RED Capital Group: The Northwest Enters 2019 with Strong Momentum, Rising Risks

For decades, the Pacific Coast has defined the American avant garde. From the Beats and Hippies of the Fifties and Sixties to today’s coders, gamers, software engineers and social network titans, the West Coast has set the standard for contemporary cutting edge social and life-style evolution.

Lately, the region has emerged as a global economic leader as well. The rise of Big Tech operations in the five Pacific Northwest metro areas we cover — the East Bay, Portland, San Francisco, San Jose and Seattle (the “Pacific 5”) — has altered their economic landscapes profoundly. From 2014 to 2017, nominal metropolitan GDP per capita increased more than three times faster than the national average, and personal income per capita — already considerably higher than the U.S. mean — increased at an 80 percent faster rate than the metropolitan norm.

Daniel Hogan
Director, Research,
RED Capital Group

Wealth creation and income growth on this scale fueled commensurate demand for rental housing space, especially the luxury infill product favored by investors and developers. Total Pacific 5-occupied apartment stock increased at a 2.4 percent annual rate over the three years ended in 3Q18 (Reis) — 20 percent faster than the balance of the RED 50, RED Capital Research’s large market peer group. Occupancy surged, effective rent growth soared and investors reaped extraordinary returns on their apartment investments.

But developers have proven to be more adept at delivering product to these “barrier protected” markets than previously believed possible. Average Pacific 5 occupancy now falls below the RED 50 average, and rent growth has decelerated from faster than 10 percent at mid-decade to less than 5 percent currently, roughly equal to the peer group mean.

Under the circumstances, do return prospects in these markets still justify their lofty valuations? We explore the question below.

Big Tech Sustains Robust Growth in San Francisco and San Jose

Bay Area residents express an abiding commitment to sustainability, but it is a matter of survival of the fittest when it comes to the metro’s economy. Only the strongest competitors can afford San Francisco’s sky-high rents and in the current environment that boils down to big tech and biotech. Retailers, food service, lower margin tech services and even established fixtures like Charles Schwab are relocating or expanding in lower cost markets, while Facebook, Salesforce and Dropbox lease space by the block.

Job creation is decelerating but personal income growth is rising as San Francisco creates fewer but higher paying positions. Establishments hired less than one-half the net payroll employees last year than 2016, but total personal income grew nearly 50 percent faster.

RED Research forecasting models suggest that metro job and income growth should sustain recent momentum this year before a slowing macro economy, stock market softness and weaker income growth trim job creation by a third in 2020. By contrast, it’s full speed ahead in Santa Clara County. Job growth in 2018 likely exceeded 34,000 (3.2 percent) positions, a near 50 percent gain over 2017, powered by the fastest hiring by electronic equipment manufacturers since 2000. Software and data farm hiring also was off the charts, and gains in healthcare, genomics and finance were strong.

Our models suggest that 2018 was likely the peak of the San Jose cycle. A 15 percent decline in job creation is the most probable outcome for 2019, and the volatile nature of the Valley economy suggests it is likely to underperform San Francisco during the “growth recession” we foresee in 2020 and 2021.

Second half apartment demand was seasonally healthy in San Francisco and San Jose, led by strong interest in Class A and B quality units. Same-store occupancy in both markets hovered near the 96 percent mark, paced by strong leasing in submarkets with concentrations of newer mid-rise product, especially SoMa and Northeast San Jose.

Rent trends strengthened, fueled by rising household income. Year-on-year growth rates were the fastest since early 2016, propelled by accelerating gains in Class A and C properties.

The near-term outlook for each market is constructive, especially for rents, which are likely to sustain above-average momentum through spring 2020. Total occupancy is likely to grind higher in more supply-constrained San Francisco and hold steady near the 95 percent level in San Jose.

In very thin trade, cap rates plumbed new depths, falling to sub-4 percent levels for quality San Francisco assets and San Jose value-add situations and trophies. High asset prices notwithstanding, our models suggest investors may still reap high total returns, particularly in the City-by-the-Bay, owing to the above-average NOI growth and relatively stable cap rate trends that we expect in these in-demand markets.

Supply and Slower Economic Growth Threaten to Hinder East Bay Returns

The East Bay maintained a brisk pace of economic growth last year, catalyzed by robust hiring by professional and technical service firms, which posted their biggest headcount increases since 2008. Employers in these thinner margin tech-related businesses increasingly decamped from high-cost Peninsular and Silicon Valley locations and relocated in the more affordable East Bay. In addition, brisk hiring by Tesla and its supply chain helped sustain job growth rates above national and state averages.

Dwindling available labor, rising wages and flattening headcount growth at Tesla’s near full-capacity Fremont assembly plant will constrain hiring in 2019, cutting net job creation about 15 percent over the year. The East Bay’s reliance on manufacturing and coastal spillover effects for growth will be a liability during the soft patch lurking on the horizon, leading our models to expect the metro to underperform San Francisco in 2020 and 2021.

Apartment absorption was brisk in second half 2018, exceeding post-recession seasonal space demand averages. Despite moderately elevated supply levels same-store occupancy was nearly unchanged year on year through November in the low-96 percent range.

Rent trends also were constructive. Same-store rents increased at a 3.7 percent annual rate in November, the fastest advance observed in more than two years.

East Bay investment activity centered on pre-1980 construction properties with value-add potential. Cap rates fell largely in the low- to mid-4 percent range for Alameda County properties, with Contra Costa and Solano County assets trading 25 to 50 basis points wider. Large scale institutional quality properties traded to mid-4 percent cap rates, highest among the three Bay Area metros, with near-term return expectations in the 4.5 percent to 5.0 percent range.

While we expect solid market performance in 2019, we are cautious longer term. Downside economic risk and the metro’s more robust supply pipeline are likely to translate to softer occupancy and rent performance than San Francisco and San Jose under recessionary stress, translating to weaker investment returns.

The Portland Economy Sizzled, But Supply Pressures Likely to Weigh on Market Performance

Following a spring soft patch, the Portland economy rebounded over the summer, propelled by rising single-family home construction and surging electronic equipment output. The economy enters 2019 with its sails filled with wind which should keep it in good stead through year-end. Like the East Bay, the Rose City’s above-average exposure to manufacturing and trade will inhibit growth under weaker macro conditions. We expect Portland to moderately underperform the Seattle, San Francisco and San Jose economies in 2020 and 2021.

Absorption was moderately below trend over the summer, while supply levels remained heavy. Total occupancy slipped to the mid-94 percent range, lowest in eight years. Same-store occupancy was rock solid, however, benefitting from healthy demand for Class A space. Likewise, rent trends were constructive, reaccelerating to the fastest pace in more than a year.

The performance outlook is mixed, clouded by a heavy supply pipeline that is likely to hold metro occupancy rates below 95 percent for the intermediate term. Rent trends will be more investor friendly this year but the trajectory is likely to bend lower under economic and supply stresses in 2020.

Recent investment cap rates fell largely below 5 percent, averaging approximately 4.6 percent. Popular suburban workforce value-add plays were priced to mid- to-high 4 percent levels, while infill trophies traded in the low-4s. Investor return targets were modest, falling in the mid-5 percent range for renovations and the mid- to high-4s for recent construction situations. RCR expects longer-term investment returns to hover near the 7 percent level, superior to East Bay but lower than San Francisco, San Jose and Seattle.

Seattle Remains the West Coast Economic Leader, But Space Demand Falls Short of Heavy Deliveries

The Seattle economy continued to expand at an astounding rate in 2018, minting payroll jobs at a 3.7 percent annual pace in second half 2018, more than twice the U.S. average. Cloud storage, e-commerce and network design shops were the principal catalysts, with an assist from the beleaguered aerospace sector, which posted its first annual headcount gains in five years.

Seattle will not be able to sustain this rate of growth much longer, but RCR models project that 2019 is likely to be another solid year, with job creation slowing moderately to the mid-2 percent region. Weaker macro conditions in 2020 will not leave the Jet City unscathed, however, as retail, manufacturing and software sales are likely to slow materially as the economy weakens, a trend that will be exacerbated by the impact of Amazon’s increased hiring focus on the East Coast. RCR forecast that Seattle will moderately underperform San Francisco and San Jose in 2020 and 2021.

Apartment demand was commensurate with job creation. Occupied stock increased at a 3.0 percent annual rate, among the RED 50’s fastest, nearly keeping pace with Seattle’s exceptionally heavy pipeline. Supply will dominate the conversation in 2019, as more than 10,000 new units are projected to begin leasing this year. Much higher vacancy is the most probable outcome in first half 2019, but receding supply and still favorable demand should allow occupancy to recover some lost ground by year-end.

Supply notwithstanding, rent trends were surprisingly healthy after mid-year. Rent rolls posted 6 percent year-on-year gains in 3Q18, according to Reis, while same-store street rents increased more than 3 percent YoY in the fall. RCR models indicate that progress is likely to decelerate in 2019 under supply pressure and further in 2020 as the economy frays at the seams, but the longer-term outlook remains attractive overall.

Investors were not deterred by Seattle’s pipeline issues. Investment sales surged 75 percent year on year in 3Q18, approaching $1 billion in total volume. Sales in 4Q18 were nearly as great. Buyers concentrated on workforce value-add plays near Sea-Tac and Southwest Snohomish County. Going-in caps ranged from 4.6 percent to 5.2 percent, with achievable pro forma yields in the mid-5s. Infill trade was thinner, with a handful of older assets selling at 4 percent caps and Ballard and Capitol Hill mid-rise trophies attracting prices equating to low-4 percent yields.

RCRmodels suggest that investors willing to brave Seattle’s supply-rich environment will be rewarded over time. Although probable investment returns fall below San Francisco and San Jose levels, performance volatility in Seattle is considerably lower than in the Bay area, elevating Jet City’s risk-adjusted returns to the highest in the region.

— This article was contributed by Dan Hogan, Managing Director of Research with RED Capital Group, which is a content partner of The views expressed herein are those of the author and do not necessarily reflect the views for RED Capital Group or of the author’s colleagues at RED. For further analysis from RED Capital Group, click here.

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