Evolving Real Estate Landscape for Apartment Investors in Southern California
In the ever-evolving realm of apartment investment within Southern California, recent developments have begun reshaping the strategies of small investors. Traditionally reliant on small commercial banks for funding, this investor segment has encountered considerable challenges in the wake of the recent financial crisis.
The current scenario underscores the vulnerability of regional banks, which now find themselves confronted with the need to raise additional capital to survive. However, experts widely suggest that the current situation could be just the tip of the iceberg. A comprehensive study reveals that regional banks are grappling with an astonishing $2 trillion in unrealized losses.
The landscape has further deteriorated with the collapse of major players like First Republic, Signature and Silicon Valley Bank. Some experts view this as an early indicator of a deeper crisis brewing within the sector. In response, banks have tightened lending standards and widened credit spreads, effectively stalling new project developments. Fortunately Venture West has several alternative sources such as credit unions, debt funds and new bank lenders to fill the gap.
But what circumstances have pushed these banks to the brink? The diminishing value of assets on their balance sheets directly stems from rising interest rates. Additionally, uninsured deposits have heightened risk perceptions among clients, prompting a mass migration towards larger and more stable financial institutions. Throughout this process, consumers have become increasingly informed about interest rates on deposits and bonds, leading to a shift in expectations away from accepting negligible returns.
These disruptions have naturally reverberated within the apartment building sector, resulting in a decline in property values. While this decline's magnitude might not be dramatic, the incongruence between borrowing costs (ranging from 6% to 7%) and sub-five cap rates has begun to stall the market. Southern California historical data indicates that cap rates typically remain within a 100 basis point range if not identical. In this landscape, investors are relying on the resilience of rent growth and minimal vacancies in one of the world's premier economies to rationalize their investments despite modest returns.
The pivotal question emerges: Should investors continue to buy apartments or wait for a market adjustment? The recent surge in rates on deposits has imparted multifaceted lessons to consumers. It's not just the financial health of banks under scrutiny, but also the focus on earning potential within these institutions. Money market funds and CDs are currently yielding upwards of 5%, a significant leap from last year's mere 0.20%. However, while the allure of higher returns from these sources exists, it might not be the wealth-building avenue many are seeking.
The decision between investing in bonds or apartment buildings is complex. A 5% return is 50 times greater than what was seen just 15 months ago. There's no hassle of dealing with disgruntled tenants, bank paperwork, or local regulations that limit profit from hard-earned work.
California is an exceptional market with historically the lowest cap rates in the country, driven by investor faith. Factors such as safety, gentrifying neighborhoods, adding ADU units, short-term rentals, and numerous reasons to stay in California contribute to this.
On the surface, bond returns seem to offer a more attractive investment option, with the highest returns in 20 years. However, we must remember why we invest in apartment buildings: landlords can continually enhance their properties, adding value and improving cash flow over time. The tax efficiencies are always appealing. Owners can depreciate assets to offset positive cash flow, and in some cases, accelerated depreciation can eliminate potential gains. Apartment investing serves as an excellent hedge against inflation. One significant advantage of investing in real estate is capitalizing on lower borrowing costs and the ability to extract equity tax-free. Many of our clients have amassed significant fortunes by improving properties, raising rents, and pulling out tax-free cash.
Drawing parallels between multifamily real estate and bonds, one observes both minimal risk and limited returns. A seasoned apartment building investor with a 30-year track record reflects on the cyclical nature of the market. Each time prices appear steep and inopportune, the hesitancy to invest emerges. However, the notion that cap rates must converge with interest rates looms large. Delaying action could potentially prove to be an error in judgment.
Investing in apartment buildings offers a unique sheltering mechanism—leveraging depreciation and property enhancement to elevate rental income. Waiting for interest rates to decrease might inadvertently cause one to miss out on a cycle that could hold the most promise in years. In this evolving landscape, embracing calculated risks and making proactive investment decisions could very well be the key to unlocking unprecedented rewards. As Warren Buffet says, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”
If your horizon is long term, investing in multifamily in well-located markets is still the best way to build wealth and generate cash flow.