Sale at CO, or a hold through stabilization, on a conversion?

Question

I'm modeling a 24 unit conversion out of a 1970s office building, all-in around $4.6m, and the two exits produce different projects, not just different returns.

Sell at certificate of occupancy: you're delivering a finished, empty building to a buyer who prices it off pro forma rents and their own lease-up assumption. You get out before absorption risk, you don't need permanent debt, and your construction lender's clock is the only clock. The discount you eat is real, because buyers price unproven residential in a building the market has never seen as residential.

Hold through lease-up and refinance: you capture the value the leases create, and a stabilized rent roll is what a permanent lender and a future buyer actually pay for. But you extend into a period where you're carrying construction-priced debt against slow absorption, and lease-up in a converted building with no comps is the assumption most likely to be wrong.

What's pushing me around is that the same building supports both plans and the choice is really a bet on which risk I'd rather own, buyer skepticism or absorption. I've hit a ceiling on solving this with a spreadsheet.

Where do experienced people commit, and do you commit before you start construction or keep it open?

brandonlee36 · Answer

My portfolio is small and what breaks at scale is always the assumption I never tested. Absorption on a converted building is that assumption. On a normal apartment building you have five comps within two miles and a leasing velocity you can defend. On a conversion in a district that has never had residents, you are the comp. If I were you I'd model the hold with absorption at half the rate you think, and if it survives that, hold. If it only works at your base case, sell at CO and let someone with deeper reserves own the lease-up. Also worth deciding early because the finish level and the unit mix you build differ depending on who the customer is.

tashaford30 · Answer

The part I'd want nailed down is the debt. Selling at CO means your construction loan needs to survive to CO and no further, and holding means you need a takeout that exists on a building with zero occupancy at the moment you need it. Those are two different conversations with two different lenders and both should be in writing before construction starts, since a mini-perm option added later tends to price worse than one negotiated up front. @keystone, do you have an extension option on the construction facility, and what does it cost?

aaron_fitz10 · Answer

I'm still choosing a strategy myself, and the thing that jumps out is that selling at CO makes this a development business and holding makes it a rental business. Those need different skills and different amounts of patience. @thicket's half-speed absorption test is the cleanest rule I've seen written down anywhere in this room.

Sale at CO, or a hold through stabilization, on a conversion?

3 replies