It’s the End of the World as We Know It
Yes, those are words from the famous REM song but they are more applicable today than ever when it comes to the New York City commercial real estate market. The recently passed new rent regulations are catastrophic for the commercial real estate market, for the New York housing market and the tenants that are going to have to live in the apartments of tomorrow.
If you are a frequent reader of Concrete Thoughts, you know my passion for my beloved New York Yankees and the vivid illustration from 1977 that I often use when discussing the housing market. During the 1977 World Series the Goodyear blimp panned out and showed several fires burning around the stadium. Howard Cosell famously pronounced: “The Bronx is burning.”
Why was the Bronx burning? In those days it was more economically feasible for property owners to burn their buildings down and collect insurance proceeds than to invest in their properties. Today’s politicians must be yearning for those days to come back because the legislation they have passed recently will undoubtedly return the market to those days of yore.
The response to the crises of the 1970s was to create incentives for the private sector to invest in the housing stock. The Major Capital Improvement (MCI) and the Individual Apartment Improvement (IAI) mechanisms became an incentive for the private sector to invest in their buildings rather than destroying them. The results were remarkable. In the mid-1970s, the dilapidation rate in the New York City housing market was experiencing a 14 percent dilapidation rate, meaning 14 percent of housing units were uninhabitable. The MCI and the IAI went into effect and the private sector plowed hundreds of billions of dollars into the housing stock to improve the quality of their buildings and simultaneously create better living conditions for the tenants. Today, the dilapidation rate is a mere 0.04 percent. I predict the current regulation changes will bring the level back up to double digits.
While not completely eliminated, MCI and IAI programs are marginalized to the point where they will not incentivize private sector investment. The MCI program will scrutinize the items investments are made on, and then, with a smaller basket of items that will qualify, the pass-through has been reduced by 67 percent. With regard to the IAI, the average investment made by owners to their apartment is about $60,000 per unit. Today, the IAI limit is a mere $15,000 over a 15-year period.
One of my smartest clients recently purchased two used appliance dealerships. The brilliance here is that no one will put new appliances in their apartments when they become vacant. They will put duct tape over holes in the wall, replace non-working appliances with used ones, and do the absolute minimum to avoid violations. The politicians who supported this legislation don’t care about the quality of life for their constituents. They just want to stick it to the private sector.
For decades, the capitalization rates, or the yields required on multifamily assets, were by far the lowest of any product type in New York. The reason for that is because rent regulation created artificially low rent levels. There were several ways to increase the performance of those buildings which is why property owners were willing to invest tremendously in their properties and over time yields would increase. Today, the new regulations virtually eliminate those ways to create additional value so the renovation dollars that previously were deployed into the housing stock will stop flowing. The housing stock will deteriorate as owners opt for the cheapest fix to their units. The bare minimum is all that will be done. This will lead to the deterioration of the housing stock and the dilapidation rate will climb toward what we had when Reggie Jackson was crushing home runs.
In fact, in the past three days, I have spoken to four clients that have fired a total of 314 laborers who were previously on staff to renovate apartments that became vacant. Seven architects who were on staff are also now out of work. These are just some of the unintended consequences of foolish legislation by officials who don’t understand how these markets work. Some owners have told me they will simply put plywood over the doors and windows and wait until more reasonable rules are implemented to put the units back on the market.
With the stroke of a pen, hundreds of billions of dollars of equity value has been vaporized in our multifamily housing stock.
So what does this mean for property values? If cap rates were low because the upside potential of properties with rent regulated tenants could be extracted, and the ability to extract that upside is eliminated, cap rates have to rise. How much do they have to rise to incentivize investment? Buildings with an overwhelming percentage of rent regulated units will see their net operating incomes drop year over year over year. What is the appropriate cap rate for a consistently declining cash flow? I have asked several clients this question over the past few days and no one could answer. It’s like having gold in a vault with no combination to the safe, no key to open it and no current technology to crack the lock. What would someone pay for this opportunity? (Answer: Who the hell knows.)
Is this the beginning of the end for New York City? This is bad and there is no light at the end of the tunnel. Public housing has demonstrated what living conditions become when there is no incentive to invest in the housing stock. I love this city and want to see it shine and thrive. There is always a reason why civilizations and cities lose their standing in the world. What will bring us down? Look around, this may be it.