PERE looks at three deals - one good, one bad and one that has the potential to be both - and the reasons for their divergent turns of fate. When it was agreed in 2007, the $5.4bn acquisition of Stuyvesant Town and Peter Cooper Village brought a high-powered beauty contest to a close. Now that Tishman Speyer and BlackRock own it, over-leverage, declining real estate values and legal action are combining to make this a particularly ugly deal. PERE July/August 2009

If living in a rent stabilised apartment in New York is considered better than marriage, then living in a rent stabilised property in the heart of Manhattan's East Village must be like winning the Lottery. Tenants, when they get one, really do hang onto such prized real estate gems. For decades, if possible.

Take US congressman Charles Rangel, who last summer was widely criticised for having four rent stabilised apartments in Harlem, paying less than half the market rate for each apartment. The politician isn't the only person of privilege to enjoy distorted-market rent. Until last year, Bianca Jagger – the former wife of Rolling Stones singer Mick Jagger – reportedly had a rent stabilised property on Park Avenue despite owing an apartment in London and only being able to travel to the US on a tourist visa. Once secured by tenants, rent stabilised properties are not relinquished lightly.

Stuyvesant Town, New York

This perhaps should have been a harbinger of things to come for Tishman Speyer and BlackRock when they closed on the $5.4 billion acquisition of New York's Stuyvesant Town and Peter Cooper Village residential complex in October 2006.

The transaction was one of the largest multifamily deals in US history and attracted considerable interest from more than a dozen parties. Not only did the Stuyvesant Town and Peter Cooper Village comprise 11,227 residential apartments, 100,000-square-feet of retail space, 20,000-square-feet of office space and six parking garages spread over 80 acres of prime real estate, but it was also one of New York's most iconic and successful post-war private housing communities. It was the crown jewel of Manhattan's multifamily properties.

For private real estate investors, Stuy Town (as the development is known in New York) also represented the zenith of a growing trend in residential property investment of converting rent stabilised units into market rate apartments. With more than half of all New York's rental inventory under some form of rent regulation, the city was unique in terms of its potential. The strategy was seen as the next “untapped goldmine”, according to one person familiar with the Stuy Town deal.

Before October 2006, a number of investors were successfully converting rent stabilised properties to market rents, producing “very good returns”, one source said. In June 2006, the president of real estate financial firm Sonnenblick Goldman, Steve Kohn, said a $100 million JV between Principal Real Estate Investors and developer The Dermot Company “should result in stellar returns”. They were not alone. Other firms targeting rent stabilised apartments, with the intention of converting them to market rents, included AREA Property Partners, the Pinnacle Group (backed by private equity firm The Praedium Group), Normandy Real Estate Partners and The Rockpoint Group.

Given the scale – and sudden – interest in the strategy, a number of private real estate fund managers pre-emptively approached Stuy Town owner MetLife about selling the East Side residential complex. They knew the insurance giant was in the mood for selling part of its vast portfolio of New York real estate, following the 2005 disposition of its 200 Park Avenue office, situated above Grand Central Station, to Tishman Speyer for $1.7 billion.

It gave the deal a “running start” so that when the property was finally marketed by Richard Ellis the interest was intense. “This was a very high-profile transaction and it was seen as golden by a lot of investors. This was a chance for them to buy a big piece of New York real estate,” says a person close to the transaction.

As a result, a bidding war broke out among more than a dozen suitors, including the Rothschild's, the Prince of Qatar, New York's leading real estate families, international banks and even a group of tenants from the complex. Together, the bids amounted to more than $35 billion.

What was at stake was the ability to deregulate units in the 110-building complex, a process that could see rents more than double. In 2006, the average monthly rent at Stuy Town was $1,721, taking account of both regulated and non-regulated rents. The average asking rent in the surrounding area at the time was $3,383, according to real estate research firm Reis.

The underwriting was seen as extremely optimistic by some industry participants. But even with such aggressive assumptions, the deal was still seen as “solid” by many deal professionals.

At the time of the transaction's close, just 28.4 percent of Stuy Town's 11,227 units were market rate. Tishman's own underwriting assumed that the New York-based firm would be able to convert approximately 8 percent of the units to market rate each year. It expected net cash flow to reach $334 million in 2008, and forecast that 57 percent of apartments at the property would be market rate by 2011.

The underwriting was seen as extremely optimistic by some industry participants. But even with such aggressive assumptions, the deal was still seen as “solid” by many deal professionals. New York's vacancy rate at the end of 2006 was just 2.6 percent, making it one of the most supply-constrained residential markets in the US. Effective and asking rents across New York's five boroughs increased 7.5 percent in 2006, with demand for multifamily rental apartments expected to rise with an anticipated contraction in the for-sale market.

“The deal had very strong attributes, even at the price it eventually sold for. It was all about buying great real estate, which was rented out at way below market rents, with very strong demand and the likelihood of very strong future demand as well,” says one source.

And in terms of debt financing, the deal was a no-brainer. Wall Street banks were fighting over each other to get a piece of the action. “It was a frenzy,” one source recounts. One bidder was even offered 100 percent financing of the acquisition costs. Tishman Speyer ultimately contributed around $112 million in equity, according to another source. Wachovia and Merrill Lynch provided a reported $5.9 billion to fund the deal, which included financing for renovations and other improvements and was securitised in a raft of CMBS deals in 2007.

Timing though is everything in real estate, and since closing the deal, Tishman's assumptions have proved not just aggressive but possibly unattainable.

Two years after buying Stuy Town, Tishman and BlackRock have converted less than 10 percent of units to market rates, taking the total to 38 percent. As a result, net cash flow in 2008 was just $136 million compared to a forecast $334 million – 40 percent below expectations – with a debt service coverage of around 0.70.

Tishman was not the only investor in the last couple of years to invest in large portfolios of multifamily assets in New York, based on the common knowledge that they would be able to bring units up to market rates.

Market sources

The deal's original $650 million of reserves have also been seriously impacted by the inability to convert rent stabilised units to market rates quickly. As of 27 April this year, Stuy Town's interest reserve account, which initially had $400 million, had just $98.9 million remaining. The general reserve account, which originally boasted $190 million of capital, had $358 left in it, while the replacement reserve account, initially funded with $60 million, had just $3.74 remaining as of the end of April. The reserves are not expected to last for more than six months, according to Fitch Ratings.

People familiar with the matter say the reserves are good “into 2010” and that Tishman's financial exposure would be isolated to its equity investments, with the Stuy Town deal having no recourse or cross-collaterialisation issues.

“Tishman was not the only investor in the last couple of years to invest in large portfolios of multifamily assets in New York, based on the common knowledge that they would be able to bring units up to market rates,” the person says.

Financing concerns are not just the only issue plaguing Tishman, though. So too are the tenants.

In March this year, the Appellate Division of New York's Supreme Court – the city's intermediate appeal court – ruled that Tishman Speyer and the former owner, MetLife, should not have been deregulating apartments while receiving certain tax abatements given for making building improvements to the complex.

The ruling followed a class action by tenants that alleged Tishman was improperly trying to vacate and deregulate units at Stuy Town, while being part of New York's “J-51” tax abatement programme which was created to encourage owners to refurbish their properties and make capital improvements. The court upheld the tenants' complaint that apartments cannot be deregulated while a landlord is part of that programme – something Stuy Town will be part of until 2017, according to the Supreme Court's decision.

An appeal has been lodged by Tishman and will be heard directly by the Court of Appeal, New York's highest court, in October. A decision is expected by the end of the year, according to lawyer Alex Schmidt, of Wolf Haldenstein Adler Freeman and Herz, which is representing the tenants. If Tishman fails to overturn the ruling though, the firm could reportedly be forced to repay around $200 million in rent refunds. It will also prove a major blow to Tishman's business model.

Rob Speyer told the New York magazine that the firm “overstepped a bit” in its efforts to raise Stuy Town's rents to luxury levels. Tishman declined to comment, but previously said it welcomed the chance to appeal the decision. Sources said the court case was completely “unexpected”.

In New York, a tenant scorned can prove an investment nightmare for landlords. Many of those firms bidding for Stuy Town in the summer of 2006 discounted the risks associated with the complex's tenants, PERE was told. Most perhaps thought they were smarter than the residents. All, undoubtedly, believed they'd be able to work alongside tenants while also executing their business plans.

Whatever the outcome of September's court decision though, the future of Tishman's Stuy Town deal faces an increasingly ugly reality.