In Search of Relative Value in Orange County’s Apartment Sector
Orange County offers residents all the key elements of the American dream. Its virtues are numerous and faults few. Indeed, Moody’s Analytics ranks the quality of life in the OC 10th highest among the 378 U.S. metros it reports on, just a half-step behind leaders Santa Barbara and Santa Cruz.
Orange County is a terrific place to live, but is it a good place to invest? Gauging by observed capitalization rate trends, one may conclude that county apartment properties are highly prized gems. Class A trophy properties trade to going-in yields in the 4.00 percent to 4.10 percent area, and Class B and C garden complexes are typically priced to yields in the mid-4s, all only 25 basis points or so behind Los Angeles and the San Francisco Bay Area comparisons.
But judging from transaction velocity, one might draw a different conclusion. Only six Orange County multifamily properties of 50 units or more have changed hands since mid-year 2019, and not a single sale has closed since February. Even by the cautious norms of the moment, this stands out as a market in search of price discovery.
Slow transaction velocity can be ascribed, in part, to the prevailing buy and hold philosophy held by Orange County investors. Many of the most valuable properties in the market are held by a single investor with an extraordinarily long investment horizon. Other participants see OC assets as core holdings that provide stable returns and capital preservation.
Data suggest, however, that investors may be sacrificing too much return for too little security. To test this hypothesis, RED Research reviewed the last 21 years of Reis quarterly rent and occupancy data, and developed a series of lookback five-year holding period return calculations for investments made from second quarter 2012 to second quarter 2015 in Orange County and four of its primary rivals (the Inland Empire, Los Angeles, San Diego and San Francisco). The lookback return calculations employ the aforementioned Reis performance data and for property valuation purposes the generic B/B+ asset cap rate series that we developed to compare expected total returns across the 50 metropolitan markets we model econometrically (the RED 50).
We used the Reis data series to assess the relative strength and stability of average property performance in each of the five markets. In respect to quarterly year-on-year rent growth, Orange County ranked fifth of five at 3.6 percent. In terms of rent growth volatility (as defined by the standard deviation of quarterly year-on-year rent growth), the county finished third at 2.9 percent. LA and San Diego were the respective growth and volatility leaders.
On the occupancy side, Orange County ranked in the middle of the pack: third with respect to highest average occupancy rate (96.2 percent), and third in regard to fill-rate volatility. Again, LA and San Diego recorded the strongest results. In sum, neither OC income growth nor revenue stability stand out among its peers.
How did investors fare over the great 2010 to 2020 bull market in California multifamily real estate? We used the lookback total return (TR) calculations to make this assessment. Over the second quarter 2012 through second quarter 2020 period, we estimate that a generic OC buyer earned an 8.4 percent annual, unlevered TR, ranking a distant fifth among the five peers, 180 basis points (1.8 percent) below fourth highest Los Angeles (10.2 percent). Analyzing the five-year holding period data, a similar pattern emerges. Orange County generates the lowest TR among the five markets in each of the 13 investment slices except for the final exercise terminating in 2Q20, when the OC outperforms tumbling San Francisco. Return volatility, on the other hand, is lowest among the peer group.
The evidence that Orange County acquisitions underperformed investments in other major California markets over the last 20 years is strong. However, data supporting greater stability of returns are mixed.
What might the future hold? Orange County performance under the pandemic has compared favorably to San Francisco and Los Angeles, and its limited supply and steady demand will support market performance in turbulent times. Still, our forecasting models remain unconvinced that prospective intermediate returns will be compelling. In fact, we estimate that an investment made during 2Q20, if there had been one, would generate an annual TR over five years of approximately 5 percent.
The low volatility of OC apartment cash flows will appeal to investors in uncertain markets, but data suggest that relative value may be less than compelling for buyers acquiring multifamily properties priced to the cap rates observed before the pandemic. It seems that price expectations must adjust before price discovery may evolve.
— By Daniel J. Hogan, ORIX Real Estate Capital’s Managing Director for Research. RED Mortgage Capital, a division of ORIX Real Estate Capital LLC, is a content partner of REBusinessOnline. 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.
For Hogan’s insight into other markets, click here.