The Property Management Shop
by Marc Wilson
What’s Up With the SF Apartment Sales Market?By Marc Wilson, Real Estate Broker
Q. What is the story with the current San Francisco apartment building sales market? I have been looking for a 6-20-unit building to buy, but there doesn’t seem to be much inventory. Whenever I see a building that looks good, there are a million people bidding up the price. Last month I lost out on a building in the Marina that sold for 15.5 times the income. My broker keeps telling me that I have to pay more than the asking price. Are sellers getting these crazy prices?
A. In a word, yes. I, too, am having trouble understanding the current level of investor enthusiasm for San Francisco apartment buildings. Bread-and-butter buildings in any reasonable location are enjoying incredibly strong investor demand. Buildings with 6 - 8 units are selling at 12-to-17 times the gross income and 12-30 unit buildings are selling at 12-to-14 times the gross income. Investors are searching for a return on investment, any kind of return on investment, and they are bidding up prices in the process. Are today’s buyers too optimistic? Are today’s apartment building prices reminiscent of the stock market in early 2000? Is the current market over valued? This is a question I am not smart enough to answer. I doubt anyone can predict the future. In June 2000, I expressed in this column my concern about dot-com rents and an inflated rental market. I was concerned that the rental market was overheated and that, ultimately, rents would fall and building values would follow. I apparently was only half right, for rents fell and building prices rose. Market rents have fallen 25 percent, but interest rates have fallen by almost 50 percent. Today’s low interest rates have not only compensated for a 25 percent reduction in market rents, they have added additional property value.
You have to be an optimist no matter when you buy a San Francisco apartment building. There has been no time in history when all of humanity has agreed that a particular property is overvalued or undervalued. In most cases, when one buys a property, one pays more than anyone else is willing to pay at that moment in time. You, as the buyer, are the most optimistic at that moment in time.
I am not all that optimistic about the current environment. I guess this lack of optimism is due to the two serious market corrections I have seen since entering this business—and I’m only 42. I worked in the acquisitions department of a large real estate syndication firm in the middle 1980s. We used to have meetings where we would sit around a table and plug our assumptions regarding a potential acquisition into our calculators. Our rationale would go like this: rents will rise at 5 percent a year, expenses will rise at 3 percent a year, the cost of debt will stay fixed, we will buy at seven times the gross income, we will remodel the property at a cost of $100,000 and then we will sell after five years at eight times the gross income. In those days, we would then push the internal rate of return buttons on our calculators and, presto, we had bought another building. We reached the point where all the syndicators were buying and selling to and from each other. Everything went fine until the tax law change of 1986 and a mild recession occurred, and then the wheels came off. All the syndication firms went bankrupt, and many of us went into real estate brokerage. Next thing I knew, I was brokering apartment buildings and selling them at ever increasing prices from 1987 to 1992. Then 1993 came along, the rental market got killed, and we had two years of falling prices and foreclosures in San Francisco.
Why am I concerned now? There are three reasons. First, prices have been rising since 1994—that’s 10 consecutive years of price increases. Second, interest rates are at a 45-year low, so the issue is not a matter of whether rates will rise but rather when they will rise. Third, the return on investment (cap rates) are historically low and gross rent multipliers are historically high. Where is the upside? Prices are high and interest rates are low. I would feel much more comfortable if the inverse were true. I don’t think that interest rate risks are currently reflected in building prices. If dramatic downward pressure on interest rates can cause these kinds of valuations, what in the world will happen if we experience dramatic upward pressure on interest rates?
Whether you want to believe it or not, the U.S. economy is booming. This economy is fueled by what appears to be the most stimulative set of economic policies in U.S. history. Gold prices are above $405 an ounce, third quarter growth was recorded at 8.2 percent and commodity prices are up 30 percent across the board. I just read an article that stated that San Francisco restaurants are currently enjoying a 90 percent increase in business compared to the same time last year. The dollar is weak, and OPEC has announced that it will consider raising oil prices in the short-to mid-term. What does all of this mean? It means that we are in inflationary times. Interest rates will rise, and believe me the federal government is not waiting for San Francisco rents to stabilize before they raise their cost of funds rates. Unfortunately, San Francisco rental rates will possibly lag far behind looming interest rate hikes. Most of you have variable interest rate debt or, at the most, three- to five-year fixed rates. The loan guy in my office is doing a crazy amount of variable rate finance deals with loan rates that can and will fluctuate with the market every six months. The fact is that the fundamentals of income/expense statements of local apartment buildings are under some serious pressure. Interest rate hikes, increases in fire and liability premiums, increase in worker’s compensation costs, increased litigation in general, tenant activists on a mission and a soft rental market could conspire to put downward pressure on building prices in the near future. If history is any indication, when the music stops it tends to stop abruptly.
What does all this mean? Probably nothing. God knows that if I could predict the future of apartment building prices, I would not be sitting here writing this article. I would be doing whatever fabulously wealthy people do for fun—going to bull fights on acid, taking world cruises on private yachts, dating models and collecting fancy art. Just remember, there are absolutely no entitlements in this industry. You are not entitled to any particular rent or any particular building value. Try not to extend yourself to a point where you cannot afford to hold on to your property in a downturn. They say that to have had money and lost it is better than to have never had money. Don’t you believe it.
What’s the good news? The good news is that even at an average building price of $250 per square foot, apartment buildings are still selling at well below their replacement costs. You can’t construct these buildings for their current selling prices. Whether you would even want to over the next 5-to-10 years remains to be seen.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the San Francisco Apartment Magazine. Marc Wilson has been managing and selling San Francisco apartment buildings for over 15 years. Please send your questions concerning property management issues to Marc Wilson at 1699 Van Ness Avenue, SF, CA 94109. He can be reached at 415-229-1275. Copyright © 2004.