Macklowe/EQR Manhattan Multifamily Deal Not Necessarily A Benchmark Transaction

I've had a couple of people ask me about the recent sale of three buildings by Harry Macklowe to Sam Zell's Equity Residential Properties. I love the title of the Wall Street Journal blog post "'Grave Dancer' Sam Zell Returns to Haunt Macklowe", which points out the searing irony that it was Macklowe's top marking purchase of assets from Zell's Equity Office Properties that drove the Manhattan real estate mogul to ruin in the first place, and now he is being forced to cough up some prize New York City multifamily assets to Zell to try to save himself from debtors prison. But I think i the story makes for slightly better copy than the reality of the deal price really reflects.

According to J.P. Morgan analyst Anthony Paolone quoted in the Wall Street Journal's original article on the deal the $475 million price tag for the RiverTower, 777 Sixth Ave and Longacre House, reflect a 30% - 50% discount to what they would have sold for at the peak of the market. The published numbers imply that the purchase price represents about $470,000 per unit and $545 per square foot. Recall that I implied in a recent article on the Stuy Town deal that a bargain for rent-regulated apartments in Manhattan proper would be $200k per unit, but realize that the buildings in this transaction are prime full market rate buildings. According to EQR's 10K it's average rental rate in New York City was $2,748 per square foot (well above rent regulated rates commonly seen).

According to EQR's press release the cap rate for the transaction is 5.52%. If we assume that the apartments being acquired, which are very high-end assets, garnered a premium $3,000 per unit /month in rent, gross Income from the 910 apartments would be around $2.7 million per month or $33MM per year. Factor in a historic vacancy and collection loss rate of 5% and operating costs of 40% (assuming these guys are really good on cost controls due to the leverage of operating 6,246 additional units in New York City according to the last 10K), the properties would be throwing off around $19 million per year from the residential segment (note that the operating expenses implied above should also cover running the retail and parking garages in the buildings). This would leave $7.2MM of NOI attributable to the 23,339 feet of retail space and 50,000 square feet of parking garage or $98 per square foot (I won't split the atom on these numbers but they make sense to me). So the stated cap rate appears not to be based on a fluffy pro forma NOI number, but rather one that would make sense as being based on actual trailing 12 months numbers, or reasonable projections for 2010.

So the question becomes, should a 5.52% cap rate be assumed to be the new "benchmark rate" for midtown Manhattan market rate multifamily transactions? Now I know there are those who will call me an old grandma stick in the mud with no vision, but I have trouble with people buying properties for cap rates below their financing rates. I am pretty sure that financing rates for these assets are around 6% today (I checked with a buddy who is closer to these kinds of deals). To the extent that these assets are leveraged to any degree (say 60% LTV), the implied return to equity would be 2% or less. This is unless the NOI somehow is much higher in the future, due to significant rate increases above operating expense inflation or conversion to condos. Haven't we already been here before and seen what happens when valuations are pushed due to expected upside that is on the come?

So why does Sam Zell's Equity Office do a transaction like this? I believe that the answer lies in its status as a REIT. As a diversified real estate operating company, a REIT can take on debt secured by its properties, but can also take on unsecured debt that has recourse only to the equity of the REIT itself. They get double leverage. In fact, according to EQR's recent 10Q, the firm has nearly $5 billion of debt secured by properties and about $5 billion of unsecured debt. The weighted average rate on its unsecured debt is just 5.32% or less than the 5.52% cap rate on this property. Not only that, the firm's unsecured debt constitutes an amount roughly equal to the firm's $5 billion of shareholders equity. When you include the firm's secured debt, it's debt to equity ratio is roughly 2:1. If they merely buy the asset for cash, using corporate level debt, leverage gives them a significantly better return than the headline cap rate.

So much for the theoretical aspects of this discussion. A buddy of mine who happened to have a discussion with one of EQR's people in their southeast division about a property in that area got right to the source. Being a New Yorker during his conversation with the EQR employee he had to ask about this deal. What he was told, was that the firm was most excited about the fact that they believed that the $545 per square foot they were paying for the properties was well below "replacement cost". To break this down a little, assuming a $400 per square foot high-end construction cost in New York City not including financing costs, they are paying $145 per FAR for the land. Considering the prime locations for these assets, that is indeed a bargain even in today's horrible land market and EQR certainly has the wherewithal to make some selective bets on land value in its portfolio.

When looking at the value of a property transaction as a benchmark for other transactions, one must always factor in whether the buyer had special financing unavailable to the buying public at large. One must also take into consideration whether the sale was made under normal marketing conditions or duress. In the case of Macklowe's sale of these properties, both of the aforementioned factors were at work. Could a better price have been garnered given a longer marketing period? maybe. Is this property worth the same amount to any old commercial real estate investor as it is to Equity Residential Properties, no way. EQR has economies of scale in property management in New York City, a purview that includes land purchases and development and favorable financing not available to just any old player (although available to a handful of other REITs).

All of the above said, it is good to see some assets trading in New York City that look to me to be at decent prices for the seller (despite that seller being somewhat "under the gun"). Such a transaction, which is partially a land bet, implies that a very knowledgeable buyer and local asset manager believes that rental fundamentals are bottoming and will ultimately improve and/or that redevelopment of the properties in question either as condos or ultimately as some higher and better use will be fruitful.

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