Investment Outlook for 2003
by Jim Scott

Real Estate Investing

San Diego's regional economy has been spared the negative effects of the moribund California and national economies. San Diego was one of only two counties that added jobs in 2002. We have also been fortunate that the oft-predicted real estate bubble never appeared nor burst. In fact, the short-term future in residential real estate seems to be generally positive for San Diego in 2003 and 2004. As long as the County continues to generate jobs, the residential market will have moderate appreciation over the next two years. To be sure there are many troubling signs around. But most of the bad news has been factored into the pricing structure. Considering the relative stability offered by San Diego real estate, perhaps it is time to look at other real estate investments to take advantage of the post-war environment.

Apartments

For most investors, investing in San Diego apartments has been a traditional and stable path to building wealth. The market can be volatile and to a certain extent one needs to pay attention to the cycle. This is different than purchasing a home. Your residence provides a utility value and typically is held for a long period of time. Even if a person is continually trading up to a larger home or a different neighborhood, the cycles are mostly irrelevant since all of our local markets are linked. A rising tide lifts all boats.

Apartments on the other hand, have to be purchased with an eye to the cycle. Apartment values are determined by many criteria, the most important being rental income. If the gross income declines, the value of the apartments usually adjusts on some proportionate basis. That in itself is generally not a problem since the investment is being held long or medium term. The problem arises if the rents decline and expenses rise (interest rates) to a point where the owner needs to start contributing cash each month to keep the building viable. During the period of 1990 to 1995, rents declined twenty percent precipitating an historical wave of foreclosures.

If an investor can ride out a period of lower rents and higher interest rates, the cycles mean little. The real damage from a period of flat or declining rents and higher interest rates is mainly psychological; buyers, lenders and sellers base their agreement on prices on a common expectation of future rents and interest rates. Only when there is a mutually accepted notion that rents are going to increase over time that prices will respond positively. Or put another way, the meager returns on apartments are far better than losing money in the equities market or making one percent in the bank. It is simply the best game in town when compared to the alternative.

Rates are nearly as important as rents as the cost of money is the largest single monthly expense in any investment property purchased with a standard mortgage. Contrary to popular belief, the only real loans available are variable rate mortgages. (You may obtain fixed rate loans but they come with a heavy price. Most convert to variables in five years or are due in five or seven years. The rate is about 2.25% higher than the start rate for most market variable loans available today.) This brings a second unknown into the purchase matrix.

Prices of apartments largely reflect supply and demand, the viability and profitability of competing investment vehicles, and some common assumption as to the future of rents and interest rates. In the past, these rules have always governed the market. These immutable rules provided some measure of stability even within the cycles. But that has all changed.

Enter the Converter

In this column two years ago I wrote that as the San Diego real estate economy matured it would more and more resemble the older metropolitan areas of the Midwest and East. Entry-level home ownership would feature converted apartments instead of the traditional single family home. At that time I recommended aggressively pursuing smaller to medium-sized apartment buildings suitable for converting to condominiums.

As with any important change, these phenomena brought good and bad. Inexpensive home ownership was created and will continue to be created by the segment of the market. Our governing bodies and the development sector cannot decide on how to create affordable home ownership. Governments court the converter as they provide cheap home ownership and a trove of fees. The only downside is for tenants. The existing stock of units will be diminished potentially exacerbating the already tight market for rentals.

There is another shoe. The converters have distorted the market place for apartments. Prices for buildings are usually set by the relationship between rents and price. This has always been so. The converter does not care about the old rules as his profit and success will be based on another set of factors. The converter bids up the prices for apartment buildings regardless of the rent structure. Ordinary investors must meet the competition of the converters, and as such are gambling on rents and rates moving in their direction. There is no room for error. They are willing to invest and not see any real return on their investment for some period of time--hoping to make a profit solely with appreciation. If they lose that gamble there may be another wave of foreclosures or at least some bargains floating around.

The Future

I would avoid buying in this market until prices retreat. If you already own units, you have reaped a bonanza and you may want to consider selling and paying the capital gains tax. There may be better opportunities ahead, especially if rates start moving upwards. Additionally, I am concerned about the recent softness in the rental marketplace. The best case in that the vacancies are war related and will normalize when the troops return. The other side argues that the gradual economic disenfranchisement of the working poor is beginning to bite the capitalist class. You pick it.

At Scott & Quinn we have developed some alternative investments in real estate that are profitable and are based on positive cash flow. Call me if you have any questions about these alternatives to apartments. As lucrative as apartments have been over the past thirty years, they have had their upsets. This has always followed, as with the stock market in 2000, some period of excessive speculation.

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.