SF Apartment : March 2017

MIGHTY SMALL

Down to Details

by Kilby Stenkamp

In the aftermath of the election, and as we continue through the new year, we’ve heard numerous economists speculate that worldwide inflation is inevitable. For example, Janet Yellen, chair of the Board of Governors of the Federal Reserve System, has indicated that interest rates will soon be on the rise. After the historically low interest rates we’ve been experiencing over the last few years, perhaps a rise in rates can only be expected.

So, what do these economic predictions mean for 2-4-unit properties in San Francisco’s micro-economy? Up until 2015, 2-4-unit properties made up about 25% of the city’s housing stock. Now, due to new construction, condo conversions, and TIC sales, this percentage has dropped—but demand for 2-4-unit properties has remained stable. Between inflation, rising interest rates, shrinking inventory, and steady demand, I expect values for 2-4-unit properties to go up. 

Unique Buyers and Properties
The 2-4-unit market stands on its own in San Francisco real estate because each building is unique, with different factors significantly determining each property’s price. For example, there are mixed-use buildings, condo conversions, TICs, owner-users, and income properties. Of course, agents and investors need to consider the type of building, but also they need to focus on the tenant profiles, leases, property condition, property history, and income potential. Tenant profile hurdles can include long-term tenancies and lows rents, protected tenants, properties rented by the room, and eviction history, which can impact the possibility to condo convert or to occupy the property as an owner-user. Other factors impact the value of 2-4-unit properties as well, including style, location, parking, views, outdoor space, and expense vs. income.

Like this niche market, buyers of 2-4-unit properties stand on their own as well, each having their own very specific wants and strategies. Some care only about income and vacancies, others are interested only in condo conversion implications, and some have a long list of required amenities. For example, I recently looked at a mixed-use building made up of commercial space on the ground floor and two residential units on the second floor. The commercial tenant’s lease terminates in 2019 and is currently under market rate; one of the residential units is vacant, and the other is rented to a Section 8 tenant. 

At an initial evaluation, we determined the property had limited value because of the lower rents and lease restrictions. But, after a more thorough evaluation of the building and leases, we saw the massive potential. Because Housing and Urban Development (HUD) recently approved a substantial Section 8 allowable rent increase in Bay Area counties, we saw an upside to the Section 8 tenant’s rent. There is also a vacant garage and space to add coin-op laundry. Our second, more in-depth consideration of the property opened our eyes to different possible scenarios. This property is a marketing dream; the ideal candidate is an owner-user looking for mortgage relief, who also needs the commercial space and wants to live in the same building. Another good candidate could be a buyer simply looking for an income property. 

New Condo Construction vs. 2-4-Unit Buildings
Condo construction is dominating the current San Francisco landscape. The cost to build a unit is cheap, and the return to the developer is high. In the case of a market slowdown, developers can hold on to the units as rentals and sell them when the market picks back up again. Alternatively, 2-4-unit buildings are quintessential San Francisco classics, built in the Victorian or Edwardian era. Later periods include Spanish, Art Deco, Craftsman, and the popular Marina style. I compared newly constructed condos and 2-4-unit buildings on the Multiple Listing Service and found that citywide in Q4 2016, 2-bedroom condos sold for an average of $1,032.34 per square foot, while 2-4-unit buildings sold for an average of $641.85 per square foot. 

Now, while I’m a huge 2-4-unit property enthusiast, I realize not all 2-4-unit properties are created equal, and that not everyone is cut out for a 2-4-unit building. However, when I consider the difference in the price per square foot between condos and 2-4-unit properties, I can’t help but conclude that a 2-4-unit property can be a prudent investment. There are always good deals in any market; investors just have to search them out. In a 2-4-unit building, even when the market falters, there is liquidity to hold and prices always rebound higher. 

However, it’s very important for buyers to thoroughly evaluate a 2-4-unit building. In the case of investment or as an owner-user buyer, defer to a landlord-tenant attorney and understand the scope of what you’re buying (tenant profiles, eviction history, deferred maintenance). Condos built after 1979 are generally exempt from rent control, however, most 2-4-unit properties were built prior to 1979 and are not exempt. And in recent years, the local laws have changed regarding owner move-in eviction and condo conversion. Ellis Act evictions are much more difficult, time sensitive, and costly than they used to be. Paying for a few hours of attorney’s fees could end up being the best money you ever spent.

Get Strategic
I entered the San Francisco market in the early 1990s. I leveraged every dime we had to buy a 3-unit building. We sub-divided the property and sold the units in the front, which were subsequently converted into condos. The proceeds of this sale afforded a substantial renovation on the back building. My next purchase was a gorgeous property with fluted plaster ceilings, an incredible Victorian interior, and a stunning Deco exterior. The property was a legal two-unit building when I bought it, and then when I went to sell, the use on the Report of Residential Building Record came back unknown. In tracking water and tax records, I discovered the second unit was original, and a permit was pulled to legalize the second unit. Eventually I sold that building, and the new owners condo converted. My primary focus has been the 2-4-unit market ever since. Some of the properties have been incredibly easy to navigate, while others have been a bit more challenging. I have a lot of good stories to tell, as does any income-property owner in San Francisco—and most of the readers of SF Apartment Magazine probably do, too. 

In closing, no matter the state of the market, when investing in 2-4-unit properties, thoroughly evaluate the physical property, the building’s history, active leases, and potential upsides, and consult a landlord-tenant attorney. 

Kilby Stenkamp is a realtor at Keller Williams. She can be reached at [email protected] or 415-370-7582.