By Brandon Polakoff
Director, Avison Young Tri-State Investment Sales Group
New York, New York
Countless articles have surfaced over the last few weeks that claim the New York City multi-family market is going to come to a crashing halt due to the rent regulation laws put into effect on June 15. However, I would argue that almost all buyers were already anticipating the worst and put their pencils down months ago as pricing did not reflect the imminent risk.
Not surprisingly, total multi-family dollar volume is projected to be $2.9 billion in 2019, which would be the lowest total for any year since 2010, according to Avison Young’s Second Quarter 2019 Property Sales Report. In addition, once annualized, the 70 multi-family sales year-to-date will be 52% lower than the five-year average.
At the same time, we saw a rapid flight to quality, in which predominantly or entirely fair-market buildings with higher net operating incomes drove the sales market. Average pricing per square foot actually climbed from $995 to $1,121, and with less perceived upside in the buildings purchased, cap rates expanded by 83 basis points to 4.49% according to the Avison Young 1Q19 New York City Multi-Family Sales Report.
Now that the laws have passed, my educated guess is that motivated, fatigued sellers that own buildings with a sizeable number of rent regulated units will accept this new reality and part with their properties at lower values after previously dismissing the warning signs and holding firm on price. Accordingly, cap rates should expand and cash-on-cash returns will improve as conventional lenders are currently offering five-year debt at 3.5-3.75%, oftentimes with one to three years of interest only (IO). Ultimately, the gap between buyers and sellers will narrow and we will see an uptick in sales velocity in due time.
I have heard some investors say they believe cap rates for New York City buildings with large rent regulation components will rise to 7% or 8%. However, I feel that this prediction is flawed based on where multi-family properties sell throughout the rest of the country. According to Real Capital Analytics data, major cities such as Los Angeles, San Francisco, Washington DC, Chicago, Boston, and Denver yielded cap rate averages of 4.51%, 4.60%, 5.22%, 5.72%, 4.27%, and 5.31%, respectively. Cleveland, Cincinnati, Detroit, Indianapolis, Columbus, and Pittsburgh reported the highest cap rate averages, ranging from 6.12% to 6.90%. So we must ask ourselves – do we really believe New York City properties will trade at a discount to Cleveland? My gut tells me no. If anything, there will just be fewer sales of these assets. The passing of these laws may have turned some investors away, but this is New York City, and bets will continue being placed. However, it is impossible to predict the future of pricing at this juncture. It will take time to see how things play out.
In the short term, we should expect heightened competition for fair-market buildings, having slight upward pressure on pricing. Especially while interest rates are still low. Yet, over time, we should see further increases in fair-market building pricing due to simple supply and demand factors in the rental market. Since property owners are limited to $15,000 in individual apartment improvements over a 15-year period, generating a maximum rent increase of $89 per month for buildings over 35 units ($83 per month for buildings with 35 units or less), they will do minimal renovation work to vacant rent-stabilized apartments. In turn, the supply of attractive fair-market units in the city will remain relatively flat. If demand for these units increases, fair-market rents will rise at a faster rate. This has been proven in cities such as Las Vegas, Phoenix, and Charlotte where demand exceeds supply, resulting in rent growth levels of 7.7%, 7.5%, and 6.5%, respectively according to the National Apartment Association. Higher rent growth assumptions means predominantly fair-market buildings will generate a higher projected gross income, and as a result, the presumed value of these properties will increase. It is safe to assume that most of the buyers employing this theory will focus on multi-family buildings in protected tax classes (10 units or less – Tax Class 1, 2a, 2b, and 2c). For unprotected multi-family tax classes in New York City, there may be concerns that tax hikes will offset rent growth.
Many multi-family buyers had been biding their time to see what the ramifications of the new laws would be. Now that they are in effect, I believe we will see investors shifting their business plans, or in certain cases, shifting asset classes altogether. Nevertheless, for those committed to multi-family, it will be very important to understand new ways to create value when faced with vacant apartments that were previously leased to rent regulated tenants. The opportunities are highly specific and nuanced. As an advisor in the field, I have taken the time to consult with landlord & tenant attorneys to determine methods for successfully adding value within the framework of the reform. I am willing to speak on an individual basis to discuss these options.
For short-term holders there will always be 1031 and high-net-worth individuals willing invest in fair-market buildings in the right locations. Our group has seen this repeatedly. For buyers who want to add value and sell quickly, I would advise you to pick your tenancy and location with discretion. Most of the trades will happen in prime locations where these outlier buyers feel more comfortable parking capital.
Right now, more than ever, it is very important to fully market a property you are selling. With this reset, the logical local buyers are pushing back. Owners need to make sure that their properties are exposed to as many buyers as possible, including 1031 buyers and high-net worth individuals who are going to pay a premium and would otherwise not know the building is available.
If you are a property owner and do not have the bandwidth or ability to properly manage your building(s) in the current environment, I strongly encourage you to bring on an experienced property manager to guide you through the storm. There are too many challenges that could result in the severe devaluation of your property.
I recently sat down with Robert Morgenstern, founder of Canvas Property Group, to further expand on this. “In addition to a property owner’s inability to raise rents in vacant or permanently rent-stabilized apartments, as well as the massive alteration to Major Capital Improvements (MCIs), there are also significant changes to the rent laws involving free market apartments,” Morgenstern said. “These changes substantially alter operational workflows relating to unit inspections, applications, and security deposits (both amount and timeliness of return, as well as a tenant’s right to self-cure). Additionally, these laws reduce owners’ flexibility regarding tenant screenings, the eviction process and acceptable metrics for choosing quality applicants.”
To better understand how to operate within the New York City multi-family landscape in 2019, I also asked Rob how his property management company, Canvas Property Group, has approached the headwinds. Rob explained, “Our experience as owner operators across multiple asset types and locations paved the way. We have created a proprietary set of workflows, which aim to take the pressure off ownership while complying with all the changing legislation. This allows us to better approach construction and property management and ensure we succeed in today’s environment.”
In light of this, it has grown very clear to me that property managers will need to be exceedingly hands on and proactive moving forward. Times have truly changed.
If you would like to discuss the implications the recent rent law changes have on your property please contact me at [email protected] or 212.230.5998.
If you are interested in speaking with Robert Morgenstern about his property management group, Canvas Property Group, please contact him at [email protected].