The Problem & Solution to Buying Rent Stabilized Buildings
Holding strong convictions and beliefs
It’s been five and a half years since June 14, 2019, when NYS legislators passed the Housing Stability and Tenant Protection Act (HSTPA) into law. At that time, President-elect Donald J. Trump was in office. Today, President Joe Biden sits in the White House. Things change in life and every four years, the most powerful person in the world steps down to give someone else a shot. Presidents come and go, and HSTPA won’t be somehow immune from the cycle of change in the world. But, unlike presidential elections, which occur every four years, it's much harder to know when 2019's rent laws will change.
Since the laws are here today, we want to know: where is the market?
It’s an open secret that the rent stabilized market is going through a rough patch, and have written about it here, here, and here. But, still - very few investors at large understand that close to half of the NYC multifamily market is under real challenge. Still, because the current environment is the one we have to contend with today, it's worth examining and spelling out (almost to a fault) exactly why some investors skip over rent stabilized buildings.
Why It Doesn’t Work
Investors have asked me what I see in the Rent stabilized market. And my response has been consistent. Assets with uncapped increases in operating expenses like insurance, heating, and (especially!) property taxes and caps on revenue growth like rents are not in vogue right now. Unfortunately, this is precisely the way rent stabilized building economics work today. In particular, there are two problems for investors:
(1) There is no reposition-ability.
As real estate has matured as an asset class, more institutional investors have shifted their collective gaze toward the alternative asset because of its preferential tax treatment. Because of this shift, many investors purchasing and selling investment property today (above, say $5m) follow traditional private equity deal structuring. Deals are highly leveraged, projected rent growth and expense optimizations (‘repositionings') are ambitious, and timelines are shorter. High NOI growth secures big sale prices, and short timelines mean investor capital + profits get returned quickly, making investments even better.
Unfortunately, none of this is possible when buying rent stabilized properties because rents cannot be increased. Many private equity-like investors driven by Internal Rates of Return (IRRs) cannot justify buying rent stabilized buildings (100% Rs) to their investors because they will not be able to provide the industry standard returns by buying and holding. Unfortunately, without a major repositioning of the asset, buying and selling a building only a few years later won't work net of transaction costs. So, it's got to be a buy-and-hold. But, buying and holding doesn't pay enough for PE-funded investors. As a result of this, the cohort of buyers for these assets has tightened.
(2) Investors are afraid that expenses overtake revenues.
If modeled into perpetuity, expenses growing at 10%, will eventually overtake revenues growing at 1%. That means a building could have negative cash flow. Even in a hypothetical scenario where gross rents are at $5,000,000 per year, and expenses are at $100,000 – the owner must consider the looming prospect of negative profitability, however far off it may seem. But let's take a more realistic scenario where a building has a $1,000,000 rent roll and a $350,000 building operating expense. If the rent roll grows at 3%, that's $30,000 more in year 1. If the operating costs grow at 3%, that's $10,500 in additional expenses in year 1. But what if expenses grow at double the rent growth rate (which is very believable today)? That would yield a growth rate of 6% in expenses and a cost of $21,000. Now, there's an argument to be made that the CAGR for operating expenses on Pre-War multifamily buildings is greater than 6%. But, let's set that aside and consider that the property is now $9,000 away from declining NOI growth. What happens when a tenant paying $800 per month stops paying rent for a year? $800 per month x 12 months is $9,600 per year.
Year 1 income and expenses now look like this
Gross Rental Income: $1,000,000 + $30,000 in rent growth = $1,030,000
(-) Operating Expenses of $350,000 + 21,000 = $371,000
(-) Lost rent of $9,600
Year 0 Net Operating Income: $1,000,000 – $350,000 = $650,000
Year 1 Net Operating Income: $1,030,000 – $371,000 - $9,600 = $649,400
Stabilized NOI has gone down from year 0 to year 1
What I am trying to communicate with this hypothetical math is that negative NOI growth is very plausible, and that’s damaging for the valuation of rent stabilized assets. Further, without the ability to undertake thorough repositionings, which is the hallmark of Private Equity's interest in the real estate market, the number of buyers who remain interested in buying these assets has shrunk. This is what the theory suggests, but what about the empirical evidence?
Big Trades Only
In the last 18 months, a few large RS portfolios have traded hands in New York City, and these sales provide good insight into what is going on in the market.
All portfolios cited above had a mix of high cap rates, some free market units, and some vacancies. The number of free-market units wasn't considerable in most of the above deals, but it added a nice layer of security, especially since some of the free market units were vacant. But most buys were high cap rate, low price per unit/square foot transactions. This tells us that:
There are buyers of rent stabilized property
Buyers are looking for scale
Buyers want premium locations
Buyers want downside protection (or some upside) with a smattering of fair market units.
To further understand what was happening in the market, I pulled some market comps from Property Shark to determine the demand for RS properties. My criteria were below.
Why it Works
Sources Used: Property Shark and the Department of Finance
My summary findings were as follows
The sales from the trailing 12 months or so confirm that investors prefer free market properties to rent stabilized ones, but the preference may not be as stark as anticipated. Across 45 trades and $720m in deal volume, rent stabilized properties account for 20% of the stack. For assets many say will lose money over time due to rising expenses, 20% is unexpectedly high. This leads me to consider:
(1) Perhaps there is a viable business plan in which investors can optimize expenses even though they cannot raise rents or improve building services. At certain levels of operational scale—whether 1,000 units or 10,000—having the proper staff and operating procedures in place can meaningfully contribute to expense management. PH Realty, Alma Realty, and Rockledge may be doing precisely that. The fact that close to two-thirds of the rent-stabilized trades were portfolio sales (60%) reinforces the operational efficiency view.
(2) Or, maybe potentially declining NOI becomes less of a concern if:
a. Investors have enough of a head start before net income declines drive a meaningful reduction in investment returns.
By head start here, I mean having a sizeable gap between gross rents and expenses. The smaller the percentage of revenues that operating expenses occupy, the less significant a big % increase in costs will be to net income. This is hard to come by (hello tax class 2a, 2b buildings). But, even in cases where expenses are 45% of revenue, and big cost increases threaten negative NOI growth, buying buildings at high cap rates means that modest rates of net income growth decline of -50bps per year could be stomached – for a time.
b. The decline is temporary.
The secret sauce that makes the individual ingredients of investing in rent stabilized buildings taste good is the belief that the law will reset. And this can't be just a casual belief. You have to have an unflinching faith in this view. Even when others express concerns, you must take an almost rebellious stance. How far must you go? When Michael Burry became interested in the subprime mortgage market in 2005 and began buying credit default swaps, his firm Scion Capital took tens of millions in losses for nearly two years before his thesis proved correct. The stress & pain of this approach was so great that Burry required treatment for bleeding ulcers during this period. And for his risk and for his conviction, Burry was rewarded more than handsomely. That's the level of dogmatism needed, and I am seeing it emerge gradually, with some well-capitalized investors making bigger and bigger plays.
The veteran investors who have recently bought and sold some of the portfolios even agree on the long term prospects.
Peter Hungerford of PH Realty that purchased ~1,300 units summer of 2024 says “Sentiment may be negative toward buildings like these…But I think at some point, in some way, that it is going to change”
Lewis Barbanel’s current doubts underlie his long term convictions to the sector “I’m still a New York operator; we are committed to New York,” he said. “But I cannot buy rent-stabilized buildings in New York City until the laws change.”
There are many more ways to make sense of fair market deals than there are for rent stabilized buildings, but that doesn’t mean rent stabilized buildings shouldn’t be sought after and bought. The main challenge for investors considering buying RS buildings is that they cannot reposition and must worry about expenses increasing more, in absolute terms, than revenue each year. For many investors, these are deal breakers, and that's understandable. But as we have discussed, there are ways to de-risk. One way is to focus on buildings with low ratios of operating expenses / gross rent. Buying tax-class protected buildings is another. Purchasing larger portfolios may enable investors to examine operational inefficiencies and stabilize cap rates to higher percentages than they were at close, thereby achieving a repositioning. But, beyond everything else, buyers of rent stabilized buildings must sit with the fact that conditions will change and de-regulations will eventually occur. Conviction in this belief is fundamentally important when addressing this asset class. And then teaching your investors to believe in it as well.
I am bullish on NYC multifamily.
Best Regards,
Romain Sinclair
646 326 2220
Editor’s Note: I am happy to announce that I have left my post at Greysteel and recently joined the NYC-focused CRE brokerage firm Terra CRG