We Lost a deal!

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We talked about how much we liked Savannah, Georgia, and we have been actively pursuing deals in the area. We thought you might like to hear about one deal that just got away from us. Our acquisition team brought the opportunity to our attention during our standing pipeline meeting and mentioned the "whisper price" was $65M. In these meetings, we first start with a visual overview of the property. We look at the location relative to amenities and criminal activity, then we look at the buildings for aesthetics and the units for size, bedroom mix and washer/dryer hookups. If the property passes the initial review, we start the underwriting process.

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Property Background:

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One owner was selling 372 units spread over three properties. As an owner, you would enjoy some economies of scale but not as much if all was in one location. The buildings were late 1980s to early 1990s vintage. The deal had $38.5M of fixed assumable 2.71% debt with 7 years remaining. During our due diligence, it became apparent that all buildings needed new roofs, and being 30+ years old, we had to plan for other CAPEX needs. One of the properties had a fire and 16 units were in the process of being rebuilt, so that added a bit of complexity. Most of the apartments were renovated but we estimated that 30-50% could benefit from some additional work. Given all this, we budgeted $6.0M for CAPEX.

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Underwriting:

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We contacted an independent local property manager and asked them to review the T-12 expenses and recommend a budget they thought would be achievable. Meanwhile, we obtained insurance quotes that came in high, between $1,450 and $1,650 a door. We contacted the city and asked for an estimate of future taxes on the properties, and it worked out to $1,600 per door. We reviewed Costar's estimated rent growth, and their projection was between 3-5% per year for the next five years. The property manager delivered their budget, and we scrubbed it based on our experience and information we had gathered, and we ended up increasing the expenses by 8%. We obtained quotes on the additional mortgage needed above the assumable loans and factored in 7.7% for interest into our model. Costar projected the exit cap rate in 5 years would be 4.8%, so we modeled 5.0%. In the excitement of getting a deal, it is easy for buyers to become overly optimistic, but our experience has been that it is better to err on the side of caution and budget conservatively.

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Bid Process:

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The first key date is the initial offer date. We were told that 25 parties were looking at the deal and potentially going to make an offer. The highest offers are then moved to the next phase, which is called "best and final". Think of it as a way for the seller to try and extract blood from a stone. We settled on an offer of $58M, a number that we believed would deliver good returns with very little risk.

Using our underwriting assumptions, you can see the returns that our model delivers at the best and final breakpoint (yellow) and the most probable accepted offer, $62M. Clearly the eventual buyer, if marketing this to investors, will not have success attracting capital with a 12.5% IRR. Most likely this will be marketed with an IRR in the 15-17% range. Investors should ask the syndicator, "What were your assumptions to get to these returns?" The only way to achieve these numbers is to assume revenue and eventual sale price will be higher and expenses will be lower. When investing, higher returns always carry higher risk.

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We have a very low close rate on deals, but we are okay with that. We will continue to evaluate and make conservative offers to increase our chances of success.

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