It's the Economy…
by Jim Scott

Word on the street is that the torrid residential market of the first quarter is cooling off. Higher home inventories and last month's interest rate spike are both worrisome indicators. If you are holding property for appreciation in the short-term or waiting for that perfect moment to sell, you may want to revisit your strategy. For existing homeowners it is just news. But the purpose of this column is not to focus on the residential market but to look at the real estate investment landscape. Although separate, they are inextricably linked when you are seeking signs of a market direction.

Numbers Don't Count or The Apartment Market Runs Amok

One of the most accessible and profitable avenues for making money in San Diego property has always been in owning apartment units. Unlike other real estate investments, this market can be more cyclical and returns are more influenced by market inefficiencies and timing. In looking back at my 30 years in the apartment business, I can only conclude that at certain times, emotion often outweighs reason. I believe we are in only of those phases now, so buyer beware!

Capitalizing on market inefficiencies and timing requires luck, cash reserves and a bit of forethought. Evaluating recent sales in apartment buildings is a lesson in a market gone awry. People are making huge bets with a low probability of a short-term reward and a high probability making a mediocre return.

We got into this situation thusly. The stock market debacle of 2000 drove many small capitalists underground and into their 1.5% CD bunkers. From 1991 to the present the development community did not produce many multi-family housing projects of any import. What was built were mainly condominiums, high-end units or subsidized apartments. To exacerbate matters, the rash of condominium conversions removed hundreds of apartments from the rental market. Given the alternatives, investors all piled on the apartment bus. This was fine in 1998 and 1999 but I doubt the wisdom of investing in 2004.

Rents and Prices

Given the above, rents should rise reflecting the laws of supply and demand, making a purchase at dear numbers a smart one in the long run. Apartment buyers are betting that rents will increase over the rate of inflation or that they will be able to cash in on the condo conversion boom. Low interest rates completes the picture-buy apartments even at these prices and low payments and increasing rents will make the investment work over time. That has been the investment mantra as long as I can remember-just hang on long enough and inflation will bail you out.

There are several problems with this approach, the least of which is that interest rates are moving higher. You cannot finance a war and substantial tax cuts with a tepid economy. The Feds will have to borrow and rates will move. Inflation remains in check thanks to outsourcing and globilization but the oil cartel can upset that wagon. That is the real joker in the pack. Since nearly 100% of all apartment loans are variable, this can spell trouble for owners who are just getting by.

Increasing rents, which should follow naturally from shortages or inflation, are not automatic in San Diego. Tenants have the ability to set aside economic law by doubling up or simply moving back with Mom. During the bleakest days of the last apartment recession about 40% of the young men in San Diego under the age of thirty-two lived at home. It is not that they wanted to live there-the economy made them do it. The same follows for all of those tenants who shared apartments instead of renting their own digs. Rent increases, in this low wage city, are driven by after-tax wages, not supply and demand. This is not New York City. If you think the after-tax wages of the lower economic one-third are going to increase eight or nine percent annually, then units, even at these prices, are probably a good idea. In this political climate I doubt that will happen as real spendable wages at the bottom have stagnated or even retreated over the past few years. Unless you can convert a building to condominiums, returns going forward may be limited or near non-existent.

Speaking of Cash Flow

But where to put your money? Apartments are being bid to these lofty levels precisely because there appears to be no viable alternative-stocks, commercial real estate, commodities, CDs have limitations. Apartments in the past have performed because they provided positive cash flow, like a bond or stock dividend, combined with debt reduction, safety and appreciation. Given the right price, they are near-perfect investment instruments. In the future they may be again, but for now the price may be too high given the price and market risk.

I have been putting money in real estate partnership ventures in markets and products other than what has been discussed in this column. I am doing it mainly for the positive cash flow, investment safety and appreciation. As a long-time apartment owner, I had to readjust my thinking prejudices about other investment vehicles. Thus far I have been very pleased. The markets and products have some degree of fiscal sanity and have paid excellent returns.

The Lure of San Diego

If you want to own units in San Diego you can still find opportunities in marginal neighborhoods. I would buy in North Park, City Heights and Normal Heights or other semi-ignored areas. There is real momentum in these neighborhoods but all of the people who own units have figured that out. Rents are still lagging behind values and if real wages for the lower classes improve, that situation could change. In spite of what I have said herein, I would still own any kind of rental housing in San Diego, no matter how painful it might be. But just as easily I would look elsewhere where easier money can be made and you do not need deep pockets to carry the investment through the rough patches ahead. Call me if you want some more information about some alternatives.

I welcome your comments; my email address is jimscott@sqre.com.

You can reach Jim Scott at his office, conveniently located in the heart of Mission Hills, at 1111 Fort Stockton Drive. Founded in 1982, Scott & Quinn is the oldest full service real estate firm in Mission Hills and is still locally owned and operated. Jim has been a homeowner in Mission Hills since 1976. He is married and has two boys. He can be reached at 296-9511, extension 100. Scott & Quinn features professional property management as well as 15 sales associates. Click here to see Jim's past Market Reports .You can also download Jim's 26 page research paper on San Diego County apartments.