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by Allison Chapleau

If you have rented out an apartment this summer, you are aware that rents have risen significantly compared to the fourth quarter of 2006, or even compared to earlier this year. The question is: how much higher can rents increase before they reach their peak? Because of continued demand for San Francisco apartment units and a growing population base, rental growth will continue to spike upward, at least over the near term. In addition, the subprime mortgage fallout and subsequent capital markets crisis that plagues homeowners in the Bay Area has made it more difficult to obtain mortgages priced at more than $417,000, or so-called jumbo loans. As a result, more would-be homeowners have entered the rental market, thus placing further upward pressure on rents and decreasing citywide vacancy rates in virtually every neighborhood in San Francisco.

Tight conditions and elevated housing costs will continue to benefit the San Francisco apartment market for the remainder of this year and throughout 2008. Healthy job creation is driving steady population growth, while the metro’s home affordability, which ranks among the lowest in the country, leaves many new residents with renting as their only reasonable housing option. On the supply side, the construction pipeline consists primarily of for-sale condos, and owners of rental units will remain in the driver’s seat when negotiating lease terms. Metrowide, asking and effective rent gains will once again exceed 7% this year, and while growth will likely moderate going forward, the gap between renting and owning remains considerable and rents will continue to push higher. With the credit markets tightening, home affordability is not expected to ease anytime in the near future.

There is no question that there is a lack of inventory in the current rental market. Approximately 900 apartment units have been completed over the past 12 months, ahead of last year’s pace. While deliveries are approximately twice as high as last year, new construction represents a miniscule addition to total inventory levels. Currently, there are only 200 units under construction and 2,500 apartments in the various planning stages of the development pipeline. The South of Market area is becoming increasingly popular with local residents. This submarket—home to many of the city’s newest development and redevelopment projects—is expected to add more than 200 units annually for the next few years. New apartment construction is expected to total 750 units in 2007, and developers will bring a comparable number of new units to the market next year. Additions to inventory are expected to lag behind household growth in the coming years.

A healthy economy and limited new construction are supporting renter demand for apartment units. Year over year, vacancy ended the third quarter at an estimated 4.5%, 0.6% higher than one year earlier, but down 0.2% since the beginning of 2007. Class A vacancy is currently 5.4%, approximately one percentage point higher than one year ago. The upward trend appears to be reversing, however, as vacancy for Class A product peaked at 6.2% in the first quarter and has trended lower in recent months. With affordable housing in short supply, demand for the metro’s Class B and C properties remains elevated. Vacancy in lower tiers ended the third quarter at an estimated 3.4%, 10 basis points lower than during the same period in 2006. A healthy local economy will continue to support renter demand. Vacancy will end the year down 20 basis points at 4.5%. Looking ahead, vacancy is also expected to post decreases further in 2008.

The good news for landlords is that rent growth will likely continue to increase well into 2008 because renting in San Francisco is much cheaper than buying a single-family home. The monthly mortgage payment, using traditional financing for a median-priced home, is more than twice as high as the average Class A asking rent. The current median income is approximately one-third of the amount needed to qualify for a median-priced home in the metro. The median price of a single-family home in the third quarter was approximately $803,000. The high price of real estate in San Francisco dictates that the majority of buyers take on a significant amount of debt when purchasing property. A jumbo loan describes a mortgage priced over $417,000, and these loans are expensive and difficult to obtain, even for borrowers with excellent credit and financial profiles.

Currently, lenders are uncomfortable with the increasing amount of foreclosures and defaults in the jumbo loan market and have therefore increased the cost significantly, making it difficult for entry-level buyers to purchase a home, thus keeping them in the rental pool. While strong hiring and low unemployment are putting upward pressure on wages, resulting in a 5.4% increase in the metro’s median household income, affordability remains an immense challenge. The Federal Reserve Board is not expected to cut interest rates again this year, and the ability to qualify for a loan is not expected to get any easier; therefore, the rental market will continue to strengthen.

Even those individuals who have acquired single-family homes in the past two years are now at risk because of the capital market shifts. People who have purchased residences with unusually low down payments enjoyed relatively low monthly mortgage costs due to variable rates, a relatively new lending vehicle known as adjustable-rate mortgages. However, that scenario is about to change dramatically. Single-family home sales prices have remained consistent and even improved marginally in the past two quarters, but with interest rates on the rise, some homeowners are forced to sell because their monthly payments are too high. This is good news for apartment owners.

Rising Rents Lead to More Deals
Tight conditions are driving healthy revenue growth. Asking rents have increased 6.8% over the past 12 months to $1,784 per month. In addition, owners have burned concessions, causing effective rents to spike 7.4% year over year to $1,696 per month. Asking rents in Class A properties have gained 6.2% over the last year to $2,195 per month. Owners of Class B and C properties are taking advantage of healthy demand, allowing asking rents to jump 8.2% to $1,459 per month. Average revenues have risen 6.7% over the past 12 months, with a similar gain forecast for 2008. With conditions tight and housing options limited, owners will be able to impose steady rent increases. Asking rents will end 2007 up 7.1% ($1,814 per month), while effective rents will increase 7.4% ($1,718 per month).

In the San Francisco submarkets, expanding residential demand in the South of Market Area has driven investor activity over the past year. Investment sales specialists in Marcus & Millichap’s San Francisco office have witnessed rising prices for all multifamily product in the city and have entertained multiple offers on most apartment buildings on the market. During that time, sales velocity in the submarket has increased nearly 20%, with properties trading at cap rates in the mid-4% to mid-5% range. In the Russian Hill/Embarcadero and Marina/Pacific Heights submarkets, average cap rates have pushed 0.6% higher.

As buyers’ and sellers’ expectations adjust and become more aligned, there could be an increase in deal flow in these areas in the near term. The Civic Center/Downtown submarket is receiving a great deal of attention from developers and investors. Several high-end condo projects are in the area’s development pipeline, which could result in some increased competition for apartment owners. Despite the potential for a modest increase in vacancy, the submarket’s continued emergence is expected to support steady rent growth in 2008.

Rent is not the only economic category increasing in San Francisco. Preliminary estimates for the third quarter have posted employment growth in the San Francisco metro at 1.9% year over year, with the addition of 17,900 new jobs. Gains have slowed in recent quarters, however, and this trend is expected to continue in the months ahead.  The metro’s largest employment sector, professional and business services, highlights the region’s overall strength. Year over year, the sector has expanded by 4,000 jobs, with another 4,500 positions expected in 2008. Employment in San Francisco is forecast to advance 1.2% this year, or by 12,200 new positions, with similar gains projected in 2008.

Healthy metrowide demographics and suitable insulation from the threats associated with overbuilding will continue to attract investors to San Francisco’s apartment properties over the coming quarters. While cap rates, which have averaged in the low- to mid-4% range over the past year, will likely edge higher, economic uncertainty in the credit markets should result in investors placing increased emphasis on quality metros and properties, a trend that will attract additional capital to local apartments. As such, there could be some shifts in the buyer profile, with local, cash-heavy investors, which are prevalent in San Francisco, playing a more prominent role. Looking ahead, established communities north of California Street, such as Russian Hill and Pacific Heights, will continue to attract buyers seeking premium assets, while investors looking for greater upside potential will investigate options in Hayes Valley and Downtown.

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The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or SF Apartment Magazine. Allison Chapleau is a senior associate in the San Francisco office of Marcus & Millichap Real Estate Investment Services. She is also a member of the firm’s National Multihousing Group. Contact her at 415-625-2159 or achapleau@marcusmillichap.com. Copyright © 2007 by SF Apartment Magazine. All rights reserved.