After three straight years of booming rent and value growth, the market is softening. The vacancy rate in San Diego finished at 3.8% in 2023, up from 3.5% in 2022, and is trending higher. There is longer lease-up time and less tenant velocity. While it is a good idea to keep rents near market with responsible increases, pushing to 100% of market rent could cause turnover as tenants have more options.
San Diego County Rents
Asking rents have risen, but that rate of growth is slowing down. Average monthly asking rents were $2,327 in 2022 and $2,348 in 2023. In 2023, one-bedroom units averaged $2,245 and two bedroom units averaged $2,857. Studios averaged $1,929- and three-bedroom units averaged $3,651.
New Construction
In 2022, 3,191 units were delivered. In 2023, deliveries slowed to 1,734 units with another 5,240 under construction. We expect both construction and deliveries to slow with interest rate increases, higher construction costs, and rent growth slowing. Most new construction is downtown, midtown and mid-city San Diego.
The majority of deliveries have been luxury or efficiency units in A markets. San Diego needs middle income and low-income non-subsidized housing. Increasing construction costs including labor, supplies, fees, permits, etc. (not to mention debt), make it harder for developers to build low- and middle-income housing without subsidies as the rents in this section of the market will not support the costs to build. We have seen a lot of ADU construction in the last three years, adding units to existing properties. However, properties that relinquish parking and garages to add ADU units suffer from less or no rent growth and poor tenant retention for the remaining existing units due to lack of parking. We are also discovering that ADU garage conversions are not worth the same price per unit as an original unit with parking.
Transactions
Deal volume is down 70% year-to-date in 2023. Cap rates in 2022 remained in the 3.5%-4% range and they rose to the 4-5% range in 2023. The average price per unit dropped 14% from $358,900 in 2022 to $307,500 in 2023. This is largely due to less institutional and class A transactions. The gap between buyers’ bids and sellers’ asking prices has widened, especially for properties with low in-place rents. A larger percentage of the sales have been C class buildings in C areas trading at or above a 5.5% cap rate and under the market-wide average price per unit for 2023 as these properties can be stabilized with a cap rate above the cost of capital. Many properties In A and B markets are listed at 2022 cap rates and are not trading.
Unincorporated areas of the county have still seen activity from value-add investors as tenant protections have made the value-add model much more difficult and expensive in the city of San Diego and certain other submarkets.
In 2022 and the first half of 2023, many of the sales transactions involved a buyer assuming a seller’s existing financing that was at a 2.9%-4.5% interest rate with 3 or more years left on the fixed term. Further into 2023, as the fixed terms of potential assumable debt shortened to under 3 years remaining, virtually no buyers saw value in assuming that debt thus further slowing down market transaction velocity. This was due to future interest rate uncertainty, as well as fewer years left for annual rent increases. =
How Have Interest Rates Affected Us?
Interest rate increases have slowed the market drastically. Short of a value-add or ADU business model, very few properties will have cash flow with today’s interest rates (even with a 50% down payment) and sellers’ price expectations. Cash and 1031 buyers are making the bulk of the purchases. Cap rates have not adjusted to account for today’s interest rates. Construction has slowed also, as most models anticipated a 4-5% exit cap rate, which would be negative leverage with rates above 6%.
Conservative alternative investments such as Treasuries and high-yield savings accounts provide low risk returns above 5% which is a better yield than the cash flow on a leveraged apartment building in San Diego purchased at 2023 values. Most investors are waiting for price adjustments or for possible interest rate cuts and are meanwhile taking advantage of conservative liquid investments.
In 2023, appraisals and broker opinions of values could reference sales comps from roughly 12 months prior, or back to 2022, when rates were lower and values strong. The longer that rates remain high, and the more comparable sales recorded from sellers of necessity versus sellers of opportunity, the more likely we are to have a trailing 12-month period of comps supporting lower values. However, there is a tremendous amount of liquidity waiting for some sort of distress or price correction which could create high demand for any sort of distressed asset.
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Benn Vogelsang is Senior Vice President of Northmarq – DRE Lic. # 01883437. For more information, call 858.675.7869 office or 415.250.4947 cell [email protected]