The Ups And Downs Of Developing Multifamily Projects In San Diego

The cost of land is rising in San Diego as it becomes more scarce. In light of that, moderator Timothy Hutter kicked off Bisnow’s State of San Diego’s Multifamily Market event last week by asking a panel of developers if there are still good deals out there and if they are still looking for sites. He also asked panelists to compare what they see happening in San Diego with other West Coast cities.

Timothy, a real estate attorney at Allen Matkins, is on the right with Rhonda Slavik and Don Gause.

Polaris Pacific business development director Rhonda Slavik, who is focused on condominium sales and marketing, said it’s a great time to be in condo sales, because there is so little product being developed in any of the major West Coast cities. While there is high demand for for-sale product, she said 80% to 95% of all units under construction are rentals, depending on the market. Only 800 condo units are underway in San Francisco, 500 in Los Angeles and 400 in San Diego.

Rhonda said overseas money coming into these markets has inflated land prices, which readjusted the expectations of sellers. “The result is a domino effect, with everything from rising land to construction costs making it challenging for developers to price the final result.” She said most for-sale product in the pipeline won’t be delivered for another 18 to 24 months, so there's an inventory desert.

The Richman Group of California Development Co president Luke Daniels said between 2007 and 2010 people didn’t care about missing out on opportunities. “During the teeth of the recession, they were worried about losing money,” he said. “Today, nobody cares about losing money: everybody’s worried about missing the opportunity." Shown left to right are Luke Daniels, Marco Sessa, Rhonda Slavik, Don Gause and Timothy Hutter.

“In terms of gauging our investor and competitor psychology, we’re more disciplined and selective than ever,” Luke said—his company’s two guiding principles for new deals are basis and high barriers to entry. He defined that as the right site, at the right basis with unique land use representing high barriers to entry. Luke’s company, the seventh-largest apartment owner in the nation with about 115,000 units, has two projects rising in Downtown SD, but is pursuing projects in Los Angeles, Santa Barbara and Orange County.

Sudberry Properties SVP Marco Sessa said his company structures deals by partnering with landowners, so with little debt to equity Sudberry was able to weather the storm in 2007 and 2008 and even added people. He said the biggest challenge for his company is the entitlement process, citing a mixed-use project at Scripps Ranch that has been six years in the process. “You must have patience. Even if you’re good at it, it is a long, expensive slog.”

Timothy asked the group how rising labor and material costs are impacting projects. Wermers Properties principal Don Gause said the lack of skilled labor is the biggest factor in getting projects done, because subcontractors go with the highest bidders. He said, while the cost for construction is up 50% from 2010, increases in commodities have been gradual.

“When you take a look at it overall, what it comes down to is: yes, there’s been an increase in costs, but it’s also the type of construction that’s going on in all of California,” he said. “It’s higher density and requires higher skills than a three-story, on-grade, and it’s a lot of specialty work—structured parking, structural steel, lumber going up 80 feet high. Again, you don’t take rookies who are just starting to learn how to frame and put them on those sorts of projects.”

He predicted over the next 12 to 45 months there will be a correction or settling and construction pricing will level off.

Timothy asked Luke (left, with Marco Sessa) if his company is seeing similar trends in other markets. “What we are seeing goes back to the teeth of the financial crisis, when the horsepower for multifamily subcontractors left to became frackers or work on an oil rig, and they’re never coming back,” he said. The number of starts from 2009 to 2013 didn’t expose the labor shortage, but in 2014 the behavior of subcontractors began to change. He said 2015 was a pivot point because there were 10,000 housing permits issued in San Diego, and many of them were tied to the multifamily rental boom.

“Additionally, suppliers said, 'We’re not going to hold the pricing for more than a month or two,'” Luke said. “So we had to really adjust our behavior in terms of buying futures on lumber and basically working on our partners to hold pricing for longer periods of time.”

Even so, Luke said San Diego is still a really good deal from a basis standpoint. He said construction of multifamily in LA is $ 240/SF and $230/SF in San Diego. He said a Type 3 podium building his company has under construction at 11th Avenue and F Street in Downtown has five levels of wood over two levels of concrete, which was contracted for $283/SF. A similar project would cost more than $300/SF in LA, he said.

Timothy asked the panel how these market conditions are affecting positioning of projects. Marco said Sudberry has a long-term view, so projects go through different cycles and are designed in a way to do well during the highs and survive the lows and be as relevant in 20 years as today. “We stay pretty consistent with unit-mix decisions and analyze the markets we’re in and design accordingly,” he said. “Our renter demographic right now is younger and is OK with slightly smaller units, so long as there are really killer amenities."

Marco stressed the importance of schedule to costs. “We live and die when we have a pro forma that expects rental income at certain time. If the schedule delays rental income for six months or a year, that’s millions of dollars of income that the pro forma was counting on, and all of a sudden you don’t have it,” he said. “So not only are we paying more to get things built, but when there’s a massive shortage of labor and we lose the schedule, we end up with a double whammy. ”

Rhonda was asked to predict the tipping point for getting condos built by someone other than Bosa. She said the tipping point should have been last year, because prices for new condos had reached the price point developers had set to consider doing condos. “But the rise in rents on apartment deals have been surprising over the last two years, so that encouraged projects, that could potentially go for sale, to stay rental.”

Rhonda said the financial aspect, including the risk related to condo sales, is discouraging condo construction. “A lot of people still have PTSD from the last cycle and are terrified of getting stuck with 200 or 300 units if the market turns. And with the apartment market being so profitable over the last couple of years, it’s just not worth the risk.” With rising land and construction costs and the labor shortage, she said, “Developers would have to add 25% to 30% to what condos are selling for now to make the project pencil when it delivers two years from now, and they’re not ready to go that far out on the limb.”

Rhonda said developers in all five markets on the West Coast are hesitant to jump back into the condo market and are waiting to see if the market shifts in the next 12 to 24 months, as Don suggested. “Our feeling is that if enough time goes by and nothing does, eventually developers will get off the fence and do something.”

San Diego has lowered barriers to entry in the Downtown market and is encouraging affordable housing by offering density bonuses, Timothy said, asking panelists if they use affordable density bonuses and how that fits into entitlement challenges.

Luke said his company does not incorporate affordable units into market-rate projects, but is paying the “in lieu” fee. “We are conscious of the density bonus, but don’t want to err on the side of diminishing return." He said in some areas of LA, 11% affordable earns a 35% density bonus.

Calling the entitlement process in Downtown predictable, Luke said while Civic San Diego pushed for density at the beginning of the cycle, it’s now going for maximum FAR. As a result, high-rise projects aren’t just ringing Downtown with blue-water views, but are going vertical in the middle of the city, and over 9,000 units have been completed or are on the books in Downtown, he said. 

Comparing San Diego's entitlement process to Orange County cities, Don, whose company is underway on a project in an overlay zone in Santa Ana, said SD is systematic in its entitlement, while Santa Ana is more political. “So we’ve been collecting our shareholder information—what are the wants and needs of the local community—for our design,” he said. “It just so happens that our next-door neighbor is the Santa Ana zoo, so it’s kind of a fun play that we have going back and forth with the zoo in our design phase.”

He said his company is also pursuing projects in Irvine, which is just as systematic in its entitlement. “It’s like putting projects in a machine and the machine grinds them out. So as long as you keep up with the machine, you should have your entitlements within six to nine months.”

Don went on to say creativity is key to success in today’s residential marketplace. “It’s all about lifestyle with the Millennials,” he said. The Santa Ana project will have a mix of Millennials and 35- to 45-year-olds living there, so there will be a blend of amenities that satisfy both generations.

Bisnow's Abigale James (pictured), who heads sales in West Coast markets, kicked off the event.

Timothy said a community's ability to express opposition to density at the ballot box is affecting housing development statewide. He cited two local initiatives, in Encinitas and Del Mar. He asked panelists if they have experienced NIMBYism with any of their projects, and what they are doing to avoid or address community opposition.

Marco said nobody is going into a community without taking the time to listen to the stakeholders. “That’s just a matter of life, at least for us in San Diego, and we do our best to try to incorporate things the community feels is important. Oftentimes that means that the project doesn’t pencil,” he said, recalling a project his company had considered developing in Carlsbad. “The nearby community didn’t want affordable housing, but affordable was required on that site, so we ended up passing on the opportunity, because we saw it as too much of an uphill climb.

“Ultimately, I think, you have to work with the community, like it or not." He said the city has established community planning groups to give residents a voice. “If you’re one of the folks living in a community you rightly should have a voice,” he said. “We never go into to a community and try to shove something down their throats, and I probably wouldn’t be sitting here if we did.”

Luke said dissolution of the redevelopment agencies carries part of the blame for the state’s affordable housing deficiency. The agencies were the state’s biggest source of funding for affordable projects. “Today, the amount of capital available to build [affordable projects] is very limited,” he said. "Policy and politics don’t always match up.”

The developer group also weighed in on the Chargers convadium proposal, pointing out Qualcomm Stadium is decrepit, but the site could be put to a higher use.

The Chargers plan may not be perfect, Don said, but the city should support it. “At the end of the day, we need a football stadium, and Qualcomm makes you feel like you’re going to a [lousy] area of town.”

Luke said the Qualcomm site could provide a financial boost for public projects if approached correctly. He said it could generate a lot of money for Mission Valley if sold off in pieces. If someone buys the whole thing, he suggested the financial benefits could be a long time coming.