FEATURE ARTICLE, MAY 2007

CAPITALIZATION RATE ARBITRAGE
Trading future upside for current yield.
Jeffrey Dunne and Patrick Bisceglia

The financial term arbitrage, defined as the simultaneous purchase and sale of the same securities, commodities, or foreign exchange in different markets to profit from unequal pricing, is an investment strategy that capitalizes on the unequal pricing of assets or asset classes. Last year, we discovered that many real estate investors are now executing an extremely profitable arbitrage strategy, a strategy that has allowed them to profit from unequal pricing of assets in different industry sectors: selling urban residential assets in New York and the Boroughs and purchasing retail and net leased assets in the suburbs.

In real estate, the pricing of assets essentially boils down to defining, measuring and evaluating one key variable: risk. Risk, whether real or perceived, comes in many forms that are unique to real estate investments, such as business risk, financial risk, liquidity risk, purchasing power risk, management risk, interest rate risk and legislative risk. These additional risks associated with real estate investment have historically translated to above average returns relative to most alternative investments. As a general rule, the higher the risk, the higher the anticipated return.

However, with the bond and stock market providing relatively low yield, investors have flooded the real estate market in recent years looking for current yield and long term appreciation. Many have settled for yields that are anemic relative to historical yields on real estate investments, satisfied with the preservation of capital and an overall yield premium to stocks and bonds. The excessive capital flowing into real estate of all types has compressed capitalization rates on certain asset classes below the rates at which one can borrow and has many investors banking on the upside to create an acceptable yield.

No industry sector has seen more of this phenomenon than multifamily housing, which has been the favored asset class in recent years due to escalating home prices, strong rental demand and conversion from rental housing to condominiums. In markets like Manhattan, Queens, Brooklyn and the Bronx, apartment buildings are still trading at cap rates in the 3 percent to 4 percent range. The continuing strong demand for housing in these locations and a progressive loosening of rent stabilization/rent control restrictions has investors willing to buy assets based on the perceived upside — deregulating units and/or converting them to condominiums. Stuyvesant Town/Peter Cooper Village, the $5.4 billion blockbuster sale of 11,232 units in Manhattan completed by CBRE, for example, traded at a 3.1 percent cap on this basis. Other Manhattan apartment deals have also traded in this range in 2006.

Even in the surrounding suburbs, well-located apartment buildings have traded at cap rates between 4 percent and 5 percent. For example, our team sold Hastings Terraces/Osborn Manor, 198 rent stabilized apartments located in Hastings-on-Hudson, and Dobbs Ferry, New York, two prime Westchester towns earlier in 2006 for what amounted to a 4 percent cap on the seller’s actual NOI. We also sold two core apartment properties — Avalon Corners (195 units) in Stamford, Connecticut, at a 4.5 percent cap and Merritt River (227 units) in Norwalk, Connecticut, at a 4.7 percent cap, as well as two conversion deals — Dixon Mills (467 units) in Jersey City, New Jersey, for a 4.4 percent cap and River Hill Tower (262 units) in Yonkers, New York, for a 3.9 percent cap. Even with interest-only debt at 100 basis points over the 10-year Treasury, which is currently about 4.7 percent, there is no positive leverage in the first few years on any of these deals, without significant rent growth.

However, capitalization rates on other asset classes, such as retail centers in the suburbs, have stayed within ranges that permit positive leverage, particularly with interest-only debt. Community centers in strong suburban locations with strong anchor tenants and inline store sales are still trading at 6.25 percent to 7 percent cap rates. For example, recently, our team arranged the 1031 sale of Eagle Road Shopping Center in Danbury, Connecticut, a 214,033-square-foot newly built power center anchored by Lowes Home Center and Best Buy. The property traded at a 6.5 percent cap rate based on in-place income. At these higher cap rates, investors can realize positive leverage, particularly with interest-only debt.

Assuming market rate financing (5.75 percent interest only, 80 percent loan-to-value), and cap rates between 6.25 percent and 7 percent, the yield on these investments can be levered up to 8.25 percent to 12 percent, representing a significant spread over the typical all-cash yield of many apartment sales as discussed above. The chart on page 58 highlights the potential yield range.

The unequal pricing of asset classes has given birth to this highly profitable strategy for investors who are willing to trade the perceived upside in their apartment buildings for the immediate high yield of a suburban retail or net leased asset, a trend that should continue into 2007. In some cases, the immediate increase in yield can be dramatic.

The seller of River Hill Tower, a 262-unit complex in Yonkers that sold in April 2006 for $52.25 million at a 3.9 percent cap for condominium conversion, bought East Sanford Shopping Center, a retail center in Mount Vernon, New York, for $68.5 million. The apartments had an NOI of approximately $2.0 million and the retail center is projected to yield an NOI of $4.3 million (6.3 percent cap) in the first year. Incorporating market rate financing (as outlined previously), the first-year levered cash-on-cash return for the new investment is projected at about 8.5 percent.

In another arbitrage transaction, we assisted a 1031 buyer who sold lower yielding residential New York properties in the boroughs and used the proceeds to purchase Spring Valley Marketplace, a 322,598-square-foot retail shopping center shadowed anchored by Target for $58.5 million at a 6.3 percent cap. The buyer viewed the arbitrage play to retail as not only a yield play, but also a security guard against rising expenses, which erode cash flows on the multifamily side but are protected on the retail side due to triple-net leases. The first-year leveraged cash-on-cash return for the new investment is projected at 8.5 percent.

In both instances, the investors not only realized an immediate increase in cash flow and yield, but they relinquished themselves of the burden of having to aggressively manage the apartment building to create the upside. They also mitigated the risk of the cap rates appreciating on the apartment buildings while trying to create the upside in the deal with higher rents and occupancy.

With Emerging Trends projecting the largest increase in cap rates to occur in the apartment sector in 2007, the opportunity to capitalize on this arbitrage strategy may be short lived. However, there is no sign of slowing in the apartment markets in the prime locations such as New York City and other prime suburban locations.

Jeffrey Dunne and Patrick Bisceglia are part of the CB Richard Ellis Tri-State Region Institutional Group.


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