market view
Values Are Up, But a Shift May Be Coming
By Jay Greenberg
In this article, the statistics through the third quarter regarding dollar volume, number of transactions, and value indicators in the 5-plus-unit market are reported. The apartment sales market has been very strong in 2007, with value indicators at all-time highs. I will try to explain how and why buyers are closing transactions at these all-time high numbers. The rental market has continued to rise throughout the year as population and job growth continue with slight gains each month. Interest rates remain at historically low levels; however, underwriting parameters have changed because of the volatility in the financial markets. The picture regarding the subprime meltdown and its effects on our local apartment market should become clearer as the story unfolds. Apartment transactions became more difficult to close as we ended the third quarter and there is uncertainty for many existing escrows as we head into the final and typically most active quarter of the year.
The following are 2007 year-to-date (through the end of the third quarter) statistics for the 5-9-unit sector versus the same time period for 2006. The average price per sq. ft. has increased from approximately $317 a foot in 2006 to approximately $323 a foot in 2007. Gross rent multipliers (GRMs) have slipped from approximately 18.23 times gross in 2006 to 17.17 times gross in 2007, and the cost per unit has increased from approximately $274,502 in 2006 to approximately $292,451 per unit in 2007.
Dollar volume for the 5-9-unit sector (through the end of the third quarter) in 2006 was approximately $155 million versus approximately $183 million in 2007. The number of transactions in 2006 was approximately 94 versus approximately 104 in 2007.
For the 10-plus-unit sector in the same time period, the average price per sq. ft. has jumped from approximately $272 a foot in 2006 to approximately $334 a foot in 2007. GRMs have risen from approximately 14.38 in 2006 to approximately 16.45 in 2007, and the cost per unit has also jumped from approximately $208,000 per unit in 2006 to approximately $244,000 per unit in 2007.
Dollar volume for the 10-plus-unit sector in 2006 for the same time period (through the end of the third quarter) was approximately $363 million versus approximately $474 million in 2007. The number of transactions in 2006 was approximately 68 versus approximately 75 in 2007. The sources of the numbers reported are the Marcus & Millichap Research Department, the San Francisco Multiple Listing Service and CoStar Comps.
In the 5-9-unit sector, GRMs have decreased; however, the cost per unit and cost per sq. ft. have risen slightly. Dollar volume and number of transactions also increased. In the 10-plus-unit sector, dollar volume, number of transactions and every other value indicator that I have reported has risen. The rise in value indicators has been astonishing: a 19% increase in cost per sq. ft., a 14.75% jump in the cost per unit and a 12.5% jump in GRMs. All of this happened along with increased dollar volume and sales. Who could imagine increases like this a year ago? Our market has produced 11 years of solid appreciation. While other markets have spiraled downward, our market has continued to climb.
How and why are buyers willing to pay GRMs that average above 16 times gross? There are several answers to this question, the first being that most buyers will not pay these kinds of numbers, as the market has been dominated by a single buying entity. Other buyers are present in the market, completing exchanges and enhancing their portfolios. Very few have been willing to close escrow at the average GRM of 16 plus. Many other “wannabee” investors are not willing to hunt for well-priced properties because of sticker shock.
There are still transactions closing at numbers that we would consider reasonable; reasonable being defined as the pricing levels that we saw a few years back. These are a few select transactions that I have closed this year: a 28-unit building in Russian Hill, 14.75 GRM, $252 per foot with big upside; 10 units with 10 parking spots in the Richmond district at 12.34 GRM; an 8-unit building in Pacific Heights, 13.8 GRM, $244 per foot with big upside; and a 12-unit in NoPa, 12.32 GRM, $272 per foot. The largest buyer in our marketplace purchased only one of these transactions.
The reason some investors are willing to pay GRMs that average above 16 times gross is because of the upside that is built into our market by our rent control laws. San Francisco has some of the highest rents in the country. In the better neighborhoods, units rented two years ago are far below market today. The experienced buyers in San Francisco are able to very quickly access upside potential in buildings by passing through operating costs, adding value with renovations and creating turnover in the buildings. In the last two years, I have personally turned over more than 50% of my rental units. Of those turnovers, the lowest rent increase I achieved after renovating the unit was more than $1,000. With these kinds of increases and very attractive fixed rate money available, these properties with high GRMs can be converted into profitable buildings quickly.
For the past 18 months, we have seen slight increases each month in population and employment in the San Francisco MSA. With a limited supply of rental units and an overall vacancy rate hovering around 3%, there continues to be pressure on asking rents. On top of this, each month more rental units are being removed from the market with Ellis Acts, TICs and condo conversion.
Homeowners will continue to search out the most affordable housing units in San Francisco. The average asking rent per room in San Francisco is $1,627, according to advertised rents in the last 90 days. The lowest average rent per room was in Bayview at $909 a month and the highest average rent per room was in the Financial District at $2,693 a month. The top five neighborhoods commanding the highest rents are Russian Hill, Pacific Heights, Nob Hill, SOMA/South Beach and the Financial District.
National Problems May Have Local Effects
At press time, there were still excellent fixed-rate loans available in the market place, though most of the lenders have tightened up the debt coverage ratios, meaning the loan-to-value amounts are lower than what we had been seeing the last few years. Many lenders have basically changed from a break-even scenario to a trickle-of-cash-flow scenario. This should be a healthy adjustment for the entire market.
The woes created by the subprime market meltdown continue and the Federal Reserve Bank has been very proactive in trying to mediate the impact. Ultimately, the severity of this crisis will be known as we move forward into the future. Some of the largest banks and Wall Street firms have taken their biggest losses in history. The aggressive lending practices that have led to the subprime meltdown have had a major effect in driving our apartment values to current levels. While most local investors finance their purchases with local lenders, the largest buying entities have been borrowing from different sources based on different underwriting. Many of the sales that have produced the highest value indicators had very high leverage components. We have seen many of these sales close with 90% financing and sometimes 100%-plus financing. Certainly, the ability to purchase properties without putting any money down would create a different pricing level when competing with typical buyers who would need down payments exceeding 60% to close. This is where the uncertainty in our current market has occurred. If the larger buying entities can no longer obtain the type of leverage they have become used to, then we are going to see an adjustment in the value indicators. If this were to occur, I do not believe we would experience drastic pricing adjustments because of the continued pressure on rents. However, I do believe GRMs would adjust downward, while price per foot numbers would probably remain steady based on the continual upward movement of income that occurs every time a vacancy occurs.
As we ended the third quarter, the top apartment brokers could feel a shift occurring in the market. Buyer appetite was still present, but securing financing for the transactions became quite difficult. Most of the agents involved in these transactions are not involved in the financing aspect of the transactions. It is not unusual for buyers to write offers without financing contingencies because of established business relationships with their own lenders. While many transactions were closed in the third quarter, many more were extended, postponed and/or canceled. As we headed into mid-August and September, I began to see a difference in the way our most aggressive buyers were writing their offers. The offering prices were below recent levels, with very small deposit amounts. This was a sign from these particular buyers that there had been a shift in their own confidence in regard to successfully closing escrows. The lack of confidence has been created from the difficulty in securing the necessary financing. In August, there were 19 transactions that closed for 10-plus units, compared to one sale in September. The fourth quarter, typically the most active for closings, should give us a clearer picture of where we are headed for 2008. Stay tuned.
The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Jay Greenberg is a real-estate broker with Marcus & Millichap and can be reached at 415-625-2115. Copyright © 2007 by SF Apartment Magazine. All rights reserved.