Part One of a two-part piece on rent-stabilized multifamily investment
When it comes to multifamily real estate investment, rent-stabilized housing can be an under-appreciated asset in the right circumstances. In cities like New York, where strict new rent regulations have dulled investor appetites for multifamily housing, recent economic developments (partially stemming from Covid-19) can actually make rent-stabilized real estate a smart, risk-adjusted, long-term investment opportunity, especially over the next three years, but there are risks to go with the rewards. Here’s what you should consider:
Using New York City as an example, rent-stabilized apartment rents can only be increased by the Rent Guidelines Board (RGB), which has kept increases close to zero over the past few years. The ability to add improvements and convert rent-stabilized units to free market units once the tenant moved out made this sub-segment extremely lucrative in the past. Owners invested capital into rehabilitating vacant units in return for higher future rent, thus creating higher property values for this class of buildings.
Still, while these were low-yielding assets (3-5% on the purchase price, depending on the location), investors saw this as an opportunity—with enough turnover—to improve the asset and its cash flow, with the option to refinance or sell. This was a reasonable risk-adjusted return for investors.
In New York City, there was a massive infusion of private and institutional capital into an otherwise dilapidated stock of apartments, but the Housing Stability and Tenant Protection Act of 2019 (HSTPA) removed significant investment incentives through a number of changes that hinder owners’ abilities to make capital improvements to units and recover revenue in the event of nonpayment of rents.
As mentioned, rent-stabilized multifamily rents post-HSTPA can only grow per RGB guidelines. Under Bloomberg, the growth rate was 3.25% per year, while under de Blasio, that rate is lower at 1.32%. These increases might help keep up with operating costs and property taxes but not with any meaningful bottom line growth. Property taxes have also been on the rise over the past six years and are likely to continue to do so. Essentially, the net operating income—the rent minus operating expenses and property taxes—is likely going to decline for rent-stabilized apartment buildings in the near term, but these buildings often still present smart investment opportunities. Here’s why:
Understanding the Unit Mix
A key to understanding multifamily investment overall lies in the building’s unit mix, such as how many of the units are currently free market as opposed to rent-stabilized. According to a report published by the New York City’s RGB, 1.2 million of the 2.2 million rental apartments in New York City (56%) are under some form of rent regulation, and almost every multifamily asset has some form of regulation.
Free market units are priced differently compared to rent-stabilized units—i.e. they are priced based on what the market dictates they’re worth, as opposed to regulations that keep rents lower for affordable housing purposes. So, if a 100-unit building has 50 free market units and the rest are rent-stabilized, it will be priced higher than a similar one with all rent-stabilized units, but the free market building could also have a lower capitalization rate than the 100% rent-stabilized building, due to the higher price, taxes and upkeep costs.
A capitalization rate (or cap rate) is the ratio of net operating income to a property’s value. That value, if you’re investing in a property, is the price you’re paying for it. If you owned the property, that value would generally be determined by the amount you could sell the property for on the market. Your net operating income would likely be lower in a rent-stabilized building than in a similar building with more free market units, but your financial outlay could be less and your capitalization rate could be higher.
Current Trends to Consider
According to Ariel Property Advisors’ Q1 2020 Multifamily Quarter in Review, once outliers—generally, large properties or portfolios that skew the numbers—have been removed from the data, sales dollar volume has risen by 34% since the previous quarter and transaction volume has also risen by 17%, while building volume decreased by 27%. Compared to Q1 2019, dollar volume and transaction volume has remained relatively flat. Keep in mind, however, that Q1 does not significantly show the effects yet of Covid-19 on the housing market.
In New York City, multifamily transactions are generally a mix of free market and rent-stabilized units, and almost every multifamily building in New York City has some component of stabilization or regulation, which creates difficulties in assessing the overall market trends of rent-stabilized units as separate from the overall residential market. Still, cap rates are expected to continue to increase and values are anticipated to decline, which could present opportunities for new investors in the near term for income-generating properties.
However, due to the effects of Covid-19, April multifamily rent collections in New York City were anywhere from 50% to 90% depending on the location and sub-segment (i.e. rent-stabilized, free market or mixed). The lower levels were generally in rent-stabilized multifamily buildings in the Outer Boroughs. May and June should continue to provide more clarity on the effects of Covid-19 for future rent collections.
The political environment for rent-stabilized multifamily buildings is somewhat volatile, as evictions are illegal at present and many lawmakers are considering freezing rents for regulated apartments. There is a high likelihood that May collections will fall short of April’s figures and put more pressure on landlords and lenders, but as with most things Covid-related, the situation is difficult to predict, especially as states, New York included, are starting to reopen businesses.
In the next article, I’ll discuss lenders’ appetite for rent-stabilized buildings, how pricing works and what the future holds for this asset class. Check back in on Thursday!