These days, there are just no easy deals in residential real estate.
With statewide median prices up over 13% in the third quarter, ultra-low interest rates, and clearly, not enough inventory, finding any sort of “sweet buy” is exceedingly difficult.
So, where can one find opportunities today and into the presumed 2021 vaccine recovery?
The clear winners in 2020 have been residential home and industrial real estate. And, to no surprise, the clear losers have been office and retail real estate.
Income properties and apartment buildings are a bit fuzzier.
So, I want to dive in a little deeper on that topic.
Major Headwinds for Apartments
There have been major headwinds for apartment buildings in 2020 thanks to COVID-19 and the sharp recession as a result.
If you follow the stock market and some of the best-known apartment REITs, you will know that in the third quarter Equity Residential and Avalon Bay were down 43% and 35% year-to-date, respectively.
Apartment operators have been crushed by “urban flight” and lockdown restrictions in major cities. To add to the pain, many renters lost their jobs and were granted rent forbearance, wiping out landlord’s revenue.
If those were not enough, evictions were put on hold, regardless of the reasons. Furthermore, financing and refinancing remained extremely difficult as banks saw added risks in lending to apartment operators.
Vacancies have gone up and rent prices on new leases are down double digits. Rent price depreciation is not just a factor to publicly traded REITs, but I have confirmed the same is true for local South Bay owners as well.
The list of challenges is long:
- Renters urban flight to suburban areas and home purchases
- Office closures, city lockdowns, and civil unrest
- Rent forbearance, rent increase freezes, and no evictions
- Lack of financing, recession, etc.
This is about as bad as it gets for income property owners, but there seems to be a light at the end of the tunnel now with a potential vaccine on the table. Pair that with insanely low interest rates and the future looks a lot better.
Huge Potential Tailwinds in 2021
What was a headwind in 2020 is likely to be a big tailwind in 2021, thanks to multiple Coronavirus vaccines on the horizon.
I want to take the list of challenges about and essentially flip them:
- Renters begin returning to urban cores and home purchases slow down
- Offices reopen in the summer and city lockdowns ease or disappear
- Rent is due (along with back-rent), low rents increase, and evictions are enforceable
- Financing returns with historically low rates and an economic rebound
Of course, these are all big assumptions.
The economy may not recover, and renters may still have trouble paying rent if job growth is slow. Return to cities might be delayed as Zoom and the countryside become integral parts of life.
Sam Zell, legendary real estate investor and founder of Equity Residential, thinks that people will return to cities sooner rather than later from his latest Forbes interview:
“The number one megatrend in my head is an un-megatrend. All this discussion about the ‘end of urbanization,’ and working from home, and the world is going to change, and you’re going to live in Noplace, Iowa and you’re going to work for a clothing company. It’s not going to happen. We’re social animals. I’m happy to be very clear that I think people are looking at this current lockdown and extrapolating results that are preposterous.”
In a nutshell, I agree with him. Humans are social animals and cities have existed for hundreds of years. I suspect that Americans will return to cities and rent apartment units in major metro centers just like before the pandemic.
The South Bay and greater Los Angeles areas have not built any more units to solve the lack of housing units in the city. And, our weather, lifestyle, and economy are about as desirable as it gets.
The headwinds should turn to tailwinds, lack of housing units will push rents higher, and interest rates are going to be a massive factor in driving gains…which I am about to get into.
South Bay Income Property Performance
While the big REITs might be getting crushed in the stock market, I wanted to share past and current performance of South Bay 2-4 unit income properties over the last few years, per the MLS.
I am essentially taking the entire South Bay with the exception of Westchester…so, El Segundo, Hawthorne, and Inglewood down to San Pedro and Carson/Gardena to the east. Additionally, since we are still riding out the last quarter of 2020, I am only covering the first three quarters of each year:
- 2017 – Q3 to Date
- Median Price: $722,500
- Sales: 370
- 2018 – Q3 to Date
- Median Price: $780,000
- Sales: 369
- 2019 – Q3 to Date
- Median Price: $819,500
- Sales: 318
- 2020 – Q3 to Date
- Median Price: $920,000
- Sales: 234
It is no surprise that sales are way down in 2020, but what was shocking, is the continued price strength in South Bay income properties. This year, 2-4 unit properties have be outstanding, posting price appreciation of 12%.
The excellent performance is not limited to just the South Bay. Here are the numbers for L.A. County, per the MLS:
- 2017 – Q3 to Date
- Median Price: $675,000
- Sales: 3,355
- 2018 – Q3 to Date
- Median Price: $747,500
- Sales: 3,434
- 2019 – Q3 to Date
- Median Price: $765,000
- Sales: 3,048
- 2020 – Q3 to Date
- Median Price: $825,000
- Sales: 2,187
Again, sales are slowing during the pandemic, but incredible strength in pricing is spread throughout our county as well.
This is pure speculation, but I do believe that 2-4-unit income properties have held strong due to some home buyers looking for duplexes over homes. Essentially, you can live in one unit, while renting out the other to help pay the mortgage.
With some of the tailwinds listed above, there are two additional drivers that could catapult income properties even higher in 2021.
- Low interest rates
- Accessory-dwelling units
Both topics I have covered extensively in past blog posts.
For a recap, please reference my interest rates blog here and my ADU blog here.
Now, I want to take a look at the 30-year fixed mortgage rates at the end of quarter three over the last four years:
- 2017 – End of Q3
- 30-year fixed rate: 3.83%
- 2018 – End of Q3
- 30-year fixed rate: 4.72%
- 2019 – End of Q3
- 30-year fixed rate: 3.64%
- 2020 – End of Q3
- 30-year fixed rate: 2.90%
Over the last three years, rates were offered between 3.6% and 4.7%. A drop to 2.9% this year is an extreme market tailwind that will have profound effects.
Additionally, most of the mortgage market is focused on home purchases and refinances. The best rates and programs have not been offered to income property investors yet because the bandwidth is not there, and lenders are still a bit skittish on tenants paying rent.
According to the Mortgage Bankers Association, applications to purchase a home are slowing. Mortgage applications are just 16% higher than a year ago and have been shrinking steadily over the last couple of months. If demand for home mortgages slow, bankers will want to continue their high mortgage origination fees. As a result, they will begin lending to other asset types like income properties. Apartment loans will get easier to obtain and rates will become more and more competitive.
With regards to ADUs, if an investor can find a property to add a new ADU unit or convert a garage, then borrowing the cost to build and earn additional rent is a no brainer.
Income property strength has been surprisingly strong; however, its full potential has not been reached thanks to huge headwinds in 2020. Those headwinds will turn into tailwinds, along with owners and buyers finally being able to realize low rates and the extra benefits of ADUs.
You can never time any investment purchase and one should always play the very long game, especially in real estate.
That said, with Coronavirus cases rising in the near-term presenting a scary winter ahead, along with the fact that some of the best deals are made during the holiday season for real estate investors, I believe that the next three to six months look to be an attractive time to enter the income property market.
Buy this asset class while it is still out of favor, and enjoy the rising tide and powerful interest rate forces as we head into the second half of 2021.