WHITE PAPER: Will a Dearth of Development Save NYC’s Real Estate Market, Again?2 Nov 2020
By: James Nelson & Craig Leibowitz
Emerging hardships in the formerly steady office and multifamily rental sectors coupled with prevailing fundamental concerns affecting the residential condominium, hotel and retail sectors have caused the land sale market to grind to a halt. Eight land sites were transferred in the second and third quarters, including those that were in contract pre-COVID. The total square footage tally of these sites is only 317,000 SF when excluding pre-COVID contracts. The annualized development potential of land sales in the second and third quarters of 2020 represents less than 10% of the development potential of peak 2007 and 2015 levels. Development sites are emblematic of elastic demand, meaning the pricing and activity of this segment regulates itself over the course of development cycles.
There has been less than 15 million square feet of land sales in the past five years, accounting for just 40% of the square footage of the five-year period before 2015 when conditions were comparatively ripe for new developments across property types. Land pricing has softened as anticipated, decreasing by 22% to $483 per buildable square foot in the past year. Should land pricing remain near or below present levels, developers could achieve sufficient risk-adjusted returns while benefitting from a temporary slowdown in construction activity and potentially stronger economic conditions in the next cycle.
Employers placed a greater emphasis on new office properties prior to the pandemic to capitalize on greater efficiencies and to favorably position themselves to attract and retain talent amidst competitive labor market conditions. Still, Manhattan is saddled with the oldest inventory of any major office market in the globe by some measures, despite the scale of new supply additions at the Hudson Yards and World Trade Center megadevelopments. Unlike Beijing or Moscow, speculative office developments are rare in New York City – the towers at the aforementioned mega-developments were only built once an anchor tenant was secured.
Think back to 2009 when the market last came to halt: that year, 11 Times Square was the only one office building built. Construction of new office buildings is positioned to remain limited unless built-to-suit projects commence, such as the new headquarters for Google and Disney in Hudson Square. Prolonged development pipelines, the necessity of anchor tenant commitments, the profitability of alternative uses such as residential and hospitality, and prohibitively high hard and soft development costs have kept the supply of the 465-million-square-foot office market relatively in check.
However, cracks are emerging in the office market. Leasing velocity has temporarily paused as many tenants are cautiously navigating the pre-vaccine workplace environment, which has postponed some long-term commitments and incentivized short-term renewals, while fair market value remains fluid. As of 3Q 2020, the office vacancy rate rose to 12.7% from 9.8% year-over-year. We are closely monitoring sublet vacancies, which have almost doubled to 17 million square feet in the past year as select companies are offloading excess space and office users across industries are reconsidering their near- and long-term occupancy strategies. The proportionate share of sublease-to-overall vacant space was 28% as of the third quarter, which is important to consider because landlords began to reprice their space when this ratio reached approximately 30% in the past two downturns.
Most would agree that downward pressure will be exerted on rents as demand remains slow and vacancy rises in the near-term; however, the available supply of new office towers remains limited and tenants could place a greater emphasis on buildings with modern systems, security protocols and floorplan layouts. These considerations would favorably position prospective land purchasers for office sites, especially in transit-oriented office districts.
According to Axiometrics, effective rents in the New York-White Plains market decreased by 9.5% quarter-over-quarter, a percentage decrease that was last reported in the third quarter of 2009. Renter demand for Class A units is poised to recover when employers return to some degree of normalcy, enabling new development projects to attain absorption and profitability hurdles that could serve a market that remains underserved by housing.
Long one of the most stable property sectors in New York City, multifamily rental fundamentals have become strained during the pandemic due to its immediate and acute impact on discretionary employers and a net-migration of individuals out of New York City.
Meanwhile, there has been much concern about the Manhattan condo market, especially the shadow inventory that exists. Market-proof estimates that 15,000 units remain unsold. According to CoStar, more than 11,200 units have been delivered in Manhattan from 2015 to present, nearly matching the total and annual unit deliveries during the 2004 to 2009 construction cycle. A development lull prevailed from 2010 to 2014, whereby just 2,600 units were constructed. There will be more supply concerns in 2021—more than 2,600-unit deliveries are expected—though just 1,000 new units are expected from 2022 to 2024 combined.
We have the lending community to thank for this supply control. Today, the only way to get a residential construction loan is if the project underwrites as a rental project with strong sponsorship. For contrarians, if a site can be acquired at a rental basis and condos can be constructed, they might be well-positioned. The question then becomes if they can secure the equity to do so. Fraught with overly ambitious underwriting standards in the past development cycle—namely elevated per-unit and per-square-foot pricing and absorption expectations—condominiums became a “four-letter word” in the private equity community. Tempering both underwriting standards would favorably distinguish projects that deliver in the next cycle.
Above all, the most important thing to consider when constructing is the delivery date. If a shovel is being put in the ground today, how much competition will exist in 2-3 years upon completion? Based on the slowdown in development site activity alone, supply risk is anticipated to remain low. When MaryAnne Gilmartin spoke to our office early on during the pandemic, she said it was a lot easier to think about future delivery in a post-vaccine world compared to the realities today. We wonder how many people would agree.