What’s the cap rate, buddy? How to get development your community actually wants

A brief summary/disclaimer: All too often, terms like gentrification and displacement are tossed around, community residents are treated as passive actors, and the ensuing conflict between market-rate developers and affordable housing non-profits plays out in the media, like a spinning, frustrating wheel with no clear concessions or answers. At the end of the day, market-rate housing is developed, non-profits build a smattering of affordable housing, and the vast majority of people are stuck somewhere in the middle.

In contrast to finding the perfect zoning solution, the perfect affordable program, or the perfect preservation technique, the following post merely attempts to create a common-language for real estate development in New York City, centered around a simple concept: return on investment. It’s neither good or bad; this is just the way it is.

Many of today’s real estate investors base their decisions off of an ROI metric called a cap rate (discussed later). While I don’t attempt to argue for or against this metric of investment, I try to clarify the role this percentage plays in real estate. It is not personal, it is devoid of emotion, there is no “one” to blame. In real estate, everyone is looking out for their own personal best interest, even long-time residents, which is often the hardest thing to swallow. But if a community can harness this number, they may be able to guide investment, and ultimately, development, in ways that best benefit their long-term needs.

image via Flickr 'PT Money' ptmoney.com

image via Flickr ‘PT Money’ ptmoney.com

How does an investor think?

People who have money need to put that money somewhere. So think of it like this:

If you have a little bit of extra money, you may put it into your sock drawer or a bank, where it sits and loses money (due to inflation) at a rate of about 2% annually. Don’t worry, most of us only have about $6,000 worth of savings anyway, so it’s not that big of a loss.

If you have a bit more money, you may give it to others to hold onto in the form of a loan, also known as a bond. These can take a bit of time to mature (a.k.a. get your money back), but if you don’t need that cash for a while, it will still most likely retain its value over inflation, and you may make about 1-2% without doing too much work.

If you have even a bit more money, you may want to buy a share of a corporation. Your goal here is to not only stave off inflation, but hope that the company increases profits and shares them back with you in the form of a dividend. This is a little bit riskier because old companies cost a lot of money and don’t grow much, while new companies bounce up and down in value a bit. You need a lot of money, be able to keep it in the company for a bit, and wait to see what happens. A good mix of shares may go up 8-10% over longer periods… if someone is willing to buy them from you… at the exact time when you need that money back. Did I mention you need a lot of money?

For other people that have some extra money lying around, they may want to invest in real things, things they can use and touch, things like land and buildings. New York City’s Real Deal published a best places to put your extra money article which focused on this type of investing.

Basically, their metric for best boils down to cap rates, which is a common method for determining how much you get back, for putting your extra money into real things. As I mentioned earlier, this is not an emotional decision, this is just part of the real estate “game”.

Buy low, sell high: the NYC real estate primer

NYC real estate is great, and why so many people invest here in the City, including internationals. At its worst, it’s as safe as the bond market since it has almost always increased at greater rates than inflation, and property ownership still has a number of hefty tax benefits. But at its best, it can be pretty fluid and can provide dividends almost immediately. And unlike stocks, you yourself can directly add value to your investment, resulting in increased yields.

So a cap rate is a metric for an investment’s ROI:

Annual net operating income / purchase price

As someone with some extra money, an investor, you obviously want that operating income to be high and the purchase price to be low, depending on your disposition to risk.

But who wants to pay you lots of rent money if they don’t want to live there? Well, as someone with some extra money, that’s your job to figure out.

Transitional Neighborhoods

Stable, high-value markets like Midtown Manhattan, cost a whole lot of extra money, and only reap cap rates of around 4-5%, which is pretty similar to the national real estate average. Unfortunately, the price of a building in other parts of the country isn’t even a down-payment in Manhattan, so the barriers to entry are very high, even for seasoned investors. Crains just did a piece on how big-time investors are now beginning to leave Manhattan in search of higher returns. Cap rates are low, risk is low, but entry levels are laughable.

Then you have outer-borough products which are not necessarily as stable as Midtown Manhattan, say in places like Long Island City, Queens, and Park Slope and Cobble Hill, Brooklyn. Investors looking for a place to keep their extra money that is relatively safe but isn’t as expensive as Manhattan would probably end up here. They aren’t going to kill it on cap rates, but since building improvements can be made, and rent prices may still have room to increase, your extra money can make closer to 6-7%. Cap rates are good, risk is low, entry level is high.

Finally, you have what the Real Deal calls “transitional neighborhoods”. This is the crux of the piece.

These are areas where products have a relatively low value (purchase price), but with some improvements, they could see cap rates between 8-11% over a short-period of time. Improvements in this case mean property renovations and the attraction of higher-paying tenants. Think neighborhoods like Crown Heights, Bedford-Stuyvesant and Sunset Park, Brooklyn. Cap rates are great, risk is moderate, entry level is moderate.

If you’re a local resident?

So what happens to the existing residents of these neighborhoods? Well if you own property, you are probably either going to sell it or increase your rent. If you’re a long-time renter,  you may just end up moving somewhere else (although this may not happen as often as we once thought).

If you’re a local community group?

1) You should have already developed a community plan, and you should have started five years ago. What are your needs, how do you want to grow, that sort of stuff. These should be geographic and site specific. Talk to your local planner: do you want to focus on open space, affordable housing, or a lunar launch vehicle? Whatever it is, you should already have a plan in-place when the money starts flowing. Which it will.

2) Next, you’ll want to track the cap rates for your neighborhood. How? Remember, compare actual home-sale prices to actual rental prices:

  • If your neighborhood’s cap rates are low, but have been trending upward, keep an eye out because you may soon be seeing investors.
  • If your neighborhood has high caps, then investors are already eyeing your community: rents are increasing but home values are still relatively low.
  • If cap rates are falling, most likely it’s too late and you can’t afford to buy anything anyway (or you just had a riot or drug epidemic and people are mad sketched-out).

3) Finally, how does a community stop a storm surge of investors? You can’t. You can only steer it.

The fact remains that we live in a capital-driven society where people want to put their extra money into an investment. “Downzoning” won’t stop them, landmarking will just drive up the price, and permitting fees will only be calculated into future rent roles. Instead, your job is to guide them based on step #1. You need to create a product that gives comparable market-value yields, which is especially true for long-time residents looking to sell.  This leaves you with two methods to achieve the community’s stated needs: give out tax credits or give them a return on your investment.

  1. Tax Credits: not only are they subject to political machinations (they can disappear), but they are also complicated (think middlemen), they are inefficient forms of investment (lucky to make 75 cents on every dollar), and not everyone needs them equally (less income means less tax liability).
  2. ROI: in contrast, most everyone is happy with a 7-10% return on their investment, so why not have people invest in your community needs? If your neighborhood project’s cap rates equal that of the market’s, there is literally no reason an an investor would choose your project, from affordable housing to an office building, over any other. Of course it’s your job to figure out how to actually make that work (formica counter-tops may be in your future).

And now is when I recommend you reread the NYC Real Deal article. In it, they suggest creating a ready-made syndication deal or local real estate investment trust (REIT); so why not for your affordable housing project? With a couple of larger investors, you could even have reduced minimum investments for locals, allowing them to get-in on the improved markets in their neighborhood, too.


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