Value-Add Multifamily Investments

Had a couple of questions relative to value-add apartment investing in the currently market. It seems as though most/many LP equity groups have re-calibrated their return expectations as multifamily has seen a phenomenal run coming out of the recession. Most deals I am seeing (I focus on the west coast) have already been bought and sold at least once since 2011-2012, not much meat on the bone, alot of partially-rehabbed deals or similar.

That being said, those of us who are in the space still need to dig for deals, and often times need to talk ourselves into believing the "upside" story.

  1. For value-add deals, are LPs generally still looking at the back end IRR as the major metric for deals? I keep hearing that LPs are drawn to multifamily due to the yield play, which would imply that they are looking at cash on cash yields, no? Most 3-5 year heavy value add deals I am underwriting have fairly shitty yields through the rehab period, unless you assume a refinance scenario after the rehab is complete and then just hold for a nice cash yield and maybe take a lesser IRR by holding longer term. Is anyone out there underwriting value deals for LP equity where the LP wants to hold for longer term to milk some cash flow post-reno?

  2. Regarding debt financing, is floating bridge debt the best execution assuming a 2-3 year rehab? I haven't done much non-agency debt on multifamily, but on some of the commercial office value deals I did, getting 65% initial funding plus 100% of capex and TIs/LCs was achievable (250-350 over LIBOR pricing). On multifamily, is it possible to get 70%+ LTC on deals and have lender fund the reno capital through the loan?

  3. Assuming that the strategy was to refinance the bridge debt after 3 years with longer term (i.e. agency) financing and enjoy 5-7 years of decent COC, how are the agencies generally sizing the take out? Debt Yield, DSCR, etc? Is interest only available on a refinance scenario, or would it typically be amortizing? Assuming that bridge debt was taken out 100% with no cash out (likely leverage on refi would be 60% of the new stabilized value).

Many thanks!

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Comments (14)

Dec 31, 2017 - 1:38pm

I can answer your first question. The answer is...and no one likes this answer - it depends. Some shops are IRR driven, some are look at cash on cash after the rehab. Going into a rehab play generally will not provide cash on cash returns that are strong during the rehab. After the rehab it will. At that point the LP can buy out the GP (or visa versa) or sell the deal entirely depending on how the markets look. Some shops will be IRR driven and say if we can get a 7% over 5 years we are happy. Others will say we are targeting a specific cash on cash. It is shop dependent.

Best Response
Dec 31, 2017 - 3:23pm

I'm a GP for a value-add multifamily group so I can share our experiences....

1.) Agree with above post but also we have been seeing LPs say we'd like to provide a current coc yield throughout the rehab period AND a decent IRR. What ends up happening there is a bit of financial engineering where a current pref reserve is built into capitalization at the expense of 50-75 bps of IRR. Markets better though (14% IRR with 5% coc out the gates that grows to mid teens vs 15% IRR with no distributions for 2 years).

2.) We've purchased with both bridge debt and floating agency. Floating agency has been the better choice due to the additional term, better pricing, and ability to refi without much or any prepayment penalties. Downside is the leverage can be a bit lower than bridge.

3.) Yes I/O is available on take-out refi with agency (and cash out is fine too). Depending on leverage of refi (we've been successful getting 80% of appraised value), 2-3 years is an easy target but we've been able to get full term if we drop leverage a bit. I will say that a 65% full-term IO refi that produces a nice lump distribution and creates mid teens coc yields on outstanding capital is very attractive to LPs right now.

Dec 31, 2017 - 4:49pm

Thanks very much for the feedback. If I may ask, what markets do you cover?

With respect to your comment about building a current pref reserve, so are you essentially building the reserve via equity and then drawing down on it to provide a specific COC during the rehab period?

I'm on the West Coast, so suffice to say finding yield in anything is a challenge.

With floating agency debt, how are those loans being sized (dscr vs debt yield vs future debt yield, etc)? Assuming the property is a heavy value add, sub 4% cap rate on in-place NOI, can you still push leverage 65%-70% or higher? How are the agencies pricing rate on these 2-3 year floater deals? L + ? I've heard people say Freddie and Fannie have programs to go as high as 80% provided there is a minimum per unit rehab budget?

It seems that the high teens LIRR standard for value add has come down in recent years, I am hearing of funds being raised around the concept of mid teens IRR for value add and it appears that LPs are ok with this given the strength of the apartment market?

Jan 4, 2018 - 9:55pm

hanks very much for the feedback. If I may ask, what markets do you cover? Southwest and Southeast

With respect to your comment about building a current pref reserve, so are you essentially building the reserve via equity and then drawing down on it to provide a specific COC during the rehab period? Exactly.

With floating agency debt, how are those loans being sized (dscr vs debt yield vs future debt yield, etc)?
Agencies have a few tests. Ltv, fixed rate test with 1.15-1.25 on dscr, stressed floating rate test (stress all-in rate to low 6's and back into 1.05 coverage). You elude to it below but with low in-place yields, you'll see cf constraining the loan proceeds you're probably looking at to 58-65 in your market I'm sure.

Assuming the property is a heavy value add, sub 4% cap rate on in-place NOI, can you still push leverage 65%-70% or higher? Yes and no. Yes in the sense that you can get that leverage, but not all upfront. immediate funds will be limited to same as if you didn't do rehab and then you'll have a loan escrow that will make up the difference which can be drawn upon as capex is completed. You still have to float the upfront $ for the capex to then get to a draw.

How are the agencies pricing rate on these 2-3 year floater deals? L + ? Deals where we are bumping rents $100-$200, we will get 73-78% LTPP on 7 or 10 yr debt at L+200-225 with 3-5 yr of I/O

I've heard people say Freddie and Fannie have programs to go as high as 80% provided there is a minimum per unit rehab budget? There is. Haven't qualified to date because our capex budget is too light to qualify.

It seems that the high teens LIRR standard for value add has come down in recent years, I am hearing of funds being raised around the concept of mid teens IRR for value add and it appears that LPs are ok with this given the strength of the apartment market? Large mismatch right now. Funds that have dry powder we're raised 2 years ago and promised high teens. Some are getting creative to push expectations lower, others are saying screw and are u/w more aggressively, and others are just going further on the risk curve.

Jan 6, 2018 - 8:46pm

Hey man, might be able to help as I work at a Fannie/ Freddie lender. I just did a Freddie Value-Add program deal (much better than the Fannie program) in Charlotte.

1.10 DSCR with as is NOI and the As-Stablized needs to be sized at 1.30x. Up to 85% LTV. Prepayment is 1%, but is waived if you refinance with Freddie.

Spread was 2.69 over the 1 month LIBOR.

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Jan 2, 2018 - 1:55pm

Great strategy on the pref reserve. I have often wondered how a developer could appease a CoC driven investor in an environment where cap rates are so low.

Array
Jan 2, 2018 - 2:45pm
1901Monkey:

What ends up happening there is a bit of financial engineering where a current pref reserve is built into capitalization at the expense of 50-75 bps of IRR.

I have never heard of this, do lenders/agencies even allow it?

Jan 4, 2018 - 9:37pm

When I say "pref reserve" I don't mean literally, but functionally. Additional money goes into "reserves" that are used for working capital, upfront escrows, etc. That bucket is what feeds cf deficits AND current pref hurdles the LP may have. Lender has never questioned the reserves and their purpose.

Also, I'm not talking about true preferred equity here with subordination of GP investment and/or collateral rights to LP.

Jan 2, 2018 - 12:39pm

I work on the LP side focused on this strategy and can offer some insight:

  1. the IRR is certainly the main metric we use, but we are also sensitive to average c-o-c throughout the hold due to the distributions that our fund investors are expecting.

  2. Freddie has a value-add program that offers pretty high proceeds (up to 85% LTV) with future funding for capital improvements, 3 year term but no fee if you refi with them. For our deals that struggle on proceeds for conventional agency financing, we will take a look at a value-add loan. Fannie also has a moderate rehab loan but I am not too familiar with how it works.

  3. We typically assume a refi with no equity cashout, just enough to cover the existing principal balance plus any fees. And yes, agencies will offer interest only. If I were to try to max out proceeds on the refi, I think agencies use a 6-7% debt constant on a 1.25x DSCR.

Jan 4, 2018 - 9:40pm

On point 3, why do you consider refi without cash out?Doesn't that just hurt your cash flow from the increase in debt service without realizing the benefit of the distribution?

I'm just curious as we've only had lps look at it with or without, but nothing in between.

Jan 5, 2018 - 8:52am

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