San Diego Multifamily Still Going Strong, But Developers Worry About Rising Rents
Seven years into the current cycle, multifamily values and rents are at record levels. The biggest questions: Where are we in the cycle, and is San Diego’s multifamily product overbuilt?
Those were the first questions McCullough Landscape Architecture principal David McCullough asked panelists at Bisnow’s State of San Diego’s Multifamily Market event. David, who moderated, is pictured on the right with Russ Murfey.
Holland Partner Group development director Brent Schertzer, who heads development of Park & Market, a $200M mixed-use project that occupies a full city block in East Village, said, “We’ve still got quite a bit of runway. Young people are setting up households, and there is demand for both rental and for-sale product, but not enough developed.”
The majority of multifamily development is happening in a few select areas, namely Downtown, Brent said, attributing the current development boom to Civic San Diego’s foresight to make entitlements predictable. “What Civic San Diego did early laid out the groundwork for development. It created a master EIR and also a planning ordinance that governs the development process in Downtown, which clearly helped to clear the hurdles, make entitlements a much more predictable process, and allow for a huge amount of growth.”
He said Mission Valley is another area that will continue to see growth. “This is another centrally located node within San Diego, and there’s a lot of land there ripe for redevelopment. I see that as the place for the next wave of multifamily development."
Pathfinder Partners co-founder/senior managing director Lorne Polger (at right with Brent) said high demand will keep multifamily strong. He said there is still a woeful deficiency in both for-sale and rental product. "Plus, what about the demographics? How many people are moving into San Diego County? Even more importantly, what are they being paid?” Lorne said there are still opportunities in the multifamily sector, but that is changing and morphing because of math and basic supply-and-demand economics.
MG Properties VP of acquisitions Paul Kaseburg (at left below with Russ Murfey and David McCullough) said as long as demand remains high, he doesn’t see a problem, but suggested there’s a tendency to overstate or understate rental growth depending on where the market is in the cycle. He said his company, which is a value-add investor, tends to look at the market from “where the opportunities are on the upside, where the risk is on the downside and how to trade off those two things.”
Paul's company does not do ground-up development, but his concern at this point in the cycle is the amount of product coming out of the ground. He said, while that’s not going to cause a crash, “it will somewhat cap your upside, because how much higher are prices going to go?”
He said low interest rates are problematic from an investment perspective, because when interest rates are high, cap rates are a bit higher. "If the economy starts to falter, interest rates will come down, and that cap-rate compression can help bail you out from a value perspective. When interest rates are low, I wouldn’t expect cap rates to fall 300 basis points to bail us out, so it’s a double-edged sword—it’s a good thing and a bad thing.”
Veritas Urban Properties principal Russ Murfey (center) , a local multifamily developer, said when he and his brother established their company in 2011 they wondered every year how much time they still had left in the up cycle. “Here we are in 2016, and it’s still going strong. I think the foreseeable future still looks positive,” he said. "It’s macroeconomics; it’s local, but at the same time it’s deal-specific underwriting." He said the fundamentals of each deal are important.
“Are you trending the rents or keeping them at or below what you’re seeing other people achieving,” he said, explaining that his company keeps rents under other new product in the market. “If you can find deals that withstand the sensitivities on your pro forma, that’s what it comes down to—good, solid underwriting and getting into the details, not just glossing over them.”
Right now his company is being extremely selective, not just chasing everything in sight, he said. The company's next project is in an area where only one other project has been built in the last 30 years due to high barriers to entry, he said.
David said housing affordability is a big issue, and asked the group if there are options available to build housing affordable for more people.
Russ said there are plenty of options to create housing that’s affordable. He said his company’s last project is “under-parked,” suggesting that parking is a significant cost that could help make projects more affordable if reduced. “It might be on the extreme end of the spectrum, but we’re looking a projects where you eliminate parking altogether,” Russ said. “Every time we build a project, we try to figure out how to build it without going subterranean. Subterranean is a deal-killer, unless you’re going high-rise.”
Russ said his company is a long-term holder, and lots can be done on the tax planning side, energy efficiency—things that can help drive tax flow, “but parking is a good start.”
His company is also looking at building micro-units and modular, Russ said, but he said the challenge with modular is there are only a couple of companies producing it, and they are the only ones making money. “The efficiency is there and you pick up schedule, which can be the silent killer in a deal, but I think modular has a long way to go as well.”
Brent said high rent on new projects has created a very narrow band of people who can live in them. “What we’re looking at is utilizing density bonuses provided by the state and recently passed City of San Diego ordinance that allows for an increase in unit count or density overall for including an affordable component within the project. It’s something that deserves a lot of attention."
Brent said Holland has done projects with 20% very low-income units in the past, which allowed for significant density bonuses for the overall project. “With that structure you can do bond and tax credit financing that helps offset most of the cost of affordable units and reduced rent,” he said. “So we’re looking at these financing options in conjunction with state Assembly bills and San Diego’s density bonus to help drive as much density on a site as possible to get to the land values that most of these land sellers are now expecting.”
Lorne said while some cities like Carlsbad make it difficult to build multifamily, there are municipalities that make it easier, like Chula Vista. His company is on its second townhome project there; he said these units are competitively priced, so it’s probably cheaper to own than rent based on where interest rates are.
“That’s a metric we love, but you couldn’t build that product in different areas of the county for that price point, because the fees would be too high,” Lorne said, adding this issue goes back to good government and whether it encourages affordability. “Some cities do and some cities don't.”
He also said there are lots of '60s and '70s office buildings in San Diego that could be converted to housing. “If the math works, these buildings could be interesting conversion opportunities,” he said, citing the Blood Bank building, which was successfully converted to housing.
Shown above is the Future Projects & The Investment Cycle panel at Bisnow's State of the San Diego Multifamily Market: Brent Schertzer, Lorne Polger, Paul Kaseburg and Russ Murfey.
Brent said Downtown Los Angeles has a large stock of obsolete office buildings that have been converted to housing, but said underperforming retail presents opportunities for conversions too. His company recently completed redevelopment of several big-box department stores at Bella Terra mall in Huntington Beach to housing, building ground-up, wrap-style apartment projects with ground-floor retail over the retail boxes. "That’s one nuanced way to do adaptive reuse, but also qualifies,” he said.
Paul suggested value-add projects can provide greater affordability. “Costs for renovations have gone up, but not as much as for ground-up development. So we focus on turning functionally obsolete projects into something that is more modern—add a washer and dryer, knock out a wall to open space up and make it more modern,” Paul said. “There’s lots of things you can do inside that box that make units more attractive. It doesn’t add units to the rental pool, but does take something that’s unattractive and create better bang for the buck.”
With the cost to rent through the roof, David asked, “What do you see in the future for San Diego rents? Is rent control coming?”
Russ said compared to San Francisco, New York and other large metropolitan areas, San Diego rents are significantly lower. “But increasing rents do scare me a little bit. We try to plug in the lowest rents we possibly can, but it’s hard to be competitive, obviously, if you continue to sandbag your revenue side.”
There’s talk of it in cities throughout the West, Lorne said. “I think it’s a question of when, not if. In San Diego, where wage growth has trailed other major cities, like Seattle, Los Angeles or the Bay Area, we are close to reaching that inflection point where housing becomes unaffordable. Typically when that happens, government steps in, so it wouldn’t surprise me in the next few years if we start to see that locally—maybe not in the City of San Diego, but perhaps in outlying cities within the county."
He said the best defense is anticipating it. "Make sure you’re not overleveraged and have enough of a cushion built into your numbers to prepare for it in advance."
Rising rents are outstripping renters' ability to pay, Paul said. “Stein’s law applies here: if something cannot go on forever, it will stop." He said rents could be slowed by market forces, incentives that create more housing or rent control.
