By Daniel J. Hogan
The economic impact of the COVID-19 pandemic has been felt more severely in Southern California than in most areas of the country. The Southland’s high concentration of employment in the tourism and entertainment sectors made it especially vulnerable to the effects of social distancing protocols and the reluctance of many to board commercial aircraft.
Not only were job losses particularly acute in the initial months of the pandemic — the subsequent recovery has been lethargic. The rate of unemployment for July in each of the four large Southern California metropolitan markets remained materially above the national average, and in the case of Los Angeles County (18.2 percent) was the highest of any metropolitan area west of the Hudson River save for Yuma and El Centro.
As it always has, Southern California will recover and is likely to do so in even more spectacular fashion than before. In the interim, how can multifamily investors position themselves to prosper?
San Diego is the ideal market to scrutinize possible changes in renter behavior during the pandemic and consider their potential investment implications. Indeed, a deep dive into this market may provide clues to some of the great mysteries of the day: To what degree are millennial renters relocating during the pandemic? Are Class A investments the contemporary real estate equivalents of a white elephant or the next great buying opportunity? How much further may rents fall?
The densest clusters of millennial renters are found in Central San Diego, Mission Valley, University City, Carmel Valley and Solano Beach. Although we cannot distinguish the age demographics of individual tenants, we can evaluate the aggregate occupancy flows and rent trends in these submarkets.
In fact, occupancy declined at stabilized same-store properties in the relevant Yardi-defined submarkets by 0.70 percent (70 basis points) February to August, from 94.79 percent to 94.09 percent on negative absorption of 240 units in our sample, while occupancy in all other surveyed properties increased 30 basis points to 96.13 percent. Likewise, average property rent plunged 4.49 percent in the identified submarkets between February and September but declined only 0.18 percent elsewhere. These data appear to support the notion that millennial tenants on the margin migrated to lower cost, less dense locations during the pandemic, materially impacting property NOI.
But a closer examination suggests that tenant attrition was largely attributable UCSD and CSSD students vacating off-campus housing when it became apparent that in-class instruction was canceled for 2020. Submarkets with large student populations accounted for a large percentage of the net tenant losses and a substantial share of rent trend weakness. In sum, the data so far don’t point to a meaningful change in the location preferences of employed younger renters except in the dense urban core, and that likely is a temporary COVID-related phenomenon. Gen Y isn’t settling for the suburbs quite yet.
As for the Class A sector, the data show no meaningful change in the longstanding decay of occupancy and rent trends observed since the pace of new construction accelerated in 2016 and 2017. Same-store fourth quarter class occupancy fell successively in each year after 2015, declining from 96.21 percent to 94.99 percent in 2019. Occupancy continued to deteriorate during the pandemic, but net absorption of units in the same-store sample was positive in March, June and August, indicating continuing renter interest in Class A segment space. The performance issue is largely one of supply, not demand.
Revenue is another story. Average rent in September settled to the lowest level in twenty-eight months, 1.4 percent below September 2018. Class A rents in Downtown buildings plummeted 4.83 percent over the trailing 12 months ending in September to $2,455, a figure 2.22 percent below the September 2017 level! Moreover, while renters continue to absorb space in new buildings at a constructive pace, concessions are rising, in some instances reaching the equivalent of 15 percent of asking rent.
Will rents fall further? Nothing in the September data indicates otherwise. Average rent declined in every submarket in September, in almost every case by 0.2 percent or greater. Seasonally weaker demand and further student lease expirations could exert still more pressure on rents in the fall. Investment returns, particularly in Class A, are down and won’t improve through year’s end or longer. Indeed, our San Diego rent model projects a 0.4 percent year-over-year decline in 2021.
May market weakness produce investor buying opportunities? Recent transaction pricing casts doubt on the premise. Unlike Los Angeles
and Orange County, the San Diego property market remained relatively active during the summer, and pricing was aggressive. Plus, the transaction cap rates were in line with pre-pandemic levels. Class C workforce apartments traded to going-in yields near 4.6 percent, and recent construction mid-rise trophies located in Uptown and Little Italy were priced to sub-4 percent rates — initial returns that make sense only if buyers are looking past current weakness.
Southern California acquisitions will demand fortitude and a grain of blind faith, particularly in Class A – where prices are steep and performance wobbly. Trophy properties aren’t white elephants yet, but this is, perhaps, a season when discretion will be the better part of valor.
— Daniel J. Hogan is 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.