Underwriting my first projected based deal with 100% of the units under a HAP contract (two phases with separate HAP contracts for each, one expiring in 2019, the other in 2021).
Deal is located in a major CBD market, in a decent area of the city (i.e. not the "projects", there are decent market rate properties adjacent to the subject). Property was developed pre-WWII.
In terms of valuation/cap rate, the broker on the deal is using proximate market rate comps and telling me that the cap rate for the subject, despite being project based Section 8, would be comparable to similar market rate deals (i.e. low 5% cap rate). I was prepared to call bullshit, but since I don't have any legit deal experience on the project based side, I wanted to get a sense as to how to view cap rates between these and market rate deals, assuming characteristics are similar otherwise.
Also, with respect to the HAP contracts, I understand that for renewals, ownership can request a mark-up to market by HUD, so that contract rents are brought in line with market. Because this project has two HAP contracts which are staggered in terms of expiration, is it possible to renew/extend both during the acquisition/escrow process such that the rents are marked to market soon after the deal closes? I was told that HAP contracts can be renewed prior to their actual expiration (i.e. if there is 2 years remaining, you can renew for say 20 years and simply tack the 2 years onto the end for a 22 year total contract). Based on my market review, there appears to be a decent ($125-$150/month) delta between average current contract rents and "market". Just trying to understand how quickly one could unlock that upside, if it could be done sooner or if it would need to wait until closer to the actual HAP contracts expiring. I suppose that if market rents grew over the next few years, it could make sense to wait and then lock in higher contract rents in a few years, vs trying to do it now.
Just trying to make sure I am approaching correctly.
Are the mark up to market, or mark to market contracts? A MU2M contract is super valuable and I wouldn't be surprised to see it trading at cap rates equal to market rate properties. M2M is slightly less so, since you take on some market risk in addition to the headache and risk of dealing with HUD.
At the risk of sounding ignorant, can you break down the diff between the two? Should I assume that the existing contracts in place will dictate whether going forward, the contracts are MU2M or M2M?
Depends on the history of the project. Haven't done either in a couple years so my memory is hazy, but IIRC MU2M contracts are the standard, while M2M are generally the result of ownership refinancing a HUD or FHA backed mortgage.
That being said, @Maineiac42's answer is probably more useful in the short term for you. Though it is also worth pointing out that for units with a high tenant-share of the rent, you are still taking some collection risk from the tenant side of the payment.
I don't have a ton of experience on the operations side of projects with a HAP but based on my UW of these deals I believe the administering agency (generally the local or state housing authority) is responsible for collecting the tenants share of the rent. I was under the impression the owner just gets a check from Uncle Sam. Anyone with operational experience care to chime in on this?
The cap rates for properties with HAP contracts are generally lower due to higher economic occupancy and the fact that your relying on the government to make a payment rather than the tenants.
You can also syndicate these things as LIHTC. If you do a big rehab funded with LIHTC money, you might be able to ask HUD for an even higher mark-to-market rent, way above FMR, that is effective before even doing the LIHTC work.
True but speaking from my experience as a LIHTC syndicator I would not want to deal with a sponsor who doesn't have LIHTC experience. Also, I have my doubts HUD will give you a huge bump in rent just because you are doing an acq rehab deal.
It's going to be market/neighborhood specific, but generally, a 100% HAP Contract building is going to be in a commensurate neighborhood. In other words, among your submarket comparables it is likely to have a cap rate equal to or less than market. On the other hand, your intuition is not necessarily wrong. In the larger market (say, regional market), your lowest cap rates will be among quality non-subsidized properties in good neighborhoods.
As far as marking to market, the existing HAP Contracts should be in the due diligence file sent out by the broker. If so, check there to see what the contract allows.
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