First, most investors recognize that investment properties provide tax shelter through depreciation. The rule of thumb is that a million dollars of apartments provides about $25k of tax shelter, depreciation annually. The value of the improvements and the building, say just less than 70% or $700k, is depreciated over 27.5 years. $700k improvement value per 27.5 years equals 25.5k annual depreciation. So an apartment investor could have no tax ability even if the building produced $20k of cash flow and reduced the principal $5k annually.
Second, when it comes time to move the equity, one can sell real estate for a profit, purchase equal or greater value, and defer the income taxes. In effect that is an interest free loan from state and federal government. Suppose the million-dollar investment grew at a long-term inflation of 3%, to $1.3 million. Investor sells the building and uses the larger equity to buy a $2 million asset. Under the provision of the 1031, tax deferred exchange regulation; there is no income tax due on an exchange. When you sell stocks or bonds for a profit there is an immediate tax liability.
Third, and especially important, is the San Diego County Income Property Pyramid. In our county there are more than 100k rental houses and condos. Each year some trade. The investor can pay the income tax or invest in a bigger property. There are 29k duplexes and triplexes in San Diego County. Each year thousands of them sell. Investors can either pay the taxes or trade up. There are 5k four-plexes. There are 3704 buildings from 5-7 units, 1063 are 21-36 units. At the top of the ever-growing pyramid are 488 parcels of 90 units and more.
So what does this physical reality mean? Every time an investor is considering paying income tax on all his accumulated profit the available choices narrow. When someone is considering paying tax on $50K from a rental condo or house, they have hundreds of choices to buy. In 20 years when they have traded a couple of times and inflation has done its magic, they can easily have more than a million dollars of deferred gain. When they are thinking of paying more than a quarter million in tax, or paying $25k more than they wish for the next up-leg, almost all of them will buy the bigger building.
In other words, San Diego is a conveyor belt of appreciation. Younger investors in a decade have a built initiative to buy bigger assets, and there are fewer of available larger properties. In a generation there is an immense incentive to buy still larger buildings and there are fewer of those available.