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Paying The Price

million, 81 units, National City, 2K per unit

Arecent report on rising rents, by the Lusk Center for Real Estate at

the University of Southern California, painted a clear good news/bad news picture of San Diego County’s apartment property market so far in 2016.

Good news for landlords, who have seen average monthly rents rise 5.9 percent in the past year, to $1,422 at the end of 2015 — a figure that is expected to increase by nearly an additional 11 percent by 2018, to $1,577.

.5 million, 114 units Oceanside complex, 2K per unit

Bad news for renters already paying an increasing percentage of their monthly income — currently around 40 percent — for their housing, as new apartment construction fails to keep up with rising demand.

The brokerage firm Marcus & Millichap projects that apartment completions in the local market will actually fall this year, for the second consecutive year, as builders deliver 2,300 new units. Last year, developers brought 3,500 new rentals online.

.6 million, 241 units, East Village, 8K per unit

One of the Tightest Markets

The result is that San Diego currently has one of the tightest apartment vacancy rates among major U.S. metro markets, at around 3.3 percent.

Darcy Miramontes

“Though multifamily construction permits are back to pre-recession levels and have provided some relief, population and employment growth are driving up demand faster than new inventory can hit the market,” said Raphael Bostic, interim director of the USC Lusk Center. “For renters, new construction has simply kept a bad situation from getting drastically worse.”

Kevin Mulhern

Partly due to the costs involved in developing market-rate housing in Southern California markets like San Diego — which have land constraints, relatively high fees and stringent building regulations — much of what does get built generally favors higher-income renters.

Paul Kaseburg
John Vorsheck
Peter Scepanovic

What’s driving the trends are generally good metrics for the San Diego County economy overall, led by the addition of 39,900 new jobs in 2015 — a reflection of what USC described as one of Southern California’s better performing economies in recent years.

Half of new jobs added in 2015 were concentrated in three industries — health care, leisure and hospitality, and construction — and the region’s manufacturing sector added jobs at more than double the statewide pace over the past year.

Despite the recent landlord-favored market trends, local industry observers note that apartment property investors are watching signals carefully. They emphasize that the larger state and national economy in coming years can just as easily send rents into flat-growth or downward mode — as happened with the Great Recession — impacting buyers’ and current owners’ return on their investment.

Local apartment property transaction volume so far in 2016 is tracking slightly ahead of where it was at the same point of 2015. According to brokerage firm JLL, San Diego County saw 114 apartment property sales in the first quarter, at a total price of $559.6 million — an average of $199,840 per unit.

In the first quarter of 2015, there were 85 sales with a total dollar volume of $434.3 million, for an average of $188,495 per unit. However, the average capitalization or cap rate — expected net annual operating income as a percentage of a property’s value — was unchanged year-over-year, at 4.9 percent.

That’s a sign, brokers said, that investors and their lenders are not getting carried away by current market metrics favoring rising rents.

“The underwriters are pricing the current conditions into these transactions,” said Darcy Miramontes, executive vice president in JLL’s San Diego office. “They’re bullish on San Diego, but they’re still only going to pay the top dollar for the best Main-and-Main locations.”

Because of the region’s chronic undersupply of apartments relative to demand, Miramontes said units currently under construction — in pockets such as Vista, the Interstate 15 corridor, Otay Mesa, Mission Valley and East Village —– will likely become absorbed quickly as they are completed in coming years.

Development parcels in high-demand markets are also highly coveted. At one multifamily land site recently placed on the market at University Towne Center by a local church, the seller is currently sifting through offers from 27 potential buyers, Miramontes said.

The Purchases

According to CoStar Group and local brokerage firms, big deals of early 2016 involving existing apartment buildings have included the $52.6 million purchase of a 241-unit property in East Village; the $26.5 million acquisition of a 114-unit Oceanside complex; the $22 million purchase of an 81-unit property in National City; the $16.75 million deal for a 94-unit property in Lakeside; and the $16.5 million acquisition of a 56-unit complex in Hillcrest.

Experts said deals involving larger properties — 100 or more units — have generally remained limited so far in 2016, with more transactions involving smaller and older properties being seen throughout the region. Many are properties that will be renovated and updated to bring in higher rents in coming years.

At CBRE Group Inc., Senior Vice President Kevin Mulhern said U.S. apartment property deals reached a high mark in 2015 for the post-recession period. However, San Diego County and other Southern California markets have seen rent growth kick in just in the past two years, as a lagging indicator of job growth happening since 2013.

Eye on National Economy

Many western U.S. cities — such as San Francisco, Portland, Seattle and Denver — have been seeing double-digit annual rent growth for the past four to five years. Current San Diego supply-and-demand trends will likely stay in place for 2016 and 2017, Mulhern said, but investors are well aware that the cycle could turn on events tied to the larger U.S. economy; the local region actually saw negative rent growth in the 2008-09 period of the Great Recession.

“At some point the rents are going to level off, not because we’ve increased the supply by a lot, but because some people simply can’t afford to pay those prices,” he said.

Generally, Mulhern said, the local apartment market is in growth mode when annual job growth remains in the range of 30,000 and 40,000 — the current level — and flattens out when job growth heads south of 30,000.

Paul Kaseburg, vice president of investments at San Diego-based MG Properties, which is focused primarily on multifamily assets, said MG and other owners continue to see strong improvements in property performance. But they are weighing this against the potential risk of interest rate increases and other factors that could impact their returns.

Generally, however, he said San Diego historically has been less volatile than other western U.S. apartment markets, with current income providing investors with some insulation against potential price decreases. “San Diego tends to attract long-term ownership and has low transaction volume in comparison with other markets,” Kaseburg said.

Trends that Kaseburg and others will be tracking in coming months include unemployment, which could lower rental demand if the jobless rate rises; further development, which would raise supply and could put downward pressure on rents at existing older properties in some neighborhoods; and potential disruptions in capital markets, which could raise interest rates and cause values on all types of properties to fall.

For now, local market variables are strong. John Vorsheck, first vice president and regional manager in the San Diego office of Marcus & Millichap, said the region saw 80 apartment transactions of $1 million or more completed in the first quarter of 2016, up from 68 such deals in the year-ago quarter.

At nearly $200,000 per unit, pricing on apartments is up 4 percent from a year ago. However, the pace of price appreciation has begun to slow, after prices rose by about 15 percent during the course of 2014.

Generally, Vorsheck and other experts said, rising demand for apartments among several demographic groups, especially 35-and-under millennials, combined with rising costs for local home ownership, should bode well for apartment investors for the foreseeable future.

Despite the apparent concentration of new projects most visible in downtown San Diego, demand is being seen throughout the region. Renters seeking to lower costs by commuting farther from job hubs won’t be unscathed by continued rises in prices.

“There is increased activity and sales volume of all classes of apartment properties along the Route 78 corridor in neighborhoods like San Marcos, Escondido and Vista, among others,” said Peter Scepanovic, senior vice president in the San Diego office of Colliers International. “Additionally, sales in these areas and others across the county by long-term owners have become more prevalent.”

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