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RENTAL MARKET ANALYSIS

By Robert Chappell, NAI Norcal

After the East Bay region bounced back to the tune of a 98% year-over-year rise in the total sales volume for East Bay Multifamily properties of 5+ units (an outlier among surrounding regions), rising interest rates look set to bring a healthy balance to market dynamics. Inflation, as measured by the national Consumer Price Index (or “CPI”) recently reached 8.1%, prompting the Federal Reserve to begin raising effective interest rates by reducing the money supply (i.e., stopping the Fed’s balance sheet expansion for now and eventually raising Federal Funds interest rates to banks and lenders).

As capital becomes scarce, it will flow away from risk into safety and terms offered by banks will follow. Recently, a prospect for our listing at 22 Domingo, a 15-unit property in Rockridge, saw loan quotes change rapidly over a span of six weeks. Interest rates on a five-year fixed loan from the same bank rose from 4% to 5% and LTV decreased from 60% to 50%. This bites into returns for investors and lowers their willingness to pay (i.e., reduces prices). In the near future, this may lower valuations but will eventually be offset by higher rents as owners pass along inflation.

Looking into Zumper’s May 2022 rents, New York has jumped to the top spot at $3,590/month in median rent for a 1-bd/1-ba unit, San Francisco slid down to second at $2,900, and

Oakland in the tenth spot at $2,050. Nationally, major cities with the top 10 highest rents have seen rent recoveries of 40% year-over-year while San Francisco and Oakland have been relatively stagnant. Oakland’s rent grew just 3.5% over this period.

Oakland’s struggle to recover rents year-over-year may be explained by any number of factors. It may be that the WFH trend has not yet reversed, although Elon Musk’s email to Tesla employees requiring a return to office could help reverse the trend. It may be due to two consecutive years of over 170K+ net population declines in California. Or it may be the “cost” of owning in a stable market like the East Bay as the Oakland City Council has moved to protect renters by capping rent increases at 3% per year for existing renters, despite the 8.1% CPI reading. This dampens the inflation hedge benefits but does not change the general recipe for success: top- performing owners actively screen for great renters and renovate between vacancies to raise the building’s profile (and rental income).

Despite the inflationary headwinds, East Bay and Bay Area owners ought to remain confident in the intrinsic value of properties in this special location. For starters, the Bay Area’s unique value over the past three decades took off as world-class educational institutions fostered innovation that led to amazing software and hardware products. Bay Area people and capital will continue to place large bets on world-changing ideas. Berkeley, the top-rated public university in the country, has performed extremely well among East Bay submarkets. Secondly, the region continues to invest in infrastructure such as the expansion of BART to the South Bay and is now making it easier to build high-rise apartments. Thirdly, the region fosters diverse industries such as biotech and agriculture, which reduce volatility of regional incomes. Fourthly, the recent recalls of the San Francisco District Attorney and three San Francisco County Board leaders before that show the population will organize and be responsive to issues of safety and education — important drivers of housing value.

For buildings financed by residential loans in the 2-4 unit range, we look at total sales volume for Q1 2022 as well as the trailing 12 months since sales activity can be seasonal. Comparing Q1 2022 to Q1 2021 in the MLS data, Alameda sales are up 50.1% from $13.8M to $20.6M; Berkeley is down 11.4% from $35.4M to $31.1M; Oakland is up 11.1% from $99.0M to $110.2M. For the trailing 12 months from the end of Q1 2022, compared year-overyear, we see slightly different numbers: Alameda is up 136.1% from $35.3M to $83.4M; Berkeley is up 88.3% from $96.6M to $181.9M; and Oakland is up 126.4% from $230.8M to $522.5M. The large percentage change year-over-year comes on the back of the pandemic and the large liquidity pumped into the system. Regionally, it’s not surprising to see Berkeley demonstrate smaller change as a large part of its market depends on steady educational spending.

For 5+ unit buildings in the East Bay Region, according to CoStar, we saw a 321% increase from Q1 2021 ($256M) to Q1 2022 ($1.08B), an outlier among neighboring regions of San Francisco, San Jose, San Rafael, and Sacramento. The trailing 12 year-over-year increase of 227% for the region from $1.05B to $3.45B. However, adjusting these figures to exclude sales of buildings with 51 units or greater, we see total East Bay Region sales volume for Trailing Twelve Months (or “TTM”) Q1 2022 grow from $415M to $1.57B, a 279% increase year over year. Some owners were likely driven to sell by the combination of recent all-time highs in rents and mature credit cycle getting ready to shift (i.e., long period of low interest rates and growing asset values followed by inflation). But, as mentioned before, the diverse East Bay submarkets offer different stories. Looking at CoStar’s submarkets of Berkeley, Alameda and

Oakland, we see: • Strong growth in Berkeley (Q1 2022 sales of $69M @ Y-o-Y growth of 289%, TTM Q1 2022 sales of $186.3M @ Y-o-Y growth of 175%); • Strong growth in Alameda (Q1 2022 sales of $29.7M @ Y-o-Y growth of 1704%, TTM Q1 2022 sales of $68.7M @ 166% growth rate); • Slightly down in Downtown Oakland (Q1 2022 sales of $2.2M @ Y-o-Y growth of -86%, TTM Q1 sales of $77.1M @ Y-o-Y growth of -20%) • Good growth in Lake Merritt / North

Oakland (Q1 2022 sales of $51.5M @

Y-o-Y growth of 153%, TTM sales of $113.5M @ Y-o-Y growth of 34.3%)

We’re not surprised to see the high sales volume and strong growth in Berkeley and Oakland since these are considered higher quality markets with more stable incomes than other submarkets. If investors anticipated volatility due to the late stages of the credit cycle we’re in or other macro factors, the highly desired neighborhoods of Berkeley and Oakland provided havens for their capital for different reasons.

In the Lake Merritt / North Oakland neighborhoods, renters may find large units in old buildings, safe streets and proximity to shopping districts with character. For example, just a few blocks in between both Piedmont Avenue and Grand Avenue in the Grand Lake Neighborhood, we sold 491 Crescent Street (27 units @ $10.55M, 12.64 GRM, 4.18% cap rate). The investor was willing to pay a relatively high price to capture a market opportunity to create high-end rentals for young professionals in the 950SF 1bd/1ba units that had recently fetched rents of $3400/month. This rent is exceptional but demonstrates the upside potential of higher-quality buildings in A locations.

Berkeley offers an ideal renter demographic in the form of well-funded students that cycle in and out of units every 2-3 years to be able to attend the best public university in the country. Our recent sale of 2333 Channing (29-unit @ $11.1M, 15.1 GRM, 3.68% cap rate) illustrates the market’s potential. The sellers achieved exceptional revenue per square foot by designing optimal unit layouts and running their own property management team, people in a bedroom which coordinated lease arrangements that could even be on a per-bed basis (i.e., 2+ people in a bedroom). The young renter profile, location and exceptional building performance allowed the sellers to achieve a valuation of $690/SF — a near market best for 5+ unit buildings in Berkeley.

Rising operating expenses due to inflation and rising debt financing costs will test owners in the rent controlled markets of the East Bay over the next two years. Valuations will fall as the Federal Reserve must control inflation to maintain credibility in the markets by raising interest rates to slow spending and investment rates. However, owners are encouraged to take the long view and optimize their properties for stable or growing cash flows by renovating, screening for quality tenants, investing in ADUs and/or eyeing potential properties to 1031 exchange into inside the dynamic East Bay Market.