By:
Jerry Ascierto
With the benefit of hindsight, the idea of “trending rents” was viewed as a deadly sin throughout the downturn.
The irrational exuberance of the last boom period inspired some wildly inaccurate underwriting on rent growth, which often culminated in delinquencies and default. Over the last year, however, value-add rehabs have come back into the spotlight as rent growth resumed in earnest. And that rebound in fundamentals over the last year has been so swift it’s defied upside expectations and inspired further confidence to again start banking on rent growth.
Rochester, N.Y.-based Home Properties spent $339 million in acquiring nine communities last year, and underwrote them at a blended 6.1 percent first-year cap rate. The company is instead seeing a 6.7 percent first-year yield—in aggregate, those deals are showing a run rate that’s $500,000 higher per quarter than was anticipated.
“We’ve seen a huge ratcheting up of increased new lease rates, higher renewal rates—it’s been a very steep climb from January until now,” says David Gardner, CFO of Home Properties. “We’re also seeing the opportunity to layer in a lot more upgrading of units at a much faster pace.”
Here are two other factors that are at play again in this value-add, rent-growth environment.
Exit Caps
In an environment with historically low interest rates, and a surprisingly swift pace of cap rate compression, it’s difficult to arrive at an exit cap rate assumption—or what you think the asset will be worth when you go to sell it down the road. Gardner, for one, stresses a cautious approach in underwriting value-add deals, modeling an exit cap rate similar to the going in cap rate.
“We believe there is cap rate compression just in the story of what we do,” Gardner says. “When we buy a C property at a 6.75 percent cap rate, we believe that over the next five years, when we rehab it, that we’ve reduced the cap rate. So if cap rates move up a little, we’ve got ourselves covered using the same cap rate exit as we had going in.”
The company doesn’t mind today’s lower going-in cap rates given the value it’s creating through rehabs. The first-year yield may be a little lower, but those second-, third-, fourth-, and fifth-year yields will grow dramatically, Gardner says.
Like Home, Phoenix-based Alliance Residential’s value-add business is growing. It’s currently working on a $45,000-per-unit rehab of a 40-year-old community in Rancho Palos Verdes, Calif., looking to move rents by $750 a door. The 90-unit community, which it purchased last year, is located on cliffs overlooking the Pacific Ocean, and the rehab should bring it up from a Bminus to an A-minus.
“The cap rate compression coupled with better fundamentals has made deep renovations feasible again,” says Jay Hiemenz, Alliance’s CFO. “When rents are falling, you can’t really see the opportunity to get a return on capital to do the renovation. But now you’ve got rents and valuations rising, and you’re moving the cap rate by bettering the asset.”
Bridge Programs
Still, most value-add deals today are a cautious enterprise. In some ways, curing deferred maintenance has become the new value-add play, an easy way to get a pop on rents without taking much risk.
Greystar has been an active acquirer over the last two years. Last year, the company acquired six properties totaling about 3,000 units for around $200 million. And through July, Greystar had closed on about 3,500 units, for about $500 million.
“A lot of times, you see assets that have significant deferred maintenance, and what we see as value-add upside for curing physical issues, and that then can allow you to improve your rent roll,” says Derek Ramsey, CFO of Charleston, S.C.-based Greystar. “And rents can move fairly materially in just one quarter in the environment that we’re in right now.”
The company has seen the market for rehab capital improve substantially over the last year as lenders such as Berkadia and CWCapital opened bridge loan programs, joining a wave of bridge loan providers, such as Wells Fargo, PNC, and BB&T Real Estate Funding.
“We’ve really seen a flood of bridge financing alternatives. The commercial banks and debt funds have really moved into the unstabilized asset lending business,” Ramsey says. “And because of the increased competition, spreads have come way in from where they were even 12 months ago.”
Indeed, the bridge loan market has gotten much healthier. Rates are being quoted with spreads of around 300 basis points (bps) on the low end, ranging up to 500 bps over LIBOR. Just four months ago, those spreads were 50 bps higher on average, and a year ago, they were about 100 to 150 bps higher.
And bridge loans are getting longer—the typical bridge loan these days is three years with two one-year extensions. In fact, Greystar just closed a bridge loan with a major commercial bank that had a five-year term with two one-year extensions.