"Pre-Stabilized" Investments - Multifamily

TheWildMan's picture
Rank: Gorilla | 643

Looking to discuss / get recommendations on an interesting (and seemlingly new) investment strategy that is growing in the multifamily space.

The strategy (as its name suggests) is to buy a newly constructed assets that are not stabilized. You get a brand new asset at a discounted price, and assume the lease-up risk. The seller (developer) can cash out early/move onto the next project, all while taking advantage of the current seller's market. The agencies won't extend permanent financing below 70% occupancy (though some programs for this strategy do exist), so you need to get creative with debt (we have typically looked at bridge loans). These deals are not common, but they exist. Developer's who have the most control over their capital stack are usually the ones that are willing/able to trade.

Has anyone had experience with these kind of deals. As the value-add market becomes more and more saturated, my firm is looking into other options. This seems like the greatest risk-adjusted return right now. The problem is these opportunities are rare. With that said, does anyone know any operators/sponsors who focus on this?

Comments (46)

Aug 31, 2017

I'm on a DUS desk in a west coast primary market and we have financed numerous institutional deals like this utilizing the agencies lease up programs with tailing-1 economic occupancy below 75%. These loans are sized on a proforma stabilized NOI and the property needs to support the loan amount on a 1.0 interest only DSCR on Trailing-1 NRI in order to close. Of course, Sponsor and Market have a significant impact on the u/w proforma NOI. Loan amounts on deals like this can vary rather dramatically for the same property depending on the sponsorship.

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Aug 31, 2017

There's a deal like this I'm sort of working on, but it's just such a stupid disposition strategy that it boggles the mind. The difference in the sales price (100 bps on cap rate on stabilized NOI) in my view does not justify avoiding lease-up risk. You've already surmounted the biggest risk in the transaction--construction risk--so why not just finish up?

Aug 31, 2017

I think this development boom has seen a lot of inexperienced developers who need to get out ASAP for whatever reason. Maybe they ended up way overbudget on construction, or maybe the surge of supply is causing for a slower lease-up than they were prepared to handle (exceeding their operating and construction interest reserve). Maybe construction was so delayed that they are need liquidity for their next project that they've been teeing up.

Aug 31, 2017

Maybe. But selling post-development and pre-stabilization is probably the worst strategy they could undertake. I'd rather pay a fat extension fee to my lender or raise some additional bridge financing than sell at that stage.

Think about these numbers: $5M stabilzied NOI at 4.5% cap = $111M value; sell 12 months early pre-stabilization at a 100 bps cap rate discount = $91M. There better be a darn good reason to forego $21M--like, it had better be the last resort after all other options have been exhausted.

Aug 31, 2017

Honestly, we've sold one or two like this and have given zero discount for it not being occupied. Sold it like it was performing to proforma.

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Aug 31, 2017

Wow, that makes zero sense. I guess those buyers never heard of cost of capital. There must be some seriously dumb money.

Aug 31, 2017

I mean every MF building is sold based on the next year's proforma. It's just the way this market is.

Aug 31, 2017

As someone said above, agencies will do these - borrower puts up security (LOC) which burns off when property "stabilizes." Would recommend giving yourself some breathing room on stabilization requirements. By definition, you don't have good historical numbers on the property, and if rents are too aggressive or expenses come in higher than underwriting, you could have difficulty getting the property to check all the necessary boxes to release your security - or worse have it drawn down to reduce the loan balance until you are in compliance.

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Sep 1, 2017

I'd never propose buying a property prestabilization, but we've certainly had buyers interested during the lease up period. We sold a property in 2016 that still under construction in a hot market. The buyer paid a 50 bps over a market cap rate and we didn't even have a C of O.

Sep 7, 2017

I am a multifamily developer at a top 5 shop as ranked by NMHC.

To your point above, as a developer, I want to live another day and do another deal. I'm happy to transact pre-stabilization. Depending upon market conditions, a slight hair cut is reasonable; I'll take a slightly lower price as project timeline gets compressed and likely lets me hit the next hurdle in my promote structure. This makes my firm more money, thus makes me more money. The only potential rub from the developer perspective is that I have to get my LP on board.

Note: the "discount" you will receive as a buyer will be limited. If you come to me proactively and pre-stabilization, this tells me you (i) may be bullish on MF in my submarket or (ii) have hot money (which you allude to above when you mention dearth of investment opportunities). Moreover, while the property is pre-stabilization, unless we are talking about a transaction prior to break even, the vast majority of risk has dissipated. I've sourced the deal, gotten it financed, overseen construction, and held hands with management through the blood bath that is reaching break even. The "lease up risk" you mention above is really to break even; once you stop the operating deficit and can service your debt, the only remaining questions are (i) can I stabilize this asset (this would be a "yes" 99% of the time), and, (ii) what does the world look like when I reach stabilization (rents, expenses, etc.).

Note: there is a certain price per unit that a buyer will pay based on recent transactions, regardless of what your model spits out and tells you that you "should" receive. In my experience, you do not simply take NOI / cap rate. NOI is subjective and the only NOI that really matters is not what you underwrite or pitch, but what the buyer calculates.

Hope this helps.

-SD

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Sep 8, 2017

I'm genuinely curious how many years you have working in the business because your entire experience sounds like that of a person operating within bubble conditions. For example, "99% of the time the answer is yes that I can stabilize this building," which I guess is true given enough time, but it definitely sounds like a bubble mentality. I live in a hot, in-demand market and brand new buildings are struggling to reach stabilization. The idea that I, an investor, would pay a stabilized price for a non-stabilized asset is just beyond absurd unless the market I'm operating in is in bubble conditions, which it sounds like is your experience.

For those of us who have operated in both up and down markets I can assure you we would not pay a stabilized price for a non-stabilized asset.

Sep 8, 2017

I cover Texas, so know a thing or two about hot markets. I also know a thing or two about down markets. Most recent example: delivering first units in Houston 6 months late in 3Q of last year. I would argue that Houston MF is the worst market in the country. I am open to your views on a market that is worse though?

Yes, we will stabilize this asset. Did we miss projections? Absolutely. Nothing you can do to control exogenous variables such as Houston economy. You mitigate your lease up risk via underwriting and wait it out until market turns. It will happen, as I said, and if you prudent in your underwriting and focus on the downside, you will survive.

Genuine question for you: If you are in such a hot market, would it not make sense to source off-market, pre-stabilized deals to (i) avoid competitive bidding once a broker is engaged and pings every potential buyer from across the country, and (ii) avoid 12 months of increasing rents in said market, which, per your NOI / cap rate equation, would increase your acquisition price?

I do not disagree with your last statement with regards to stabilized vs. non-stabilized asset and pricing thereof. My view, as I said, is that such a discount will be limited.

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Sep 8, 2017
Slap Dick:

Note: there is a certain price per unit that a buyer will pay based on recent transactions, regardless of what your model spits out and tells you that you "should" receive. In my experience, you do not simply take NOI / cap rate. NOI is subjective and the only NOI that really matters is not what you underwrite or pitch, but what the buyer calculates.

And this is patently false. Price/unit is used as a guide that helps back-of-the-envelope a deal and/or ensure that we're not way over-paying for a deal. Cash flow, however, is always, always, always the driving force behind the price paid for a building.

Sep 8, 2017

In the example you provided, you indicated a price difference of $20M. That is completely unrealistic. Given the info. you provided., we're talking about a deal with cost basis of $70M - $80M. A $20M swing is not consistent with a deal this size...that is not a discount, that is a fire sale. Moreover, this is the kind of trouble you can get in to when you simply take NOI / cap rate.

Not even 6 months ago, an LP on one of our deals had an interested buyer with whom he had previously dealt. We all toured the property, etc. Potential buyer reached out to our partner for price, partner took NOI / cap rate, and offered that up. We never heard anything back. Price was 20% higher on a per unit basis than high water mark in submarket, which was a deal purchased by a 501(c)(3). We sold the deal for about 5% below this high water mark.

Note: the example you provided used NOI / cap rate. You are now switching to CF (there is a difference). This difference aside, I concur with your approach to valuation. The problem though is that both NOI and CF are subjective and susceptible to manipulation. As I said before, the only thing that matters is what you, as the buyer, underwrite...not what I have in my model. Moreover, if you are relying on my CF, you will most certainly over pay. Do those lease up concessions hit below the line? One could mark valid arguments for such classification. How about that extra leasing gal that "we only need during lease up"? Well, let's just go ahead and drop that below the line while we're at it. Now what I put in front of you has artificially high income and artificially low expenses. Still want to do your NOI / cap rate?

-SD

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Sep 8, 2017

So kind of as a case in point, we have an investment--a Class A apartment building in an incredible location in Arlington, VA. Construction completed fall 2014 and the property is still struggling to stabilize. 2016 DSCR was 0.87:1 and 93% LTV (according to lender). The idea that lease-up risk isn't real is kind of laughable. If you had purchased the property in the fall of 2014 based on reasonable U/W assumptions you'd be out tens of millions of dollars in NAV today--and this is a relatively strong market with net positive absorption overall.

In other words, lease-up risk is real and investors SHOULD price that risk into a pre-stabilized purchase. If they aren't pricing the risk then they are making a non-economic investment; enough investments made in a marketplace that are made independent of underlying economics creates a bubble.

Sep 8, 2017

What do you mean "you have an investment"? Your firm owns this?

-SD

Sep 8, 2017
Slap Dick:

What do you mean "you have an investment"? Your firm owns this?

-SD

Yes. I'm looking at the numbers right now. They're an embarrassment.

Sep 8, 2017

Sounds like a late-cycle fad

Reach for that yield, people

Sep 8, 2017

If you can prove leasing velocity you can usually get out a little early (80-90% leased or roughly break even NOI) without taking much if any of a haircut on the exit cap. I haven't heard of any deals selling at 70% with no haircut.

There are a few small groups that just put deals together and sell off to other firms who will take on the construction/lease-up risk. Most of those guys are fee developers though, so they don't really care about taking a haircut on the exit.

Sep 21, 2017
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