This post first appeared in: Cirios Trends – Special Edition: The Year Ahead

While most of the positive press in 2010 surrounded the single family home market, perhaps no segment fared as well last year as apartments. Investors piled into multi-family properties for a host of reasons, which leaves the sector at a critical crossroads for 2011.

First, a quick tour of last year’s data. According to Integra Realty Resources 2011 IRR-Viewpoint, the multi-family sector is typically the first to turn around after a recession, and 2010 was no different. Integra saw 81% of US markets recover or begin an expansionary phase, compared to just 9% in 2009. Vacancy rates dropped dramatically, a finding echoed by REIS: Nationwide vacancies dropped to 7.1% in Q3 of last year.

A major factor pushing down vacancies was a snap back from the massive demographic upheaval of the Great Recession. According to Marcus and Millichap, between 2005-2009, the number of 18-34 year-olds living at home increased by 2.2 million, the highest level recorded in the past 25 years. Since this demographic is the highest population of renters, vacancies skyrocketed as the economy soured.

But vacancies started dwindling as the economy slowly got back on track. Call it pent-up demand to move out of mom’s basement: As young adults began to find jobs (or became more hopeful they would do so soon), they moved into their own places in droves. Further, the housing market’s dramatic collapse coupled with tightening mortgage guidelines is forcing many young people to delay the home buying decision for more clarity in the market’s future.

Meanwhile, falling vacancies and an influx of investor cash pushed down capitalization rates to levels not seen since before the crash. During the early stages of the downturn, investors raised huge pools of cash to buy up distressed commercial properties as banks foreclosed on troubled borrowers and pushed the buildings out to market. But as Washington encouraged lenders to extend loans and modify terms, the flood of distressed properties never came.

Marcus and Millichap noted that the pendulum has swung full circle, and that 2010 exhibited a flight to quality trend, as investors focused on geographic markets with strong liquidity characteristics and resilient economies. New York City, Washington DC and San Francisco have been the beneficiaries of investor money seeking high quality, cash flowing assets. Cap rates, as a result, have compressed, leading some observes to wonder if the apartment market has gotten ahead of itself.

Here in San Francisco, there has been a marked change in the rental market just in the past six months. Gone are the days where tenants could negotiate a lower rent or get a couple months free. Back are the days where multiple applicants are common and the most pro-active prospects show up with deposit checks and completed applications in hand. Rents have risen in kind, as employers like Twitter, Salesforce.com, Zynga, Trulia and others are doing their part to repair the battered Bay Area employment market.

A second trend, which has been noted both nationwide and locally, is the divergence between high end and mid-low end buildings. Just last week, the popular economic blog Calculated Risk noted “the apartment market has bifurcated. Upper half of apartments are improving, regardless of geography. Lower half are struggling.” This echoes Marcus and Millichap’s view that there is a flight to quality ongoing.

So where are the opportunities, if big players are snatching up all the “high quality” properties and banks are delaying the flushing of distressed assets onto the market? The answer, in our view, lies somewhere in between.

As anyone who has spent considerable time as a renter can tell you, landlord quality varies widely, if not wildly. Often, owners of small buildings (duplexes, triplexes, etc) can offer high touch, personal service, resulting in a good tenant experience. On the other end of the spectrum, large institutional landlords may be impersonal, but generally their service adheres to a reasonably acceptable level of quality. Meanwhile, there is a middle band of properties that lie somewhere beyond the scope of the small-time landlord but below the radar of the institutional owner. Typically in the 5-30 unit range, these buildings are often older, landlords less pro-active and amenities lacking. Low rents can be found, but tenants likely have to settle for outdated kitchens, old appliances and fairly mediocre living conditions.

This is particularly true here in the Bay Area, where large numbers of such buildings were constructed during the 1950s and ‘60s. Many of these properties have been owned by the same individual, family or small investment collective for decades and haven’t been updated since Reagan was President, or before.

Rents are low, systems are out of date and the properties in general are in need of some love. The opportunity exists for savvy buyers to come in, make smart improvements, raise rents, lower operating costs and dramatically increase the value of the property. Couple this straightforward, time-tested investment strategy with downtown redevelopments ongoing in cities like San Mateo, San Carlos, Redwood City and Sunnyvale and you have a recipe for opportunity.

Of course, such properties are scarce and sellers often unwilling to bring prices down to where it makes sense for an investor. Which begs the question, where are the real sellers and will they finally come out of the woodwork in 2011?

This post first appeared in the September edition of: Cirios Trends: In Search of Real Estate Opportunities

Is Google Getting Long Real Estate?
(Silicon Valley Business Journal)
Google, the web behemoth, appears to be stepping further outside its sweet spot of Internet search. The company is investing $19 million in a senior housing development in nearby Sunnyvale, aiming to support building low cost affordable housing in California. Also, making a couple bucks doesn’t hurt. Google is investing in Low-Income Tax Credits, facilitated by Union Bank. Developers use tax credit investors to generate early-stage operating cash by selling cash credits to investors at a discount. Upon completion of the project, the credits mature and investors, in this case Google, earn the difference between where they bought them and the full value of the credits.

(Read more here)

Sunpower Gets Pop from Stimulus
(Silicon Valley Business Journal)

San Jose based Sunpower Corp., a solar power integrator, announced plans to install solar power systems on a host of US government properties, which the company said could generate around 1,000 new jobs in the Bay Area. In particular, the bulk of the new jobs will be focused in the construction sector, an industry badly hurt by the anemic home building environment of the past three years. This isn’t the first government gig Sunpower has won, as the company started working on government contracts as early as 1999. And while 1,000 jobs is a drop in the bucket compared to the broad economic outlook, it is certainly a welcome influx of work.

(Read more here)

Still Ugly, San Francisco Economy Outperforms Peers
(San Francisco Business Times)

The nationwide employment outlook may not be getting better, and may have even started to deteriorate again, but at least its no longer in free fall. And although San Francisco’s 9.7% unemployment rate is nothing to write home about, it’s better than most other large cities in the country, and is certainly the strongest in California. According to Ted Egan, chief economist for the city, between mid 2008 and the end of 2009, jobs in software, internet publishing, intellectual property transactions, directory publishers, translation services and performing arts and management all grew at least 20%. These are not the nations largest industries, but many are centered right here in the Bay Area.

(Read more here)

Local Investor Diversifies into Apartment Buildings
(The Registry SF)

900,000 square feet of office space is coming to market, according to CB Richard Ellis, the real estate brokerage tasked with marketing the properties. The Sobrato Organization, a family-owned real estate investment group, is selling a 12-building Silicon Valley portfolio. The company’s stated reason for selling is its ongoing diversification away from office towards multifamily properties and equities. As noted in the RegistrySF.com, a local real estate website, the flood of foreclosed commercial properties never came, so demand for the Sobrato portfolio should be healthy.

(Read more here)

This post first appeared in the June edition of: Cirios Trends: Finding Real Estate Opportunities.

“Mow much should I pay?” is about the most common question we get here at Cirios. Unfortunately (or fortunately), the answer to this question is never black and white. Depending on a buyer’s desired use for a property, there are many ways to determine value and what the right price to pay is.

An investor looking to rehab and sell a home quickly may put a different value on it than an investor looking to buy and rent for several years. Since each investor has different profit targets and time horizons, formulas that determine what price the investor would pay nearly always differ.

Still different is the price a regular home buyer would be willing to pay after accounting for mortgage payments, tax breaks, upkeep expenses, etc.

This piece covers a couple different methods for valuing a property, and is at best a cursory examination of these topics. Each one contains many further levels of complexities and nuance.

Many investors that purchase and hold income generating properties use the Income Method of valuation to determine an attractive purchase price. If an investor wants to earn, say 6% on his money, he would use the annual operating cash flow generated by the property to calculate what purchase price would achieve that level of return.

This type of investor often uses the concept of a “Cap Rate” to figure out how much properties are worth. A Cap Rate (short for Capitalization Rate) is the rate of return generated by net cash flows – that is, rental income minus all operating expenses associated with owning the property. For example, if a 6-unit apartment building bought for $400,000 generated $30,000 in net operating income, the Cap Rate would be 7.5% ($30,000 / $400,000).

If a nearby 6-unit building generated $45,000 of income, applying the same Cap Rate you would arrive at a value of $600,000 ($45,000 / .075). In general, as markets improve and property values go up, Cap Rates go down. This makes sense: When times are good, there are usually more buyers than sellers, so sellers can demand high prices which push down rates of return.

The reverse is true when prices fall and markets tighten up. Investors demand a higher rate of return for taking the risk of buying a property in a hard environment, which drives down the prices they are willing to pay and thus pushes the Cap Rate up.

For home buyers, the decision of what price to pay is determined by two primary factors. First, the buyer’s ability and willingness to pay. Monthly income and savings will often dictate how much a buyer can pay, then more emotional factors kick in to determine how much he or she is willing to pay. The confluence of hard numbers and soft feelings creates a price range where the buyer can be satisfied both economically and emotionally.

Second, recent sales, other listings and general market conditions will determine what a fair price for a given home is. Subjectivity plays a huge factor in comparing like properties, so valuing single family homes is much more an art than a science.

Often, relative affordability between different cities is evaluated using a “Rent Ratio.” A Rent Ratio is exactly what it sounds like, a ratio between the cost to buy and the cost to rent. If a $200,000 home would cost around $16,000 per year to rent, the Rent Ratio is 12.5 ($200,000 / $16,000). According to Rent.com, which compiles rental data nationwide, a Rent Ratio around 15 means the buying and renting are roughly equivalent options. Below 15 and buying may be the best route, while above 15 and it may be best to hold off.

According to the most recent data, San Francisco is actually ranked as the best city to rent, with a whopping Rent Ratio of 37. That’s higher than New York at 21 and Honolulu at 24.

So, does that mean it’s a terrible idea to buy a home in San Francisco? Far from it. There may be plenty of valid reasons not to buy in San Francisco, but a broad metric like this doesn’t tell the story of individual neighborhoods.

What this high ratio does tell you, is that if you are lucky enough to find a property in San Francisco where buying and renting cost roughly the same, you are probably getting a pretty good deal.

This post first appeared in the May edition of: Cirios Trends: In Search of Real Estate Opportunities.

Silicon Valley Defies California Gloom
(Silicon Valley Business Journal)

Even though consumer confidence in California has fallen to a historic low, Silicon Valley residents remain some of the country’s more optimistic folks. California’s Index of Consumer Sentiment registered an all-time low of 68.8, five points lower than last April’s 73.8 tally. Silicon Valley, on the other hand, came in at 75.9. Just 14% of the state’s residents believe they are better off now than they were a year ago. On the flip side, only 13% believe they’ll be worse off next year at this time. So, even though Californians think the current situation generally stinks, by in large we don’t think it can get much worse!

(Read more here: http://tinyurl.com/ciriostrendsmay1)

Calls for a Bottom in Commercial Real Estate Ring … Softly
(Cornish and Carey Commercial Real Estate)

A growing consensus is emerging that despite fears of a collapse in commercial real estate, the market may be quietly healing itself. In its latest quarterly survey of San Francisco commercial real estate activity, brokerage Cornish and Carey reported that Class A asking rents inched up by 0.4% from the previous quarter. A smidgen indeed, but this marks the first Q/Q increase since the market peaked in Q2 2008. Even though unleased inventory still appears massive when you look at the data, most of it is concentrated in vast, empty swaths of space. Smaller chunks and premium view space are in limited supply and deals are on occasion seeing multiple bidders. Recovery? Not yet, but investors are licking their chops.

(Read more here: http://tinyurl.com/ciriostrendsmay2)

Are Mortgage Backed Securities Back?
(San Francisco Business Times)

For the first time in almost two years, investors placed bets that mortgages not backed by the government were a good investment. Redwood Trust, a Mill-Valley based real estate investment firm, issued and sold the first private label jumbo mortgage backed security since 2008. The deal, small by bubble-craze standards, consisted of 255 mortgages issued by Citigroup for a total deal size of $222.4 million. The secondary market for mortgage backed securities not insured by Fannie Mae or Freddie Mac has been literally non-existent, as investors have proven unwilling to buy debt without Uncle Sam’s implicit (or explicit) stamp of approval. The deal, adding more fuel to optimists fire, was over-subscribed.

(Read more here: http://tinyurl.com/ciriostrendsmay3)

Foreclosures Continue Steady March Upwards
(San Jose Mercury News)

For all the signals that the housing market may actually be improving, that nasty fly in the ointment, foreclosures, just won’t go away. Despite hundreds of billions of dollars thrown at the problem, foreclosures in Santa Clara County rose 72% from a year ago. This trend is being echoed around California and indeed the country, where foreclosures, the market clearing mechanism everybody loves to hate, continue to plague local economies. One bright spot, however, is that investors are stepping into the market. 4,000 homes were sold directly to investors at auctions – up almost 4-fold from 2009.

(Read more here: http://tinyurl.com/ciriostrendsmay4 )