity available at the duplex level is not available to triplex owners. A three-year owner occupancy requirement of one unit is needed before entering into the condo lottery. Thereafter, 40% of the remaining tenants need to sign an intent-to-purchase statement. This barrier to conversion has translated in recent years to a less than proportionate value comparison between duplexes and triplexes. Essentially, if a duplex costs $1 million, you can buy the third unit at half the rate for the first two: for example, a duplex equals $1 million and a triplex equals $1.25 million. This illustrates the premium paid at the duplex level for the opportunity for condo conversion.
Three units will be an interesting category to watch in 2005, for this category could serve as a barometer of the duplex market demand. One could say that it could function as an overflow valve in the already growing pool of duplex buyers.
The market for four-unit buildings did something different than its smaller counterparts this year. The appreciation rates over the course of the year were significantly smaller than the two- and three-unit buildings. There was an increase of 6.7% between the first and second quarters and then a drop between the second and third quarter. Something happened in the third quarter that affected the sales data. Could it have been a simple supply and demand issue or something else? In June, the Appellate Division of the Superior Court ruled that landlords must own at least a 50% interest in a building to do an owner move-in (OMI) eviction. This decision settled a dispute that arose from the passage of Proposition G in 1998, which also limited the number of OMIs to one per building. Essentially this meant that a group of four buyers, each with a 25% interest in a property, could not evict a fully occupied building for their own residency. This may explain the less than stellar performance for this property class in 2004 (see Chart D).
One can also interpolate by the available data for building square footage that the typical fourplex consists of units in the range of 750-1,000 square feet. Typically units of this size are moderately sized one-bedroom or small two-bedroom units with the double parlor utilized as a bedroom. Average prices paid for one-bedroom TICs in 2004 were between $450,000 and $500,000. That said, developers can work a pro forma backward, making allowances for capital investments (remodeling), carrying costs, marketing/sales costs and, of course, allowing an equitable rate of return. Once these factors are considered, the purchase price of a four-unit building ostensibly cannot be more than $1.35 million given the current market for one-bedroom TIC flats.
Despite their individual characteristics, the 2-4 unit market generally moves in unison. Legislation that impacts one property type will inevitably be felt in other parts of the market. Category 3 will undoubtedly be interesting to watch as the 2005 buying season unfolds, beginning in February.
*Data for some of the charts were taken from the San Francisco Association of Realtors and may contain irregularities.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or the San Francisco Apartment Magazine. Robert Link is real estate agent with S & L Realty, a family-run property management and real estate brokerage firm based in San Francisco’s Richmond district. Copyright © 2004 by the San Francisco Apartment Magazine. All rights reserved.