We have a great listener question today.
What are your Key Performance Indicators for underwriting a rental building (100m+) on Park Avenue NY in the current market conditions (decrease in occupancy and increase in concessions). There is also few sales comps in the last decade.
Thanks in advance
This is a great question.
This is an area of NYC that I know well. My father had his dental practice on the corner of Park Avenue and 73rd Street. My mother was an architect on the Pan Am building, now called the Met Life building on Park Avenue and 43rd Street.
Park Avenue luxury rentals are complex buildings to own. Most of the land underneath those buildings, North of Grande Central Station is owned by the Pennsylvania Railway and leased to the buildings.
Those ground leases are expensive which is part of what contributes to the high rent needed to merely break even on those assets. Eventually those buildings could be turned into condo buildings, or rebuilt to even higher density.
You are correct that these buildings don’t change hands very often. Most of the luxury apartment buildings that are rentals along Park Avenue have not experienced a large increase in vacancy. Many of these older buildings date back to the early 1900’s.
These buildings along Park Avenue are not a commodity. Those who are renting in those buildings are paying $5,000-$7,000 per month. They’re paying that because they want to be in that location. At the purchase price of several million dollars, even a rent of $7,000 a month is a relative bargain. So these tenants are not moving out in search of something cheaper. The turnover in these buildings is extremely low.
Some have been updated and converted into condominiums in the process. Those that have been converted to condo are pricing around $6,000 per square foot.
However, given the excess of supply that has opened up in Manhattan in the past two years, it’s going to take several years for this market to recover. I don’t believe we’re anywhere near the bottom of the market in NYC.
Even before the pandemic hit, there was a lot of new supply having entered the market. There was an estimated inventory of about 9,000 vacant brand new construction condos in the market. That represents about 7 years of inventory at 2019 absorption rates.
So who would be buying buildings like this at such inflated prices?
Buildings like this are considered to be trophy assets. The buyer of such a building is someone with a lot of cash to put to work. They’re looking for an asset where it’s more important to tie up a large amount of cash to protect it for the long term, rather than simply maximizing the rate of return.
Some international wealthy families have their money in places like Brazil or Argentina where they face considerable ongoing currency risk. More important than earning a high rate of return, is protection from 10-15% annual foreign exchange loss. These families sometimes like to park cash in a stable asset that is safe by virtue of being in a high demand location in a global gateway city like NY.
Some of these buildings are being valued at cap rates in the mid 3’s. That means the cash on cash return would be approximately 3.5%, with zero leverage. At that price the property won’t generate enough free cash flow to service any debt.
It all comes down to being clear on your investment criteria. We would not buy a building at a 3.5% cap rate. That’s not for us. We prefer to build new construction at a 6.5-7% cap rate and then refinance the property at a lower cap rate that is consistent with the market valuations around 5%. Remember, the difference in price between 3.5% cap rate and 7% cap rate is double the price. One of the key metrics is price and the ability to use debt to finance these buildings. But we’re comfortable building new construction. That’s not for everyone.
