Jason M. Barr       June 13, 2022

New York’s resurgence in the 21st century has led to a housing affordability crisis. More than half of the city’s renters pay above 30% of their income for housing. Of this group, one-third are severely rent-burdened, spending more than half of their income on rent. And, of those earning less than $25,000 per year, 85% are severely rent-burdened.  Furthermore, between 2009 and 2019, there was a 59% increase in people living in the city’s shelters.

Now that the pandemic is abating, housing access and costs are worsening. All these problems exist despite a ten-year housing affordability plan implemented by Mayor De Blasio in 2014.

Why the Crisis?

If you ask people why housing is so expensive, you will get different answers. To many, the affordability problem is a result of gentrification and the rise of skyscrapers along Billionaire’s Row. If you were to poll economists, they’d likely point to overly restrictive zoning, which often prohibits densification. To others, the problem lies with the city government, which does not do enough to encourage or build low-income housing. And yet, to others, the fault lies with “greedy” landlords who allegedly gouge their poor tenants.

While all of these might be true to some extent, the bottom line is that the demand for housing across the income spectrum is greater than the market’s ability to supply it. New York has nearly 3.6 million housing units, so one can’t pin the problem on a single cause.

In a fluid housing market, however, rising prices should lead to a rise in housing supply which would moderate price increases. To the degree that there are “frictions” or barriers to creating new housing, housing is under-supplied, particularly in lower-income markets, where the returns to new development are smaller.

Aim for the Middle

The best way to make housing affordable for lower-income residents is to add an abundance of units in the middle range. Middle-class households, who move into the new buildings, will generate higher vacancies in the older ones, reducing their rents and making them more affordable for those of more modest means.

What barriers to new housing prevent supply from keeping up with demand, especially in the middle range? This post—the first in a series on this topic—will explore the economics (or lack thereof) of urban densification with a particular focus on one neighborhood in the Bronx, Norwood.

Norwood

This neighborhood remains far off the gentrification path that, in theory, could house a larger population because of its easy access to parks, mass transit, jobs, and retail. A stroll through the area reveals a building stock virtually frozen in time, with 85% of its residential structures built before 1940.

Norwood is a middle- to low-income neighborhood in the north central Bronx. It consists of mostly low-rise buildings built out between the arrival of the subway after 1904 and the Great Depression. About 70% of its residential structures are four stories or less. And another 25% are five- or six-story apartment buildings.

It is surrounded by parks:  Van Cortlandt Park to the north, Mosholu Parkway to the west, the Bronx River to the east, and the New York Botanical Garden to the south. In the center is the Williamsbridge Oval with recreational facilities.

The Montefiore Medical Center complex along Gun Hill Road is the neighborhood’s largest institution and employer. There are two retail corridors, one along Gun Hill Road and the other along Jerome Avenue. There is easy access to two subway lines—the D train and the elevated 4 train—and there’s a Metro North commuter rail stop on the eastern border.

The neighborhood has about 40,000 residents with a gross density of about 110 people per acre (similar to Greenwich Village). In terms of ethnic and racial composition, it is diverse. About 63% of residents are Hispanic, 20% are Black, 10% are White, and 10% are Asian. Immigrant groups include those from Albania, the Arabic-speaking world, and the West Indies. The median household income is $36,800, less than the median for the Bronx, which is $41,900. 96% of households are renters.

TOD?

While, like all urban neighborhoods, Norwood has its share of problems, it strikes me as a vibrant place that should have more housing for low- and middle-income residents. This extra housing would ease the rental burden by lowering rents from increased supply and benefit those who can take advantage of its local amenities.

Given its excellent parkland and easy access to mass transit, it seems a prime candidate for transit-oriented design (TOD), where denser housing is built adjacent to parks and rail lines. Since the neighborhood is far from Manhattan, it is precisely the kind of neighborhood that could, and should, remain affordable for those in the lower-income brackets.

And yet, virtually no new housing has been built in decades. Why not?

I reached out to Lev Mavashev, the Founder and Managing Principal of Alpha Realty, a real estate brokerage firm specializing in mid-market multifamily properties, to get his take on Norwood’s lack of redevelopment. His response, “It’s a supply-constrained market.  There just isn’t much to develop on. Most properties in Norwood are your typical rent-stabilized multifamily buildings.  And the sites that are available for development are constrained by zoning.”

Well, let’s see what the numbers say.

The Economics of Redevelopment: A Case Study

As a case study, let’s take the blocks of apartment buildings that face Mosholu Parkway, a large strip of green land with a parkway in the middle. The buildings are all five- and six-story apartments, and there is no reason why they couldn’t be redeveloped to house 10-story or even 15-story structures (say with setbacks).

In this case, what would the economics be of tearing down an older low-rise apartment building and replacing it with a medium- or high-rise that could accommodate more people. What would the return on investment (ROI) look like, and what are the major barriers preventing redevelopment?

Return on Investment

Let’s look at a hypothetical development’s return on investment (ROI). Here we define the ROI as the net operating income (NOI) divided by the total cost of constructing a new building, ignoring financing costs to keep things simpler. The NOI is the total income from rent minus the expense of operating the building, including real estate taxes.

The idea is to look at the four major pieces of the puzzle: (1) the costs of buying the land and creating the new building, (2) the expected income from rent, (3) the net operating income (the profit), and (4) the return or profit rate.

The Cap Rate

We need a benchmark to see if a project is worth going forward. In this case, we can use the so-called capitalization (cap) rate, which is the building’s current net operating income divided by its market value. In other words, if an investor buys a rental property, the market price will be adjusted relative to the operating income to give a satisfactory return.

For the average multifamily property in the Bronx, the current cap rate is about 6%. That is, on average, investors expect at least a 6% return (though this varies above or below 6% based on the neighborhood). If new a development produces an ROI greater than the cap rate, it makes sense to redevelop the property, and if not, it’s more profitable to retain the older building.

To make matters as simple as possible, as a hypothetical exercise, we will pick an existing structure, tear it down, and redevelop the lot. We’ll look at three scenarios: (1) replacing what’s there now with the same number of units, (2) creating a building with twice as many units, and (3) a more detailed scenario that looks at the return from building heights that range from six to 26 stories. (The information on the data sources, assumptions, and analyses can be found here). For now, we ignore the zoning regulations.

The Land

To redevelop a property requires buying an old building, having the tenants vacate, and then tearing it down. We can use recent sales prices of these buildings to get a sense of what the land would cost. In fact, one apartment building that recently sold along Mosholu Parkway has all the right elements for a hypothetical teardown/redevelopment.

This 6-story apartment building, completed in 1928, is on a lot of 15,000 square feet and has a total building area of 70,650 square feet (with a Floor Area Ratio of 4.71). In October of 2021, it sold for $12 million. It has 72 residential units (with no retail). It is a relatively large lot and could certainly accommodate a much taller building (in fact, in Manhattan, recent construction on 15,000 square-foot lots frequently rises 20 stories or more.)^[i]

Land Cost: $12 million

The Construction Costs

With the property in hand (for now, we magically assume we can empty it. I’ll return to this issue below), we must tear it down and rebuild it. To give redevelopment a “fair shot,” I will assume a relatively low but typical range for construction costs (both hard and soft) of between $300-350 per square foot. Costs are determined by wages and materials, the quality of the finishings and appliances, and the amenities. For this project to work, we must consider one that is relatively modest in scope.

Construction Costs: $300-350 per square foot

The Income

Based on my discussions with real estate professionals, new construction in the Norwood section of the Bronx would likely have average monthly rents of $2,200-$2,400. Rents in the older buildings (most of which likely fall under rent stabilization) are between $1,500-$1,800 per month. The premium for new construction reflects tenants’ preferences for newer buildings.

Average Monthly Rents per Unit: $2,200-$2,400

Net Operating Income

Older buildings typically have expenses that run 35-45% of gross rental income because of aging equipment and less efficient designs. And they often pay full real estate taxes. Newer buildings with new plant and equipment, and more efficient heating and electric systems, will typically have operating expenses at about 25% of gross income (this includes tax abatements as well). Again, to give redevelopment the “best chance,” we assume zero vacancy.

 

Scenario I: A New Building the Same Size as the Old One

In this scenario, we tear down the old building and replace it with one that has the same size, height, and number of units (72). The advantages are a higher rental roll and a higher NOI from a more efficient building (and tax breaks). But the downside is the high construction cost. Here we assume the lower construction figure of $300 per square foot and the lower monthly rent of $2200.

Does the ROI hit the 6% threshold?

The answer is no. The best case for this project is an ROI of 4.3%

 

Scenario II: Replace with Double the number of units

But the low return for replacing the building may partly be due to the high land values. Therefore, we need to cost out a taller building. In this scenario, we assume there will be 144 units, and the building will be 12-14 stories high (ignoring the zoning, which currently prohibits this kind of structure).

Let’s assume that the average per square foot construction costs will be the higher $350, given the extra costs associated with a larger building. However, a taller building might increase the average rent if people on the higher floors pay more for better views. Again, to give this building a “fair chance,” we’ll assume average monthly rents on the higher end of $2,400.

Does it hit the 6% ROI threshold? The answer is no.

The taller building generates a high return, but it still does not pay to construct market-rate housing in this neighborhood.

 

Scenario III: The Search for the Profit Maximizing Building Height

The above two cases show that new construction does not pay. However, it’s only two examples. Maybe we are missing the sweet spot? To this end, I crunched the numbers to estimate the ROI for buildings that range from 6 stories to 26 stories. The idea is to find the building height that generates the highest return.

In this case, I needed to make additional assumptions about rents and construction costs. If you are interested, the details are here. So, what are the conclusions from this exercise?

First, no building would ever hit the 6% ROI benchmark. Second, the profit-maximizing building height is 15 or 16 stories.

The Frictions Takeaway

The takeaway from this analysis is that under a reasonable scenario where we have a large lot with a good location, the economics of densification do not pay in this lower-middle-income neighborhood in the Bronx. But if the city eliminated some of the main frictions to densification, much more housing could be supplied. It’s clear that the threshold to unleash new housing is not—from an economic point of view—that far away. If the city eliminates the current zoning restrictions,  you would still not likely see much development because construction costs are too high relative to the potential income, even if tax abatements are available.

What’s to Be Done?

The policy strategy, in this case, would be a two-fold plan. First, subsidize construction costs directly so that the developer of a lower- or middle-income high-rise building pays, for example, only a fraction of the hard construction costs per square foot. The lower the income of the residents in the neighborhood, the greater the subsidy. In this way, unlike tax abatements, the program can directly target the residents that need help the most.^[ii]

The second element is upzoning. Right now, along Mosholu Parkway, for example, the allowable floor area for new construction is less than the actual floor area of the buildings. If a developer tore down an old building, by law, the new one would have to be smaller! Once new construction is subsidized, then the planning rules must increase the allowable units. In other words, subsidizing without upzoning is like someone stepping on a car’s gas pedal while the clutch is in park.

Rent Stabilization: The Catch-22

Another issue ignored above is that of rent stabilization. The rent stabilization rules limit the rent increases landlords can charge tenants and prohibit tenant evictions for those in good standing—great benefits to residents.

However, this limits a neighborhood’s ability to provide more housing. Specifically, it’s nearly impossible to evict tenants. And, even if the economics favored neighborhood densification, the time and resources needed to empty the building are so large they reduce the return, eliminating what slim incentives for redevelopment that might be present.

But tenants are rightly reluctant to move because they have few alternatives. Since there is limited new construction and low vacancy, where will they go? And if they did move, they’d have to pay more for rent.

Rent stabilization thus creates a Catch-22: Residents don’t move because there is no new construction, but there is no new construction because residents are not moving.

Jump-starting the Process

The government needs to act to pop a neighborhood out of its stasis. I think the best strategy for this is for the government is establish a new program where an agency or authority buys up large lots or assembles them from smaller ones, clears the land, and then auctions off long-term ground leases to developers who will construct more lower- and middle-income housing.

To the extent possible, the program can focus on areas of underdeveloped or industrial lots. The ground leases would state what must be built and what the rents will be. This way, the government buys the land and then resells the development rights, and if there is a resultant loss in land values (which there would not likely be), they can be directly absorbed by the government.

The government has the power over eminent domain and has planning rights to centralize, coordinate, and jump-start the growth in the housing stock outside of the center. It can begin this process through the selling of ground leases from land it purchases. Once the neighborhood starts to see a rise in vacancies from this new construction, the market itself, along with construction cost subsidies and upzoning, would do the rest.

Can We Get to Affordable Housing?

The only way to get out of the affordability problem is to create more units, especially in the outer boroughs, where gentrification is less an issue. Ironically, the best way to help poorer households is to boost supply for the lower-middle income range. Since new units tend to rent for a premium, higher vacancies in the older units will then reduce their cost and increase affordability.

New York City has vast areas primed for transit oriented design if the government takes the next steps of promoting development along the subway lines and parks. The Norwood neighborhood in the Bronx is one such place given its vast parkland and access to mass transit.

At the end of day, we must recognize that the free market for housing made New York City the world’s greatest metropolis and it will be the market that continues to provide housing for Gotham in the 21st century. As  real estate broker Lev Mavashev put it, “Developers need the government to be their partner. The government needs to incentivize construction and new development, not restrict it via red tape and regulations.”

The data support this notion.

 

Continue reading Skynomics Blog posts on New York City real estate here.

 

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