New York City office REITs trade at a significant discount to private market values. Given the multi-year duration of the dislocation, the two camps have clearly planted flags. The question is: Who is right?
The answer, as always, is nuanced. In general, the REIT market has a few great arguments in its favor. First, net effective rent growth in New York has been and is likely to continue to be muted, thanks to competitive new supply and onerous capital expenditure requirements. As growth diminishes, the multiple you should pay for any given asset also diminishes, even if that asset is in Manhattan.
Second, the evolving preferences of tenants are at odds with most of the antiquated office space prevalent in New York. Tech tenants, coworking firms and now even major banks like JP Morgan are demanding space with open floor plates, natural light and speedy elevator banks. Most of the bricks and beams in New York City simply weren’t configured that way and never can be.
The final point in favor of the REIT discount is the shadow supply caused by increased efficiency of office space. Gone are the days of large file cabinets and carefully kept color coded cases. In the digital age, all that many employees need to be productive is a laptop and a WiFi signal. The result is a dramatic decrease in the amount of space needed per employee, from 250 square feet per person down to, in some extreme cases, just 50. This trend has been a significant hinderance to many landlords’ abilities to push rents.
The amalgamation of these factors has reduced cash flow growth for office landlords, which exacerbates the detrimental effects of the high prices it takes to become an owner of New York City real estate. In a world of ever-increasing investor sophistication, these quantifiable concerns are beginning to triumph over the premium paid for the New York brand name.
However, the private market has a few reasonable rebuttals that merit review. The first one is perhaps the most obvious: REITs represent a portfolio of assets, meaning investors are buying the whole New York City market. Private investors, however, can buy individual assets. On a one-off basis, one can still find opportunities that present upside even at current prices.
The second reason the private market might pay more is efficiency of deployment. REIT investors have the luxury of putting large sums of investment dollars to work in trailer parks as easily as they can the Empire State Building. Private investors that need to deploy large sums of equity, however, generally do not have the option to allocate quickly across numerous small investments. Sometimes buying a large office asset in New York makes sense not because it has the best returns, but because the purchase allows an investor to deploy $100 million at once.
So who is right? Both sides have valid arguments, but at the end of the day we believe the private market corrects towards the public market more often than the other way around. Already, stories have surfaced of landlords pulling assets off the market when they didn’t receive the bid they wanted, and many have preferred to refinance assets in the debt market as a way to extract proceeds. If you were able to peek at New York City office cap rates 10 years from now, our bet is that the REIT market looks smarter today.