Strong rental market drives housing recovery

San Francisco Business Times  - Friday, June 24, 2011 

A new housing construction boom is shaping up in San Francisco, but this time, it’s all about renters.

Construction cranes have reappeared, first on Third Street, where Martin Building Co. is working on the 198-unit Potrero Launch, then at AvalonBay’s 173 units out on Ocean Avenue. More recently, San Francisco’s only non-rental housing project, Bosa Development’s 329 condos at 435 China Basin, has been rapidly rising beyond the San Francisco’s Giants Lot A surface parking lot.

It’s a modest beginning in a city that has had virtually no new housing starts since 2008. Yet if you listen to the proclamations housing builders are making, the city could see 3,500 rental units under construction by the middle of next year. Production could rival the 3,366 units that were delivered in 2009 or the 3,019 built in 2008.

But this building boom that is taking shape now will look entirely different than the last one. In 2006, San Francisco had 5,000 units under construction. Of the 5,000, 4,000 were upscale condos, with just 300 market-rate rentals and 700 affordable rentals. This time, instead of 80 percent condominium, it’s 90 percent rental. Instead of glass and steel towers, it’s mostly wood-frame over podium. And instead of building for well-heeled empty nesters relocating from the leafy suburbs, the new target audience is the 20-somethings feathering their nests with paychecks and stock options from Twitter and Square, Yammer and Yelp, Dropbox and Zynga.

The rush to build housing for this generation of worker is prompting public REITs and institutional investors to snap up land across the city.

“San Francisco was the first apartment market to see recovery in land sales,” said Chris Macke, senior strategist for CoStar. “It makes sense because you guys have employment growth and are so supply constrained. Contrast that with Austin or a Raleigh-Durham, where they did such a great job building before the downturn they are pretty well-stocked for a while.”

Among the major projects in the pipeline:
BRE Properties, Urban Housing Group and UDR are each gearing up to start construction in Mission Bay — a combined 630 units.
Avant Housing (a joint venture between TMG Partners and AGI Capital ) is looking to start in the fall on on two apartment projects, 194 units at 1880 Mission St. and 269 units at 900 Folsom St.
Oz Erickson’s Emerald Fund is teeing up a July ground-breaking for the 308-unit 333 Harrison St.
In the Mid-Market, Angelo Sangiacomo’s Trinity Properties is aiming to start shoring and excavation July 15 on the second phase of Trinity Place, which will be 417 units.
On Upper Market, Prado Group will start work on 82 units over a Whole Foods at the old S&C Ford dealership at 2001 Market St., and MacFarlane Partners is getting ready to go on 113 units at 1844 Market St.
And, Crescent Heights and constructor Swinerton are lining up subcontractors for the 750-unit 1401 Market St., a redesigned twin-tower condo project that was shelved three years ago.

Calm before the storm

Yet, while the nascent apartment boom is more talk than action so far, there is an increasing sense that developers who don’t start digging in the next six to 12 months will miss the party. Shubhra Jha, director of investment research for CB Richard Ellis Investors , said she expects 5 percent to 6 percent annual rent appreciation over the next few years.

“We are going to see strong rent appreciation in 2011 and 2012 and into 2013, and after that point there will be pushback from renters,” said Jha. “So if you are not ready to deliver by 2013, you are going to be late to the game. At this point it’s a race to the finish and there is definitely a sense of urgency.”

Dan Safier, CEO of the Prado Group, which is also about to build 15 units over retail at 1266 Ninth Ave. in the Sunset, said it has seen an average of 10 percent rent appreciation across its 600-unit portfolio since 2009. At Trinity Place, the rates on the best corner one-bedrooms in the first building have jumped from $1,899 to $2,750/month since the building opened in 2009. Avant Housing Executive Vice President Eric Tao said a year ago when he started lining up financing for the Folsom Street and Mission projects, his firm underwrote 10 percent rent growth over the next three years. That anticipated appreciation occurred in three quarters, not three years.

“Based on what we see in marketplace, I think that we will see a general continued demand and pressure for apartments for three to five years,” said Tao.

Amid all the bullishness, Emerald Fund Chairman Oz Erickson cautioned that so far the apartment boom has been mostly chatter.

“Everybody is talking about starting, but they have not started,” said Erickson. “It is still exceedingly difficult to get financing. You are talking about 65 percent loan to cost. You are talking about very, very significant cash outlays and guarantees. The lending community has not gotten wild. And there is still no financing for condos, none at all.”

While a year ago it was nearly impossible to find financing for any new housing, the lenders are back, if not completely bullish. Banks, life insurance companies and pension funds are all looking to invest in San Francisco multi-family.

“They love multi-family, they love grocery/drug-anchored retail, and San Francisco is just a market a lot of folks have had difficulty getting into,” said the Prado Group’s Safier.

How many units is too many?

In a new report, the Association of Bay Area Governments assumes that the Bay Area will add some 1.2 million jobs by 2035 and will need 903,000 more housing units than currently are available. Under this scenario, the agency states that 70 percent of the growth, or 632,100 new households, will go into places that have been designated ‘close to transit’ by local jurisdictions. The Bay Area’s biggest cities — San Jose, San Francisco and Oakland — are expected to account for nearly one-third of all new housing units, more than 200,000. That’s 8,700 units a year between the three cities.

The reality is that San Francisco produced just under 10,000 units between 2006 and 2010, with a high of 3,366 in 2009 and a low in 2010 of 1,082. Along with San Jose and Washington, D.C., San Francisco is at the very top of every report on the nation’s strongest rental housing markets. Vacancy is about 4 percent.

But San Francisco has produced so few rental units in recent years that it’s difficult to say how deep the demand is. Builders across the city are counting on tech employment growth to fill all the new buildings, with Mission Bay developers also hoping to tap into biotech and health care workers.

“When you look at Mission Bay, yes, there are a lot of units, but when you look at the number of jobs that are being created down there, it’s probably a pretty good balance,” said Safier. “In San Francisco when rents go down, it’s typically an under-demand issue rather than an over-supply issue.”

Building for techies

For Trinity Properties President Angelo Sangiacomo, the explosion of tech companies in San Francisco is reason enough to fast-track the whole 1,900-unit Trinity Place. The first 440-unit building leased rapidly and Sangiacomo expects the next one to fill up quickly when it opens in March 2013. As soon as that one is built, he plans to break ground on the third, 540 units.

“We are going full blast — I’m going to do the whole darn thing,” he said. “Twitter up the street? They need something like this. Guys from Google ? I call them nerds. They want to live in the city. And they can move right in here. They can live here for $70 a day. How can you beat that?”

A key factor in the next generation of apartment construction will be building product that young technology workers like — and it’s not necessarily the same pool-and-spa package of amenities that deluxe condo towers promote. Avant Housing’s Tao said they want to create buildings that reflect the interests of the San Francisco workforce.

“Every REIT, every big developer, does a fitness room and a deck and outdoor patio,” said Tao. “We are going to create a garage — not to park your car, but a place to have your tools, to tinker, to make things with your buddies. Maybe a sewing machine, maybe a silkscreen machine. A table with clamps. A place to fix your bike, paint your Ikea furniture. Library space for people who want to sit around together on their laptops.”

Conversion down the road

But for developers accustomed to building and selling, the condo market always beckons.

Tao of Avant Housing said that all-in costs on his company’s two projects (land, entitlements, construction) will range from $425,000 to $475,000 a unit. He estimates that should housing prices start to rise again, say to $625,000 to $650,000 for an average-sized unit, some of the apartments will be converted to condos. While for-sale units tend to have fancier cabinets and bathroom fixtures, new apartment communities in San Francisco have most of the other flourishes — workout room, decks, barbecue pits, in-unit washer-dryer — that buyers expect in their condos.

“All of us condo guys learned our lesson (in the downturn), we are going to make these building work as apartments,” said Tao. “But I think two or three years down the road when there is a glut of apartments and dearth of new condo projects, you will see developers re-purposing their apartments as condos.”

In addition, institutional buyers and REITs are paying more and more for apartment buildings. Behringer Harvard recently paid $525,000 a unit for the Argenta at One Polk Street, a 297-unit tower that was built as condos, but converted to apartments just as the housing market collapsed.

Jha of CBRE Investors said “San Francisco is a buy and hold strategy for most investors.

“I don’t think we are close to a condo conversion play in the next five years. I don’t think condo prices will recover to the point where it makes more sense to do that.”