Inside the Bay Area’s Dynamic Investment Market
- Feb 13, 2019
Despite a few changes that have impacted investor sentiment, the San Francisco Bay Area multifamily market seems unflappable. Levin Johnston Senior Managing Directors Adam Levin and Robert Johnston are confident about the strength of the market through 2020. The two shared with MHN what they see as the strategies of investors looking for higher yields in this West Coast region and reveal the submarkets that will see solid growth in the next five years.
How has the multifamily investment environment changed over the past several years in the Bay Area? What are the main trends?
Levin: Investors are still quite confident in the multifamily market here, and investment levels remain strong. That said, buyers recognize that this expansion has been extremely long, and they are more realistic about the pace of price growth now than they were a few years ago. We’ve seen a sharp slowdown in multifamily construction in the Bay Area, which has caused prices to appreciate significantly, and this has prompted investors to reposition their portfolios toward areas showing significant tenant and rent growth. We believe that as the development pipeline builds back up in 2019, we will see opportunities for new construction creating some market dislocations. This shift encouraged many investors to complete their leasing and portfolio transactions before year-end 2018.
Johnston: Investors have also grown more realistic about the pace of rent growth now that the debt markets have shifted. The increased cost of debt became evident to everyone fairly quickly, so they are more accepting of prices leveling a bit because of the higher interest rates. Rent growth is expected to be highest in commuter locations in second- and third-tier suburbs, where the rental rate remains below the metro average.
What type of multifamily properties are investors looking for in the Bay Area?
Johnston: With valuations of Class A multifamily properties in this market run-up so high, investors are seeking the best path to higher yields. For a great majority of investors, this path has been through value-add plays. There are many great opportunities to purchase properties that have some age on them, reposition them, and sell them to eager buyers.
How did Opportunity Zones change the discussion around multifamily investment in the Bay Area?
Levin: Opportunity Zone legislation has sparked the creation of new funds in which people can invest to help economically disadvantaged areas. The Bay Area still tends to attract mostly seasoned long-term investors, so many of our clients are interested in 1031 exchanges, and they don’t need Opportunity Zones to take advantage of that tax code. Our clients would need to see strong stock gains at cash-out to make that type of investment worth their while.
Johnston: There are some specific Opportunity Zone buyers looking for Class C and D properties in which to invest, but we haven’t seen a lot of that in our business.
What are the challenges in the market and how do you overcome them?
Levin: While demand for multifamily is solid and there are compelling reasons to invest in this sector here, there’s still a considerable delta between sellers’ expectations and what buyers are willing to pay. We have been encouraging sellers to be more realistic in their pricing and to take heed of current cap rates, educating them on how this awareness will benefit them in their efforts.
Johnston: There was a lot more certainty in the economy a few quarters ago than there is now, due in part to several potential legal and political changes in the midterm elections that impacted investors’ views on debt levels and debt rates somewhat. But buyers are not sidelined or overly nervous. They still want to close deals, and they’re allocating more toward long-term holdings. They’re also doing more asset analysis now and are proceeding with more caution than before. There’s still so much 1031 exchange money to be deployed, and investors need to buy, which is keeping the market moving.
How are high property values and other factors influencing multifamily investment in the area?
Levin: Investors are focused on good core locations as well as solid growth markets where there is evidence of future job growth and where appreciation on properties purchased there has legs. Some investors prefer the East Bay submarket for its higher yields, and core-located assets in places with strong job fundamentals remain strong. Absorption of new construction seems healthy, so active investors are still investing, but they’re studying asset condition a lot more now in terms of where current income is. Sellers are not selling as much on future income because buyers want higher returns coming in to the deal.
Johnston: In specific markets, like Mountain View, developers are looking to repurpose multifamily properties into homes because of the great need for housing, so home builders are among the strongest buyers when multifamily properties are brought to market.
How did the acquisition financing process change due to interest rate hikes and what do you expect going forward?
Levin: People are looking more into longer-term debt, and we expect this trend to continue. Interest rates on five-year money have risen so much that there’s almost no spread between five-, seven- and 10-year fixed debt, so borrowers are looking more into 10-year debt. In the Bay Area, where prices are high, buyers have to be prepared for high down payments on deals—as much as 40 percent to 50 percent—which is narrowing the pool of investors in this market somewhat, but there will always be buyers interested in this market.
Tell us about your expectations for the year ahead. How do you expect the market to change this year?
Johnston: Multifamily fundamentals will remain strong in 2019. There’s a good amount of velocity, and there continues to be a lot of capital that needs to go to work in the Silicon Valley and Bay Area as a whole. Multifamily is the best place to invest capital: The stock market is too vola