Downturn Upgrades

SFAA: August 2016

by Robert Link

You don’t need to look far to find concrete evidence that our housing market is changing. Can you feel it? The rent trajectory has cooled significantly in the last six months; some areas are experiencing 5% to 10% reductions for units that lack amenities or have locational challenges. The rent trajectory that we experienced over the last four years, which was founded in job growth and employment stability, made San Francisco one of the most expensive housing markets in the country. Those factors are now at the doorstep of what may be a major change in housing market, including real property valuations and market rents.

lg_cover_aug2016Job growth in the Bay Area has always been a reflection of the apparent strength of the tech industry. The sharing economy is starting to show signs of weakness as startups are failing and the VC capital that has kept them on life support is drying up. The probable success of a tech startup has always been low: 1 in 9. We are now entering the “post-unicorn” era—a culling of the weak.

Layoffs and cost cuts in the tech sector incite expectations of a hiring slowdown. Data shows that Series B, more advanced startup companies, have increased their interviews by 11% since the beginning of the year. While series A companies, newer start ups with a single round of financing behind them, are logging 60% fewer interviews during the same time.

Larger, well-known tech companies are showing signs of pragmatism. Dropbox initiated a cost cutting protocol to reduce $38M from its budget, cutting many ancillary employment benefits. Zenefits, a benefits and insurance brokerage start-up went from 1,800 employees to 950 employees after three rounds of workforce reductions. Twitter has reduced its global workforce by 25%, had a leadership change last year, and has not been treated well on Wall Street, as the company faces serious challenges in subscribership growth. This is the same fate that has befallen yahoo.com, which is currently entertaining acquisition offers.

Tech layoffs in the four-county Bay Area (SF, SC, SM, ALA) doubled for the first quarter of 2016 compared to the same time last year, according to Wells Fargo senior economist Michael Vitner. Tech firms added just 800 jobs per month in Q1 2016; half of the number of adds from Q1 2015. Announced layoffs (forthcoming) spiked from 1,515 to 3,135 in the same period last year. Actual numbers of layoffs may be considerably higher, as companies of fewer than 50 people are not required to file under California’s WARN act.

A slowdown in job growth will translate to net reduction in average market rents. This is simple supply/demand economics; if layoffs experience an uptick, the result will be vacancies as people are no longer able to afford Bay Area price tags. We are already starting to see this.

How to Deal with a Downturn

There are multiple short-term remedies to meet the challenges of a softening rental market. There will inevitably be some rental turnover; some turnover is good and some not so good. Naturally, vacancies from longer-term tenants create opportunity to increase revenue, as they were likely paying under-market rent. If the vacancy comes from a tenant who just fulfilled their 12-month lease commitment, be prepared to temper your expectations in order to fill that vacant unit.

Capital Improvement Pass Through vs. Rent Increases

If you have good tenants who are paying market rent, consider temporarily holding annual rent increases. Rent increases in excess of actual market rent compels people to look at alternative housing options. This also applies to capital improvement pass through amounts. Many of us have already started soft-story retrofit projects, which can be passed through to tenants, and many more will ensue over the course of the next two years.

Since capital improvement pass through petitions will only be considered on work completed within a five-year timeframe from completion, prioritize the pass through assessment over the allowable annual rent increase amount. The annual allowable increase is bankable in perpetuity, such that a landlord may go back as far in the past as there are records to substantiate the last increase.

Be Wary of Rent Rebates

A good tenant may make the case that his current rent is above the market rate, but he does not necessarily want to leave; he has made the space his own, has friends in the building, and loves the neighborhood. Instead of leaving, he may inquire about a rent rebate, in which he continues to pay his full rent, but would receive a rebate check for a determined amount until the market recovers.
These agreements are rife with problems because the Rent Board may deem the rebate to be a base rent reduction, at which point the base rent has been effectively reset. Consult with a landlord attorney prior to making any such concession.

Common Area Improvements

In a prolonged downturn in the rental market, the variance in the highest and lowest priced one-bedroom apartment will be reduced, affecting the luxury market first. The principle that spending big dollars on an apartment remodel will yield a proportionate increase in rental income then becomes void for the time being.
Instead, invest in common area improvements that provide real utility to your residents. Start with the lobby or entrance of the building: make sure it is clean and well lit; fresh paint and some décor will go a long way. Add flowers, even good artificial ones, as they’ll enhance the atmosphere.

If your building doesn’t have onsite laundry, install a laundry room if there is room for it. Going to the local laundromat is a huge drag for anyone. Providing that service, even coin-operated, is a huge asset to the resident experience. In a competitive market, many perspective tenants will not even consider a building without laundry facilities.

Also consider creating a personal storage or bike storage area. These services provide spatial solutions for people who might otherwise be shopping for a larger unit to accommodate them. It is common practice to charge a nominal fee for bike storage and a slightly higher amount for storage spaces. An HD security camera system in the common areas of the building, including the bike storage area, is also a huge asset. This will add to the residents’ general sense of comfort and safety and could also deter petty crime. Be sure to add a disclaimer of non-responsibility in the use agreement in the event of theft or break-in.

Expand Marketing Outlets

Expanding your advertising methods will better position your property in the apartment search. By now, most landlords know that Craigslist is not the only game in town. Craigslist is still a necessary platform, but there are a handful of other sites with a much better user interface, providing a plethora of useful data to the more sophisticated end user.

Over the last 18 months, I have noticed that more and more apartment search inquiries are coming from Zillow, Trulia, and Zumper, a locally based firm. These platforms provide rent estimates, school test score information, and comparable rentals in the area, thus providing the end user with a number of navigation instruments and filters to pinpoint the property characteristics they most value. They also syndicate to other industry-related search platforms, increasing exposure.

For high-end rentals, enlist the services of professional photographers and use dedicated websites, especially for units listed for $6,000/month or more. Having a dedicated website with high-end photography and 3D interactive floor plans with measurements presents your product in a unique way compared to the rest of the field.

Overall, landlords should expect apartment marketing to take longer than in the recent past, but the extra effort will pay off.

What to Expect

Inventory will continue to rise and it will take longer to fill vacancies. Be prepared to see some bundling of residents (two people in one-bedroom apartments, three people in two-bedroom apartments, for example) as people seek to manage the cost of living in San Francisco.

To optimize your time, hold hour-long open houses on weekends between 11:00 a.m. and 2:00 p.m. To further cut back on the “flake factor,” call back interested parties to confirm their attendance.

Regardless of how pronounced the market adjustment becomes, it’s important to have a few of these tools at your disposal in the coming months. Don’t be reluctant to adjust pricing to meet the market, for example, decrease asking rent by 5% if you don’t get a good candidate within 10 days. It can mean the difference between having one person or five people at your open house.

Good luck to everyone on the ride.

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