To make money on their new buildings, whether luxury condos or offices, developers have typically followed a simple rule of thumb: The profit margin should equal around 20 percent of the project’s cost.
In the current market, though, that’s becoming increasingly difficult, as labor and materials costs remain overheated. Another obstacle is if projects drag on for longer than expected, owing to structural problems, bad weather or community opposition.
Consider the enormous mixed-use Atlantic Yards development in Brooklyn. Last month, in response to a Freedom of Information lawsuit, developer Forest City Ratner Companies released documents showing that by 2015, it would clear $650 million on the $4.2 billion project — a 16 percent profit.
That’s if Forest City sells thousands of apartments, as well as the Nets basketball team and its arena.
While 16 percent may seem healthy for a regular business, it’s much lower than most developers expect to see on deals, particularly with residential projects, according to brokers, property managers, real estate analysts and developers.
Speculative commercial development in the city is still rare, though inching up, sources note.
Profits squeezed
Currently developers are finding that once they pay back any borrowed capital — and subtract smaller expenses like closing and recording costs, and brokers’ fees, in addition to transfer taxes — their profit is thin, and in many cases growing thinner.
Also, the price of admission — buying the land that the developments will sit on — is getting prohibitively high, now often about $450 per buildable foot in Manhattan. Materials and labor can now cost about $500 a foot; architect, loan, and sales and marketing fees are additional costs.
It also doesn’t help that demand for homes has fallen off, meaning that selling 10 units now might take 10 months — not three months like a few years ago, says Abraham Hidary, president of Hidrock Realty, which recently completed Kensington Townhouses, a ground-up 10-unit condo development in Kensington, Brooklyn.
Hidary has two more projects planned: a 30-unit condo in Midwood and a 24-unit condo in Bensonhurst.
But he has no aspirations to get rich quick; while a 20 percent rate of return is still the goal, it will require patience, he says.
“Some developers estimate an 18-month turnaround, but it ends up taking two or three years,” Hidary notes. Then, as carrying costs such as interest and maintenance increase, “their profit margin erodes.”
But waiting out a downturn, hoping that higher prices will offset escalating costs, can be risky, developers say.
“They hope they will be bailed out by inflation, but it doesn’t always work out that way,” says Jack Guttman, a principal of Chelsea Development Group, which partnered with Bass Associates recently to build Chelsea Arts Tower, a 20-story commercial condominium at 545 West 25th Street, between 10th and 11th avenues.
High land costs
Even upfront costs like steel and concrete can be prohibitive. Materials are pricey now because large-scale projects in Asia and the Middle East are sapping the supply; manpower, however, may actually be more affordable than it was in 2005, at the height of the condo boom.
“Labor costs have definitely subsided because there is not as much condo construction now,” says Anthony Westreich, president of Monday Properties. “We’ve even seen a difference in the last year.”
Monday, a New York-based owner-operator, controls 8 million square feet split fairly equally between Gotham and Washington, D.C. Nearly all of its portfolio is commercial, though 260 Park Avenue South, a luxury condo Monday owns between East 20th and 21st streets, is about to sell its last condo unit.
Still, that project was a redevelopment, since land costs are too high to even consider building new, Westreich says. “It comes down to the fact that there’s really just a shortage of land,” he says.
If returns are dwindling, developers may sit out the downturn, refusing to lower their prices in order to preserve their slim gains, according to brokers. Or they may change game plans, shelving plans for luxury condos and putting up hotels instead, sources say.
Still, the market hasn’t plummeted so far that developers are yet turning to Treasury bills for smaller, but perhaps more dependable, returns. The current rate on a 10-year T-bill is 5.2 percent, and even the weaker development projects — ones that are strung along for years, annualizing their returns and thus diluting them — are still yielding 8 percent profits, Westreich says.
Commercial strength
Though the profit potential today may be lower with residential buildings, in terms of commercial development, the inverse may be true.
In the face of a ravenous demand for office space, developers are sticking their toes in the water of speculative commercial development for the first time since the mid-1980s, though it’s still been relatively uncommon in New York, brokers say.
Because demand for office space is eclipsing that for residential real estate, developers are hopeful that 20 percent profit goals are still achievable.
A decade ago, average rents in Midtown hovered around $25 or $30 a square foot for office space, and the vacancy rate in some buildings hung around 10 percent, which kept developers from building speculative high-rises.
Later, they would undertake them only with a commitment from a major tenant up front, sticking to a hard-and-fast rule of thumb: Pre-lease two-thirds of the building before the first shovel hits the ground. That approach, which persisted up through a few years ago, typically resulted in buildings that for the most part were the headquarters for their sponsors, like Four Times Square (otherwise known as the Cond Nast building) on Broadway and West 42nd Street, or Five Times Square, a.k.a. the Ernst & Young building, at Seventh Avenue and West 41st Street.
Now, though, Midtown office rents average $76.56 a square foot — they’ve jumped 40 percent since 2005, brokers say — and the average office vacancy rate is 5.3 percent, according to Cushman & Wakefield’s second quarter numbers. That scarcity is a powerful incentive to build now and lease later, says Nicholas Sardone, a senior vice president at Cresa Partners, a national brokerage representing tenants with a New York office.
Examples include 11 Times Square, at West 42nd Street and Eighth Avenue, developed by SJP Properties; 505 Fifth Avenue, at East 42nd Street, developed by Axel Stawski; 510 Madison Avenue, at East 53rd Street, being developed by Harry Macklowe; and 150, 175 and 200 Greenwich Street, to be built as part of the World Trade Center site reconstruction by developer Larry Silverstein.
Another possible spec property is being developed by the Related Companies and Boston Properties on Eighth Avenue between West 44th and 45th streets, and a Boston Properties tower is planned for 250 West 55th Street at Eighth Avenue.
“The market is just not supplying enough space for the need,” Sardone says. “We may even be getting to the point now where old smaller buildings will be replaced by new bigger buildings.”