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Equity Residential spent $93.1 million to buy Hudson Crossing, a 259-unit apartment complex on the western edge of Midtown. Signs of the late-stage condo boom are hard to ignore. These new units, many of which are not flying off the shelves, are fueling speculation that New York City is facing a condo glut. Real estate research firm Reis Inc reports a 2.9% apartment vacancy rate in New York City at mid-year, the lowest of any major US market. Paring down the number of rental units proved healthy for the apartment market, but the trend will not likely last. The trend of falling condo prices and rising apartment rents has not gone unnoticed by investors, either. One thing that is fairly certain is that New York City's apartment market will continue to lure hordes of capital.

Equity Residential made quite a splash in 2004 when the behemoth apartment REIT chaired by billionaire investor Sam Zell made its first foray into Manhattan's rental market. The Chicago-based company spent $93.1 million to buy Hudson Crossing, a 259-unit apartment complex on the western edge of Midtown.

The price wasn't steep enough to raise eyebrows. But the deal was exceptional for another reason. Unlike most investors that had recently bought New York City apartment buildings, Equity Residential chose not to convert Hudson Crossing into high-priced condos.

Alan George, chief acquisitions officer at Equity Residential (NYSE: EQR), says it wasn't an easy decision. "Condo conversion is like a drug. It's very hard to resist doing this in a market like Manhattan," says George. Equity Residential has spent more than $1.07 billion on Manhattan apartment properties over the past four years, including shelling out $816 million to buy Trump Place, a three-building apartment complex.

Signs of the late-stage condo boom are hard to ignore. Some corridors of the city are so crowded with shiny glass condo towers that entire block-long stretches of sidewalk are hidden beneath protective sheds.

Supply concerns

These new units, many of which aren't flying off the shelves, are fueling speculation that New York City is facing a condo glut. Miller Samuel, a local appraisal firm, reports that 3,535 new condo units hit the Manhattan market in the second quarter compared with 1,827 units for the same period a year ago, a 93.5% increase.

One hotspot is West 18th Street, which cuts across the eclectic Chelsea district. No less than three condo towers, all conversions or new construction located within as many blocks of one another, have risen along this street within the past two years. Developers aren't being too picky about sites, either. One 15-story project rising on Seventh Avenue and 19th Street is being developed adjacent to one of the city's busier fire stations.

There's just one problem. Many of these new condo units are colliding with slackening demand. Miller Samuel reports that only 1,934 Manhattan condo units were sold during the second quarter this year, a 14.8% decline from the same period in 2005. That drop is significant because the second quarter typically generates the highest sales volume of the year.

Ripple effects from this overabundant condo market are changing the way some investors view the market. Specifically, the flood of condo units is steering some investors toward the rental market, which in New York boasts incredibly low vacancy rates and rising rents. As George of Equity Residential puts it, New York City's tight rental vacancy and huge barriers to entry are extremely attractive features for any investor.

Rental calculus

There's no question that New York City's strong real estate fundamentals, propelled by a growing economy and a scarcity of land, are enticing for investors. Real estate research firm Reis Inc. reports a 2.9% apartment vacancy rate in New York City at mid-year, the lowest of any major U.S. market. Manhattan, the epicenter of New York City condo development, registered a paltry 0.5% apartment vacancy rate at mid-year.

"[Apartment] vacancy is extremely low in the New York City market, especially in Manhattan," confirms Dr. Sam Chandan, chief economist at Reis. His firm tracks 143,221 investment-grade rental units throughout all five boroughs. Most of those units are located in Manhattan.

"You also have so much demand in this market because it's so expensive to buy condos or co-ops in the entire city," he says. Chandan adds that two-thirds of all residents living in the New York City metro area rent apartments. For the nation as a whole, however, the reverse is true: roughly two-thirds of all Americans own their homes.

The New York City market certainly is not cheap. Based on data from the National Association of Realtors, the median sales price of a single-family home in the New York metro area registered $458,500 at the end of March compared with a national average of $217,900. The flip side, however, is that New Yorkers take home fatter salaries than most Americans. According to the Bureau of Labor Statistics, per capita income in the New York metro area averaged $43,277 in 2005. That registered 31% higher than the national average of $33,050.

This buying power, propelled by lofty bonuses paid out to Wall Street executives, is what condo converters have bet on in recent years. Plus, as residential values have soared since 2001, condo conversion activity has followed suit. Nearly all new housing units added to Manhattan's inventory in the past three years have been delivered as condos, be it new construction or conversion from rental buildings, reports Miller Samuel.

Chandan, the Reis economist, notes that many older apartment buildings, not to mention office buildings, have been converted into condos. He credits this conversion trend for thinning the rental inventory by 7,345 units over the past three years.

Chandan declines to estimate how many additional units will be thinned out of the rental inventory over the next few years. Like other New York real estate experts, Chandan believes that a certain number of condo conversion projects will switch gears to rental use in the coming months.

Conversion-led sales momentum

Apartment investors looking for deals may actually benefit from a slowdown in conversion-led apartment sales. The reason? Condo-mania, which has pitted aggressive buyers against each other for deals, has chiseled away at apartment yields. The average capitalization rate - the initial return based on the purchase price - on Manhattan apartment buildings fell by 100 basis points to hit 4% between mid-year 2005 and 2006, reports Real Capital Analytics, which tracks sales $5 million and higher.

No other market in the U.S. posted such a sharp decline in apartment cap rates during the period. According to Dan Fasulo, Real Capital Analytics' national director of market research, Manhattan's $2.5 billion deal volume during the first half of 2006 represented almost 40% of all mid- and high-rise sales volume in the nation.

It's easy to see why. Converters have spent more than $12 billion buying up older apartment and office buildings in New York City over the past two years, reports Real Capital Analytics. During the preceding two-year period, converters spent less than one-quarter of that total on apartment buildings. It also appears that 2005, which broke the record for the single-most expensive apartment sale to a condo converter, was a peak year for conversion-led apartment sales (see sidebar, p. 46).

Paring down the number of rental units proved healthy for the apartment market, but the trend won't likely last. At least one local sales broker says that conversion deals are becoming increasingly rare in the New York City market (see sidebar, p. 48).

"The capital markets have really shut down on these conversion projects," says Jeffrey Appel, managing director of Manhattan-based residential brokerage Pari Passu, who hasn't come across any new conversion loans of $100 million or more over the last eight months.

According to Appel, the average price of a new condo unit in Manhattan has fallen by as much as 10% over the past six months. It's a different story on the rental side of the aisle. Appel says that some Manhattan apartment rents have risen by as much as 10% during that period.

Meanwhile, the average rent for a New York City apartment unit rose by 6.7% between the end of 2005 and mid-year 2006. The average rent in New York City registered $2,469 per month at mid-year, up 1.6% from the end of March.

The trend of falling condo prices and rising apartment rents has not gone unnoticed by investors, either. Local sources believe that an increasing amount of capital will flow into new rental development in the next few years. There is already a fair amount waiting in the wings.

According to the New York City Rent Guidelines Board, which tracks new apartment growth in the city, 20,382 new rental units were completed in 2005, the largest number in any year since the mid-1970s when federal housing construction brought 21,000 units to the market. Permits for roughly 31,559 new rental units were issued in 2005, up by more than 6,000 units in 2004.

Sources credit two trends for this jump in new rental supply. Years of rezoning campaigns have left many areas of the city, particularly large swaths of lower Manhattan and the Brooklyn waterfront, ripe for residential development.

Couple that with New York City's ability to boost apartment rents every year for the past 15 years and it's easy to understand why developers have raced to get building permits in recent years.

Trusts remain active

One thing that's fairly certain is that New York City's apartment market will continue to lure hordes of capital. REITs such as Equity Residential, Archstone-Smith and AIMCO are leading the charge. Up until two years ago, the REITs largely avoided this market.

But the seeds of that change were planted in 2002. That year, Archstone-Smith spent $209 million to buy 101 West End Avenue, a high-rise apartment complex on Manhattan's upper West Side.

Archstone-Smith also plunked down another $125 million in 2004 to buy a rental tower on East 39th street. Both apartment buildings, which Archstone continues to own and operate, remain rental properties.

Only two years after its Hudson Crossing deal, too, Equity Residential continues to whet its appetite for Manhattan apartments. Last summer, for example, the REIT spent $803 million to buy Trump Place, a 1,325-unit high-rise located on Manhattan's far west side. That deal now stands as the second most expensive apartment acquisition in Manhattan history.

But a record breaker may be in the offing. In July, insurer MetLife announced plans to sell its sprawling rental apartment campus, known as Peter Cooper Village and Peter Stuyvesant Town, for an undisclosed price. The 11,200-unit complex, which straddles seven acres of land below East 23rd street, contains the most units of any single apartment complex in New York City.

For the past four years, MetLife has been selling off its real estate holdings. MetLife stated publicly that it will only entertain "acceptable" offers on the Peter Cooper Village and Peter Stuyvesant Town complex. In early August, the insurer hired CB Richard ElUs to market the complex. Neither CB Richard Ellis nor MetLife were willing to discuss the sale as of late August.

Analysts and local brokers believe that the campus could fetch as much as $4 billion. A sale of that magnitude, of course, would enable bidders to place a record-breaking bet on the future of Manhattan's residential market. And the possibility of 11,200 condo units hitting the market at some future point could be huge.

"This could be such a large deal that it might attract a group of private equity firms or some combination of private equity and REITs," according to Fasulo of Real Capital Analytics. "Nobody really has any sense of what the pricing could be on this deal though."

One REIT that Fasulo expects will eye this deal is Equity Residential. The REIT has a solid track record of buying large rental complexes in Manhattan in recent years. George, the chief acquisitions officer with Equity Residential, declined to comment on whether or not the REIT is seriously considering a bid on the complex, but his remarks certainly left the door wide open for such a bid.

"I think it's a fascinating deal, but it would be quite a challenge," says George. "It's something we would look at, though."