For 40 years my wife and I have owned rental property. For 35 years I have been a San Diego apartment broker. I learned a lot, too much the hard way. Some of what I learned is summarized below. I’ve been blessed to spend my brokerage career in a supply-constrained market. Supply-constrained markets make apartment investing a low-risk escalator to wealth
What Is a Supply-Constrained Market?
The U.S. has about 330 million people and hundreds of real estate markets. Most apartment markets offer no significant barriers to entry other than capital and supply and demand. Other markets are “supply-constrained.” In supply-constrained markets, the government or geography, or some other force restricts new apartments.
The apartment market is efficient. Better properties obtain higher rents. When investors do good for their residents, those investors also do well for themselves. When you enhance the value of the property and make it more desirable for residents, you’ll receive greater cash flow.
If the local economy is not growing, supply constraints are irrelevant. A farming community with fewer potential renters now than a decade ago is not likely to be a good place to buy apartments. With passing time there will be less demand, more vacancies, more concessions, and less income. Apartment values would likely go down. Don’t buy in those markets.
In the markets with relatively low barriers to new construction, there’s probably not much pent-up demand. As jobs are created and new households form, these markets routinely build more apartments. But, in supply-constrained markets, the demand for new rental housing routinely outpaces supply.
Why San Diego is a Supply-Constrained Market
Two forces create supply-constrained markets. Major cities which are built out, New York, San Francisco, simply don’t have any more usable apartment land. San Diego is a supply-constrained market because of government policies. Here’s how it works. California returns some sales tax to the city where the sale is made. So, every mayor wants “The Mile of Cars” and the mall because tax revenue helps the mayor’s city. $100,000,000 of retail property needs relatively little fire, police, schools, sewer, water, or other services which may cost the city government money.
In contrast, apartments of the same value bring no sales tax revenue but cost local government lots of money for public services. In other words, each city is rewarded for building retail and penalized for allowing apartments. Consequently, every mayor wants all the area’s retail and wishes the city next door would allow the new apartments. Guess what? For 30 years cities have zoned and allowed plenty of retail, but not enough condos and apartments for their population need. The result? San Diego County has a 100,000+ rental unit shortage. Rental owners benefit, but renters pay more.
Supply-Constrained Markets are Great for Apartment Investors
San Diego is an investor’s dream come true. Growing markets that are supply-constrained are likely to have rents exceeding inflation. When demand increases faster than supply, rents climb.
Thanks to rapid growth and government policies, San Diego County has an immense rental unit shortage. If we doubled our apartment construction for a decade, San Diego County still would not have enough rentals for the people who want to live here.
There are lucrative strategies that work well in a supply-constrained market. Here’s one.
Renovate the 40-year-old kitchens and bathrooms to upgrade the units. Higher rents are good, but the increase in value far exceeds the larger rental income. Income properties sell for multiples of the income. In simple terms, higher value creates dollars whereas more cash flow only provides you dimes. That strategy doesn’t work as well in markets without supply-constrained magic. There, you can renovate the units, but you don’t get a big return.
Another truth is the importance of leverage. Leverage is a power tool, a force multiplier. Most investors buy using a loan, maybe one-third cash down payment and two-thirds debt. If a building increases in value 5% from $1,000,000 to $1,050,000, that is a $50,000 boost. Suppose the investor put $333,333 down and borrowed the rest. $50,000 value increase / $333,333 equity is 15% increase on the equity. 5% times three. $1 of equity and $2 of debt controls $3 of property. The equity’s impact is tripled. In supply constrained markets with superior appreciation, leverage is extremely important. Leverage plus higher rents are what causes supply-constrained markets to dramatically outperform balanced markets.
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).