A Winding Path Ahead

To look at the San Francisco-Oakland-Fremont, Calif. unemployment rate, which was 10.5 percent, as of April 2010, according to the U.S. Bureau of Labor Statistics, one would not suppose that the market is performing particularly well, especially when compared to the national average of 9.9 percent. But when the state budget crisis and its high unemployment rate—12.6 percent—are taken into account, the outlook for the Bay Area is not quite as gloomy as compared to other Golden State markets—not to mention that the unemployment figure is actually down 60 bps from the previous month.

“California’s real estate economy, like everyone else’s, is driven by jobs,” points out Merrie Turner Lightner, CFO and vice president of Lightner Property Group, a boutique-sized property management and development firm specifically focused on rent-control properties in San Francisco. “San Francisco, particularly, is driven by people coming from out-of-state, landing and needing to rent. When the economy goes sideways and there are no new jobs and no new people, the real estate market falters.”

The increase in home prices and sales throughout the San Francisco Bay Area may be good news for the apartment market, though, as it is an indicator of what is to come for both the Bay Area and for Silicon Valley, asserts Cheryl O’Connor of O’Connor Consulting, lead consultant for Bridge Housing’s Mission Walk and Armstrong in San Francisco, and CEO of the Homebuilders Association of Northern California.

While new residential permits were up about 20 percent, from 3,526 to 4,290 year-to-date, multifamily permits were down from February to March 2010. Year-to-date, San Francisco had only 47 permits, which O’Connor attributes to the “challenges of making something pencil out, particularly high-density housing, because fees and financing to get projects started are so cumbersome.”

This lack of construction, however, will undoubtedly contribute to a rise in the area’s occupancy rates, as well as pricing for both rental and for-sale multifamily units. As Alan Mark, founder and president at The Mark Company, a San Francisco-based residential sales and marketing firm, reports, for example, there won’t be any condo product under $1 million by the end of 2010-early 2011. This is expected to positively impact the rental market, as the city could become too expensive for many to own homes.

Market fundamentals

Since the middle of the first quarter, there has been some strengthening in the market, with stronger leasing velocity and fewer requests for concessions, reports Lightner.

According to Cassidy Turley BT Commercial’s first quarter 2010 Apartment Market Report, multifamily communities in San Francisco/Peninsula with fewer than 100 units had a 4.9 percent vacancy rate, while those with 100 units or more averaged 6.2 percent vacancies, an increase of 70 bps from the fourth quarter of 2009.

At the same time, East Bay properties with 100 units or more saw an average of 5.7 percent vacancies, South Bay had a 4.4 percent vacancy rate for properties of the same size, and North Bay experienced higher vacancies, at 7.6 percent.

While there was some effect of the shadow market at the beginning of the recession, the increase in new home sales has leveled off the number of condos being rented, reports O’Connor. “Particularly in the city, the rate of foreclosures and short sales is smaller than it has been, so there’s not much of a shadow market in San Francisco and South Bay,” she notes.

Most buyers also tend to be end-users, often either first-time homebuyers or young empty-nesters who “want a place in the city and still hold onto their homes” in the suburbs. And, because most of those residences that went into foreclosure were those that were highly leveraged, these end-users are not being forced out of their homes with the frequency that has been seen in other markets.

Furthermore, as Mark notes, much of the product that was converted to rentals has already been returned to the for-sale market. “It’s really hard to get things entitled in San Francisco, and financing pretty much started to dry up as the market was getting difficult—we really didn’t have an oversupply of condos,” he recalls.

Shifting demographics have also impacted the market, as more Baby Boomers are downsizing, moving from the suburbs to the city. And while this group often chooses to buy rather than rent, they are often able to do so without first selling their homes, making closings that much easier.

Meanwhile, properties in San Francisco/Peninsula achieved the highest rents in the market; those with 100 units or fewer had monthly rents of just over $1,600, with larger communities averaging just over $1,900 per month, according to the Cassidy Turley BT Commercial report.

Smaller properties (fewer than 100 units) in the region reported average monthly rents of $1,153, $1,211 and $1,300 for East Bay, North Bay and South Bay communities, respectively, while the larger properties achieved rents of $1,338, $1,254 and $1,545.

While concessions are not considered prevalent in the market, per se, Ryan Abel, associate-Multifamily Group, Cassidy Turley BT Commercial, San Francisco, points out that residents continue to look for bargains, particularly in Class A assets. “Higher vacancies allow tenants to search for more amenities for their price,” he asserts.

Meanwhile, transaction volume in the San Francisco/Peninsula market slowed to $86 million in the first quarter, from $53 million in the quarter prior, which represented 38 transactions, or 555 units, according to Cassidy Turley BT Commercial. Price per unit declined 18 percent, to about $152,800, while cap rates averaged 6.2 percent in the first quarter. GRMs (gross rent multipliers) have fallen into the 10 to 12 percent range, according to Abel.

At the same time, volume in the East Bay market fell to $26.3 million, representing 272 total units with an average cap rate of 6.76 percent, a decrease of nearly 20 bps from the previous quarter. The South Bay market reported a mere $11.7 million in transactions, which included just over 100 units at a cap rate of 6.61 percent, or 54 bps higher than from the fourth quarter of 2009. And the North Bay market saw 317 units traded in the first quarter, for a total sales volume of $42 million and a cap rate of 6.7 percent, or a 73 basis point decrease during the same period.

The Lembi Group’s over-leveraged portfolio, and subsequent bankruptcy, delivered a lot of REO product to the market, making it difficult to “pin down a good value, as far as where the market is in terms of cap rates, since the majority of buildings being sold are bank-owned properties,” reports Abel. “It’s difficult for investors to get their arms around where the apartment market is going and where the economy is.”

Even in good times, “San Francisco is a very difficult market to purchase in because it is so competitive and it’s hard to get returns that one would hope to get,” explains Lightner. “Unit values have held strong, and everyone has been waiting for the shoe to drop…You can’t throw up a new apartment building easily in San Francisco. It’s difficult to build new housing here, and that keeps the pressure on and prices up.”

An uncertain future

While there appears to be a consensus that the San Francisco market has indeed already hit bottom and is on its way to a recovery, it still has a ways to go. Regardless, it appears to be in better shape than many other cities within The Golden State.

“Overall, from the level of activity we’ve seen from institutional clients, people know we are on the cusp as to when things will turn,” asserts Abel. “Moving forward, you’re going to see a pick up in activity—buyers will be opportunistic, but judicious, with available equity,” he predicts.

For those with the equity and cash on hand, Abel adds, “you can negotiate with the potential seller, [because of] the simple fact that with the lending market the way it is, there’s no guarantee you’ll get any transaction [done] with a deal that has to be financed.”

For the most part, the industry believes that the San Francisco market is bright. “We have so much research and development coming out of San Francisco; we have UC Berkeley and [we have] so much appeal for companies [moving to the city]—that will bring us out of the recession pretty quickly,” O’Connor forecasts.

And, as Lightner adds, the creative nature of San Francisco’s population can only help to fuel the city’s growth. “I think that San Francisco, when government gets out of the way and allows things to percolate on its own steam, will create jobs, new ideas, new things to sell. There’s always someone with a new great idea and because [we are] so close to Silicon Valley, we have natural access to the venture capital market.”

In addition, Mark points out, the growth of biotech companies throughout the city—“five years ago we had one biotech company and now we have 50; now it’s a vital part of the city”—will help the city’s recovery, as will the expansion of social media, since many of the firms are headquartered within the city limits.

“Our experience has been that if you’re looking for a stable market, San Francisco is a great place to be because even when things go down, they don’t go down as far,” notes Lightner. “It all goes back to old-school real estate 101: location, location, location.”

The one potential downside in the market, however, is the uncertainty in the state capital, particularly with the upcoming gubernatorial election this November. Lightner adds, “the whole state is waiting with bated breath to see what solutions will come out of that place and who will lead us into the future.”

To comment, e-mail Erika Schnitzer at [email protected].