The market for owning and investing in residential income properties in San Diego has never looked better. Vacancy rates are at record lows, capital for debt and equity is abundant at bargain basement rates, and the probability of a new supply of apartment units to fuel competition -- for anything but Class A apartments -- is practically non-existent.

C. Wise

San Diego apartments have placed high on the desirability scale for both local and global investment capital. Our weather, to be sure, is part of the draw, but so is a burgeoning elite standing brought about by natural and political boundaries to development -- creating a "barrier to entry" market, not unlike San Francisco, Santa Cruz or Hong Kong. A further attraction is the diversity of employment, education and cultural experiences tailored to specialized knowledge workers in digital- and science-based industries.

So, the market is hot, hot, hot! Our collective long-term memory of real estate as a cyclical business has been hammered out of our consciousness by the constant glowing reports of profits being turned overnight in the rush to purchase a stake in such a sure thing.

I am a true believer. I have experienced the monumental growth in equity value in both client and personal holdings. So, I really want this party to continue, and I have a nagging awareness that this is a market priced for perfection. Any change in our "perfect" market will bring a change in the value of our equities. A change for the better would, in most recent acquisitions, brings actual investment performance closer to the pro forma target.

A negative change could trigger a dramatic change in equity value. How dramatic? Let's look at the typical purchase scenario in today's market:

According to CoStar Comps, 64 apartment transactions, eight units or larger, have closed since April 1, 2002 in San Diego County. The average price per unit was $94,243 for an 850-square-foot unit. Of the 64 sales, 20 of the transactions involved property constructed since 1982. The average price per unit of these newer properties was $101,937 for an average 925-square-foot unit. Reported cap rates in each group were at or near 7.5 percent with gross rent multipliers around 8.5. This would translate to rent in the 1982 and newer group of $1,000 per month.

To achieve a 7.5 percent cap rate with an investment of $101,937 per unit, the net income would need to be $637 per unit per month, leaving $363 for vacancy and expenses. We know that property taxes will be around 1.2 percent of the purchase price, so $120 of that $363 is cast in stone. Vacancy at 3 percent, or $30, leaves $213 per month for utilities, landscape, insurance, turnover, management and all other monthly expenses. This does not leave a lot of room to maneuver around obstacles that are currently looming on the horizon, let alone handle normal replacements and maintenance.

Lenders have been addressing this concern in the recent underwriting of loans. While 80 percent financing is "available," the ratio for loan payments to net operating income has increased to 1.3 (debt coverage ratio).

So in our example, a lender would first deduct 5 percent for vacancy and 35 percent for expenses, leaving $600, and then divide by 1.3 leaving $461.54 per month to cover the loan payment. Lenders will then calculate the amount of financing possible by calculating the loan with the remaining variables; rate and term.

Even on variable rate loans with low start rates, lenders are using 7.5 percent to 8 percent to underwrite the loan. OK, so our 80 percent loan amortized over 30 years at 7.5 percent produces a real loan commitment of $66,008 per unit, or a 64.75 percent loan to value. If you are in an exchange, this requirement for additional equity capital can come as a rude surprise, if not an outright deal killer.

Now that we have completed the acquisition, let's address some of the potential challenges on the horizon:

* Vacancy and turnover. In his Index of Leading Economic Indicators dated May 23, 2002, Alan Gin, professor at the School of Business Administration at University of San Diego, reported that "an extremely negative reading for initial claims for unemployment insurance" led the local index to a net loss of 0.3 percent, in spite of a positive 2.46 percent increase in consumer confidence. Even if the overall vacancy rate remains below 3 percent, the cost of turning a unit over to a new tenant takes a big bite out of cash flow. The double-digit rental increase that we have enjoyed in the past three years is flattening out as rents bump against the reality of resident income and units take longer to fill with a qualified tenant.

* Fixed and variable expense. Property insurance, workers comp, utilities and interest rates are likely to put upward pressure on the cost of operating an apartment investment. Insurance premiums alone have increased 40 percent or more, with many companies excluding the current hot issue of toxic mold from coverage.

* Capital focus. At a CCIM Investment Forum in San Diego on March 30, 2002, each panelist agreed that developers and investors are flush with capital being diverted from other markets. Much of this capital is OPM -- or other people's money -- with fund managers, developers and syndicators being pushed to compete for projects. As investors are forced to accept true cap rates in the 6 percent to 6.5 percent range with minimal rent increases and growing expense factors, pro-forma returns will not be realized and the capital source will look elsewhere for better returns and less risk.

Market momentum has created a spike in local values out of all proportion to the reality of the fundamental return. I am certain that San Diego is one of the greatest places in the world to live, work and invest in real estate for the long term. The key is to be prepared for some surprises in the short term.

Wise, CCIM, is president of Wise Investment Properties Inc. and senior broker associate at Sperry Van Ness in San Diego.