I know, I know…buying multi-family properties comprised of mostly rent-stabilized units with nominal rental upside and increasing expenses in an elevated interest rate environment can’t possibly make any sense. However, I think it is time investors revisit the asset class and here’s why:
Purchasing Below the Cost of Capital
Unlike most properties on the market where there is a wide spread between the bid and ask prices, rent-stabilized properties can be acquired for cap rates in the range of 7.5%-8.5%, or below the cost of capital. Sure, current laws limit ownership’s ability to add any meaningful value through major capital improvements or apartment renovations but that also means no out-of-pocket capital expenditures will be incurred. Like an investment in a business development company or covered call ETF, you can expect limited appreciation but a consistent and healthy yield. At a cap rate in the 8% range with borrowing costs where they are today, these properties can be acquired at an undemanding valuation for investors to jump in.
Future Interest Rates
Owners and operators found out the hard way what Warren Buffet knew all along and that is “everything in valuation gets back to interest rates” and commercial real estate is no exception. The oft-quoted metaphor is that Interest rates are to asset prices what gravity is to an apple. However, if interest rates have peaked or will soon, investors can expect more favorable financing and valuations in the years ahead.
Over the next five to seven years, investors may be able to re-finance at a rate well below current market rates. Furthermore, if asset prices drop with higher interest rates, the inverse is also true. That is, if we move to a 5% interest rate world, it stands to reason that the appropriate cap rate for rent-stabilized buildings could be in the 5.5%-6% range.
To illustrate, imagine an investor buys a 15-unit rent-stabilized building with a $220,000 net operating income at an 8% cap rate in 2023, or $2.75 million. Five years later, assume the net operating income didn’t change (i.e., the rent roll increased nominally as did expenses), but the appropriate cap rate is 6%. The value of the asset increases to $3.67 million with no improvement in the rent roll or net income.
Predictable Income Stream with Long-Term Tenancy
When a tenant receives a favorable regulated rent, they tend to pay on time and stay for a lengthy period of time. Rent stabilized rents are typically nothing to write home about but the arrears and vacancy loss is very manageable making the revenue and income very predictable. Peace of mind has its benefits.
Future Legislative Changes
Hoping that the HSPTA goes away or its impact is substantially diluted by chipping away at the law may be wishful thinking. But there are a few things legislators in Albany would be wise to re-think as we approach the five-year mark since the passing of HSTPA. Any landlord-friendly amendments to the HSPTA law, could result in a surge in the value of rent-stabilized buildings.
The HSTPA is widely perceived as an unmitigated disaster and not just by landlords. Tenants sit in unrenovated units and receive only the bare minimum required of landlords. There are an estimated 40,000-90,000 rent-stabilized units that remain vacant as owners would rather warehouse the units than rent them out for the paltry legal rent they can achieve. For context, there are approximately 88,000 homeless people in NYC, of whom 31,500 are children. Regardless of your politics, this is a failure in policy with heart-wrenching implications.
Final Thoughts
Should you run out and buy as many rent-stabilized properties as you can find? Probably not as not all rent-stabilized buildings are created equally. When performing your due diligence, a few things to be mindful of include (i) the current taxes (is the asset in a protected tax class 2A/2B), (ii) any serious violations and penalties, (iii) the arrears report, (iv) whether any preferential rents exist and perhaps most importantly, (v) the delta between the legal rents in place and market rate. The last point matters as there can be value creation in vacating the property which is more challenging to accomplish when rents are well below market rate.
For those who remain unconvinced, there are risk free federal money market funds yielding 5.25% and for the more adventurous out there, consider the over/under that interest rates decline substantially in the next few years along with inflation and the folks that occupy the Senate and Assembly in Albany come to their senses even if just a bit.
Website Sources: Long, C. (2023, April 10). NYC Commercial Real Estate Sales Fell By Over 50% To Start The Year. Bisnow. https://www.bisnow.com/new-york/news/capital-markets/uncertainty-slowed-q1-investment-sales-but-distress-is-only-just-starting-118456 Hall, M. (2023, October 5). “The Worst Market I’ve Seen”: NYC Commercial Real Estate Sales On Pace For Worst Year Since 2009. Bisnow. https://www.bisnow.com/new-york/news/capital-markets/new-york-investment-sales-is-down-65-on-last-year-120975 Basic Facts About Homelessness: New York City - Coalition For The Homeless. (2023, November 8). Coalition for the Homeless. https://www.coalitionforthehomeless.org/basic-facts-about-homelessness-new-york-city/#:~:text=In%20September%202023%2C%20there%20were,each%20night%20in%20September%202023.
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