The Real Deal New York

Despite low returns, building prices set to rise

By Philana Patterson | November 16, 2007 12:20PM

Owning commercial property in New York is a less lucrative proposition than last year, but even declining incomes can’t slow a surging sales market.

Despite a decline in cap rates – the annual income derived from a property as a percentage of the total purchase price – brokers expect prices for commercial buildings to rise as much as 15 percent this year.

Large chunks of office space in Midtown and Midtown South are hard to come by and landlords are finding that they have to make slightly fewer concessions to get tenants. Past inducements, such as six months’ free rent, are being cut back slightly as market watchers anticipate continued demand.

“I think we could see some rapidly escalating rents over the next 12 months,” said Dan Fasulo, director at research firm Real Capital Analytics. “A lot of smart money purchased office properties in Manhattan last year. A lot of the high prices paid in 2005 will be justified when rents and fundamentals start to improve.”

Buyers are willing to accept lower cap rates and pay high property prices for several reasons, the clearest of which is that New York is attractive to foreign investors who see it as an improvement on European cities where rates are much lower. European buyers see a 6 percent cap rate in New York and see that as great compared to the 3 percent or 4 percent they would get in London or Paris, Fasulo said.

“The money supply is really global now,” he said. “It makes sense that markets that are considered as global cities should settle in the cap rate range of European cities.”

Another factor is 1031 exchanges – a provision of the tax code that allows investors to defer capital gains taxes if the proceeds from one property, owned for at least year, are used to buy another property within 180 days. Investors using the 1031 exchange save so much on taxes – in many cases around 33 percent of the sale price – that it’s not so painful to buy an income-producing property that might be a little expensive, said Adelaide Polsinelli, senior executive broker at Besen & Associates.

In Manhattan, cap rates for buildings sold by her firm in 2005 were around 5.9 percent, down from about 6.2 percent a year earlier. That means a building purchased for $10 million would currently have an annual return of $590,000.

“This market is going to continue,” she said. “I don’t expect cap rates to increase until 1031s are no longer allowed.”

There’s also an increasing propensity for investors to join forces and buy a large property they couldn’t afford individually in joint venture companies and syndicates.

“There have been a lot of new groups coming from overseas in the last year,” said broker Eric Anton, principal at Eastern Consolidated.

Deals such as the royal family of Dubai’s purchase of 230 Park Avenue and the Essex House get headlines as trophy properties changing hands, but Steve Kohn, president of investment banking firm Sonnenblick Goldman, said a wider range of buyers is making its influence felt in New York.

Part of Manhattan’s allure is that if an investor has a large amount to spend, New York is considered a safe bet for big chunks of money, particularly if it’s in euros or another currency that’s strong against the U.S. dollar.

“You can get a lot of money out in a few transactions and not feel overexposed that you have too much [invested] in a [particular] market,” Kohn said.

On the residential side, the picture isn’t as rosy for buying buildings, but it’s not considered bleak, either. With numerous condo conversions in the pipeline, rising interest rates and the slowdown in residential sales, money for new developments may not be as cheap or as available as it was the last three years. Some lenders are already beginning to take a closer look at proposed projects, Anton said.

“Not that they are turning off the faucets,” Anton said. “They are being a little more conservative. We’re getting the sense that the quality of the development sponsor is very important, whereas two years ago a guy with not a lot of experience could convince a lender to back his project.”

However that doesn’t mean residential buildings are going to be a steal. Although many people in the industry are more positive about the commercial market, investors who plan to convert buildings to condos are often willing to pay more for a building than a buyer who plans to use it as rental property.

“You can pay more for a building you can convert because you can get more [when you sell the units],” said Michael Goldenberg, executive director of sales for the West Side at Halstead Property. “You are not looking for an annual return.”

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