Rumors of the Death of Silicon Valley’s Apartment Market are Greatly Exaggerated
Some stories are just too good not to be true. This may explain in part the outpouring of reports regarding population outflows from the San Francisco Bay Area. Multiple mid-August articles in national newspapers took up the ongoing Silicon Valley exodus. These articles make a convincing case that the COVID-19 pandemic and increased opportunities to work remotely — particularly in the high-tech industry — are prompting many Bay Area residents to consider relocating to more affordable areas, even if remote work causes their incomes to decline.
The evidence supporting the theory is by no means entirely anecdotal. The number of owners listing homes for sale has increased significantly, the pace of home price appreciation has decelerated materially (less than 5 percent in May) and apartment rents and occupancy have eroded since winter. It is hard to deny that Peak Northern California is fading in the rearview mirror.
This should be no surprise. The Bay Area is not only the most expensive real estate market in the country, it also is one of the most congested. Its many virtues come with a steep price tag, not only in terms of cost of living but also in aspects lumped in the quality of life category — long commutes, lack of parking, spartan rental housing amenities and considerable risk of finding one’s car door window in tiny shards on one’s driver’s seat come morning. At some point, price resistance emerges.
This story is rewritten with regularity every nine years or so when some event triggers a correction in the regional labor and housing markets. The details that change are the precipitating event and the make of car depicted heading north on the Golden Gate bridge: a Honda in 1992; a BMW in 2001; a Prius in 2010; a Tesla now.
The lure of the Bay will return, if history is any guide, and the comeback will start in about 18 months. The interesting question is how real estate owners and investors should best manage their portfolios in the meantime.
How weak is the multifamily market? By historical standards, not very. Employing the Reis average unit rent history, Santa Clara County rents declined peak-to-trough by about 1 percent in 1993-1994; 37 percent in 2001-2004; and 8 percent in 2008-2010. The same series recorded a 0.02 percent peak-to-trough decrease between April and June, while year-on-year comparisons remain solidly in the black.
Same-store comparisons depict a somewhat weaker situation. Unit-weighted average rent among a Yardi-surveyed sample of 98,971 professionally managed units in stabilized properties peaked in June 2019 at $2,953. Thirteen months later the sample mean was $2,800, a 5.2 percent decline. Between the implementation of social distancing protocols in March and July rents tumbled 4.7 percent.
Slack demand played a role. Recent same-store occupancy topped out at 95.89 percent in May 2019 and declined sequentially in each subsequent month, falling 131 basis points by July 2020 to 94.58 percent, the lowest rate ever in this seven-year series and most likely the lowest since 2009.
These data suggest that renter price resistance has been building for more than a year and was only strengthened by the pandemic. The work-from-home phenomenon provided a housing substitute for tenants seeking to rationalize shelter costs and address some of the non-economic shortcomings of Bay Area life, causing tenant attrition on the margin.
The market will find a new equilibrium as it always has in the past. Investors must determine where the market clearing price for apartment space is and how to react accordingly.
Linear multivariate regression techniques can take one only so far in the non-linear market environment in which we find ourselves, but they can shed some light on where the market is heading. Our baseline economic forecast foresees an elongated V-shaped recovery that returns U.S. output to pre-COVID-19 levels by mid-year 2021. Under these circumstances, rents in the Reis series are projected to stabilize next spring 3 to 4 percent below second quarter levels, and occupancy is expected to recover to pre-pandemic levels in a similar time frame if supply is pushed back on the calendar, perhaps by summer if it is not.
The small number of property trades recorded so far this year suggest that multifamily cap rates have moved 15 to 20 basis points higher from pre-pandemic lows, translating to about 4.5 percent for standard Class B gardens. Even at this level, summer buyers will be hard pressed to generate 6 percent or greater annual unlevered returns over intermediate-term holding periods given the rent weakness that is likely to unfold over the next nine months.
Investors seeking to capitalize on this decade’s Silicon Valley collapse are more likely to find attractive opportunities next winter when property NOIs approach the cyclical bottom and cap rates, perhaps, return levels last observed in the early days of the last boom phase approximately 10 basis points above recent observations. Risk-averse owners may choose to divest sooner rather than later or elect to enjoy a Cabernet and have the last laugh when the next nine-year Bay Area property boom begins in 2021.
— 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 about the San Jose market from RED Capital Group, click here.
For Hogan’s insight into other markets, click here.