Nine months of diligence on a 264 unit deal, and I lost most of $150k anyway

Bought in mid 2022. 264 units, 2015 vintage, Sun Belt metro that everyone including me thought was undersupplied. Basis $51.7M, $196k a unit. Floating bridge, 70% of cost, SOFR plus 285, 36 month term with two 12 month extensions. Rate cap 24 months. My check was $150k of a $17.2M raise.

Property sold in a lender-driven process last quarter at $39.1M, $148k a unit. LPs got back about 9 cents. I read the PPM, the LPA, the third party property condition report, the phase one, and I built my own model. Here's what my model got wrong and where.

Rent growth. I underwrote 4% for three years. The sponsor had 7%. I thought I was being conservative. Actual was negative 2.1% in year two and negative 3.4% in year three as deliveries hit the submarket. There were 4,600 units under construction inside four miles and I knew that number. I looked at it and decided the job growth absorbed it. It didn't, and it wasn't close.

The cap. I noticed the 24 month cap on a 36 month loan. I wrote a question about it, got an answer about the cost of the longer cap and how it would compress returns, and I accepted the answer. Debt service went up about $2.1M annualized when it rolled off. That's the number that ended the deal.

The exit cap. Sponsor used 4.75% against a 4.4% going-in. I ran 5.25% and thought that was my margin of safety. Sale cleared at something closer to 5.8% on trailing income that was itself down.

The part I'd do differently is narrow. I treated the cap term as a returns question when it was a survival question, and I let the sponsor's answer close it instead of asking what happens to the deal in month 27 at a rate 300bp higher. I also never once asked for the quarterly delivery schedule for the competitive set, only the annual metro number, which averaged out the thing that killed us.

I'd still be down on this deal with a full-term cap. I don't think I'd be at 9 cents.

3 replies

1omar_haddadActivePRO11

I'll disagree with flint, mildly. The debt is what closed the casket. The reason the property couldn't refinance out of the bridge before the cap rolled was that NOI never got where it needed to be, and on these value-add deals the NOI miss is usually half market and half execution.

canton, do you know how the renovation ran? Units completed against schedule, average days from move-out to rent-ready, and whether they kept renovating into the soft market. Because the pattern I see over and over is a crew of the right size for 20 units a month, a schedule that needs 28, and eight months of slippage nobody reports as slippage. By the time you're behind on units you're behind on the refi appraisal, and then the cap date arrives and you have no options left.

If the sponsor renovated 200 units into a market giving away two months free, that's $2M of capital spent for premiums that evaporated, and that money would have bought a lot of cap.

1mitchell_ray4 Get yoursPRO6

I mostly swing tools and I'm trying to understand the money side. So the thing that broke wasn't the building at all. The building was fine, 2015 vintage, presumably nothing structural. It was two contract terms and a construction schedule in another county.

The 4,600 units inside four miles is the part I can't get past. That's a number you had. What would have had to be true for you to walk on it?

Nine months of diligence on a 264 unit deal, and I lost most of $150k anyway

3 replies