Value-Add Opens Doors For Multifamily Buyers
Written by Taylor Williams
Cortland Partners acquired the 376-unit Copper Springs in Houston in 2015 and spent about $15,000 per unit in renovations. Rents at the time of acquisition were roughly $1,060 per month. The property’s asking rents currently stand at $1,325 per month.
Capital sources of all types see opportunity in the apartment sectors of core Texas markets, which regularly lead the nation in employment and population gains. With so many investors trying to park money in this space, sales prices have risen, cap rates for multifamily properties in major markets have compressed and lenders are competing among themselves to finance acquisitions.
When lenders compete, borrowers win. For multifamily lending in sizable markets, value-add borrowers are seeing tighter spreads on their loans, a factor of both more lenders entering the space and the Federal Reserve’s decision to raise short-term interest rates.
But rising land and construction costs have also contributed to skyrocketing prices on newly built multifamily product, which has weeded out some potential investors. Rather than shun the market entirely, however, many of these buyers are targeting Class B and C assets for value-add plays that will attract residents who can afford higher rents. In Texas, these kinds of deals are being executed at record paces.
“The transaction velocity for value-add multifamily deals has been at historical highs in this cycle,” says Warren Hitchcock, senior vice president in NorthMarq Capital’s Houston office. “The significant amount of capital flowing into the space, combined with the general lack of Class A product for sale, has pushed buyers toward the potential higher returns of the Class B and C value-creation deals.”
Hitchcock adds that value-add multifamily plays feature capital structures that appeal to small operators and national owners alike. In addition, the amount of liquidity in the space ensures that a variety of financing options are available to borrowers.
Of course, the sword cuts both ways. The more capital and buyer interest directed toward Class B and C properties, the more the sales prices and property taxes for these assets will appreciate. In turn, buyers will have to spend even more on capital improvements to achieve cash flows that will yield greater returns on investment.
For all of these reasons, value-add deals vary tremendously in terms of the extent of the upgrades and the type of loans used to finance them.
One Size Doesn’t Fit All
From a lender’s perspective, the beauty of financing a value-add deal lies in the flexibility. Every borrower has different numbers it needs to hit to make the economics of a project pencil out. For some, that means gutting the unit interiors, adding new communal amenities and everything in between. For others, the plan may entail little more than touched-up landscaping and a fresh paint job.
“In today’s market, borrowers can very easily raise the capital they need for value-add deals,” says Chuck Patenaude, senior vice president at Dougherty Mortgage LLC. “Acquisition business represents 75 percent of the business we’ve done this year and value-add represents about 80 percent of those deals.”
High variance in the scope of value-add plans translates to heavy discrepancies on loan terms for these acquisitions. For properties in core urban locations that have high occupancies and don’t need too much work, lenders may go as high as 75 or 80 percent loan-to-cost (LTC) on a floating-rate loan. Spreads on these highly leveraged loans will typically run 300 to 400 basis points over LIBOR.
But in general, as more lenders have gotten into the game, the finance side of the business has shown a tendency to offer more aggressive pricing on a value-add loans while scaling back the average leverage, says Stephen Farnsworth, managing director at Walker & Dunlop.
“The market is more competitive now and on the buying side, you’re lucky to get 75 percent of purchase for traditional financing,” he says. “So when you layer in the cost of adding value, LTCs drop to about 65 percent. That’s about as aggressive as we’ve seen for moderate to heavy value-add deals.”
While the nature and depth of value-add plans run the gamut, the key metrics by which lenders evaluate them don’t fluctuate much from deal to deal. A value-add program is all about cash flows, specifically the difference between the cash flow at the time of acquisition and the anticipated cash flow after stabilization. Those numbers continue to govern underwriting standards for value-add loans.
According to Hitchcock of NorthMarq, lenders are more likely to underwrite stronger rent growth if a value-add strategy includes actual property improvements.
“Rental growth of 10 to 15 percent over a three-year period with property upgrades is in-line with lenders’ expectations,” he says. “If the market is experiencing significant, organic rent growth, then 20 percent or greater can be modeled with appropriate interior and exterior property improvement. Rent growth at these levels is necessary to underwrite an exit on a higher cap rate in line with historical trends.”
Deep Pockets Pay Off
True, value-add is a vehicle through which smaller players can get a slice of the Texas multifamily pie. But it’s also true that bolstered cash flows from higher rents represent the end-all goal of value-add plays. As such, buyers that have the capital and the resources to execute renovation plans quickly have an advantage.
Earlier this year, CBRE brokered the sale of The Marc in College Station. A value-add program that delivered significant interior upgrades has allowed the owner to operate the property as a true multifamily asset rather than as a student housing community.
Lenders are more likely to finance a value-add plan from these types of buyers simply because they can generate returns to investors — and repayment of the loan — more quickly.
“In today’s market, you can’t buy an asset and renovate it over three or four years,” says Farnsworth. “It needs to be knocked out in about 18 months, and it’s the operating partners of larger firms that have the ability to make that happen, often because they have the architects or contractors in-house.”
Farnsworth notes that spreads on these deals, which tend to involve international equity sources and well-known domestic owner/operators, have tightened by about 75 to 100 basis points over LIBOR.
NorthMarq is currently working on an acquisition loan for a 320-unit, Class B property in Houston on behalf of a local buyer that has in-house construction and management services. The seller, which bought the property several years ago and made some exterior and interior improvements, contracted all the work out to third parties.
From a lender’s perspective, NorthMarq’s client is an ideal buyer because it can continue to the capital improvements on its own dime. Whereas the seller incurred higher operating costs from contracting the renovations, the prospective buyer will be able to push higher rents without shelling out more cash. Such factors figure prominently into lenders’ thinking when it comes time to back a particular buyer.
Healthy supplies of multifamily product are not an issue in core Texas markets. According to a report from Yardi Matrix, Dallas-Fort Worth (DFW) will see its apartment inventory increase by about 22,000 new units by year’s end. Houston, which still has some multifamily space to burn after three years of depressed oil prices, is projected to add 14,000 new units in 2018. Fast-growing San Antonio will bolster its supply by nearly 10,000 units.
Suffice it to say that Texas renters have options. And in general, these renters have demonstrated demand for quality apartments and a willingness to pay higher rents if they genuinely perceive the property to be nicer and better managed.
So how do renters qualify and quantify these evaluations? How do developers and owners judge the success of their value-add programs? According to Chris Deuillet, a member of CBRE’s multifamily capital markets team who specializes in Class B properties, the answers to these questions have changed quite a bit recently.
“The life of a recently renovated unit has shrunk to three years or so, where it used to be five to seven years,” he says. “If a unit has a faux wood floor with thin planks or an accent wall, it looks outdated. But there are still many apartments that truly need improvements even after a long stretch of multifamily growth.”
Chandler Sims, Deuillet’s partner in the multifamily capital markets group, notes that the quality of certain rooms and features has become closely linked to healthier returns.
“In the single-family space, the kitchen contributes to the best return on investment,” says Sims. “That holds true for multifamily properties as well. With a full backsplash, granite countertops, brushed nickel hardware and black or stainless steel appliances, renters can feel at home with upgraded kitchens and be willing to pay more rent to get it.”