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Two Possibilities For NYC’s Rent-Stabilized Real Estate Market

June 18, 2020 – By Shimon Shkury, President, Ariel Property Advisors

As I wrote in a previous breakdown of the rent-stabilized multifamily investment market, there are risks and rewards to consider when it comes to investing in this property sector. For instance, cap rates can be very attractive for investors, as can the relative stability of the multifamily market in a city like New York, but there are also regulatory and political uncertainties to consider, as well as expenses and revenue. The mix of rent-regulated versus free market units in a building is also important, because it impacts the amount of revenue you can raise through rent increases to cover, for instance, property upgrades.

Especially now as Covid-19 brings another layer of uncertainty, it’s crucial to consider a range of forward-looking factors.

Shimon Shkury,
President and Founder,
Ariel Property Advisors

 

Pricing

Over the six months ending March 31, 2020, capitalization rates across New York City compressed by nearly 20%, though Brooklyn did remain steady at nearly a 5% cap rate.

However, to see what the future holds, you need to look back to June 14, 2019, when pricing for New York City rent-stabilized multifamily real estate changed fundamentally with the passing of the Housing Stabilization and Tenant Protection Act (HSTPA). While investors could previously rely on future rents rising as they renovated units or converted them to free market, that option is no longer available.

Now, investors require an immediate cash yield from rents to mitigate the lack of income growth in the foreseeable future. This will impact building maintenance, as owners will potentially defer upgrades and expenses. The reduction of costs can help create higher capitalization rates, even if the building’s market value doesn’t increase as it would with better infrastructure or units. Capitalization rates should continue to rise into the near future, which does also imply lower valuations for this asset class.

Lender Sentiment

Given the extraordinary circumstances, lenders have largely been working with owners, offering forbearance for the first few months of the lockdown. However, if the situation forces many lenders to keep rent forbearance (or take more extreme measures) beyond the first 90 or 180 days, many may reassess their exposure to the rent-stabilized multifamily asset class as a whole, which might lead to discounted note sales over the next 12 months.

Once the environment stabilizes, though, I predict lender appetite will return, because this is a safe asset class, especially in relatively stable housing markets such as New York City. Covid-19 is unlikely to change the fundamentals of the New York City housing market by itself. Although, when the market recovers, financing may be extended at lower values, at higher interest rates and with more extensive principal escrow payment buffers. (These buffers are already a standard practice, as borrowers may need to pay an upfront amount of cash to cover annual bills and multiple monthly payments, in the event of default or forbearance.)

The Future of the Investment Market

Of all the potential scenarios right now, there are two that stand out as more likely.

Scenario 1

Due to protracted and high levels of rent nonpayment by tenants and regulations preventing evictions, the State and City Of New York will be forced to provide long-term revenue subsidies to ease the burden on owners of rent-stabilized multifamily assets and units. With the HSTPA in place, which already limits owners’ abilities to take recourse in the event of nonpayment, landlords will face eroding incomes and face further rent collection challenges.

If this happens, multifamily buildings with a significant amount of rent-stabilized units will lose market value in the near term and lenders will foreclose or sell debt notes at a discount.

Under this scenario, owners can really only create value on the property through lowered expenses (e.g. lower taxes) and the use of city, state and federal subsidies for maintenance. New York City would have to respond to the tax burden by providing incentives that, at the moment, are rarely available, such as abatements and tax shelters. Under pre-Covid-19 rent-stabilized property laws, government subsidies usually apply to necessary maintenance on units and building infrastructure, such as New York City’s 421-a Tax Incentive.

Essentially, in this future scenario, there is a dearth of private and institutional capital to maintain rent-stabilized units and, over time, city and state governments will have no choice but to respond.

Scenario 2

Seeing the shifting landscape, there will be swift rent regulation reform. Currently, there are actually several legal contestations of the HSTPA as unconstitutional. One, in fact, has already succeeded: Regina Metropolitan Co. v. New York State Division of Housing & Community Renewal, which deemed that overcharge calculations cannot be applied for dates before the HSTPA was enacted.

In this scenario, pending legal lawsuits will bring lawmakers, landlords and tenant groups together to discuss adjusting the legislation for everyone’s benefit.

What This Means for Investors

Regardless of which scenario happens for the New York City rent-stabilized multifamily market, opportunity is coming. Specifically for this sector, higher capitalization rates and investment returns are poised to perform well even under current income struggles, though the risk of regulation is still a factor to consider.

One way to mitigate the regulation risk is by investing in assets that include a portion of free market units. Still, free market units or no, rent-stabilized buildings present a long-term investment opportunity with significant upside potential.

INSIGHTS ARCHIVE

The information contained herein has either been given to us by the owner of the property or obtained from sources that we deem reliable. We have no reason to doubt its accuracy but we do not guarantee the accuracy of any information provided herein. As an example, all zoning information, buildable footage estimates and indicated uses must be independently verified. Vacancy factors used herein are an arbitrary percentage used only as an example, and does not necessarily relate to actual vacancy, if any. The value of this prospective investment is dependent upon these estimates and assumptions made above, as well as the investment income, the tax bracket, and other factors which your tax advisor and/or legal counsel should evaluate. The prospective buyer should carefully verify each item of income, and all other information contained herein.