Manhattan Cap Rates and Real Estate Investors

Bloomberg Businessweek reports today Manhattan Apartments Lure Investors Seeking Market Foothold.  Down in the rental trenches, we’ve seen a lot of building transactions as the 2008 financial crisis dislocated REIT balance sheets across the country.  One notable includes Longacre House in Midtown West, one of our original RentHop landlords.  In the middle of 2009, they transitioned from a Macklowe, famous among brokers for generous OP and free-rent incentives, to ownership under EQR, one of the largest REITs with a strong Manhattan residential presence (and sadly very few OP payments).

An interesting paragraph in the Blomberg piece stood out:

Demand for Manhattan apartment properties has pushed up prices and lowered the yield for investors. Capitalization rates on multifamily buildings in the borough averaged 5.1 percent in the fourth quarter of 2010, compared with 6.6 percent nationally, according to Real Capital.

The capitalization rate is the real estate equivalent of the P/E ratio in equity fundamentals, except that it is quoted as the percentage of the property purchase price earned each year in net operating income.  In simpler terms, for every $100 used to buy real estate in most of the country today, a building owner expected to earn $6.60 per year.  In Manhattan, a building only expects to return $5.10 per year, almost 23% less income for the same price!

Of course, when evaluating any investment, the cash flow yields are not the only concern.  After all, a cap rate doesn’t consider cost of financing, and when was the last time anyone bought a stock solely because of its high dividend yields? (I’m assuming value/income mutual fund managers are not RentHop blog readers)

I suspect there are a few reasons to be bullish on highrise landlording in Manhattan:

Financing rates are near an all-time low.

After almost three years of large real estate deals gone bust, banks are finally taking on a bit more risk and that includes providing attractive financing to experienced real estate investors.

Cap rates in Manhattan traditionally trade below the nation.

In 2007, cap rates for luxury highrise residential buildings are comparable to what they are now.  Keep in mind that Manhattan rental prices during the 2002-2007 boom rose at a much greater pace than the nation.  The cap rate only captures a snapshot of net-operating-income the year prior to the purchase divided by the purchase price at closing.  If the investors can rely on rents to rise at rates significantly faster than inflation, then the actual returns over a multi-year holding period can be significantly higher than the cap rate (couple that with low borrowing costs and you’ve got a recipe for a great cash-on-cash return).  Unfortunately for renters and brokers, that also means we should expect rent increases in the coming years.

Plain and simple, investors like to bet on appreciating assets.

It’s a sad truth in real estate, but quality property management and reliable tenants are not the primary concern for owners.  Most landlords know that annual cash flows and yields are simply the icing on the cake, and that the real money in real estate is flipping a property at appreciated prices, often with a healthy dose of leverage and intelligent tax planning.  Professional real estate investors obviously care about maintaining healthy income statements, but in the end the balance sheet is king.   Other than a few distressed opportunities such as Florida, Vegas, and Michigan; one of the best metro areas due for a real estate turnaround in Manhattan.  It’s definitely a gamble on a large rebound in the financial sector and Silicon Alley bidding up housing demand, but year over year rents have been quite encouraging.

As always, we do our best to follow the NYC Apartments market and watch with great interest as the Manhattan recovery continues to develop.