Apartment Buildings Deal Near San Diego Marks Latest Bid To Preserve Middle-Income Housing

California Programs Could Face Headwinds From Rising Costs, Investor Competition

By Lou Hirsh
CoStar News

January 4, 2022 | 10:31 A.M.

Investor Waterford Property Co. bought three Escondido, California, apartment properties for $157 million, the latest in a statewide program that seeks to preserve middle-income housing amid fast-rising rents and limited new construction.

The Escondido properties, totaling 314 units, mark the latest acquisitions by the Newport Beach, California-based Waterford in a joint-powers bond financing program overseen by the California Statewide Communities Development Authority.

Such programs have fueled several large California apartment deals over the past year, though future transactions could be hampered by rising costs and heightened competition from private investors flooding the state and willing to pay top dollar for properties in many high-population regions.

“We still see opportunities out there, but it could be challenging to keep up the volume of projects that we saw in the past year,” Jon Penkower, the authority's managing director, told CoStar News.

The agency announced it oversaw the issuance of more than $202.1 million in tax-exempt Essential Housing Revenue Bonds for the acquisition, which will also allow for future upgrades and renovations at the properties.

The state authority teams with investors and local governments to issue tax-exempt bonds that go toward the acquisition of apartment buildings that are then preserved as affordable housing for middle-wage families for a set period. The state has long looked to serve a “missing middle” of households led by nurses, military personnel, teachers, first responders and others generally earning 80% to 120% of regional median incomes and increasingly pressed to meet rising housing costs.

“When we look at the essential housing portfolio we’ve built this past year, we can see how powerful this program can be in bringing housing affordability to the missing-middle demographic,” Waterford co-founder Sean Rawson said in a statement on the Escondido acquisitions. “The timing of this essential housing program is critical, as it provides immediate savings at a time when market-rate rents across the state continue to rise.”

Waterford made several similar apartment purchases through the bond financing program during the past year in Southern California cities such as Pasadena, Pomona, Anaheim and Long Beach. It now oversees middle income-focused properties in 15 California communities.

The state deploys bond financing to encourage developers to invest in affordable housing and minimize their expenses in doing so, even if they don't earn big profits. Government bond financing usually comes at lower interest rates than conventional financing, and interest paid to bond holders is exempt from federal income tax. Developers who use tax exempt bonds at the state level can also qualify for federal tax credits for some types of affordable housing.

Statewide Challenge

A dearth of construction over the past two decades has left many families struggling to afford apartments in California amid rising rents and shrinking vacancies in many regions. The issue increasingly goes beyond lower-income residents traditionally served by government-backed housing programs.

The Escondido properties, acquired from original developer Lyon Living, mark Waterford’s first San Diego County acquisitions. The investor purchased the 126-unit Rowan Apartments, built in 2020 at 700 W. Grand Ave.; the 112-unit Alcove Apartments, built 2019 at 650 N. Centre City Parkway; and the 76-unit Haven76 Apartments, built in 2016 at 2414 S. Escondido Blvd.

Waterford officials said monthly rents in the portfolio average $2,800 but will average $2,459 as new renters come into the properties. Those rates would mark a 12.2% reduction for the properties and would be 13.8% lower than average rates for the city of Escondido, as calculated by the city and developer.

While current residents will not be displaced from existing leases if they don’t meet the 80% to 120% requirement for qualifying household incomes, incoming renters at the properties will need to meet them.

“Middle-income housing is something that doesn’t get built in our state and it’s highly needed,” Escondido Councilmember Consuelo Martinez said in a statement. “What is important for me is ensuring that Escondido residents can stay living in Escondido and that rents don’t continue to skyrocket.”

CoStar data shows the North County area that includes Escondido has an apartment vacancy rate of less than 1% and has seen rents rise 12.6% over the past year. The San Diego region overall has a 2.3% vacancy and rents have increased 13.4%.

Officials in Escondido during 2021 also approved agreements involving the California Municipal Finance Authority, another sponsor of tax-exempt bond financing, which led to two acquisitions under which private investors acquired and preserved apartments for middle-income renters in San Diego County’s fourth-largest city.

“These are the first such agreements we’ve entered into for the preservation of middle-income housing, and we believe they will be effective in addressing the ever-increasing cost of rent in California,” Adam Finestone, Escondido’s interim director of community development, told CoStar News. “The city is waiting to see the results of these recent approvals before we would consider additional transactions in the future.”

Real estate economist Alan Nevin said he does not know of other states with the same bond-focused programs for preserving middle-income housing, adding that most other states have at least a few regions where residents can escape rent hikes in the largest job centers. More such programs may be needed in California, because new construction is unlikely to provide significant relief in the near future when it comes to affordable housing.

“In California, it’s just very difficult to build anything at a rate below $300,000 per unit,” said Nevin, director of economic and market research at construction consulting firm Xpera Group in San Diego, noting this encourages developers to build high-end luxury units, rather than basic mid-level housing, to recoup their costs.

Contributors to the problem include rising costs for land, labor and construction materials — the latter two being exacerbated by the pandemic and supply chain bottlenecks, he said.

Competition for Investments

Working with cities, the California Statewide Communities Development Authority has since 1988 issued $65 billion in tax-exempt bonds for affordable housing and other community projects, with a particular emphasis during the past year on middle-income apartment deals where private investors serve as project administrators.

During 2021, the authority worked with local governments and investors to complete bond packages totaling more than $4.3 billion for workforce housing acquisitions in California, according to its website. The agency is processing proposals for further purchases, generally in communities on the outskirts of major metropolitan hubs, though it remains to be seen if the volume of deals seen in 2021 can be maintained in 2022 and beyond.

Penkower said challenges include a rising tide of institutional equity flowing into California from across the nation and world seeking a piece of coastal markets where apartment rents and property pricing have been soaring the past year. The community development agency is hard-pressed to compete with deep-pocketed investors in the largest California cities, and currently cheap bond financing could lose its attraction for some investors if interest rates rise in a persistent inflationary environment.

“The rent trends are showing why a program like ours is so necessary, but it’s really terrible for the families out there where we haven’t established this,” Penkower said, noting the agency-sponsored purchases have resulted in monthly rent savings for families ranging from $900 to $1,300, depending on the region.

For the Record

Kyle Pinkalla of brokerage Northmarq represented the seller in the portfolio sale; the buyer was self-represented. Goldman Sachs served as bond underwriter. Law firm Orrick, Herrington & Sutcliffe served as bond counsel.