California Market Report

As development picks up, competition is heavy for existing assets.

CA_MktRpt_CapRate_online thumbnailBy Joshua Ayers, Senior Editor

Slow and steady wins the race. Multifamily supply remains somewhat flat in California, but some markets in The Golden State are showing signs of life with regards to new development, and experts are anticipating a gradual increase in that supply over the next three to four years to accommodate job growth in the state.

San Francisco proper tops the list for multifamily growth, due largely in part to the surging tech industry that has seen major industry players grow their companies within city limits rather than expand toward established tech hubs in South Bay communities. Orange County’s job growth has also captured the attention of developers, who are rushing to get units on the market in that county’s central cities, and while the economies of Los Angeles and San Diego have been a little slower, there are still indications of some growth.

“In general most markets continue to enjoy very tight vacancies,” says Michael Cohen, director of advisory services at Property & Portfolio Research (PPR), a wholly owned subsidiary of the Costar Group. “It’s going to vary by market. Certainly it’s going to vary by demand drivers, population growth household formation, job gains and supply constraints, but I think in general, like most of the country, fundamentals are still pretty tight.”

On the existing properties front, supplies remain tight, and companies that focus more on value-add deals are finding fewer opportunities for acquisitions in most markets according to Phoenix Realty Group (PRG) Managing Director Alex Saunders.

“We’re having a real big supply and demand imbalance from the acquisition side,” Saunders says. “There’s a lot more money facing a lot fewer deals, and so that’s caused a lot of stress on pricing, and unfortunately cap rates are at all-time lows so people are buying these properties at cap rates that people have never seen before.” According to Saunders, Phoenix Realty Group has been successful at finding these opportunities, but it’s an enormous amount of effort and time, and often times its not overly obvious.

Saunders adds that there has been a significant drop-off in sales activity recently citing uncertainty in potential changes in interest rates and low cap rates as the primary reasons, with regards to value-add type transactions.

“If you manage your debt maturities well, you can afford to overpay a little bit because you know there’s going to be growth down the road, and you’re seeing it,” he says, “especially for the guys that are tuned into their markets.”

On the lending front, Fannie Mae has listed the Bay Area, which it defines as the San Francisco, Oakland and Freemont MSA and the San Jose, Sunnyvale and Santa Clara MSA, as a strong market, and it is one of only a half-dozen markets nationwide to make the list.

According to Kevin Mignogna, director, production at Berkeley Point Capital LLC, which specializes in acquisition loans and refinancing, markets on that particular list “qualify for lower underwriting floor interest rates, and Fannie will generally approach them more aggressively than it will other markets.” He adds that Freddie Mac does not publish a “strong markets” list, but does maintain internal market ratings. According to Mignogna, several California markets are rated highly by Freddie Mac, garnering favorable underwriting and pricing structures.

Outside of GSE interest, Mignogna says insurance companies and banks are bidding competitively in almost all of the California markets. “There’s a lot of interest in placing debt on California multifamily real estate,” he explains.

San Francisco

While tech jobs are driving well-paid renters into San Francisco, finding a place to develop seems to be one of the largest hurdles to overcome in The City, which closed 2013 with a vacancy rate of 3.11 percent following 3.04 percent in 2012. The recent vacancy rates in San Francisco are at their lowest since the Dot Com era of the late 1990s and early 2000s, while rent rates were at an all-time high at $2,553 in 2013—a continuation of the upward trend from $2,201 in 2011 and $2,445 in 2012.

“In general San Francisco historically is difficult to build in. It’s limited in terms of land and very costly, and the approval process is quite long. However we are seeing a surge in supply,” notes Carlos Ortega, real estate economist with PPR. Ortega also notes that the bulk of the new development in San Francisco is happening in the SoMa and Mission Bay neighborhoods, saying that those neighborhoods still have sizable portions of land available to develop.

“Developers have been able to move forward in those areas and continue to do so at a very strong pace,” he says.

Typical renters at these new developments tend to be highly skilled well-paid workers such as software engineers that are in short supply for the city’s thriving tech companies that are choosing to stay in San Francisco unlike other cycles where growing companies would move south to Palo Alto and other suburban areas.

“For example, Twitter [and] [are] heavily expanding in the CBD area, so that’s helping to pull more of these high incomes in the area into the San Francisco area,” Ortega says.

Delivery of new units soared in 2013 at 2,726, following 684 in 2012 and 170 the year before that. Cap rates, which were at 1.60 percent in 2010, jumped to 3.44 percent in 2011 and slowly rose to round out 2013 at 3.65 percent.

Los Angeles

Los Angeles multifamily has been a little slower to recover from the economic downturn than the Bay Area or even neighboring Orange County. Job growth has picked up as of late, and the metro has seen the addition of 10,000 jobs per month for the last six months dropping the unemployment rate below 10 percent, according to Cohen.

“You’ve got the makings of a good part of the economy,” he says.

Los Angeles developers delivered 4,887 units in 2013, up from 1,734 in 2012 and the highest number since 2008, when 6,724 units were delivered. Vacancies have changed very little in the past two years, finishing 2013 at 5.12 percent and 2012 at 5.3 percent, while cap rates have somewhat stabilized just under 4 percent.

“One thing that’s worth noting about Los Angeles and why it’s a perennial favorite for apartment investors is that about 52 percent of households rent in Los Angeles,” Cohen says citing a Harvard Center for Housing study. “It’s essentially a renters market. You have the higher cost of housing in most parts of LA, and that tends to keep most folks as perennial renters.”

Job sectors showing the strongest growth in Los Angeles tend to be show business, tourism and technology, but some jobs such as trade distribution and warehousing are moving east to the Inland Empire cities. Another potential blow to jobs will be when Boeing discontinues its C-17 production line in Long Beach, which will result in the closing of 2,000 to 4,000 jobs.

Saunders says that PRG, which focuses primarily on Class B and C value-add assets, was aggressive with acquisitions in the Inland Empire, and the shift of momentum to the area has allowed for the company to move forward with asset improvements. He says that owners are trying to figure out how to squeeze out as much NOI as possible without missing out on interest rates and cap rates.

“It’s meaningful enough to where we’re willing to take some of our cash flow and redeploy it into unit renovation because we think we can get an 18-20 percent margin on any dollar that we spend.”

Cohen says the metro’s strongest areas for multifamily are West Los Angeles, followed by the South Bay and North Los Angeles, respectively. Developers have also been active with rental projects in the downtown Central Business District, which showed significant output for condominiums during the last cycle.

“Where we are seeing some real construction activity though is the downtown CBD,” Cohen says. “That sort of attracts housing options. We saw a fair amount of condo construction in the CBD last cycle. We’re starting to see higher levels of rental construction in the CBD, and that’s sort of the one submarket that we expect to see an outside share of completions relative to the existing inventory.”

With regards to this year’s supply, Cohen expects to see much more than in recent years with the delivery of close to 9,900 units in the Los Angeles metro by the end of 2014.

“If you look at the impact on vacancies, it’s marginal,” he says. We’re talking something on the order of 30 basis points with that level of supply. It shows you how LA is perennially under-housed and tends to have this very high permanent rental class.”

San Diego

San Diego, much like its neighbors to the north, has also had a slow recovery. The market was hit particularly hard by sequestration’s “weighing on the local business climate,” according to PPR Real Estate Economist Sam Tenenbaum. Additionally, he says the search for a new mayor following former mayor Bob Filner’s resignation from office also had an impact on multifamily productivity in the area.

San Diego, which has typically been a hub for well-paying jobs in the life sciences, wireless tech sector and education, saw growth of those types of employment opportunities give way to lower-tiered service-sector jobs. The combination of that, with soaring single-family home prices, have made the market prime for renters by necessity, according to Tenenbaum, who specializes in the San Diego markets.

“Most of the drivers of San Diego have been in life sciences, wireless technology and education, which are all well-paying jobs; but, over the past year it’s been mostly retail sales, warehousing and administrative and support. These are kind of lower-paying jobs, which are great for apartment demands because, as is the case in Orange County and LA, house prices in San Diego keep renters in the rental pool instead of converting them into owners,” he says.

The majority of development that is happening is occurring in the Downtown and East Village areas to the east of Petco Park near the Gaslamp district, with a few projects scattered in peripheral areas such as Mission Valley and Mira Mesa. The downtown projects on the table include Ballpark Village near Petco Park that will contain 634 units that have yet to be determined to be rentals or condos, as well as Blue Sky, which was approved in 2013, and will add 939 rental units to the city’s downtown.

“It’s really a downtown CBD construction story,” Tenenbaum says, “but we’re also seeing a lot of construction in Mission Valley with the Cevita development (300 units) and now there’s construction for West Park which is another 600 units.”

Another hurdle that owners and developers will be keeping an eye on is the potential looming increase in the commercial linkage fee, which is a government-mandated contribution toward affordable housing that is required by developers. Tenenbaum says that the fee was created in the 1990s and was supposed to be revised every few years but wasn’t.

“Now the local government is proposing doing the full adjustment, which will increase the value of current existing projects, but will make development more expensive because now you will have to contribute more money to the affordable housing construction fund,” he says, adding that the adjustment will likely have an “impact on sale prices, cap rates as well as ground-up construction.”

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