San Jose is known, first and foremost, for its robust tech industry. But if things in the apartment market keep on pace, the city may soon become synonymous with rent growth, as well. Several economic development initiatives will amplify demand for apartments this year, thanks to the presence of some of the world’s largest tech firms.

Facebook recently gained approval for an expansion of its headquarters in Menlo Park. The social media firm will bring an additional 3,000 employees on board at the facility. The new Cupertino campus for Apple is also expected to be approved by local authorities this year and has already sparked several redevelopment projects around the site. The 2.8-million-square-foot building is scheduled for delivery in 2015 and will increase the company’s local head count to 14,200 workers.

These developments and a positive ­employment outlook have reinforced ­apartment demand in these specific submarkets while also boosting rental conditions in the broader metro area. And despite the spike in apartment construction on tap for 2012, operators are not concerned about a supply-induced vacancy jump in the near term.

Buoyed by Strong Demographics

Employers in San Jose hired 30,400 individuals over the past year, expanding total employment 3.5 percent. The gains were led by the private sector, which hired 20,900 new employees. While Google, Apple, and Facebook are steadily expanding, small companies are hiring hundreds of employees too. Infobox, for instance, will add about 200 employees by the end of the year as it expands its headquarters in nearby Santa Clara.

Overall, the metro’s professional and business services sector has added 7,300 jobs in the past year. Accelerated population growth and expanding health insurance coverage have also translated into an increase in health-care jobs. In fact, over the most recent 12-month span, the area’s education and health services sector added more than 7,000 positions, driven primarily by hospitals and private medical practices.

As employment grows, so has San Jose’s rental inventory. Since the second quarter of 2011, approximately 2,240 units have been added. The Crescent Village complex in Northeast San Jose has accounted for most of the gain, delivering 1,750 units.

Nearly 5,500 units are currently under way in the metro, more than half of which will wrap up by the end of this year. This amount will expand the rental stock 5 percent. Projects containing about 9,000 units are planned in the metro, with most of the activity concentrated in Northeast San Jose.

Aided by strong employment gains, rental demand in San Jose is at one of the highest levels since 2001. Vacancy has improved 60 basis points (bps) in the past year, to 2.6 percent, following a 100 bps dip the year before.

Class A demand continues to surpass supply as white-collar employment grows. Vacancy for properties in this sector fell 50 bps in the first half of 2012, to 2.8 percent. The vacancy rate for lower-tier units also has improved in the past four quarters. Specifically, Class B/C vacancy dropped 80 bps year over year, to 2.3 percent. In the corresponding stretch last year, vacancy declined 90 bps.

Operators have responded to heightened demand by lifting asking rents at a more aggressive pace. In the most recent 12 months, asking rents advanced 5.1 percent, to $1,560 per month. Effective rents gained nearly 6 percent in the same time frame, to more than $1,470 per month. Class A asking rents rose 4.8 percent, to $1,779 per month, while lower-tier operators raised asking rents 4.9 percent, to $1,308 per month. During the corresponding period last year, Class A and B/C asking rents increased 5.1 percent and 4.4 percent, respectively.

Meanwhile, diminished concessions incited a sharp gain in average revenue. Operators trimmed lease incentives by two days, to 22 days of free rent, over a 12-month period. As a result, average revenue jumped 6.3 percent in the same span.

In 2013, we expect rents to eclipse the most recent 12-month level by rising 7 percent on a year-over-year basis.

Low Rates, High Investment

The Federal Reserve recently pledged to sell $267 billion in short-term securities to buy long-term Treasuries in order to maintain low borrowing costs. The purchases will occur in the second half of 2012 and extend a program known as “Operation Twist.” The target to keep short-term interest rates low is now late 2014.

Several major lenders appear willing to underwrite construction on select projects. The primary considerations for lenders include the quality of sponsorship and strong market fundamentals, including low vacancy rates and rising rents.

The potential for elevated development may encourage the government-sponsored enterprises (GSEs) to underwrite acquisitions more conservatively in markets with large pipelines like San Jose. In many metros, however, the agencies will underwrite deals at up to an 80 percent loan-to-value ratio, and offer rates that are just 200 to 250 bps above the 10-year U.S. Treasury. Life companies, meanwhile, are also active in the Class A arena, offering rates competitive with those of the GSEs.

Commercial banks generally offer shorter-term financing for acquisitions from $1 million to $5 million, at interest rates starting in the low–3 percent range for three-year terms and up to 4.5 percent for seven-year loans. In the growing CMBS market, looming issuance of several billion dollars in the next few months will affirm spreads for AAA bonds and establish investor appetites for B-rated tranches. A Seller’s Market A strong rental market and expanding buyer pool will accelerate sales velocity in the South Bay.

Top-tier assets in the metro are being acquired quickly with aggressive bids and are mostly concentrated in areas such as Palo Alto, Mountain View, and Sunnyvale. Cap rates for deals at the top of the market average around 4 percent, while lower-tier returns average in the low–5 percent to 6 percent range.

As the demand for two- and four-unit properties grows, owners are able to sell their smaller residential units and obtain assets in the $1 million to $5 million range. Lenders have expanded financing capacity for these properties, further supporting deal flow at the lower end of the apartment market.

These entry-level buyers typically target buildings that have been owned for several years, and that generally have below-market rents and deferred maintenance. This provides ample opportunity for a value-add strategy in a market dominated by REITs and institutions. But for big and small owners alike, San Jose’s strong fundamentals offer promising returns.