Looking South
Like the coast, southern Orange County along the Interstate 5 corridor follows its own investment pace. The area has some room for new development and vacancies can fluctuate. As new projects come on-line and wait to be absorbed, vacancy rates can go as high as 5 percent. New construction also has pushed the average price-per-unit to $185,000, slightly higher than Anaheim and other mid-market areas in Orange County. The average monthly rent in the submarket is $1,250 for a standard two-bedroom unit.
Southern Orange County is also more closely tied to San Diego, which worries some. “The condo conversion market in Orange County is heating up, and we may be following San Diego’s trend,” says Susank. “I am beginning to see lenders shy away from condo conversion opportunities in secondary and tertiary submarkets of San Diego because of concern that the market has saturated. Absorption in these outlying locations has slowed in recent months.”
The initial stages of an Orange County condo conversion phenomenon wouldn’t tarnish fundamentals too terribly. On the upside, conversions will have a good value composition against the median O.C. home sale price of nearly $600,000. Conversions also will be more competitively priced than new construction units at projects like The Plaza-Irvine and Watermarke. On the downside, converters care little about cap rates as they relate to operating expenses, a reality that has driven cap rates on many San Diego apartment deals down to an average of 4 percent.
Orange County Options
That said, investors continue to flock to Orange County, where value, rents, and occupancy are still rising and capital is still cheap and liquid. One of the only falling figures in Orange County, in fact, is cap rates, down from 6.23 percent at 2003’s end to 5.33 percent one year later. The wild card is what will come next.
“It’s not hard to imagine some fairly significant increases in the yield of the 10-year treasury over the next 12 to 24 months,” says Susank. “If we don’t see commensurate rent growth, there could be issues going forward relating to refinancing balloon payments.”
Pacillio believes that if rents increase by somewhere around 6 percent or higher, investors could potentially make up for cap rate erosions over a several-year period and still have a valuable Southern California investment property. His company is now under contract on one of Orange County’s biggest deals this year—a repositioning property that, even without the company’s planned physical improvements, achieved more than 6 percent rent growth during the last 12 months. “That is almost unheard of anywhere in the country, but it is happening in Orange County,” Pacillio says. “That’s why investors want to be here.”
It was hard for most to get there in 2004. Between the election, the war, deficits, terrorism, and rising interest rates, many Orange County investors were in a “wait and see” mindset, and the volume of multifamily transactions above $1 million fell to almost half what it was in 2003. Last year, just 176 deals closed on a total of 4,356 units for a value of $602 million.
In contrast, 2003 recorded 240 apartment transactions above $1 million representing 9,332 units and a value of nearly $1.2 billion.
Transaction activity should increase in 2005 to about the $800 million mark and largely among B and C complexes as sellers emerge from their holding pattern. In today’s market, owners need to look at what they own, how long they want to hold it, and what their options are for the long term.
Some in this scenario have chosen to sell while others hold tight, asking themselves, “What would I reinvest in if I did sell?” Those that sell and leave the market have great opportunity in areas where buy-in prices are lower and cap rates are higher.
But those unwilling to leave have a few options: Make a significant down payment on a local multifamily exchange product (under the premise that they will be holding a scarce product with stable rent upside over the long term), or trade into another local product type. In terms of cap rates, retail is Orange County’s single most improved product, falling to a 6.6 percent cap rate at the end of 2004 from 7.8 percent at the same time in 2003. Industrial currently averages mid-7 percent and office almost 8 percent, in terms of cap rates, with some upside in vacancies that can be filled and improve the property’s value.