The Deadly Math of San Francisco Apartments

A friend of mine has a favorite saying about San Francisco multifamily real estate – buying apartments in San Francisco is not a financial decision, it’s a religious decision.

He’s not wrong. The list of questionable judgments involved in buying San Francisco apartments is long. Buyers are often acquiring old buildings, sometimes more than one hundred years old. Many require expensive repairs or seismic retrofits. Most are outdated and under-improved. Most have tenants in place (often rent-control restricted), and those tenants are protected by arguably the most tenant-friendly set of regulations in the United States.

Beyond the property challenges, San Francisco has a notoriously tight and aggressive purchase and sale market with buyers often paying over ask, agreeing to very short due diligence periods, paying large deposits, and accepting terms on purchase contracts that would turn investors in other parts of the country green and nauseous just thinking about them (much less signing).

So, what does one get for buying into this set of risks? Well, if you had bought in the last 5 years or so, probably somewhere in the 3.0-3.75% cap rate range (often worse for rent-controlled apartments). And probably less than that once you realize that many deals are presented with no management fees or personnel expenses (SF apartments must manage themselves), and plenty of other wishful thinking.

All that said, San Francisco apartment investors have often been rewarded for their faith. Coming out of the Great Recession, San Francisco experienced a combination of extreme rent growth (~50% growth between 2011 and 2016) and declining cap rates. Those that invested were richly rewarded in a short period of time. Even those investing around 2015 have done reasonably well – rent growth became more tame but cap rates continued to decline and most investors did OK – assuming they sold.

But COVID has really made a mess of the gravy train. The San Francisco Chronicle reported yesterday that rents have plummeted by 20% from peak in San Francisco (and even worse for newer CBD apartments). It’s probably not entirely fair to just apply that number to the typical property as there are many factors that come into play (rent control most notably), and also the rent reductions will play out over time (most people aren't just going to up and walk on their lease in the middle of COVID), but let’s do it anyway, unfairly.

A recently marketed San Francisco apartment property was offered with a not unusual 60% operating margin (NOI / Rent) at an approximate 3.0% cap rate. Using that as a rough guide, a 20% rent reduction translates to a reduction in NOI of 33%. If you had bought at the 3.0% cap rate on the in-place NOI, hoping to get to a 4.0% with some improvements in rent and operations, you are now at 2.0% and hoping to get to a 2.7%, and then sell at a, wait, a 3.0%? Not great.

This is probably the moment we should introduce the other important actors in this play – lenders. Debt has flowed freely to San Francisco apartment acquisitions over the past decade. San Francisco did exceptionally well through the Great Recession, and most lenders came to view the market (and especially apartments in the market) as basically bulletproof. Financing for these properties was available with low debt service coverage ratios (the amount by which income from the property exceeds its mortgage payment), and often even available up to zero net cash flow after debt service, in some cases debt was available even to the point where the owner was expected to put money into the property each year to cover a part of its debt service costs. The argument of lenders was that, San Francisco being bulletproof, the owner could always resell the property and repay the lender. Obviously, none of this was designed to endure a 33% decline in income, and that's without considering how the sale market may change in coming years.

Put all of this together, and many of those that bought or refinanced San Francisco apartments recently are now facing a challenging problem – once rents at a property reset to market, the landlord will be unable to service debt from property income for the foreseeable future.

So far, not much has happened as a result of this, and at least from the outside looking in properties still seem to be out there for sale at nose-bleed prices (whether they are transacting is another question).

Another positive – lenders across the board (not just in apartments) have held off on pursuing properties and borrowers aggressively due to COVID, and forbearance and watchful waiting have been the orders of the day. Beyond that many owners do have the resources to continue feeding these properties for a time. And there is always the hope of a quick return to pre-COVID rents. But it seems sort of likely that without some type of relief in the coming months the circumstances may start forcing the hands of owners and lenders alike.

The open questions now are how the market will adapt to or endure these challenges, how widespread the distress might be, and whether the government or lenders decide to take any unusual actions to forestall the problems.

I for one remain long-term bullish on San Francisco apartments, but it seems like we may be in for a rough ride here in the near-term.