Rates of Return on Office Buildings in Manhattan vs Other CBDs

By James R. MacCrate, MAI, CRE, ASA

 Introduction

No one can deny that Manhattan is an interesting city that attracts real estate investors from all over the world. Properties in Manhattan command higher prices per square foot and lower capitalization rates in comparison to most places. In fact, it is often said that investing in Manhattan is as safe as investing in treasuries. Motivations for investing in income properties in Manhattan are many, including an inflation hedge that preserves real value of capital as well as a return on capital. Over the long haul, the returns historically are commensurate with the risks involved, and real estate performs as well as alternative investments (common stocks). Do investors accept a lower pre-tax return on investments in Manhattan in comparison to other central business districts? One measure of investment performance is by comparing overall capitalization rates (Ro) or, alternatively, discount rates in different metropolitan areas for the same or similar competitive investments. By analyzing the expected returns over time published by various companies in various metropolitan areas, an investor can determine if the expected returns are lower in Manhattan.

 Definitions and Sources

For the purposes of this demonstration, the definitions that will be used have been obtained from the Appraisal Institute, The Dictionary of Real Estate Appraisal, Fifth Edition or the studies reviewed. The capitalization rates, discount rates, and other data are based on the Korpacz Real Estate Investor Survey, PricewaterhouseCoopers‘ Korpacz Real Estate Investor Survey®, and PwC Real Estate Investor Survey™. The returns are the expected unleveraged returns reported over time.

The overall capitalization rate (RO) is defined as “an income rate for a total real property interest that reflects the relationship between a single year’s net operating income expectancy and the total property price or value (RO=IO/VO). This is also known as the “going-in” capitalization rate. According to the survey, “the overall cap rates reported in this survey reflect investors’ expectations of property performance.”

The discount rate is defined as “a yield rate used to convert future payments or receipts into present value; usually considered to be a synonym for yield rate.” A yield rate considers all expected property benefits, including the proceeds from sale at the termination of the investment and is synonymous to the internal rate of return (IRR). According to the survey, “discount rate (IRR) is the internal rate of return in an all-cash transaction, based on annual year-end compounding.”

The residual capitalization rate is defined as the “overall capitalization rate used in calculation of residual price; typically applied to the net operating income in the year following the forecast.” The residual capitalization rate is also known as the terminal capitalization rate (RN), “going-out” capitalization rate, or the reversionary capitalization rate.

Since it is difficult for real estate appraisers to obtain overall capitalization rates and discount rates from actual transactions, surveys are useful in providing support for the expectations of investors at the specific point in time that the appraisal is being conducted. An appraisal is a “snapshot” in time of one’s opinion of market value based on the actions of informed market participants. The historical relationships between the various rates of return on real estate investments and similar returns on alternative investments provide a test of reasonableness for the rates selected by an appraiser. Appraisers must be careful using this data because yield requirements vary and the survey may reflect biased yield rate expectations from buyers and sellers.

Expected Average Overall Capitalization Rate Comparison

The average expected capitalization rates reported in the survey for Manhattan office buildings was compared to the average expected capitalization rates for office buildings in the national central business districts.

Historically, the average expected overall capitalization rates for office buildings in Manhattan have been lower than the average expected overall capitalization rates for office buildings in the national central business districts. There was a brief period during the late 1990’s, during 1998-1999, when the reverse was true.

Over the time period that was reviewed, the average difference in the expected capitalization rates for office buildings was approximately 0.62% lower in Manhattan, while the median difference was 0.68%.

 Expected Average Discount Rate (IRR) Comparison

The average expected discount rates (IRR) reported in the survey for Manhattan office buildings was compared to the average expected discount rates (IRR) for office buildings in the national central business districts.


This graph indicates a slightly different story in that the average expected yield rates were quite comparable between the first quarter 1995 and the third quarter 1999. For a brief period after 9-11, the average expected yield on office buildings exceeded the national average, but quickly the yields expected in Manhattan on office buildings fell lower than the national average in the central business districts.

Over the time period that was reviewed, the average difference in the expected discount rates for office buildings was approximately 0.25% lower in Manhattan, while the median difference was 0.32%.

 Conclusion

There are many factors that impact the expected returns on real estate investments, including interest rates, supply and demand, vacancy, rental growth rates, changes in expenses, etc., but over the long term, office buildings in Manhattan have commanded lower returns in comparison to other central business districts in the United States. This tends to indicate that the market participants see less risk in investing in office buildings in Manhattan in comparison to other central business districts. In addition, Manhattan data is also included in the national data and after culled out, the spread would even be wider.

 Special Thanks to Maureen McGoldrick, MDM Appraisals, LLC and Max Ramsland, MAI, CRE, Ramsland-Vigen, Inc for their contributions.

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About Jim MacCrate

Real estate appraiser and valuation consultant for more than 30 years specializing in reviewing real estate appraisals, risk management and quality control.
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