The pref in this conversion fund doesn't pay cash for three years

Been through the PPM twice on a fund buying obsolete office for residential conversion, and I want other eyes before the next closing.

The seed asset is a 1974 tower, 180,000 sf gross, bought at $38/sf. Plan is 140 units at $210k/unit all in including acquisition, exit underwritten at $310k/unit. Bridge facility at 65 percent of cost, floating, two 12 month extensions each conditioned on a debt yield test and a 25 bp fee. Waterfall is an 8 percent pref, then 70/30 to a 15 percent IRR, then 50/50. Pref accrues from funding but is not paid in cash until stabilization, projected month 34.

What's bothering me:

Floorplates are about 42,000 sf on a center core. Sponsor's test fits show units up to 32 feet deep with borrowed light in some bedrooms. That's a design and code question I'm not qualified to judge, and the unit count carries the exit.

Sources and uses shows $9.20/sf of hard cost contingency on a $148/sf hard cost. Under 7 percent on a full gut of a 50 year old core.

Entitlement isn't complete. Sponsor says the city is supportive and has a conversion program.

I have $250k earmarked. Question in front of me is whether to fund at this closing or wait for the closing after entitlement, at a step up they haven't priced yet.

Answer

1renee_dubois Get yours

The pref accruing to month 34 is the sentence I'd sit with longest. You send $250k, you receive nothing for roughly three years, and the accrual only becomes real money if the exit clears the debt plus the accrued pref plus return of capital. That's not an income position, it's a development equity position with a coupon written on it. Fine if that's what you wanted. You said you do passive positions, so check whether zero distributions for three years actually fits.

On the construction side, I've done gut work on old buildings at a much smaller scale and the two things that blew my budgets were plumbing and vertical distribution. A center core office tower has waste stacks in two or three places. Residential needs them at every wet wall, so you're coring 12 floors of post tension or thick slab and rebuilding risers, and that work is discovered as you open the building. Under 7 percent contingency on that is thin. On the multifamily conversions I've watched from the outside, the ones that finished on budget carried 10 to 12.

The 32 foot deep unit with borrowed light is a code question that depends on the local adopted code and how the building official reads light and ventilation, so someone licensed needs to answer it before you rely on the unit count. If the answer trims 140 to 120, rerun the exit. $310k times 120 against the same cost stack is a different fund.

What I'd actually ask for: the sources and uses with carry broken out separately, the sponsor's last two conversion budgets at original underwriting versus final, and the extension test math at 12 units a month absorption. If they won't show budget versus actual on prior deals, that's your answer about waiting.

7 replies

1ryanmck27SC2C

How long does entitlement usually run on something like this? Sponsor saying the city is supportive and the city actually issuing an approval feel like they could be a year apart, and you're paying interest on a bridge the whole time.

1laurenkim53Passive

The exit at $310k a unit is doing all the work here. $210k in, $310k out, that's a 48 percent spread and every dollar of overrun eats it. What's the current rent per unit that supports $310k, and is there comparable new product delivering in that submarket at the same time? Nobody sells a converted 1974 tower at a premium to new.

3nicole_adeyemiPassivePRO5

On the entitlement piece, conversion approvals and any incentive program are city and state specific, so you'd need to read the actual ordinance and confirm status in writing rather than take the sponsor's characterization. What I'd ask for is which approvals are discretionary and which are by right. If change of use is by right under the current zoning and only the building code work needs sign off, waiting for entitlement buys you very little. If it needs a rezoning or a variance with a public hearing, the gap between funding now and funding after approval is the entire risk of the deal and I'd pay the step up.

Also ask what the sponsor's plan B is for the asset if approval fails. At $38/sf they may be fine holding it, or they may be fine holding it only with a lender who agrees, which is not the same thing.

1mikeoconnell7SP2APRO6

Who leases up 140 units? A sponsor that has done office all its life is now running a residential lease up in a downtown that probably has thin evening amenities. The absorption assumption matters as much as the construction number. I'd want the month by month lease up curve and what happens to the extension tests if it comes in at 12 units a month instead of 20.

2diane_kowalskiPassivePRO9

canton, the carry through entitlement is the line I'd rebuild myself. Taxes, insurance, minimal utilities and interest on the drawn balance for however many months, and it accretes into basis before a single unit exists. On 180,000 sf that adds up fast even at a low per foot number. If the sponsor is running that through the contingency instead of a separate carry line, the 7 percent contingency is really less than that.

1tashaford30PB2APRO7

cairn's point about zero cash for three years is what I'd have missed. I'm still planning a first purchase so I'm nowhere near this, but reading it, the step up they haven't priced yet seems like the cheaper problem. You can negotiate a price. You can't negotiate a rezoning.

The pref in this conversion fund doesn't pay cash for three years

7 replies