Real estate investors competing to buy Manhattan apartment buildings have sent prices to record highs as rental demand surges, reducing yields on the properties to the lowest in more than six years.

The capitalization rate, a measure of investment return that declines as prices rise, averaged 4.4 percent for Manhattan multifamily buildings in first three months of this year, the lowest since the third quarter of 2005, according to New York- based data firm Real Capital Analytics Inc.

“It’s the strongest of all asset classes,” said Doug Harmon, senior managing director at Eastdil Secured LLC, who brokered deals for six Manhattan apartment properties priced at more than $100 million in the past 13 months. “There is still plenty of room to run on rents, and I see absolutely no reason why this action will or should stop anytime soon.”

Investors including UDR Inc. and Kuwait’s social-security system are homing in on rental buildings as stricter mortgage- lending standards limit home purchases. Tenant demand for Manhattan apartments drove the median rent in the first quarter up 7.1 percent from a year earlier to $3,100 a month, the largest annual gain since 2007, appraiser Miller Samuel Inc. and brokerage Prudential Douglas Elliman Real Estate said. New leases jumped 14 percent.

The vacancy rate for borough apartments was 1.22 percent at the end of last month, brokerage Citi Habitats said. Landlords can expect rental revenue to climb as much as 6.75 percent this year from 2011 as occupancies rise, according to Axiometrics Inc., a Dallas-based multifamily research firm.

Gains ‘More Limited’

Apartment investors may have to rely solely on rent increases to profit from their deals as yields on the buildings approach the 2 percent return on risk-free U.S. Treasuries, according to Sam Chandan, a real estate economist.

“The gains are more limited going forward,” said Chandan, president of Chandan Economics LLC, a New York-based research firm. “That being said, the market is significantly supply constrained, and that’s one of the key factors that will support rent growth irrespective of market conditions.”

Institutional investors are willing to “stretch” what they will pay to acquire high-end property in Manhattan because of projected revenue growth and the limited supply of new units on the market, Harmon said. Many top-quality apartment buildings are held for decades by family owners, which limits how many become available for sale, according to Paul Leibowitz, executive vice president in the investment properties division of brokerage CBRE Group Inc.

New-Building Premium

Manhattan multifamily buildings sold at an average of $493,980 per unit at the end of 2011, the highest in 11 years of record keeping, Real Capital data show. Before last year, the previous peak was in the first three months of 2007, when the average was $379,970.

Deals for new buildings this year have commanded much higher prices. In January, Wafra Investment Advisory Group Inc., an arm of Kuwait’s social-security agency, bought 2 Cooper Square in the Noho neighborhood for $134.1 million, or $993,403 per unit, according to Real Capital and New York City records. The capitalization rate — a property’s net income divided by the purchase price — was 3.5 percent, the data firm said.

The 144-unit tower, which was completed in 2010, was Wafra’s first residential acquisition in Manhattan, according to Harmon, who brokered the deal.

UDR, the third-largest U.S. apartment real estate investment trust, and MetLife Inc. in January bought the five- tower Columbus Square complex on the Upper West Side for about $630 million. It was the fifth multifamily deal in the borough for Highlands Ranch, Colorado-based UDR, which estimates the transaction at $887,000 per unit, according to Harry Alcock, senior vice president of asset management.

Driven by Profitability

The price for the complex, which began leasing in 2009, “was really just driven by the profitability of the apartment building,” Alcock said.

Columbus Square was acquired at an estimated initial cap rate of 3.9 percent, said Mark Biffert, senior REIT analyst at Bloomberg Industries. UDR estimates it can increase the yield to 4.5 percent over the next 12 months as the property becomes stabilized with 95 percent occupancy, higher market rents and the elimination of leasing concessions typical for new buildings, such as a month’s free rent, according to Biffert’s report on the deal.

Rent Increases

In UDR’s four other Manhattan properties, leases are being renewed at average rents that are 9 percent to 14 percent higher than a year earlier, Alcock said. New agreements are commanding rates that are 9 percent to 13 percent more. The buildings are 97 percent occupied.

The company, which entered the New York market last year, owns about $1.5 billion of assets in the borough and “would be comfortable” adding others, even as limited deals draw more competitors, Alcock said.

“It’s not obvious to me that values have moved to a point where we simply will not be able to invest,” he said. “When you have a market where vacancies are so low, we just know we’re going to continue to move rents.”

About 3,000 new apartments are expected to be built in Manhattan within the next three years, the same as the annual average for the past 15 years, according to Leibowitz of CBRE.

“The lack of a supply pipeline makes a lot of investors comfortable with the market,” he said.

‘A Safe Bet’

Competition is heated even for older properties that require rehabilitation and upgrades. After Silverstone Property Group Inc. toured a 34-year old apartment building in the Kips Bay neighborhood, it took only three days to conduct due diligence, make an offer and sign a contract, said Martin Nussbaum, a managing member of the New York-based company.

Silverstone, through an affiliate, bought the 128-unit tower in February for about $53 million, or $414,063 a unit, according to Real Capital. It plans to gut-renovate the apartments as tenant leases expire, he said.

The cap rate at time of purchase was about 3.5 percent, according to Nussbaum.

“It’s a safe bet, but for taking the safe bet you’re arguably looking at lower returns,” he said, adding that he expects rents to increase by 35 percent to 40 percent when the improvements are finished in the next 18 months.

Prices of high-end multifamily buildings are also being pushed higher as investors begin considering properties for condominium conversions, now or as an eventual exit strategy, according to Leibowitz.

Exit Strategy

Of the 12 buildings that sold for more than $100 million last year, two are slated to become condos. One of those conversion plans is by developer Harry Macklowe, who paid about $253 million, or $2.34 million per unit, to acquire 737 Park Ave., a property that had been owned by the same family for 65 years.

In a deal for a building that remained a rental, Leibowitz’s group arranged the sale of the Corner on West 72nd Street to retirement account manager TIAA-CREF for $1.1 million per unit in May. The lowest rent for a one-bedroom unit at the luxury tower, which includes a rooftop terrace and children’s playroom, was $4,475 in 2010 when the building first opened, according to Christopher Butt, a broker with Citi Habitats. Today, the cheapest one-bedroom commands $4,800, he said.

The competition to acquire apartments means it’s harder to find Manhattan properties that are discounted because of financial distress, said David Schwartz, co-founder of Chicago- based Waterton Associates LLC. The company seeks “opportunistic situations” where a multifamily owner wants to reduce debt or has a loan coming due and can’t refinance, he said.

Tribeca Deal

Waterton last year bought 88 Leonard in Tribeca, its first and only Manhattan apartment building, for about $207 million from Africa Israel USA, which at the time was working to restructure and refinance more than $1.5 billion in debt. Waterton, which agreed to assume Africa Israel’s mortgage on the property and pay off its mezzanine loan, acquired the building at a cap rate of 4.6 percent, according to Real Capital.

“The distress is at the tail end,” Schwartz said. “Things are being priced at full retail at this point.”