Penciling out 737 Park

A look at the calculations behind Harry Macklowe's newest purchase

Jun.June 01, 2011 05:21 PM

737 Park Avenue

Last month, developer Harry Macklowe signed a contract as the operating partner to buy the 108-unit rental apartment building 737 Park Avenue for $255 million, reports said.

The property, on the corner of 71st Street, is located on one of Manhattan’s most sought-after residential blocks, and that fact hasn’t escaped Macklowe’s notice. He has not formally announced plans, but sources say he intends to convert the building to luxury condominiums.

Once closed, Macklowe’s acquisition will be the most expensive residential building purchased for conversion since Maurice Mann and Africa Israel bought the Apthorp for $391 million in 2007, data from Real Capital Analytics shows. The deal marks the return of developers doing large-scale luxury condominium conversions following the real estate downturn.

“This is a litmus test [for whether] a condo conversion is a viable strategy for the next few years,” said Ben Thypin, senior market analyst at Real Capital Analytics. “This is a pretty bold move for [Macklowe]. If he can execute, that’s great, he’s still got it. But if he can’t, I don’t think that will surprise many people, because his basis is so high.”

When a property is offered for sale, the selling brokerage, in this case a Jones Lang LaSalle team led by Jon Caplan, creates a “confidential offering memorandum,” which is sent to select potential buyers, who sign confidentiality agreements. This includes the internal finances of the building, as well as a breakdown of the rent-regulated and free-market units, two of the most important pieces of information for buyers deciding how much to pay for a building. This month, The Real Deal took an exclusive behind-the-scenes look at the 73-year-old property through these rarely seen documents, usually shared only with a selective group of potential bidders.

The memorandum, obtained by The Real Deal, is a prism through which to examine one of the biggest deals in recent years.

1. Building finances

Developer Sam Minskoff & Sons constructed the 20-story, 216,246-square-foot building in 1940. Four years later, real estate developer and investor Louis Katz acquired it. He died in 1965, and the building is now in the hands of his one surviving daughter, Ruth Haberman, and eight of Katz’s grandchildren.

The building has 103 apartment units, five professional spaces totaling 7,500 square feet, and an additional 1,603 square feet of space on the ground floor that could be rented or sold, the JLL marketing information says.

But a look at 737 Park’s closely guarded income and expense records from the last four years reveals one reason the Katz family likely wanted to sell. Despite being valued at $255 million, the property only generated an annual net operating income of $2.77 to $5 million between 2007 and 2010, providing a capitalization rate of only 1.5 percent in 2010.

Because of that, the actual annual distribution for the nine Katz heirs is low. In 2009, just $3 million was distributed among them, the records show. While nothing to sneeze at, that is a far lower annual return than one would expect from an investment of such value.

The building also has a high number of vacant units: 14, according to the memorandum. The bottom line is also impacted by some rent-controlled units in which tenants, some affiliated with the owners, pay an envy-inducing annual rent of only $300.

2. Rent-regulated vs. free-market units

One of the single most important factors in determining the value of a rental building is the ratio of rent-regulated to free-market apartments.

At 737 Park Avenue, 69 of the 103 units, or 67 percent, are free-market, the result of years of efforts to remove rent-regulated tenants. Such a high number of free-market tenants is unusual, and increases the value of the building for several reasons, brokers said.

“Seventy [percent] is rare. You pray for 50 percent,” noted Iva Spitzer, an executive vice president at Corcoran Group Marketing who has marketed dozens of conversion projects.

The advantage to a developer of a low number of regulated units is clear: In the short term, the building collects significantly more rent from the free-market tenants. The average market-rate tenant at 737 Park pays $66 per square foot, while the 30 rent-stabilized residents are paying about $22 per square foot, according to the memorandum.

For example, veteran real estate broker Carol Cohen and her husband, Lester, live in 1,622-square-foot, rent-stabilized Apt. 6F, where they pay $3,061 per month for the two-bedroom unit. (Cohen left the Corcoran Group in December amid controversy surrounding a lawsuit filed by the Katz family, who alleged that the Cohens lied about their income on state forms to prevent a rent increase. Cohen is now licensed with Brown Harris Stevens.) Two floors up, a tenant is paying about three times as much, or $9,900 per month, for the same-size apartment.

3. Removing regulated tenants

At first glance, armchair investors might assume that the 34 rent-regulated tenants, 26 of whom are paying more than the critical luxury decontrol threshold of $2,000 per month, would be easy to remove.

The JLL memorandum suggests as much: “With the average monthly stabilized rent over the $2,000 threshold, the property offers great opportunities for luxury decontrol.”

But conversion experts say Macklowe won’t be able to remove many tenants, in the short term at least, because the owners have already worked for years to dislodge them. Often, that means petitioning the state for “high-income rent deregulation,” which applies if a unit’s tenants are paying more than $2,000 per month, and the combined income of those renters is greater than $175,000 annually for two years running.

The owners of 737 Park have applied “year after year for the same units for high-income decontrol,” Maggie Russell-Ciardi, executive director at the housing advocacy group Tenants & Neighbors, said after reviewing the documents. Petitions are filed annually for more than two dozen apartments in the building, but the state has granted only one since 2004.

Buyouts are common practice in conversions, but with rents this low, developers likely have to pay astronomical sums to get tenants to move. Lawsuits, like the Katzes’ suit against the Cohens, are another favored tactic, but can be cumbersome and costly.

Another way to pressure tenants to leave is by making life unpleasant. Some cynical conversion experts note that the noise and turmoil of a gut renovation of the building might help push some renters to take a buyout.

Certainly, dislodging rent-regulated tenants isn’t for the faint of heart. But industry insiders noted that Macklowe, who once had buildings demolished in the dark of night to make way for a Times Square hotel project, has a tough stomach when developing around in-place renters.

“Harry has always been aggressive,” one attorney said. “Doing a gut renovation with tenants does not scare [him].”

In addition to restrictions due to rent laws, there are three very valuable upper-floor apartments at 737 Park that the owners can’t immediately convert. The tenants, including a daughter and granddaughter of Louis Katz, have life-leases that a new owner must honor, for three-, four- and five-bedroom units on floors 18 and 19.

4. Underutilized space

Another option for would-be purchasers is expanding the amount of residential space by repurposing underutilized floor area (see “Selling the cellar”) or converting professional space. Jones Lang LaSalle’s materials suggest that five ground-floor doctors’ offices at 737 Park could be combined with second-floor apartments to create sought-after maisonettes — apartments with their own entrances to the street. There is also a 1,603-square-foot space, once used as maids’ quarters, which could be turned into an apartment.

Getting the doctors to move out could be tricky — one tenant has an option to extend his lease to 2023. But “if you throw up a construction bridge, a commercial tenant very often will make a reasonable [buyout] deal,” said an attorney who has done litigation at the building and asked not to be identified.

5. The stacking plan

A new luxury condo conversion on Park Avenue would likely attract wealthy families looking for large apartments. So maximizing the value of 737 Park means combining units, most of which are currently around 1,800 square feet each.

“Most people who pay a lot of money need about 3,000 square feet,” Georgia Malone, a conversion expert and president at brokerage and consulting firm Georgia Malone & Company, said.

According to JLL, four-bedroom condominiums in the area sell for an average of $2,500 per square foot, but apartments with three or fewer bedrooms go for less than $1,500 per square foot.

However, a new owner can’t combine units by fiat, because the rent-regulated tenants are blocking them on nearly every floor. So in determining the value of a building, would-be converters need to pay careful attention to the in-place free-market and regulated apartments as they craft their so-called stacking plan, a diagram of apartments by floor.

A new owner would most likely want to combine units on the same floor rather than duplex them, because of the space considered wasted in the latter for stairs.

6. The competition

Nearby new-construction luxury buildings have achieved sales prices of about $3,000 per square foot, such as Vornado Realty Trust’s One Beacon Court at 158 East 58th Street. One three-bedroom apartment there sold for $14.45 million, or about $4,921 per square foot, last month.

However, conversions have not always garnered the same top numbers. In March of this year, Extell Development, the sponsors at the former Stanhope Hotel at 995 Fifth Avenue, sold a five-bedroom apartment for $21 million, or $2,513 per foot, according to the real estate listings website StreetEasy.

Luckily for Macklowe, there are few other prewar condominiums on Park Avenue in the Lenox Hill neighborhood. Two nearby condo conversions, in 715 Park Avenue and 838 Fifth Avenue, are both in less desirable postwar buildings.

7. Development costs

Conservative buyers may look at the project as if it were two buildings: one a condominium conversion, the other a rent-regulated rehabilitation.

Since there are only 122,136 square feet of residential free-market space (plus any additional space that can be added from underutilized areas), the acquisition cost of $255 million is about $2,087 per square foot, which is a high basis, as Thypin pointed out.

However, brokers said it was impossible to estimate the sell-out price or profit that Macklowe is projecting, because it is not known how much he expects to spend on renovations. Renovation costs range from $300 to $500 per square foot or more, depending on the quality of the finishes, Spitzer said.

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