OF THE MAJOR COMMERCIAL real estate “food groups,” multifamily has always enjoyed particularly good strength in San Diego.

Geographical, economic, and political forces have conspired to keep supply constrained, resulting in rent growth and high occupancy levels in the county.

However, even the San Diego multifamily market could not avoid the grip of this recession, as metrics sagged in 2009. As in most of the nation, unemployment grew in San Diego and surpassed the 10 percent rate in 2009. But that rate is now decreasing, and the metro is expected to be back in positive territory by 2011 with a forecasted 2.6 percent increase in job growth, according to market research firm Reis.

The improving employment picture, coupled with newfound housing affordability, has slowed the pace of out-migration. These factors should help to drive above-average population growth over the next three to four years. What's more, about 23 percent of San Diego County is between 20 and 34 years old, the fourth-highest concentration of that age bracket in the nation.

The local economic recovery, already under way, is expected to drive vacancy rates back into the 4 percent range (levels not seen since the early 2000s) within 24 months, according to Reis. And rent growth should return by the end of this year. In short, these trends indicate that the worst is behind the city, the recovery is right around the corner, and the sun is starting to peek out again in the San Diego market.

A Tight Pipeline

In the past year, oversupply has not been the culprit behind the market's sluggishness. Only 1,300 units were delivered in 2009, and no major projects will be completed in 2010. Doubling up in units, “boomerang” youth, and shadow inventory combined to drive market-wide vacancy to an enviable low of nearly 6 percent.

In fact, the market has demonstrated a taste for new product. Projects built in the past decade charge rents up to 50 percent higher than their older counterparts. Of the few deliveries in 2009, H.G. Fenton's 254-unit Aquatera project in San Diego's Mission Valley reported brisk absorption and some of the highest rents in the submarket. Other new deliveries included the 505-unit La Jolla Commons (already more than 95 percent occupied); Simpson Housing's 289-unit Mira Bella in the Kearny Mesa market; and Hanover's 139-unit, luxury product Strata.

Next year will likely be another light year for new product, but 2012 should see the completion of Sudberry Development's first multifamily phase in Quarry Falls, a 230-acre master planned community in Mission Valley.

Transaction Trends

Investment activity was kicked off in 2009 by Northwestern Mutual's portfolio sale of the 234-unit Montecito Village and 424-unit Villages of Monterey in Oceanside. These projects sold for $136,750 per unit and $122,600 per unit, respectively, with reported cap rates in the mid-7 percent range.

Also in '09, AEW purchased Archstone's 350-unit Presidio View in Mission Valley. This newer project reported a cap rate of 6.5 percent and garnered about $192,000 per unit, ushering in additional trades, such as Equity Residential's sale of The Casas in Mira Mesa for $137,000 per unit.

While private buyers dominated the market in the first half of 2009, institutional buyers including cash-rich REITs will continue to figure prominently in 2010. The REITs are enjoying renewed success in both the equity and unsecured debt markets, and private buyers continue to take advantage of historically-low agency rates.

Slave to the Capital Markets

Freddie Mac and Fannie Mae continue to offer 10-year loans for up to 80 percent of purchase price at rates in the mid-5 percent range. As a result, the agencies own the permanent debt market for multifamily financing of loans of more than $3 million.

The life companies and banks have been locked out of most of these financing opportunities for the past 24 months, despite an increased underwriting scrutiny by both agencies over that period.

Similarly, the supply side of the equation will be hampered by a continued lack of construction financing from banks. And like the banks, institutional equity investors will stay away from development opportunities, preferring instead to buy existing product. These opportunities have largely failed to materialize, however, so if these conditions persist, one should expect some of the “shovel ready” Class A projects to attract equity and debt financing.

Currently, institutional investors are looking for returns on cost of at least 7.5 percent for new development. If cap rates stick at or below 6 percent for existing product, investment dollars will likely flow into new build opportunities as the delta between development yields and exit cap rates offers compelling premiums.

While 2009 gave San Diego area multifamily owners a scare (something they had not experienced in a while), a slow recovery appears to be under way. The lack of significant inventory, along with employment and population growth, will help to burn off the “June gloom” that was 2009 and hopefully give way to some beach weather soon.

Tim Wright is senior managing director and Rob Hinckley is an associate director in the San Diego office of Holliday Fenoglio Fowler.