Despite being in the commercial real estate business and not the residential market there is a surprising amount of emotion involved in my day to day. Many of the clients our team has represented in 2024 have been selling long-held family heirlooms disguised as rent stabilized apartment buildings. My goal is to clarify the underwriting norms for rent-regulated buildings in 2024, easing emotions and setting realistic expectations from the onset.
How We Got Here
New York is different than the rest of the country. Vacant buildings can often be more valuable than an identical one with full occupancy. While this has been changing in recent years, information on a building’s history is often limited. However, buying in the heart of the world’s most dynamic city offers a clearer view of future potential. As the NYC market evolves, it is gradually aligning with national trends as lending institutions adapt their underwriting practices. For sellers, this shift means that adapting to these changes is crucial. By understanding what buyers and lenders are prioritizing, such as transparency in financials and realistic projections, sellers can position their properties more attractively in this competitive market.
When asked about investing in commercial real estate, Warren Buffett once said: “real estate values are determined by whatever the buyer can borrow with non-recourse financing”. He brings up a good point – as the debt markets go so do valuations. From 2009-2016 the Treasuries went down; money was cheap and easy to get, and pricing went bananas. The inverse is also true. Capital markets have tightened up and underwriting standards have changed. Regulators are taking a closer look at our business and the banks’ number one priority is to stay out of the doghouse. Sellers can leverage this understanding by working closely with their brokers to present their properties in a way that aligns with current lending requirements, potentially making their listings more appealing to qualified buyers. Expect to provide historical data to your purchaser to allow them to obtain the financing they need to close their transaction. This complexity is making cash buyers much more valuable. This August we had a seller take almost $200k less on an almost $9 million deal, for a 10 day all cash closing rather than a 90 day closing that required debt. 55 days from listing to closing. Although I have no doubt the other buyer would have closed, this was a smart move, and more sellers should emulate this decision if their current debt levels are low enough to justify taking less.
Change in Underwriting
I believe one reason the investment sales market has slowed is because of the discrepancy between buyer and seller underwriting. Prior to HSTPA brokers and sellers could get away with fluffing the expenses as “market estimates”. I can find old setups that show insurance, repairs, and water projections at $500/unit. 3% management fees, 3% collection loss and $10k for a super were commonplace. After HSPTA the market went from a future cash flow business to current cash flow. There was no way to fluff your projections – current cash flow and interest rates went from low priority to paramount. The political and judicial environment in New York has made it extremely difficult to effectively managing apartment buildings.
A New Perspective
This business is too unpredictable, and the cash flow is too inconsistent to look at a building in one moment of time. I think owners should be taking a five year average on their cash flow and then look at their return on equity. The previous four years plus next year’s expected cash flow inclusive of all capital expenditures should be the new norm of how to underwrite a building. Each buyer is underwriting expenses like façade repair, boiler, roof and lead remediation. Buyers are saying that their true cap rate is based on return on cost, not return on purchase price.
For example, consider a 100-unit rent-stabilized building listed at $13,750,000 with a projected NOI of $1 million. A 7.25% cap rate – not bad. Here is where the chess match begins during negotiations. The lenders are looking at arrears reports and any apartment with a 90+ day growing balance doesn’t exist – the rent for that apartment is $0 therefore no debt can be allocated to that unit. Not only that, but the purchaser anticipates collecting no rent from that unit for two years while they work their way through L&T court paying their attorney. We just found our first hole in our “7.25% cap”. By way of example, we are currently selling a large building in the Bronx and the bank placing the debt is taking a 27% vacancy/collection loss!
Back to return on cost… here are examples of what the buyer is factoring in.
- Local Law 11 needs to be completed; $400,000.
- Roof and parapets need upgrading; $100,000.
- 10 apartments with Class C lead violations need immediate remediation – $10k/apartment: $100,000.
- Closing costs 3% of the purchase price, $400,000. (lawyers, mortgage broker, title, inspections, survey, phase 1, etc.)
- Total out of pocket additional costs: $1 million. This money is not financeable, it’s straight equity with no expected return on capital – it’s just the cost of doing business in NYC.
That extra million dollars added to the purchase price takes our cap rate from 7.25% to 6.75%. We went from positive leverage to neutral. The additional equity significantly hurts the “cash on cash return” making the investment less attractive to those people willing to roll up their sleeves and “buy for cash flow”.
I look at a lot of T12 reports and if they are anywhere near accurate, the buildings require a significant amount of cash to be reinvested in them. Strip out whatever depreciation is left from your T12 for a more accurate representation of your cash flow. Do this for the previous four years and then run a budget for next year inclusive of cap ex likely needed. Take the average cash flow and then determine what your return on equity really is. Don’t forget to factor in Shaun Riney’s new pricing metric – Return on Headache (ROH). Investments with headaches should have a high cash flow relative to other investment opportunities.
Why Are Buyers Still Buying?
Sellers and investors sitting on the sidelines continue to ask: I don’t get it, why are people still buying these buildings? More often than not the answer goes something like this: “I believe I’m buying a fair deal on cash flow relative to my all-in and I’m making a political bet that eventually there will have to be relief and the laws will change. This business model is unsustainable but if I can outlast the worst of the distress and not be in the first or second wave of foreclosures or any more bank failures, then over the long term these deals will be bargains.”
Many of the buyers today are in 1031 exchanges. People are looking at this opportunity as a way to get rid of buildings they don’t want or upgrade into something better than they have. This year we’ve sold rent stabilized apartment buildings to 1031 buyers who offloaded development sites, warehouses, unsold co-op portfolios, and even property outside of New York. The buyers are out there, you just have to get the building on the market to find them!
Looking Ahead
We’ve been incredibly active this year and can share dozens of success stories of selling rent stabilized buildings at or below neutral leverage for clients just like you.
Selling today is a personal choice and after you’ve educated yourself and considered all the variables and decided you’re ready to see what else life has to offer, put together a plan and have an honest conversation with your favorite real estate broker! Reach out to a NYM team member to see how we can help you!
