High Costs, Slow Rent Growth Squeezing San Diego Multifamily Market

Multifamily has had a strong run in San Diego, and demand is still high — but so are the costs of development, while rental growth has lost some steam. That has made new development more difficult and investment a trickier proposition than only a few years ago, according to the speakers at Bisnow's State of San Diego Multifamily.

CityView Senior Director Stephen Anderson said demand has never been higher locally for multifamily product, but costs — labor and especially land — have made it almost impossible to do development deals.

Even so, capital is still interested in urban infill, especially in California, because the barriers to entry are considered assets.

"Once a property is entitled, that's like a moat around your business," Anderson said.

"Everyone got used to great returns in the last eight years or so, but now it's really difficult to replicate those returns. The pipeline is slowing down, even though the demand is strong."

Compared to other California cities, San Diego is still fairly pro-development, Anderson said.

"Los Angeles just passed a linkage fee, which is punitive, to fund affordable housing. The Bay Area is even more expensive."

On the affordable housing side, Chelsea Investment Corp. Government Relations Manager Bob Cummings said demand is so high that there is a 10-year waitlist for most of his company's projects.

"California cities are beginning to require inclusionary housing — often 10% of units mandated as affordable housing, under pressure from the state. Whether you like it or not, that's going to be the norm."

For infill sites, neighbors are often opposed to affordable housing developments, Cummings said.

"The biggest fear is what the property will look like. Is it going to look ugly, and who is going to move in?"

Those fears are unfounded, he said, since affordable developments these days look like market-rate properties, and the people who live there are ordinary working people who just happen to be paying about half of their income for rent. 

In condo projects, Bosa Development in-house counsel Ashley Gosal said, amenities are what people are looking for — and not just in the properties, but in the neighborhood, such as restaurants and retail and entertainment and open space. 

"We see that in the buildings we develop, and we see that Downtown," she said.

"Downtown in the '90s is completely different than it is today. It's becoming a place with amenities — becoming the place that it should be. That's important to the condo market and the rental market, for that matter," Gosal said.

Downtown has reached a tipping point, Gosal said.

"The more bodies there, the more opportunities for retail and entertainment, which attracts more people."

AVRP Skyport CEO Doug Austin said the toughest challenge for San Diego multifamily stems from the fact that there hasn't been any recent residential development that middle-income families can afford to buy. Downtown is particularly difficult.

"The density on the older housing stock is so low that you could replace 10 or 20 units with 100 units, and the city wants that density, but somehow it isn't happening yet," Austin said.

"We have to find a way for families to live Downtown, not just young upper-income professionals. We're looking at architectural solutions and land use to make that possible. It isn't going to be easy."

McCullough Landscape principal David McCullough said it is important to look at the demographics of a neighborhood during the development process. 

"The demographics of Little Italy and Chula Vista, for example, are incredibly different," he said. "It's important to know who you are working for. There are more young people in Little Italy, and fewer families, just to name one difference. You need to design for your client base."

The city of San Diego has changed in recent years to be more development-friendly, McCullough said, but even so entitlement is an achingly slow process here, especially compared to other places, such as Vancouver, where approvals are quicker.

Properties Chief Investment Officer Paul Kaseburg, whose company has been buying value-add and stabilized product, said rent growth is slowing.

"We tend to have more workforce housing-oriented [properties] rather than new product, so we've been a little less impacted by slowing rent growth than owners of new product, but the trend is real," Kaseburg said. 

"In the current environment, we focus more on the quality of the property and the submarket than the exact rent growth profile," he said.

"Interest rates have also been going up, which is more of a concern to longer-term holders like us," Kaseburg said. "If you're in a deal for three years, with max leverage and floating rate debt, in and out, the deal will probably still work.

"Combined with lower rent growth assumptions, you either do fewer deals if you're planning to hold, or accept lower returns. But given the broader investment climate, even those lower returns on apartments are still attracting investors."

Meridian Capital Group Managing Director Seth Grossman, whose company is a commercial mortgage broker, agreed that rent growth has slowed while interest rates have risen, so everything points to the market slowing. "And yet we are busier than ever," he said. 

"People are complaining that they aren't getting the rent growth, and that pricing is too expensive, yet they're still doing deals regularly. Existing clients are refinancing more quickly than they used to, and purchases are up. This can't last forever, but the last year has been a lot busier than I expected."

Housing on Merit Executive Director Jennifer Litwak, whose company is an affordable housing developer, said for the last 12 months, tax-credit pricing has fluctuated more than in the previous five years. 

"The most significant upcoming change for the affordable housing industry is because of the tax reform bill," Litwak said, adding that the reduction in corporate tax rates means that companies won't buy as much low income tax credit.

Since affordable housing projects tend to span a few years, most of the deals ongoing now were financed before the tax law changed, so its impact isn't being felt so much yet, Litwak said. But the industry is nervous, and thus tax-credit pricing has been less stable lately.

"What that means in the longer term is that there will be $1.7B less equity for affordable housing transactions each year," Litwak said. "We will start to feel that loss as an industry."