Since the Baby Boom generation was in its infancy, Southern California has represented the apex of American popular culture, with its freedom, fun and limitless opportunity. But in the last few years the Southland’s place in the American imagination has been superseded to a degree by the digital prowess of its Bay Area and Pacific Northwest neighbors.
Recently, the tide has begun to turn. While still wildly successful economically and culturally influential, the Bay Area, Seattle and Portland seem to be bumping into resource constraints that have dimmed their luster. By contrast, the Southland has found its stride, attracting increasing amounts of venture capital, building powerful digital and biotech platforms and proving a bit more adept than the cities to the north at finding space to facilitate economic and population growth. Venture capitalist Peter Thiel hasn’t been the only titan to notice.
Daniel Hogan
Director, Research,
RED Capital Group
The impact on multifamily markets is palpable. Property sales volume records were shattered last year and cap rates fell to historic lows. Investors are increasingly embracing the value-add strategies popularized in lower-cost growth markets, driving prices of aging Class B garden properties higher and fueling faster rent growth in submarkets where the renter-by-necessity tenant predominates.
Although increased supply is exerting some downward pressure on occupancy rates, rent growth firmed in most areas in the second half of 2018, especially in Los Angeles and the Inland Empire. While conditions vary across metros, the outlook for property and investment performance remains promising in spite of the real estate cycle’s advancing age.
Los Angeles Rents and Incomes Soar, Occupancy Steady In Spite of Rising Supply and Moderate Job Growth
The Los Angeles economy plodded along in the second half of 2018. Job creation trends were slower than state and national averages, restrained by the impact of U.S. and China tariffs on the trade and transportation industries. Indeed, metro employers created last year less than one-half of the payroll jobs added in each of 2015 and 2016.
But slow overall job creation obscured important positive developments percolating under the surface of the LA labor market. Rapid expansion in the digital media and tech sectors, fast developing biotech and medical clusters and increased content demand in the entertainment industry propelled faster high-wage job creation. As a result, the average hourly wage increased 7.6 percent year over year in the fourth quarter — the fastest advance recorded since these data were first collected by the BLS in 2007.
High-wage job growth boosted demand for professionally managed apartment space, particularly in the more accessible Class B segment. Occupancy remained above 96 percent overall and near 97 percent in the B and C segments at year-end, despite delivery of more than 30,000 units since 2016.
Rent growth also was robust, accelerating from an annual rate of 4.8 percent (Reis) in the first half to nearly 6 percent in the second. Lower average rent submarkets posted the fastest gains, but even the heavily supplied Hollywood and Downtown markets recorded average same-store increases in the 4 to 5 percent range. By contrast, West LA and Santa Monica notched considerably weaker growth.
Investors focused on 15- to 25-year old Class B properties with repositioning potential after moderate renovation. Cap rates fell in the low- to mid-4 percent area, and buyers targeted first year pro forma yields in the 4.75 percent range. Several trophies also exchanged hands, including a Downtown luxury high-rise priced at $750,000 per unit, generating an estimated 3.75 percent going-in yield.
Orange County Job and Rent Growth Lag West Coast Peers, but Cap Rates Plunge Near 4 Percent
Trade activity was considerably slower in Orange County. Only 10 trades valued at $5 million or more were closed in the second half 2018, the fewest in any six-month period since 2014.
Sluggish economic trends were at least in part responsible. BLS data from the Current Employment Survey through December indicate that job growth as measured on a year-over-year comparison basis slowed to a 0.7 percent annual rate in third quarter 2018, and further to a 0.3 percent pace in the fourth quarter. Seasonally-adjusted figures suggest that headcounts actually fell 7,500 jobs in fourth quarter and were 4,200 jobs lower for the year.
These data may be misleading, however, and likely overlook job creation in the entrepreneurial tech and services sector. By contrast, more reliable Census of Employment and Wages (CEW) data are more upbeat. This series reports materially stronger payroll growth through September, and vigorous 5.0 percent county wage growth during the first half of 2018.
The CEW data dovetail nicely with OC’s strong apartment market performance. Renters expressed heathy space demand, absorbing 992 vacant units (Reis) in fourth quarter 2018, and nearly 3,500 units for the full year, a 40 percent increase over 2017. Average occupancy held firm at 96 percent despite growing supply levels. Effective rents increased 3.4 percent year over year in fourth quarter (Reis), slowest in the Southland, but consistent with trends observed here since 2016. Rent trends were strongest among Class B and C properties, while top tier assets managed only 2 percent same-store gains.
Investors favored pre-1990 construction North County garden apartments with value-add potential. Buyers paid an average of about $320,000 per unit, producing going-in yields in the low-4 percent range. Class B/B+ assets in coastal neighborhoods also attracted attention, garnering per unit prices in the $350,000 to $400,000 area. Higher-quality properties traded to initial yields in the high-3 percent vicinity, while Class B addresses garnered interest in the low- to mid-4s.
A pair of more recent construction Central and South County Class A properties also exchanged hands late in the year. Both traded to per-unit prices in the $425,000 area, also to low-4 percent cap rates.
Investors Warm Up to the Inland Empire, Attracted by Higher Yielding Value-adds
Buyers were more active in Riverside and San Bernardino counties but their targets were largely the same: older garden properties that can be repositioned, especially those located within commuting distance of LA employment centers. The Empire established new transaction volume and velocity sales records during the fourth quarter, as nearly 20 investment sales were closed for total proceeds of greater than $1.2 billion, eclipsing the previous single-quarter volume high water mark by 60 percent.
Class B/B+ value-adds located in Southwest San Bernardino County near the LA County border were the asset of choice, garnering prices producing 4.4 percent to 5.0 percent going-in yields. Potential first year pro forma returns fell in the high-4 percent to mid-5 percent range. Investors also acquired several Class C+/B- garden projects located in Central Riverside County. Cap rates were considerably higher, however, gravitating to the 6 percent range.
Employment and wage growth decelerated in the second half 2018, as soft housing demand contributed to comprehensive decreases in construction, retail and finance hiring. After rising at a brisk 50,000-job, 3.5 percent annual rate during the first nine months of 2018, job growth slowed by one third in the fourth quarter. Likewise, average hourly wage growth decelerated to 2.8 percent, down from nearly 5 percent earlier in the year.
But the impact on multifamily performance was negligible. Healthy tenant demand, particularly in the Coachella Valley and Fontana/Rialto submarkets, returned metro occupancy near the 97 percent level (Reis), the strongest metric since mid-2017. Likewise, rent growth reaccelerated to near 5 percent, with similar gains observed across property grades, led by faster than 6 percent same-store gains in some lower average rent submarkets.
Booming Tech and Manufacturing Employment Powers San Diego Economy, Heavy Supply Pipeline Contributes to Investor Caution
Fueled by rapid growth in the high wage electronics and defense capital goods manufacturing sector the San Diego economy posted the strongest growth among Southern California’s three coastal metro areas. Payroll employment increased at a 27,400-job, 1.9 percent year on year rate in fourth quarter 2018, including more than 5,000 manufacturing jobs, representing the 27thconsecutive quarter of trailing 12-month gains of 25,000 jobs or more.
The booming economy attracted workers to San Diego County by the thousands. Consequently, the unemployment rate held steady throughout the year in the low-3 percent range, rapid employment growth notwithstanding, and average hourly wage increases were limited to only 0.7 percent over the year, the smallest hike since 2014.
Apartment demand fell on the soft side late last year, irrespective of rapid headcount growth. Reis reports that renters absorbed only 417 vacant units during fourth quarter, fewer than the seasonal average. In the same period, a 120,000 unit same-store sample experienced a 429-unit net tenant loss. Likewise, rent momentum slowed after strong summer gains, a trend that appeared to carryover over into early 2019.
Investors exhibited a degree of caution, particularly in value-add situations, reflecting increased pipeline supply and rent growth concerns. Total sales volume fell about 35 percent from 2017. The pace of transactions accelerated late in the year, however, after a rent control ballot initiative was defeated in November, giving investors more confidence that target returns could be achieved from value-add strategies.
Acquisitions with renovation and repositioning in mind also dominated San Diego trade as 30-year-old and older properties accounted for 75 percent of fourth quarter proceeds. Sub-4 percent cap rates were the norm for sales of infill assets, while suburban properties exchanged hands at 4.4 percent to 4.8 percent yields. Several newer stabilized assets also exchanged hands, including an infill Mission Valley mid-rise and a Chula Vista garden complex that traded to respective yields in the low- and mid-4 percent neighborhoods.
Low Purchase Cap Rates and Uncertain Rent Momentum Hinder Expected Returns
Southern California cap rates now approach levels observed in the Bay Area and are roughly comparable to the mid-4 percent discount rates typical of Portland and Seattle. In order to achieve average or better investment returns from acquisitions at these going-in yields RED Capital Research estimates that compound annual property rent growth must reach or exceed a 3 percent threshold over a five-year holding period.
Although recent performance is encouraging, RCR’s unbiased, historically-specified econometric models suggest that rent growth of this magnitude is not the most probable outcome for these markets. Rather, our models project that average effective rents in Los Angeles and San Diego are likely to rise at about 2.9 percent compound annual rates; the Inland Empire at about 2.7 percent; and Orange County at about 2.5 percent. Resulting total returns are estimated to vary in the mid-6 percent to low-7 percent range, materially lower than the current 7.4 percent large U.S. market peer group average.
Overall, Southern California markets should perform well, particularly with respect to occupancy rates. But our models project that the other principal drivers of rent trends — personal income and job growth — are unlikely to be powerful enough to propel rents at above market average rates. While value-add strategies appear attractive from per-door cost and potential NOI growth perspectives, overall return prospects seem inferior to Northwest and Intermountain Region alternatives.
— This article was contributed by Dan Hogan, Managing Director of Research with RED Capital Group, which is a content partner of REBusinessOnline.com. 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.