Tenderloin Heights

Are We Paying Too Much for Real Estate?

by Jim Forbes

Although my ability to predict real estate trends vastly exceeds my insight into the stock market, I am beginning to have my doubts about the former. At this time last year, I was convinced that San Francisco real estate prices had peaked, overshooting their intrinsic value by several percentage points, and that we were in for a lengthy period of slow decline or flatness. Instead, powered by minuscule interest rates and fears of a tanking stock market and Osama bin Laden, money continued to pour into real property, sending values even higher and even more out of whack when compared to rents.

With that gross error in judgment, I am even more afraid than ever that I haven’t the slightest idea what I am writing about when it comes to the direction of the real estate market. To put it in high-tech jargon, I have no “visibility”—not for the prices of commercial real estate and not for the future of rental rates.

But, if I were forced to make a guess, I would say nothing much is going to change from the mushy bottom where we have been in the last year: rents will slip a bit more but basically stay where we’ve been over the last six months, while prices will continue to be outrageously expensive (so long as there’s nothing better to do with one’s money).

Unless of course, I am still in the dark about some very mean economic trends—similar to those Japan is still grappling with—that have made some investors quite jittery.

How is it that the stock market, a leading index of investor sentiment, has rolled back five or six years to the deepest bear market on record and yet investors in real estate—a very illiquid commodity—are crawling all over themselves to buy empty office buildings or rent-controlled apartments?

If Wall Street investors are indeed correct and the value of the country’s employers and tax generators are no more than what they were five years ago, shouldn’t real property values be in the same neighborhood? When office building rents have fallen back to levels of more than five years ago—in reality the levels are probably closer to those fifteen years ago—how can office buildings still trade at $300 per square foot (figures that have only been reached once before).

Maybe there is just something about investing in real estate that causes people to react more slowly to changes in market value and industry trends. Could it be that because we can’t close on a piece of property with a click of a button, the whole industry’s decision-making process is sluggish and prone to mistakes? Add to this the tax rules on deferred exchanges, which cause people to have to buy or else lose giant amounts of their equity. The result is an otherwise thoughtful investment process infiltrated by a kind of frenzied hunt, often followed by a confused resignation when somebody actually looks at the numbers. The bottom line is that people are currently paying too much for real estate, especially now when rents are weak and the future cloudy. They will continue to do so until some other alternative comes along, including foreclosure and bankruptcy.

Former Labor Secretary Robert Reich had an interesting op-ed piece in the New York Times not long ago. His prescription for the economy is payroll tax breaks for the working-class to create demand. He is not worried about supply. I concur completely. As a residential property owner, tax breaks on my income do not help me nearly as much as more money in the hands of my tenants. People in the working class will spend all that they have. In fact, few of them have a choice.

The effect of reduced demand can be seen in our declining rental rates. Obviously, office rents—down around $20-per-square foot from a previous $80—are the best example, but as demand fades, residential rates have been falling as well.

Rental Rates
Based on my survey over the last six months of ads in the San Francisco Chronicle, rents in San Francisco’s rental market have been flat to slightly lower for 2002 and are now back to 1998 levels. On September 30, 2002, the median rent for a two-bedroom apartment or flat in the city stood at $1,950, the lowest it’s been since July 1998.

Tracking unemployment rates is one good way to judge relative demand. During the height of the high-tech boom in San Francisco, the city’s unemployment rate rarely exceeded 3 percent. Vacancy rates in the city were thought to be even lower during this time.

In July 1998, the unemployment rate was 4 percent. In September 2002, the percentage of jobless had increased to 6.7 percent, with three months so far this year at 7 percent or above.

Vacancies
During the super-soft early nineties, when vacancies exceeded 5 percent for a lengthy period of time and rents dropped for the first time since the sixties, the unemployment rate varied in the same 6-to-7-percent range that we are experiencing today.

If I use the buildings we manage as a measure of vacancies, rents have stabilized around 5 percent recently, but naturally it took some rate dropping to get there. If the jobless rate stays as it is, I could definitely see some additional softening in rents.

The difference may be in total numbers, also a contributor to demand. In 1994, the total San Francisco labor force was around 405,000. Now, it’s nearly 430,000. Unless 25,000 homes were constructed in the last eight years (they weren’t), these additional workers could keep things propped up a little better than the recession of the 1990s. All this depends, of course, on where these additional workers want to live.

Then, again, we might have a war, or another terrorist attack, or maybe people will figure out that the Internet is the best thing since sliced bread after all, in which case I do not know where rents and real estate prices are headed. As I said, there isn’t much visibility right now.

The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. Jim Forbes is President of Urban Properties, a real estate investment and brokerage firm. He is a SFAA board member and publisher of SF Property Report. He may be reached at propnew.com. © Copyright 2002.