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San Diego's apartment market: A shift in the playing field

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On the surface, it appears as though the course of the San Diego County apartment market in 2004 can be summarized as a simple upward path of price escalations.

Robert Vallera

Albeit true, this summary also ignores the powerful shift that has occurred in the valuation of land underlying many existing residential and commercial buildings within the region. This shift foretells a potentially dramatic remaking of the urban landscape in various locations throughout the county. Some of this renewal will be visible within the current market cycle, but this will represent just an inkling of the changes to occur in San Diego County over the next 50 years.

The primary market driver

Acquisitions of apartment buildings for condominium conversion continue to serve as the primary driver within the apartment sales market.

Buyers are obviously motivated by potentially substantial profits that may come from these conversions, providing that the condo market retains its current strength. Many sellers are taking advantage of an opportunity to sell the buildings at price levels exceeding what they believe is justified by the current cash flow.

However, the high price and corresponding low yield (cap rate) that sellers are able to obtain act as a double-edge sword.

For sellers seeking to defer the federal and state capital gains taxes, it becomes a difficult challenge to locate a replacement apartment property within San Diego County without accepting a similarly low yield.

Owners most apt to sell their apartments are those who are motivated to diversify their assets, either moving equity into different property types or geographic regions, or reallocating some of their capital entirely outside of the real estate sector.

Local apartment sellers are frequently acquiring triple net leased commercial properties as replacement properties, either purchased in their entirety or as a fractional interest under tenant in common arrangements.

Increasing conversion pipeline?

I still remember my first economics professor repeating his favorite line in his drawn out English accent, "Super-normal profits bring ruinous competition." This was his obviously successful effort to emphasize the dynamic nature of a free market.

Profits that could clearly be described as super-normal have been reaped by quite a few San Diego condo converters over the past three years and are drawing substantially more apartments into the conversion pipeline.

Considering the recent increase in the inventory of unsold houses, it would appear that the inventory of unsold condominiums might rise in the near future. Such an increase in inventory of competing condominiums available for purchase will place more emphasis on the features and amenities of any apartments slated for conversion.

The rapid escalation in condominium prices has increased the value of apartments with good conversion potential.

However, the definition of what constitutes good conversion potential will become more rigorous if the inventory of unsold condominiums rises.

A new highest and best use

Rapid condominium price escalation has also increased the underlying land value of multifamily and mixed-use development sites. For the first time in almost two decades, there are a significant number of buildings within San Diego County that no longer represent the highest and best use for their underlying land.

In addition, construction costs have also risen precipitously. On the demand side, apartment values have risen, but the primary driver has been escalating condominium values. Apartment rents have been mostly flat over the past year.

This combination of higher land and construction costs, a near-flat rental market, and escalating condominium prices dictate that, at least in the near term, most new multifamily development projects will move forward as for-sale condominiums rather than rental apartments.

This shift in the development of multifamily housing from a for-rent to a for-sale orientation was last experienced in San Diego County in the latter half of the 1980s.

At that time, developers were faced with a combination of flat rents and a cost structure being driven upwards by escalating land prices and rapidly increasing development impact fees.

However, a closer spread between apartment and condominium prices led a number of those condominium buildings to eventually be sold in bulk to apartment investors, who then rented the units. Those buildings constitute a significant portion of the rental units now being sold off as condominiums.

It is difficult to predict how long market conditions will favor the construction of for-sale condominium over rental apartments. Clearly though, the substantial gap that has recently opened between the capitalized value of apartment rents and condominium prices will need to close before another shift will occur.

Making more land

Higher land values are effectively increasing the supply of land available for multifamily development. An example of where this phenomenon will soon be evident is along San Diego's El Cajon Boulevard between Park Boulevard and Interstate 805.

For many years, this corridor has been dominated by relatively low-rent, tired-looking, functionally obsolescent commercial buildings. This commercial district never recovered from the consumers' shift to regional shopping centers in the 1960s and the growth of big-box retailers in the following decades.

Meanwhile, the regional housing shortage and increasing traffic congestion have combined to accelerate the gentrification of the surrounding communities of University Heights and North Park.

Couple the improvement of San Diego's urban neighborhoods with an increasing number of non-traditional households (i.e., without children) and the net result is a growing acceptance of urban condominium and townhouse living as a first choice rather than as housing of last resort.

In response to an increasing demand for urban-infill housing, anticipate seeing the much discussed, but previously little implemented ideas of smart-growth development begin to come to fruition. Redevelopment is finally becoming cost-effective in certain urban-infill locations.

It is most likely to occur in older commercial districts and along major thoroughfares where municipalities will allow sufficient building density to justify replacement of the existing buildings. The above referenced western portion of San Diego's Mid-City will see several new developments of surprising scope and quality built in the near future.

These redevelopment projects will not be limited to the two- or three-story, wood frame and stucco townhouse designs, or the two- to four-story apartment flats over parking garages that have dominated San Diego's suburban multifamily development in recent decades. Expect to see true urban mid-rise developments of similar caliber to some of the buildings now going up in downtown San Diego and Uptown.

Hopefully these redevelopment projects will begin to yield some of the much-ballyhooed promises of smart growth development.

These include an increase in the number of residents walking to both commercial services and employment within their own neighborhoods, and a corresponding revitalization of the neighborhood.

Moving forward

In summary, selected locations within San Diego County appear to be poised for an upsurge in redevelopment activity. A significant number of older, under-utilized commercial properties will grow upwards, incorporating a vertical element of multifamily housing. This will effectively increase the supply of residential land.

Remember that the optimal balance between for-rent and a dynamic market determines for-sale housing. Absent government interference, expect developers to react to market economics and provide the type of housing that is in the greatest demand by consumers at any given time, be it apartments for-rent or condominiums for-sale. The net result is that in the near future, redevelopment will be biased in favor of for-sale condominiums.

Vallera is a senior vice president with GVA IPC (IPC Commercial Real Estate) and can be reached at (858) 228-1830. For more information about the company, visit www.gvaipc.com.>

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