So, it happened again, for the third time in less than a month. Another client was interested in an asset and asked us to recommend the amount he should offer. We consulted recent comparable transactions, noted that inflation concerns are increasing, and there is an astounding shortage of rentals. We offered an assessment of the likely appraisal value. Then we suggested a bigger price that we expected would be high enough to obtain a counteroffer and low enough not to overpay.
What Once was Unusual is Happening Frequently
For the third time in less than a month, a strong client’s offer did not receive a counteroffer. In the past, this was rare. It seemed to happen less than a third of the time.
In this asset, most apartment rents were more than 30% below the market value. Lenders consider the property income in determining assets value and the size of the loan the property can support. In California, rent control limits rent increases. Our client wrote less than 90% of the list price, but above where we estimated what the lender would appraise it for.
The seller told us that two all-cash buyers offered full price. The all-cash buyers did not care about the lender’s appraisal. Appraisal value did not matter to them.
The other two clients selected different options. One buyer wrote full price offer on his favorite
opportunity. The other client wrote an offer above full price on his target property. In both cases, the seller selected other, stronger, offers from other buyers, without even countering our offer.
The market is unusually excited.
In San Diego County there have been 10,000+ apartment listings in the multiple listing service in the last 25 years; 40% have sold during the listing period. In other words, 60% failed to sell while the broker had a listing contract.
San Diego apartment values have climbed an average of 8% annually for 30 years. When a buyer puts a third down and borrows two-thirds, then the equity is leveraged, 3 to 1. An 8% increase is multiplied by the leverage (3), which means the equity growth rate of 24%. That is close to mafia returns, but it is legal.
Our team typically closes 20 to 25 income property escrows annually. Slightly more than half the time, we represent buyers. Even though our clients have written more than a dozen credible offers in the last 90 days, only one has put an apartment building into escrow. That is another example that the market is intensely hot.
What I Think is Happening
I estimate there are 1,000+ local millionaires who hope to buy within the next year. Probably less than 400 buildings with four-units or larger assets will sell. That has been true for most of the last decade.
Investors know that bank returns are pitiful, far below inflation. Many San Diego County income
property investors have the bulk of their wealth in real estate. I suspect that households who hold the bulk of their wealth in stocks don’t own any rental assets.
CoStar, a national income property information firm, reports San Diego rents increased more than 10% last year. The intense demand for rentals has pushed rents higher.
Properties 15 years old and newer are exempt from rent control. More than 90% of local properties are older than 15 years and so are subject to rent control. Their rents have climbed slower, but still faster than inflation.
So, what is the answer? Successful buyers will need to make larger down payments. Lenders base the loan on the cash flow after vacancy and expenses. For five units and larger the cash flow must be at least 120% of the mortgage payment. Buyers may need to put 40% down instead of 35%.
Is a Bubble Likely?
I think not. The signs point to an increasingly robust San Diego economy. San Diego has gained jobs as Alphabet (Google), Amazon, Apple, and Facebook have shifted jobs away
from more expensive cities and grown faster in San Diego and other more affordable areas. Biotech is accelerating and San Diego is one of the nation’s three biggest biotech hubs.
San Diego has a more diversified economy than most states or other major cities. Our military presence won’t shrink. Tourism is returning as the virus becomes less deadly. Students are returning to campuses as COVID has calmed from pandemic to endemic. Our other strong sectors are doing better than the national average.
Interest rates will rise, but that won’t reduce prices, because the rental housing shortage will continue. That’s how I see it. But then, my wife will tell you that I am often wrong.
Terry Moore, CCIM is an investment real estate broker with a proven history of success in creating value, 1031 (tax deferred) exchanges, and building wealth through apartment investments. He has taught at UCSD, National University’s MBA program, the Appraisal Institute, SD County Tax Assessor, California Association of Realtors and is a National Certified Commercial Investment Member. For more information contact Terry at [email protected] gmail.com, call 619-497-6424 (Direct), 619-889-1031 (Mobile) or visit www.SanDiegoApartmentBroker.com.(License #0091851).