Are valuation rules changing?
The Americanization of residential real estate

By Dan Margulies
Senior Vice President,
Georgia Malone & Co., Inc.

One of our major assignments at Georgia Malone & Co. is acting as buyer-broker for AIMCO, the largest residential REIT in the country.

AIMCO is looking for properties to buy in New York, an activity which has caused us to really focus on building valuations here.

Of course, I've been hearing about building valuations from the beginning of my former life as executive director of CHIP.

At my first board meeting one owner was telling another that he just sold a building in Washington Heights for twelve times rent roll.

"Twelve times rent roll in the Heights," exclaimed another owner walking in the door. "Who paid that?"

"You did," Was the response.

The startled owner immediately walked out of the meeting and went to have a long conversation with his partner in the deal. The partnership broke up over their differing views of valuations. Now, with 17 years of hindsight, I can tell you they were both right.

During the late 80's and early 90's values fell and some buyers who paid 12 times rents, even in Manhattan, lost buildings. Twelve times outside the Manhattan core was almost uniformly a bad investment.

But, if the buyers were able to hold on, the late 90's turned out pretty good for properties citywide. Rents had amazing resilience.

Now that multiples are multiplying again, the prevailing wisdom seems to be that, sure, the bubble may burst, but values won't drop as far, interest rates will support returns, and the cycle will pick up again in two or three years at most.

Unfortunately, I think there is at least one fundamental difference this time.

Until now, perversely, rent regulation has supported high multiples. Ten times a $400 rent controlled rent is a heck of a lot less than ten times a $4000 decontrolled rent, and those rent control vacancies were very rewarding.

The problem this time, as I see it, is that a combination of deregulation, vacancies, recession and sheer time has brought market rents and regulated rents together outside the Manhattan core - and even on most smaller apartments in Manhattan below 96th St. Rent rolls that had 70% of rents significantly below market in 1986 have only 15-25% below market today.

An equal percentage, 15 - 25%, is now often preferential rents, where the regulations simply permit more than the market will bear. The upside isn't what it was in the last cycle because we are starting from basically a market rent level.

That brings me to how buyers and sellers should value buildings today. As a buyer broker for AIMCO we are looking at property all the time with an "owner's eye."

What I am seeing is that New York City's real estate is beginning to look like the rest of America's.

We have institutional buyers looking to make steady cash returns instead of local entrepreneurs able to do a cash out refi in five years or a flip in three.

Oddly, the highest multiples are still being paid by the local families. I suspect that they don't see the fundamental change in rent quality, or don't believe it.

In fact, I'm not sure I believe it because, over time, New York's lack of housing supply could push rents up more than inflation would otherwise suggest.

But I am sure that short term they are going to be out of pocket. I saw two deals reported recently that prove math isn't always a buyers strong suit.

One was an eleven unit building bought with an alleged cap rate of 7.3%. After about $20,000 in taxes, the building could apparently be operated for $16,000 a year.

Another was a major package in Queens that, working backwards from the reported 10 plus multiple and 6.3% cap rate, had to be operated on 35% of rent roll. Sorry, that's not happening with today's taxes, fuel and insurance costs. The real cap rate has to be under 5.

REITs like AIMCO can pay fair prices in today's market and still make good returns, however, because, unlike most buyers, they can offer strategies for sellers to defer capital gains.

Ten million dollars tax deferred is equivalent to almost $14 million taxable for New York residents. Other investors can make deals on select properties because they can use foreign capital with interest rates in the 3-5% range, or pay slightly more and wait decades for a higher return.

What I am not sure of is how the traditional New York player plays this market.

Finally, I think the marketplace, in its own way, is telling us values are too high. Last year, according to CoStar reports, there were about 1060 transactions in New York City involving apartment buildings over six units. If the last quarter of 2003 maintains the current trend, there will be 40% fewer deals this year.

Copyright Real Estate Weekly, November 26, 2003