market view

By Jay Greenberg

Last year was another excellent year for apartment transactions, but third and fourth quarter numbers reflect another story. After 14 years of positive or steady value growth, many factors are stalling our market. Uncertainty in our current economy has created a wait-and-see attitude for many investors. Fundamentals remain strong for apartment operators as we weather current conditions. The statistics are reported below with value indicators comparing 2006 with 2007.

The following are 2007 year-end statistics for the 5-9-unit sector versus the same time period for 2006. The average price per sq. ft. has increased from approximately $271 in 2006 to approximately $323 in 2007. Gross rent multipliers have slipped from approximately 17.43 times gross in 2006 to 17.01 times gross in 2007, and the cost per unit climbed from approximately $235,000 in 2006 to approximately $294,000 per unit in 2007.

Dollar volume for the 5-9-unit sector in 2006 was approximately $187 million versus approximately $243 million in 2007. The number of transactions in 2006 and 2007 were virtually identical.

For the 10-plus-unit sector in the same time period, the average price per sq. ft. has increased from approximately $281 in 2006 to approximately $314 in 2007. GRMs have risen from approximately 14.21 in 2006 to approximately 15.95 in 2007, and the cost per unit has increased from approximately $220,000 per unit in 2006 to approximately $233,000 per unit in 2007.

Dollar volume for the 10-plus-unit sector in 2006 was approximately $285 million versus approximately $667 million in 2007. The number of transactions in 2006 was approximately 74 versus approximately 129 in 2007. The source of the numbers reported is from the Marcus & Millichap Research Department, the San Francisco Multiple Listing Service and CoStar Comps.

The 5-9-unit market had a 16% increase in the cost per foot, a 20% increase in the cost per unit, and a 23% increase in dollar volume, all without an increase in the number of transactions and a slight dip in GRMs. I believe the 5-9-unit sector is currently more stable than the 10-plus-unit market. The buying pool has greater diversification, a larger owner-user component, and a smaller cash down-payment
requirement for purchases. All these factors combined should help keep this segment of the market stabilized. Regardless, we have seen approximately 14 years of value growth and some adjustment in pricing and/or transaction volume will probably take place this year.

The 10-plus-unit sector of the market had an 11% increase in the cost per foot, a 6% increase in the cost per unit, and an 11% increase in gross rent multipliers, combined with a whopping 57% increase in dollar volume and a 42% increase in the number of transactions. The increases mentioned above do not seem to really show the run up in value that occurred last year. These numbers can be skewed on a year-to-year basis depending on where the volume of transactions took place. For example, if we compare two consecutive years when there was a large volume of sales north of California Street to the subsequent year, which had many sales in the Downtown area, we might see a decline in some value indicators even though, in reality, prices continued to escalate.

Sales numbers for this sector in 2007 need to be more closely examined. From January through August, sales activity was robust. However, at this time, the subprime meltdown started hitting the front pages and investors began scrambling in an attempt to secure financing for purchases. In the last four months of 2007, the monthly average of 10-plus-unit apartment sales fell by more than 50%. Many more pending escrows were eventually cancelled because of financing issues. Today, the largest apartment landlord, who had invested more than $1 billion in apartment buildings since 2005, is offering 17 buildings for sale, with a combined asking price of $112 million. MLS inventory is up and activity levels are down. Many agents are grumbling about the lack of activity for current listings. Investors have taken a wait-and-see approach to the current market.

At this time last year, prices were at all-time highs and financing was not
an issue. Lenders wanted to loan and hungry investors wanted to borrow. Many properties were purchased with high leverage components that cannot be duplicated today. Since August, we have seen a blood bath in the banking and financial sector. Many of Wall Street’s biggest names have taken the largest losses in their histories, amounting to hundreds of billions of dollars. The mortgage and credit companies could still be in the early stages of this crisis with further bad credit issues around the corner. Currently, the turmoil is spreading over into many other industries and pushing our economy to the brink of recession.

In the past few months there have been some significant sales matching all-time-high value indicators, but I do not believe the market can sustain these numbers. The principals in these transactions are local knowledgeable operators who seem to continue adding quality properties to their portfolios with purchases every five to ten years. They are not investors who purchase multiple buildings annually. In all likelihood, they are out of the market for years.

It is too early to say that the market and the pricing levels of the past few years are gone, even though signs are pointing in the direction of caution. We are currently in the first quarter of the year, which is typically the slowest quarter for apartment sales. On the flip side, the fourth quarter is usually the most active quarter of the year; but this was not the case in 2007. There are many local apartment operators who purchase multiple properties annually; however, these clients are not buying at current pricing levels. Pricing based on sales comparables for the past 12 months will not demonstrate what is happening today. Agents and owners need to pay attention to what is not selling when pricing properties. There are investors with funds looking for well-priced properties; however, very few sellers have made adjustments to pricing based on current market conditions. While we may see big numbers for special properties, it seems that (given current inventory levels) some adjustments need to be made in pricing levels to get noticed. The apartment market is slowing, but it is not in a free fall like many other markets around the country. To date, the San Francisco apartment market has held up remarkably well.

For owners, fundamentals are sound. The rental market is strong and vacancy factors are low citywide. The commercial real-estate market is strong in San Francisco. Many tech, clean-tech, and bioscience companies are in the market for big increments of space in the city. Recently, there has been a tremendous influx of tech companies opening offices in the city because of our diverse work force. Names like Yahoo, Microsoft, Google, Cisco, Intuit, MySpace, Stubhub and Autodesk have helped San Francisco gain some technology prominence over Silicon Valley. It is a trend that harkens back to the boom days of the late 1990s. But this time, tech companies are proceeding conservatively and are more frugal in their future build-out ambitions. Now, a wide range of tech firms have chosen to diversify themselves physically in San Francisco to better tap into the talent pool that does not want to live in suburbia. Tech companies are global and need to make all their employees feel comfortable in their working environments. A lot of top talent lives in the area and, with all the city has to offer, employees prefer to work here.

The demand for new housing remains strong, but constrained supply contributes to high prices and high rents, with lower price depreciation. Apartment construction remains limited as developers concentrate their resources on condo projects. This year, 800 units are forecast to come online. Trinity Properties has broken ground on the largest residential development in San Francisco since Park Merced. This 1,900-unit apartment project will replace the existing 360-unit Trinity Plaza. The high-rise complex will include 60,000 sq. ft. of retail and office space.

While fundamentals in San Francisco’s apartment market remain strong, many lenders in our market have been affected by tightening in the national and global capital markets. This means that most lenders are employing higher debt-service coverage ratios and “back to the basics” underwriting criteria, which means lower loan-to-value ratios than were common through the third quarter of 2007. High-leverage apartment loan programs are still available, but stronger borrower sponsorship is a necessity to qualify. Generally, aggressive underwriting tactics like using pro-forma rent projections and interest-only loan payments have become things of the past. Because of a perception of risk and uncertainty in the economy, lender spreads have steadily increased since August of 2007. At the same time, key indicies such as Treasury yields, swaps, the London Interbank Offered Rate, and the prime rate have decreased substantially, bringing all-in interest rates on apartment properties down to historically low levels. Therefore, today’s investors have an opportunity to lock in low fixed-rate debt for apartment properties as the economy continues to steer interest rates lower.

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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 © 2008 by SF Apartment Magazine. All rights reserved.