Pricing for real estate in Southern California continued to surge in the first quarter of 2004 but appears to have slowed and possibly peaked in the 2nd quarter. In Orange County, the manager of a Remax office told me that inventory of available single family homes for sale was quickly building as sellers rush for profit taking and buyers aggressiveness has become more subdued. Only 13% of the population in Orange County can afford a median priced home, which is an all-time low. In Southern California as a whole, approximately 18% of the population can afford a median priced home. At the same time, approximately 75% of new home buyers were opting for adjustable rate financing, presumably so they can stretch in purchase price and afford the payments as fixed rate loans come with a higher interest rate and payment. On multi-family (apartment) properties, the prices hit new highs in all areas around Southern California do to several factors:
1. Very low interest rates
2. Stable asset class for which to invest
3. High barrier to entry for new home buyers and for new apartments
My thoughts on each factor are as follows:
1. Interest rates
The current rates (which went up in the 2nd quarter) are artificially low. Mr. Greenspan has indicated that he is inclined to move the overnight rate up in the coming quarters if the economy continues to improve and signaled that the Fed would be aggressive if inflation becomes a concern. The overnight rate of 1.25% is just 25 basis points off of an all-time low and the rate should level off at around 4%. This would push the 30 year fixed rate loan on a single family residence above 8%. It would also push the adjustable rate loans up as well. If the rates move up, we can expect an increase in foreclosures since so many homes have been purchased using adjustable rates, little down payment, and often times very little borrower qualification ("stated income," sub-prime lending for bad credit, etc…) as more and more loans have been packaged off to Fannie Mae and Freddie Mac. The last point is of particular concern since lenders / mortgage brokers don't have to portfolio the loans they write and thusly the incentive can be solely on closing the transaction. The higher interest rates will create a squeezing effect for those with adjustable loans, leaving them less spendable income for cars, trucks, televisions, and restaurant visits (a negative for the economy). It will also cause the affordability index (referenced above at an all-time low) to temporarily sink further. This WILL cause home prices to fall which in turn will turn houses upside down (the debt being higher than the asset value) for those who purchased late in the cycle with little or nothing down and for those who used their homes as credit cards during the refinance mania of the last few years. Historically those who are upside down are more likely to let their homes go back to the bank than those that have equity built up. Lastly the feeling of wealth will disappear (like it did when the dot.com bubble burst) which will cause the household spending to be curtailed and real estate won't be the "smart" investment anymore.
Regarding interest rates on commercial properties, I would expect them to go up as well since they are primarily based on spreads over the U.S. Treasury bond yields. The treasury yields have fallen consistently as the overnight rate has been moved down. Since a large percentage of the ownership of our bonds is from foreign investors and foreign governments (over 1/3 owned by Japanese and Chinese), factors beyond the control of the Fed could cause those rates to become violent if large sell-offs occurred.
2. Stable asset class
I feel safe investing my money in apartments due to the fact that everyone needs a place to live, even in down economies. With that said, there is risk in any investment and the reward for taking this chance is return on investment which we emphasize in a "cash on cash" return analysis. I view appreciation (with the exception of equity created by a "value add" opportunity) as gravy to a good deal and don't like the idea of buying an asset solely on the hope that it will be worth more simply because of market appreciation. The fundamentals by which I evaluate deals for purchase at Beach Front have brought me to the sidelines and will keep me there until the risk/reward ratio balances again. Whether other investments like equities become more favorable in the near-term or not, I believe factors will cause the euphoria of purchasing apartments in Southern California to wane.
3. High barrier to entry
The high barrier for purchasing real estate in Southern California as equated in the affordability index will continue although it will become more favorable for home buyers. Housing prices as discussed previously will go down but compared to most areas west of the Mississippi River, Southern California will remain prohibitively high for most renters to become home owners. Our properties in Southern California (and Austin) are located in "in-fill" locations, meaning there isn't abundant available land in that particular submarket to build new properties. Furthermore, our apartments are B - C class properties with a focus on the middle to low end renter while the overwhelming majority of new units built target the high-end renter. Most of the municipalities do NOT want new apartments built as they are viewed (and I was told this explicitly by the Santa Ana City Manager) as drains on public resources. Because of the high barrier to entry for new competitors, we decided not to sell and instead hold on to a number of properties in the portfolio. We expect them to weather any difficult markets and continue to do well in the future.
