“Sellers may move money across
the bay in search of higher
yields or park capital in
less management-intensive
single-tenant retail assets,” says
Mishkin.

SAN FRANCISCO-A research report that GlobeSt.com exclusively obtained from Marcus & Millichap Real Estate Investment Services shows that for the San Francisco apartment market, renovating existing properties is key to outsized returns. According to the report, the apartment market here is arguably the strongest in the nation, and the impending construction boom will only have a minor impact on operations.

Job growth in the tech industry remains the key driver for occupancy and rent gains, and owners will likely have a strong negotiating position into next year, says the report. However, some early indications are emerging that rent growth will slow to a sustainable pace during the next several quarters, the report says.

Jeffrey Mishkin, first vice president and regional manager of the San Francisco office, notes that “class A vacancy is leveling off, while lower-tier vacancy tightens. As rents in the top-tier have climbed, many tenants are choosing to move down the quality scale rather than spending more of their income on housing,” he says. “Although new demand has been sufficient to offset these losses, new supply could tip the supply-demand bal­ance. Several thousand units will come online during the next two years, creating competition for class A properties. As a result, operators are expected to slow rent gains to maintain occupancy rates until the development cycle wraps up in 2015.”

Investors will remain active in the San Francisco market, though deal flow could be impeded by the number of available listings, he adds. “Sellers may move money across the bay in search of higher yields or park capital in less management-intensive single-tenant retail assets,” he says. “Some owners see the low cap rates and low interest rates as a favorable time to divest. Buyers, meanwhile, remain focused on the spread, which points toward a strong buy stance.”

Many of these investors are seeking older, larger units that can be upgraded, he says. “Changing a large studio to a one bedroom or a large one bedroom into a two bedroom can have a significant impact on asking rents.”

The new owner may have to wait for rent-controlled units to be vacated to execute this strategy, which could tie up capital for an extended period, adds Mishkin. Nonetheless, he explains, “the return could be much more lucrative than the average 5% yield for a class B asset in today’s market.”