This post first appeared in the October edition of Cirios Trends: Getting to the Bottom of the Housing Market

For anyone who has tried to rent an apartment in the past six months
– especially in big cities like San Francisco or New York — the
pickins have been extremely good, to say the least.

As the economy has remained mired in its post-almost-financial-apocalypse quagmire, tenants’ willingness and ability to pay what now seem like exorbitant rents has evaporated. In particular, a traditionally reliable source of rental demand which came from new attorneys, investment bankers and other young professionals armed with absurdly large paychecks has disappeared.

(Source: The Wall Street Journal)

Landlords, in turn, are slashing rents as vacancies rise and tenants move out of ritzy buildings in favor of more modest, affordable digs.

In one particularly poignant example here in San Francisco, a renter who paid $2,200 for a 1-bedroom apartment in North Beach last September, just months ago renegotiated his rent down to $1,600 per month. That’s more than a 25% drop in a year! I mean, his landlord is the largest apartment owner in San Francisco and has seen scores of buildings foreclosed on by its lenders, but who’s counting.

As you can see from the chart in the top right of this page and from the table of cities with the biggest rent declines over the past year, California has not been spared in this decidedly deflationary trend.

The easy — and accurate — conclusion to draw from rents tumbling is that sales prices for condo, especially in big cities, aren’t stabilizing any time soon. Rents are typically leading indicators for condo prices (both on the way up and on the way down), since rental turnover is more regular and transactions are much shorter. Rents therefore react more quickly to changing market dynamics.

This analysis, however, isn’t terribly helpful other than for warning would-be condo buyers that now may not be the time to stretch for that penthouse apartment in SoMa.

What is interesting is what these falling rents mean for real estate investment opportunities in the not too distant future. Apartment buildings are traditionally valued using some multiple of the cash flows generated by rents, less the monthly operating costs for the building as a whole (including loan costs).

So, as rents fall, naturally so too do the values of apartment buildings. But, since apartment buildings are not often bought and sold, it can take months, if not years for a drop in rents to translate into meaningful price depreciation for multi-family buildings. Price
Discovery, a concept often-discussed at Cirios, is delayed, as buyers are wary of making investments in a declining rental environment.

And as owners of these multi-family buildings are pinched with weak rents, many will become distressed and motivated sellers. These are the sellers opportunistic investors should look for in the months and years to come.