Archive for March 15, 2014

Are We Kidding Ourselves?

Earlier this week I attended a real estate panel in Manhattan called Beyond the Headlines:  New Development, Sales & Rental Market, put on by the Real Estate Service Alliance (RESA).  RESA is a group of people who, as its name suggests, provide services to the real estate industry; their periodic presentations are attended by brokers, attorneys, contractors, insurance professionals, environmental consultants, title insurers, expeditors, and the occasional owner’s representative (that would be me).  For this panel, a prominent local residential developer and three residential brokers who specialize in the marketing and sale of new developments discussed the current state of play in Manhattan and Brooklyn residential development.

On the condominium side, not much news here:  inventory is at an all-time low, sale prices are at all-time highs, and all the development activity is focused on the high end of the market.  The developer did acknowledge, to the agreement of all, that new rental development in Manhattan is all but impossible.  In view of the stratospheric price of development sites, you just can’t get these projects to pencil out to any acceptable return; there are no more “easy” 50 x 100 foot sites left; the only development deals in Manhattan that can be done are the ones that involve really difficult sites and significant entitlement risk; if only one could find a site that can be had for around $500/Buildable Square Foot, one could build condos that will sell profitably, and quickly, for under $2,000/SF.   Construction of new condo product, while climbing slowly out of the post-2008 cellar, remains well behind the pace set pre-crash, and still below historical norms.  The prediction was that the current scarcity will continue into 2016 at least, which means that sale prices will remain high for the foreseeable future.

On the rental side, average residential rents in Manhattan, while still higher than in Brooklyn, fell slightly at the end of last year; the feeling was that the market pushed back.  On the other hand, rents in Brooklyn are surging, and while rents there are still lower than in Manhattan, the gap between Brooklyn and Manhattan residential rents has never been so narrow.  Not surprisingly, Brooklyn is home to a lot of new residential rental projects.  One of the panelists noted that of the approximately 10,000 units slated to come to market in Brooklyn in the next two years or so, only 10% will be for-sale units, and the rest rentals.  These new rental projects are underwritten based on earning $55-$65/SF in annual rents: that means to you as a tenant, that your 400 SF studio apartment will cost you somewhere between $1,833.00 and $2,166.00 monthly.  These are big numbers for Brooklyn.

The most notable part of the discussion, for me, came when one of the panelists acknowledged that incomes are stagnant, and have been for some time, and job growth is virtually nonexistent.  Which led to the question I put to one of the panelists after the Q&A session:  if wages really are stagnant, and there really is no job growth, how does one reconcile these high rents?  And where are these tenants getting the money?

The answer was, simply and without blinking an eye:  Parents.  All of the tenants have parents who guarantee the leases, and who likely cover the difference between Junior’s income and the cost of Junior’s pad.

Put this in perspective.  A reasonably sized newly built rental apartment building in New York these days represents a development cost of between $90MM and $200MM by the time you’ve bought the land, built the building, carried the acquisition/construction financing, paid the architects, all the other consultants, fees, insurance, and so on (it’s a broad range, to be sure, but there are a lot of variables here).  In order to make this investment pay, the building has to be filled with tenants who pay the rent at the price that brings the needed return.  But in this environment, the tenants really don’t have the means to pay the rent because their incomes are too low, or they don’t have jobs, or they don’t have jobs that pay adequately.  Which everyone acknowledges.  So the economic success of this multimillion dollar investment rests on the parents’ guarantees, or on the ability of one generation to pay for another.

If we were tapping an endless supply of very affluent parents in perfect health who are extending their peak earning years well into their eighties, this might work in theory.  The reality is very different.  The parents are getting older.  They’ve seen their own investments hammered (at least until very recently).  At some point in the near future, they will either stop working, or work less, and their incomes will plummet.  Throw in the desire to see the world before leaving it, or some medical problems, or the need for extended care, or some other indignity of age that comes with a staggering price tag these days, and sooner rather than later the parents will need their money for themselves.  When this happens, forget the guarantee.  Any support that goes to Junior dries up, and if Junior’s earnings don’t pick up, which doesn’t look likely, there’s nothing to pay the rent.  You can guess the rest.

All in all, it’s a very shaky foundation for a very significant investment.  A better way would be to revert to the world the parents came of age in, when incomes really did rise, wealth was created broadly, and our economy really did grow.  Is that too much to ask?