Feature
by Marci Riseman & Evan Sagerman
On November 20, 2006, the Fisher Center for Real Estate and Urban
Economics at UC Berkeley hosted its 29th Annual Real Estate & Economics Symposium in San Francisco. The daylong conference offered an excellent snapshot of the real-estate market in a number of sectors: locally, regionally and nationally. Like many SFAA members, the authors of this article are small-scale real-estate investors and property managers. While we’re mostly concerned with the local residential market, we’ve found there’s a lot to learn from what is going on in other markets and regions. Mostly, however, our purpose in attending these conferences over the last seven years has been to get an answer to our eternal question: what’s next?
The Market Today
James Curtis III, of the Bristol Group, Inc., started off the day by asking enthusiastically, “Is this the greatest market you’ve ever seen in your career?” The audience’s mix of “Yes!” and “No!”—mixed with a lot of bewildered laughter—was a perfect mirror of the mood of real-estate investors today.
Generally, the speakers agreed that the real-estate market is still strong, due to a number of factors. After the dot-com bubble burst in 2000 and stocks took a tumble, many investors who had never sunk their finances into property before moved their money into real estate because they liked the idea of owning a tangible asset. The economic downturn after the September 11 terrorist attacks caused further insecurity among stock-heavy investors, and a subsequent increase in real-estate investment. At the same time, as real estate became a respectable asset class in people’s minds, low interest rates made borrowing cheap. With a sudden influx of people and institutions looking for investment real estate, prices soared.
“There is so much money flowing into the real-estate market,” said retail and multifamily developer Louie Delmonte. “I haven’t seen anything like it in 40 years.” Ned Spieker, managing partner of Spieker Partners, noted that even as his REIT stock income dropped by 30%, the stock value rose by 60%: “People are betting on the future.” Doug Shorenstein, CEO of Shorenstein Properties, agreed. Buying now, he explained, means betting that rents or sales prices will rise enough to make the investment pay off—and many buyers still feel that will happen. Shorenstein noted that in the past he used to have two or three competitors when buying Class A office buildings; he now has 20 competitors per deal.
These sentiments echo what we see in San Francisco residential buildings: rents alone do not justify the prices buyers are willing to pay, yet many buyers are still eager to buy.
What’s Next?
A few years ago at this conference, single-family homebuilders insisted that prices were strong and had no place to go but up. Now that the single-family home bubble has burst, speaker after speaker at this year’s conference made a point of reminding the audience that real estate is a cyclical market. The big question on everyone’s mind wasn’t so much “Will the market go down?” as “When?” Given that the market has behaved recently in a way that it hasn’t in the working lifetime of anyone at the conference, speakers were generally reluctant to guess.
Joseph Azrack, president and CEO of Citigroup Property Investors, agreed that real estate is currently overly prized as an asset class and will sooner or later “return to the mean,” although, he added, “not anytime soon.” Institutional real-estate advisor Geoffrey Dohrmann said that he understands why real estate is where it is and how it got here, but it doesn’t feel right to him. “It’s like an airplane ride with plenty of booze and food, but not enough fuel: it’s fun while it lasts.”
The conference’s keynote speaker was UC-Berkeley economist Ken Rosen, who was one of the few people to insist, before the dot-com crash, that 98% of dot-com companies would disappear. It was an outrageous claim when he made it, but when it came true, Rosen’s reputation for good economic analysis and common sense was well established.
Rosen’s picture of the economy was mixed. On the one hand, the national job market is strong and there’s low unemployment; consumer confidence is strong. However, the California economy as a whole is slowing, and nationally the picture is more troubling. Government and consumer debt are at an all-time high, oil prices are triple what they were in 2002, our trade balance has become extremely negative over the last five years, the federal budget isn’t balanced, and there’s no sign of federal spending discipline. Rosen asserted that every country in modern history with this set of financial circumstances has had a recession.
Rosen believes that our present set of economic imbalances can continue for a while, but not forever. His prediction for the national economy was that we stand a 65% chance of a moderate recovery, with 2.2% economic growth in the coming year, and a 35% chance of a recession, which would mean a 2% decline in the coming year. Although the factors are in place for a national recession, Rosen feels a recession would only be precipitated by an event external to our economy, such as a worsening international conflict or a new, major natural disaster.
Rosen doesn’t think the Federal Reserve Bank will lower interest rates—as there’s too much money around already—unless there is a recession. Rosen predicted that there would probably be a moderate rise in interest rates, or changes in monetary policy that would have the same effect.
Single-family home prices have not stopped dropping, and Rosen predicts they won’t for another two years. The gap between prices and incomes has become just too great, with only 25% of California households able to afford a median-priced home.
The Girls All Get Prettier at Closing Time
“A lot of smart money is selling. A lot of money is buying,” joked Rosen. “It is time to hedge at least—if not sell.” When asked what sectors he’d invest in, Rosen named eight financial investments, in his order of preference. Only the last item on his list was real-estate related.
Shorenstein said that his company is still buying, but only properties that are off-market. They are also very carefully assessing the downside and risk when they look at new deals. Spieker’s company’s current strategy is to avoid the boom areas—like San Francisco—for the time being, and in fact has moved to developing continuum-of-care facilities for seniors (a part of the industry with fewer competitors). Azrack believes unbuilt land is a good buy, as distressed single-family homebuilders try to liquidate their assets. Rosen and others agreed that builders of single-family homes are walking away from unbuilt land as fast as they can, and that prices wouldn’t hit bottom for another two or three years. Their advice was to buy that land cheap, entitle it, and wait for the next upward cycle. Unfortunately for SFAA members, the land these speakers were referring to lies outside of San Francisco’s 49 square miles.
Delmonte shared his philosophy: “Today, I’m a seller. This is ridiculous. It’s a bubble; it will not go on. There is nothing intrinsic going on that would lead people to pay the prices they’re paying [for investment real estate].” He asked the audience to remember the insight of “noted social philosopher” Jerry Lee Lewis: “The girls all get prettier at closing time.”
The Significance for San Francisco Apartment Owners
For SFAA members, Rosen’s description of San Francisco’s economic picture was positive. Job growth has been good, with the addition of 15,000 jobs in the last year, diversified through all the sectors of our economy. However, only 17% of households can afford a median-priced home in San Francisco County. These two factors have kept a steady upward pressure on rents, with San Francisco rents up 10% in the last year. There is solid demand for the available supply, with only a 4% vacancy rate. This is all good news for San Francisco landlords.
For buyers interested in San Francisco apartment buildings, discretion is advised. The conference speakers aren’t assuming real-estate values will continue to rise, or continue to rise for long. The experts are only looking for properties with particular characteristics: those that aren’t on the market, are near upcoming infrastructure improvements, that have owners who haven’t put in the work or money required to maximize value (they noted that such properties are often held by families), and/or have rising rents that will eventually make the purchase price worthwhile. It would be wise for any buyer to follow these words of caution.
For owners assessing their current holdings, clearly the properties worth keeping are those where the cash flow, adjusted for risk, makes a better return than other investments. As SFAA members know, there are a number of risks involved in apartment ownership: fires start, tenants disappear, lawsuits materialize and the San Francisco Board of Supervisors passes new legislation. Speaker Delmonte claimed that the risk adjustment for apartment building ownership should be 3%—so if you’re earning a 5% return, in Delmonte’s view you’re earning 2%—making a CD at 5% look pretty appealing. However, Delmonte noted that one place to look for value in today’s market is in inefficiencies in currently held properties—maximizing the value and minimizing the risk on property in hand.
Owners may wish to become sellers when the risk-adjusted value of their property lies not in the rents, but in the sales price. We need to ask ourselves: if the value of my property comes down 10%, will I wish I’d sold? What if it comes down 20%? Am I in a position to survive the risks and downsides if I need to wait for the next up-cycle to sell?
Rosen advised that sellers of real estate not reinvest in real estate, but instead put their money into the bank earning 5% interest until the market comes up and/or the right opportunity comes along. “Don’t be an aggressive real-estate investor with your own money these days,” he emphasized. Like others, Rosen cautioned that real estate is a cycle, even if that cycle is off its traditional seven- to ten-year period.
Are We Doing the Right Thing?
All the talk up on the podium about selling real estate made us a little nervous. So we used the break time between sessions to review our current holdings. Did they have good cash flow, a reasonable amount of risk and/or the potential for future increase in value because of location?
As we wrote in a previous article (SF Apartment Magazine, June 2006), in November 2005 we sold a residential property with good sales value but low, unraisable rents, and significant risk due to its tenant profile. We had done a similar analysis to Delmonte’s, and even without his handicapping factor (3%), we still calculated we’d be better off selling and putting the money in the bank. Coincidentally, we took our profits and did what Rosen recommended; we parked the money until the market changes. As we keep track of the local market, we’ve also started looking at land outside of San Francisco. We’ve had a longstanding dream of building in the country. The prices are still high, but they’re dropping already in nonpeak areas. It could take a while to locate what we want, but the time it takes us to do our research will hopefully coincide with the bottoming of values for unbuilt land. And then—if all goes well—we’ll take our money and buy.
The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of the SFAA or SF Apartment Magazine. Marci Riseman is a real-estate developer and writer. Evan Sagerman is an architect, writer and real-estate developer. They both co-own Pomegranate Design & Development in San Francisco. They can be reached at 415-826-8860 or marci@pomegranate.to and evan@pomegranate.to. Copyright © 2007 by SF Apartment Magazine. All rights reserved.