Nine rural facilities, $85k in, and an expense ratio that was fiction

This one closed out in the spring and I've had a few months to look at it straight.

2022, I put $85k into a nine-facility aggregation vehicle buying in small markets, populations 8,000 to 30,000, average purchase price around $1.4M per facility. That range is my whole interest in real estate, so the thesis read as written for me. Total raise $6.2M against $13.8M of bridge debt, floating, three year term with two one-year extension options. 8% pref, no promote until a 1.6x multiple.

What they underwrote: 62% expense ratio going in, dropping to 38% by year two on the back of a single management platform, remote leasing, kiosks at the smaller sites, and centralized call handling. Occupancy going from an average 74% to 88%.

What happened: expense ratio landed at 57% in year one and 54% in year two. Never got near 38%. Occupancy got to 81% and stalled. Distributions ran at 8% for five quarters, went to 4% in quarter six, stopped at month fourteen.

The floating debt did what floating debt does. Extension came with a fee and a rate cap purchase, which cost real money, and the lender required a cash management arrangement, so the sweep ended any distribution conversation. A $1.9M capital call went out at month twenty-two. I passed. Diluted from 1.9% of the vehicle to about 1.1%.

Six facilities sold last year in two tranches at roughly a 9.1 blended cap on in-place NOI that was lower than the NOI they bought at. I got back $31k on $85k. The remaining three are still held and I'm treating them as zero until told otherwise.

What I'd do differently, plainly: I'd have asked for the actual expense ratios of the sponsor's existing rural facilities, by property, before believing the 38%. And I'd have refused floating debt with a three year term on a lease-up story that needed four years.

Answer

1derekj19SB1B

I want to push back gently on where the failure sits, because I think the expense ratio was a symptom.

The strategy was operational efficiency across many facilities. Efficiency at scale is real, and it works because a platform's fixed cost, the software license, the call center seat, the revenue management team, the regional manager, gets divided across enough revenue to disappear into the rounding. That's the whole mechanism. The denominator has to be big.

Nine facilities at roughly $180k of revenue each is $1.6M of portfolio revenue. A centralized platform with revenue management and a call center costs a meaningful fraction of that no matter how well it's run, and the platform serving nine rural sites has the same overhead as one serving forty. So the sponsor took an institutional playbook, which needs the denominator, and applied it to a portfolio a quarter of the size that playbook requires. The 38% wasn't a bad estimate, it was a number copied from a class of portfolio this wasn't.

Which means @hollow, the diligence question that would have caught everything was not really about the expense ratio. It was: what is the smallest portfolio you have ever run this platform on profitably, and what were its actual results. If the answer is forty suburban facilities, the model has never met your deal.

The floating debt turned a slow disappointment into a wipeout, and I'd separate those. Bad basis on the operating assumption is what killed the equity. The rate cap and the sweep just set the date.

5 replies

1karen_whitfieldPG4APRO7

The 74% to 88% occupancy assumption is the piece I'd have stumbled on first. In a town of 9,000 people, the reason a facility sits at 74% is often that 74% is the demand. Nine facilities in nine small markets and every one of them assumed to have 14 points of hidden demand waiting for better management is nine independent bets that the previous owner was the problem. Some of them were, surely. Not all nine.

Sorry it cost you $54k to learn. It's a clean lesson though, which is more than most losses give you.

1gregpowell66AG4BPRO8

Kiosks and remote leasing at a 300 unit facility in a small town is a construction and hardware line item that also needs somebody to drive out when the gate controller dies. I've built and installed enough of this equipment to know the travel time is the expense nobody puts in the model. Nine sites spread across a region means a district manager who is in a truck four days a week, and that's fuel, hours, and a vehicle, all sitting in the line that was supposed to fall by 24 points.

2tonyv88SO4CPRO6

Centralized management drops expense ratios on facilities that are big enough to spread the fixed cost. A $1.4M facility does maybe $180k of gross revenue. A 38% expense ratio on that is $68k of total operating cost including property tax, insurance, utilities, and payroll. In a lot of counties the tax and insurance alone eat half of that before anyone answers a phone. The number was arithmetically unreachable, and it could have been checked in ten minutes against one facility's tax bill and insurance quote.

Property tax practice and reassessment on sale vary by state, so anyone checking this should pull the actual assessor record for the specific county rather than assuming.

3mitchell_ray4 Get yoursPRO6

@beacon that framing is the useful part of the thread. Small sites carry the same overhead per site and less revenue to hide it in.

@hollow one practical add. When you get a capital call and you pass, ask for the pro forma of the vehicle assuming the call is fully funded and assuming it isn't. Sponsors will produce it if you ask. If the funded case still doesn't clear the debt, dilution isn't a decision you needed to agonize over, and it sounds like that was your situation.