For three decades, San Jose and the greater Silicon Valley have been among the fastest growing areas in the western United States. While the market no doubt suffered through a not-so-pretty dot-com bust in 2001, that era is past. Taking its place is an economy that is once again deep into a cyclical rise based less on boom fundamentals and more on steady, sustainable growth.

These fundamentals are putting San Jose on a back-to-basics approach for making money in multifamily real estate: Operate your property well, seek maximum efficiency and minimum downtime, and base your outlook less on the steep appreciation rates of San Jose's recent past and more on the steady, significant rent growth predicted for the future.

THE FUNDAMENTALS Among the greatest benefits a multifamily investor may reap from San Jose are its extremely high cost of home ownership, its extremely low inventory of developable land for new multifamily units, and solid gains in the employment sector. Together, these factors keep the market operating with a vacancy rate of just 3.7 percent, down from 4.1 percent last year, and with a chronic shortage of affordable housing.

ON THE REBOUND: San Jose and the Silicon Valley constitute a strong market with good long-term fundamentals.
ON THE REBOUND: San Jose and the Silicon Valley constitute a strong market with good long-term fundamentals.

While San Jose's rent-controlled properties allow no more than an 8 percent annual increase, the significant inventory not held to this restriction has experienced rent growth of as much as 11.5 percent from this time last year. That's among the fastest rent growth in the western United States and the nation. It's also significantly higher than the declining rents that San Jose was experiencing in the years following the dot-com bust, when literally tens of thousands of high-tech, white-collar workers left the area in search of employment. Before the bust, the Silicon Valley was red-hot, and savvy investors were buying properties and enjoying the rise in rents, cash flow and appreciation. After the bust, occupancy, rents and cash flow dropped almost simultaneously.

Only in the last 18 months has San Jose begun seeing recovery, including a rise in average rent to $1,482 per unit. This places San Jose as the second most expensive place to rent an apartment in the West (Los Angeles/Orange County earns the No. 1 spot) and even beats out its neighbor to the north, San Francisco. Compared to the median price for an average home—which sits in the $650,000 range as San Jose is also one of the most expensive housing markets in the country—that puts the cost of owning at 2.8 times the cost of renting in the Class A category. In 2000, this ratio in San Jose was at just 1.5.

Adding to the mix is San Jose's local employment growth. While commercial real estate research firm REIS says that growth is still 180,000 jobs shy of a peak in 2000, the job market is warming up with a 1.2 percent growth in the past 12 months, with greater gains predicted for the future. The job market is particularly picking up in the higher-salaried technology sector, enhancing the local renter pool with more high-paid professional workers.

THE PLAYERS As much as developers would like to charge in and build, alleviating the surging demand for affordable housing in this increasingly densely populated area, they remain shackled by an extreme shortage of land and by physical boundaries that include the San Francisco Bay in the middle of the market and tight building restrictions in the surrounding hillsides. They are equally constrained by the resulting high land prices, which in a recent development opportunity reached to $22 million for 5 acres in downtown San Jose and ultimately debunked a potential new multifamily property.

HOT SPOT: Archstone Cupertino is located between the San Francisco peninsula and downtown San Jose.
HOT SPOT: Archstone Cupertino is located between the San Francisco peninsula and downtown San Jose.

The South Bay has only 13 multifamily properties, totaling just 2,049 units, currently under construction. In San Jose, only about 1,000 new units are expected to deliver this year, following only about 630 new units delivered last year. Additionally, the condo market—after converting nearly 1,000 units itself in 2005 and further tightening the apartment market—has dried up. With this said, the only place for San Jose to go may be up, both in price and construction.

On the investment front, San Jose's fundamentals have traditionally served local developers and tuned-in regional developers, but with the market becoming increasingly favorable for long-term investment, San Jose has become increasingly popular among REITs and other large equity investment institutions.

According to New York-based research firm Real Capital Analytics, 47 percent of all transactions for San Jose garden-style properties—which are the dominant type of property in the area—are going to institutional investors and REITs while the remaining 53 percent of sales are to private individuals. In the western United States, barely one-quarter of these properties are being sold to institutional investors (including REITs), while more than 75 percent are being traded by individual investors.