The Real Deal New York

Built to rent as market cools

As market tune changes, rental development starts looking more attractive
By Alison Gregor | February 01, 2006 11:08AM

Residential property developers looking for a twirl on the Manhattan dance floor have shunned rental properties for the past several years, but the market is rapidly losing its wallflower status as the sales segment slows.

Rental development is getting its second wind as the condominium market, particularly at the high end, recedes to normalcy. But is a perkier rental market enough to coax previously reluctant developers to signing its dance card?

Developer Zeyad Aly said he and his partners at Yabba LLC believe market conditions are right for a new rental development in Manhattan.

“Everybody thought we were building condominiums, but we’ve opted to do the opposite, which is high-end rental,” he said of the group’s six-story, 24-unit glass building at 115-119 Norfolk Street on the Lower East Side, which is scheduled for occupancy at the end of 2006.

The development, designed by the architect that did the Hotel at Rivington – Grzywinski Pons Architects – will have a lap pool on the roof. It will have both unfurnished units and units furnished for corporate clients, Aly said.

“We are confident the rental market has begun to recover,” he said. “Part of that has to do with the fact that the heated real estate market of over $1,200 a square foot has priced a lot of people out of the market.

“The old theory of buying being cheaper than renting may be no longer – it’s now favorable to rent versus buy.”

Overall vacancy rates in Manhattan were at 0.87 percent in December 2005, according to Citi Habitats data. Many rental units are being lost as buildings are converted to more lucrative condominiums – meaning there may eventually be a scarcity of rental units. There also has been rampant job hiring.

But new rental buildings are still few and far between, even with indicators pointing toward a rousing Manhattan rental market. Another developer on the fence who may elect to go condominium is Harout Derderian, who is working with his wife Ekaterina Derderian. He said they’re almost certain they’ll convert a commercial loft building at 116-122 East 124th Street in East Harlem to condominiums.

“Right now, we’re talking about rental, but it’s probably going to go condo,” Harout Derderian said. “The problem is condos cash out so well, it’s hard to resist.”

For the past few years, developers have found it hard to create rental apartments. Land prices hovering around $300 a developable square foot in many areas combined with exorbitant construction costs made it financially unfeasible. Though many developers believe land prices have peaked, while rents grew healthily throughout 2005, most agree the change is not large enough to shift the market.

“I think the rental market is strengthening,” said Fred Harris, senior vice president for development at AvalonBay Communities, a real estate investment trust that recently began constructing its second rental building in the Cooper Square development on the Lower East Side. It will have 206 units.

Real estate investment trusts, which are deep-pocketed long-value funds, are largely limited to investing in rentals, Harris said. Those making large-scale rental plays in New York include Archstone-Smith and Equity Residential. However, for other developers, “condos are still probably viewed as a higher return proposition,” Harris said. “Land is generally being priced by the condo market, not by the rental market.”

That means developers are forced to do condominiums to recoup their land costs. Developers doing rentals are typically getting government incentives and doing them on land held for years.

“Banks are not willing to finance rental properties if there’s an acquisition involved in the property,” said Aly, who has owned his Lower East Side property for years. “The dollars just don’t make sense.”

Developer Edward Minskoff of Edward J. Minskoff Equities has planned to do rentals at 270 Greenwich Street for the past five years. With tax incentives and Liberty Bond financing, which requires that rentals be developed, Minskoff plans to do 163 rental units as part of a mixed-use complex of dark bronze limestone, which will also include a condominium tower.

He said he believes there is a market for rental units in Manhattan.

“I think, absolutely, developers are weighing it both ways to determine the best alternative, whether it be a rental or a condo,” Minskoff said.

Some industry experts say that short-term shifts in the marketplace have less to do with whether a developer does rentals or condominiums than the investment goals of the developer. Still, a hot condominium market has made condos almost irresistible to most developers.

“They’re in it for a quick return on their investment,” Aly said. “The fact that we’re doing a rental property is indicative of the fact that we are going to also manage the property and be in it for the long haul.”

One developer with a long track record in New York City, who didn’t want to be identified, is collaborating with an established real estate family on a rental development.

“These are people looking for long-term income versus a big chunk of cash, because, from their perspective, a big chunk of cash would have to be invested,” the developer said.

Despite those considerations, one industry expert said he doesn’t believe rentals will become economically feasible any time soon. Andrew Heiberger, founder and CEO of Buttonwood Real Estate, said existing rental buildings have been trading at a cap rate (or return on investment) of 4 to 5.5 percent over the past couple years. Those trades were always less than the prevailing interest rate, thus those buildings, if operated as rentals, would do so at a negative cash flow.

“They always seemed to be priced a half point to a point below positive cash flow,” he said. “In some instances, they could be even two points below cash flow, and that’s when the building is considered ripe for a condominium conversion.”

But not all buildings are ripe for conversion, for instance, if they have cheap finishes. However, one obstacle to conversion has recently gone by the wayside, Heiberger said.

“Buildings that were heavily concentrated with studios or one-bedrooms used to not be prime condominium conversion buildings, because you had to combine units,” he said. “But in this market, [smaller units] are actually a good thing.”

Heiberger said sales prices may have peaked, and the differential between cap rates and interest rates has been tightening, but it’s still a seller’s market. And even if the differential is only a point, a building still would need an increase in profitability of about 18 percent just to break even.

“I’m fairly confident we’ll see a 15 percent or higher spike in apartment rents in 2006, but you would still have to have another year of that before it becomes worthwhile to do a rental,” said Heiberger, whose next project is a 458-unit condo conversion at 88 Greenwich Street. “And that’s assuming the building didn’t need any capital investment to make that rent spike happen, and that there are no rent-stabilized units in the building.”

Taking this into account, along with the turnover needed to raise rents, it could be four or five years before turning a profit on a rental, he said.

“As a developer, I’d love to do rentals right now,” Heiberger said, “but I can’t afford to pay for the land and build and make a rental work.”

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