Fund PPM sets hard cost contingency at 5 percent on office conversions

The PPM in front of me is for a fund that buys obsolete office and converts to apartments. Target equity $180m, three year investment period, four buildings under letter of intent at signing. What stopped me is the hard cost contingency, set at 5 percent of the construction budget. The sponsor's own building summaries say two of the four need new plumbing risers throughout and full facade window replacement. Five percent is the number you carry on a product type you have built twenty times in a row, not on a first pass through a 1980s tower with a core in the wrong place.

Second thing. Feasibility and pre-development spending comes out of committed capital before any deal closes, and dead deal costs are borne by the fund with no cap I can find anywhere in the document. On a strategy whose whole discipline is rejecting most buildings, that could be a lot of capital spent on buildings nobody ever owns. I would like to see a number, even a soft one, for how much they expect to burn on studies that end in a pass.

The economics as presented: acquire at $40 to $60 per square foot, spend $250 to $320 per foot converting, exit around $340 to $420. The spread is real if the cost side holds and only if the cost side holds.

My decision is whether to commit $250k at the first close or wait for the second close, when at least one building should have a permitted drawing set and a guaranteed maximum price from a general contractor. Waiting costs me the fee reduction they are offering early money. I have not decided which of those two I care about more.

2 replies

3sonia_alvarez Get yoursPRO6

Ask them how the construction loan interest reserve is sized and what happens when the schedule slips past the reserve. On a conversion the schedule is the risk that eats everything else, and a reserve built on an 18 month build gives you nothing at month 24. Whatever they tell you, get the lender's current terms confirmed in writing rather than taking the PPM summary as the deal.

2dmitri_v6CapitalPRO6

The dead deal cost language matters more than the contingency to me, fathom. I would want a hard annual cap on pre-development spend that does not close, plus whether the sponsor can extend the investment period without an LP vote and who pays for that extension. Also check what happens to your capital if the named conversion principal leaves. Funds like this run on two or three people who can actually read a building. Have a securities attorney read the LPA before you wire anything, since the document controls and my reading of it does not.

Fund PPM sets hard cost contingency at 5 percent on office conversions

2 replies