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Are South Bay Income Properties Safer than U.S. Bonds?

Oftentimes you’ll hear people around the South Bay say, “Beach real estate never goes down…it’s the safest investment around.” Is that actually true?

U.S. bonds offered by the U.S. Treasury are more generally considered the safest investment in the world and they are oftentimes considered “riskless” investments.

In this blog post, I want to share what the local market thinks about the best income properties, and if premier South Bay real estate is considered the safest investment by investors.

 

U.S. Treasuries

Since 1776, the U.S. Treasury has never failed to pay back its lenders. When you purchase a U.S. bond, it is backed by the “full faith and credit” of the U.S. government. This is an entity with a perfect credit score for the last 242 years…it’s hard to beat that track record.

 

Premier Real Estate

Over the long term, premier real estate by the beach and in large metro areas have generally been a safe investment. But even the safest real estate investments have endured difficult times where values have plummeted. Here are a few examples that come to mind…

 

  • What if you owned real estate on Bourbon Street in New Orleans before Hurricane Katrina?
  • What if you owned real estate in San Francisco during the 1989 Loma Prieta earthquake, or even worse, during the 1906 earthquake and fire?
  • What if you bought prime real estate in Detroit in the postwar car era and watched it decline from the 1970s to its eventual bankruptcy in 2013?
  • What if you owned the World Trade Center Towers in New York City or surrounding buildings in the area during the 9/11 attacks?

 

Here in the South Bay, real estate does have its risks. For example, property values and returns went down everywhere (including the South Bay) during the great recession, Los Angeles real estate was greatly harmed during the Northridge earthquake, and even the 1992 riots took some property values to zero. Other potential risks include rent control, tsunamis, wildfires, flooding, and acts of terrorism. So, I think it is safe to say, real estate does not have a perfect credit score.

 

Premier South Bay Income Properties vs. the 10-Year Treasury Yield

Why am I comparing the 10-year bond yield to South Bay income property? Most real estate professionals agree that you need to hold real estate for at least 10 years to weather any impending economic cycles. This hold period corresponds directly with a 10-year bond. Additionally, real estate loans loosely follow the 10-year as it is used as a benchmark for lenders. As a result, income property prices are heavily dependent on the cost of real estate loans (and the 10-year). Thus, income property and the 10-year are very much intertwined.

Currently, the 10-year bond is yielding around 2.88%.

The current average sales, of prime South Bay income properties, are yielding about 3.8% (CAP rate).

Let’s look at some of the nicest and most well-located income property sales in the South Bay to compare to the 10-year bond.

1810 12th Street in Manhattan Beach
10-units sold for $5,750,000
3.8% CAP rate or annual yield
$900 price per sq. ft. and $575,000 per unit

812 Manhattan Avenue in Hermosa Beach
7-units sold for $4,753,125
3.9% CAP rate or annual yield
$1,229 price per sq. ft. and $679,000 per unit

530 S. Irena Avenue in Redondo Beach
8-units sold for $4,150,000
3.7% CAP rate or annual yield
$693 price per sq. ft. and $518,000 per unit

As you can see, investors are asking a 1% premium in yield to the 10-year for the added risk of owning real estate (3.8% – 2.8% = 1% difference). Clearly, investors still value the perfect track record of  the “riskless” 10-year bond and still demand higher returns, even of turnkey, well located, Los Angeles beach property.

The above prices and CAP rates are already some of the highest sales ever for turnkey real estate and there is no room for value to be added (through remodels or raising rents). The vast majority of real estate investors want a return with a larger spread than just a measly 1%.

 

Potential “Riskless” Hermosa Beach Listing

Looking at the recent sales above, are you surprised there is a new listing looking to sell at an even more expensive price? The latest prime turnkey income property hit the MLS last week and it is representing a better than “riskless” investment.

 

3302 Manhattan Avenue in Hermosa Beach
6-units asking $5,895,000
2.6% CAP rate or annual yield
$1,637 price per sq. ft. and $982,000 per unit

 

It is hard to argue this income property does not deserve a higher price than the past sales listed above. It is superior to them all by its Sand Section location, ocean views and prime location between both the piers.

However, at a 2.6% yield, the Seller is saying that this property has less risk than the “full faith and credit” of the United States currently offering 2.88%. That’s bold.

 

There could be two arguments here:

  1. Eventually over time, rents will slowly rise and return more than the current yield. Additionally, real estate yields generally (as long as it’s not rent controlled) can keep up with inflation, unlike the 10-Year bond, which is fixed.
  2. Another premier sale not discussed occurred in 2016 at 1534 Manhattan Avenue and 1542 Manhattan Avenue in the Hermosa Beach Sand Section. Those properties sold at about a 3.3% yield, which is the most expensive comp on record. (see my past blog on these property sales)

 

The counter points to those arguments are:

  1. The building is already fully rebuilt with shockingly high rents for one-bedroom rentals. How much more can rents go up? And of course, real estate can move with inflation, however, in 10 years there is a chance (risk) that it could be worth less than today. Whereas, a 10-year bond will return all of your money.
  2. Although the 3.3% comps do exist, those Sand Section properties sold in August 2016 when the 10-year was yielding 1.56%, a spread much better than what current sales are getting today.

 

Conclusion

All in all, this Hermosa Beach property is just a listing, not a sale. The question remains: will an investor be willing to trade in their “riskless” 2.88% return in exchange for real estate that would return 2.6%? Or, will buyers continue to demand a 1% premium on a 10-year bond to purchase prime real estate assets?

The final sale price (and corresponding yield) of this new listing will tell us a lot about how far the market is willing to go for premier South Bay income properties. Is this going to be the property where investors finally proclaim that Sand Section income property is a safer asset than the U.S. government with the 242-year perfect credit score? For the market’s sake, I hope not.

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