WHITE PAPER: What To Buy In An Ever-changing Market? A Contrarian's Guide To Investing

February 7, 2022

By: James Nelson

When I started in the business over twenty years ago, investors stayed in their lanes. From a broker’s perspective, it made our job easy as the same group of buyers seemed to show up each time. Multifamily operators would buy apartment buildings in their specific neighborhoods. Retail investors with great tenant relationships bought in the same corridors. The office owners continued to grow their massive portfolios in their submarkets. We knew the developers who had the track records to borrow and build. Specialty asset classes such as data centers and life science didn’t exist. The business back them was predictable.  

I also don’t remember buyers talking about other markets. Owners were proud that they could walk to their entire portfolio. Post-COVID, real estate investing has been turned on its head. The hybrid work model has scattered employees, and along with it, investors all over the county.  

That doesn’t mean people all left New York for the Southeast, a popular anecdotal conversation. If PopulationU’s data is correct, New York City’s 2021 numbers increased a modest .22% to 8,823,559, albeit much better than the feared mass exodus. P.S., the same site predicts Miami’s population will grow by less than 300,000 from 2020-2025.  

Clearly, the residential rental market would support New York’s resurgence. According to Jonathan Miller, its latest vacancy rate is sub 2% and Manhattan average rents set a record at $3,400 in December, a typical sleepy month. With this in mind, job growth may no longer be the most active indicator for a real estate growth as jobs are now portable. All remote workers might not be sitting on the beach – many are hanging out in East Village coffee shops. 

Adding to the complexity of where and what to invest in is a whole host of regulatory pressure especially for multi-family. Universal rent control has happened in California and Oregon, as well as in Minneapolis. New York’s State Senate has been considering Good Cause Eviction which would also create universal rent regulation. As a result, investors now are thinking of diversification for both location and asset class selection.

With this all in mind, excluding industrial and medical which have performed well throughout COVID, I would suggest that investing in New York all together is contrarian with varying levels of risk depending on the asset class. In order, I would rank them along the risk profile:

1. Multifamily

We have witnessed several New York families who have been quietly selling their New York multifamily holdings and buying in red states where the tax treatment, and arguably business climate, is more favorable.  Many residential operators and developers are piling into these States. As a result, cap rates have even dipped below 3%. The anticipated rent growth to justify these acquisitions in many cases are at north of 10% per year. Meanwhile, Manhattan’s average multifamily cap rates for 4Q21 were 4.6%. 

The tradeoff for multifamily investors is to buy into higher yields, while taking on the risk that Good Cause may cap future rent increases.  In my mind, much of this also depends on an investor’s timeline. For those looking to reposition and sell within a typical five-year hold, the passing of Good Cause could be disastrous if passed. Whereas if not, the stabilized return on cost could end up well into the 6% range if not higher.  In Southeastern cities, the hope might be to stabilize at 4.5-5% returns which is where you start off at in NYC. Those who can take a longer view, can also put accretive long-term debt and just enjoy the cash flow. This certainly applies to a fully regulated building where rental increases are dictated by the City’s Rent Guideline Boards, which currently posted a negligible increase of only 1.5% in the second half of a one-year lease, which in most cases will not keep up with real estate taxes increases. 

2. Retail 

I am a strong proponent of retail investment, especially on New York’s high streets. The average cap rates in NYC this past year were 5.19%. After the impact of eCommerce and then COVID, retailers have been reeling. The neighborhood retailers and restaurants have been able to survive in many cases with landlord help, granting concessions. We are now seeing many arrangements where the base rent was cut and then the balance is tied to a percentage rent.  Guesst.co makes it possible to track these types of arrangements, which might become the new norm and a win-win for landlords and tenants. 

I believe high street retail could be the best investment bet today. It is clear to me that the drop in international tourism explains rents that in some cases are now off 38-63% in cases from peak (REBNY’s report sites Fifth Ave rents in the 50s down 38% from Spring 2018, Broadway rents in the 40s down 59% from 2015, and SoHo’s Broadway rents are down 63% from 2015. NYC tourism numbers were 66.6 million people in 2019 and then dropped 67% in 2020 to 22.3 million. Gov. Hochul announced a $450 million plan to bring back tourists. Inside Out Tours is predicting there will be 55 million visitors this year.   Once tourism comes back, the pendulum will swing back on rents, maybe not to their all-time highs but certainly well above where they are today. 

3. Development

Although Gov. Hochul has stated her support for development by proposing the removal of residential height caps, the details of the new 421a program still needs to be hashed out. The good news is that it looks like the valuable 35-year tax abatement could stay in place, provided there are greater affordability thresholds met. The popular Option C of the current program Affordable New York, allowed for 130% of the Annual Median Income for its 30% affordable requirement which in many cases produced market rents. Without that, developers will have to wait to see what levels of AMI will be required and if the 35-year abatement will stay in place. The current program expires in June, so developers are staying on the sidelines until this is confirmed. I would view this as a very risky proposition to purchase without knowing the viability of the future plan.

Meanwhile, I view condo development as an incredible opportunity.  Condo units have witnessed record sellouts, so the inventory as been depleted. With the dearth of land sales over the last two years, there will be little competition. Private lenders looking to place money are willing to lend and developer friendly pricing. Anecdotally, there hasn’t been much land on the market as long-term owners have held back which makes the need to be creative an assemble all the more important. 

According to Compass, during 2021, despite a 16-year high in new listings, supply was overpowered by demand not seen in over 30 years. These competitive, high-velocity markets provide sellers with a perfect environment for unearthing maximum sales price. 2021 sales volume totaled $30 billion, 6% higher than the 2007 record and median price rose 11% YOY; pricing is largely back to pre-COVID levels (~2019).

4. Hotel

Hotel investment is without question the riskiest and most contrarian investment.  There are still thousands of rooms offline and many hotels may no longer be viable. The expense of running larger, union hotels make them unprofitable to operate especially in tourist driven locations. That being said, I’ve heard that many of the hotels are beginning to fill up again with an ease of travel restrictions. There are also surprisingly more hotel units planned for delivery.  

Developers are closing watching if hotels in commercial zoning will be allowed to be converted to residential and if so what the affordability requirements will be. Like the 421a program, the devil will be in the details. 

5. Wild Card - Office

Lastly, it is difficult to consider all office investment as contrarian as it’s a tale of two markets. Last year in NYC, the average cap rates were 4.43%. There has no doubt been a flight to quality with the best buildings achieving triple digit rents again. Meanwhile, the overall market has an 18% availability rate which constitutes roughly 100 million square feet of space. Class B and C offices will be hit the hardest. The question here again is if this office product can be converted to residential and whether or not it makes economic sense depending on what types of affordability requirements are mandated by Albany.