Finishing up a really nice little deal

Regular readers know we’re not sellers; once we complete a renovation and lease the property back up, we refinance, return capital to our investors, then hold.

The downside of this strategy is that it can take some time before Adaptive gets to participate in the cashflow generated from the property. Even when we are able to refinance 100% of the cash invested back out, we don’t participate until we pay the investors the preferred return that has accumulated during the renovation period (typically ~12 months).

That’s why the refinancing we closed on a small deal last week was so cool: We were able to pull out 100% of the cash invested AND enough to pay off the pref.

Here are the details:

  • Acquired the property in early 2017
  • Total investment of ~$1.7MM
  • Cash out refinancing of ~$1.9MM closed in September 2018

So, our investors put in ~$1.7MM and then, about 16 months later, got back ~$1.85MM. Plus, now they own 70% of a very nicely renovated building which will spit out cash forever.

Adaptive did OK, too: In exchange for our work on the project, we got a nice fee, plus 30% of the building.

It’s a small deal, so the cashflow isn’t going to change anyone’s life. But we’re happy to just keep chopping wood, repeating the process over and over and over again.

Why we focus on unlevered yield

Had someone write in and ask me why we focus on unlevered yield when we look at deals.

To be clear, unlevered yield is calculated by dividing the forecast annual net operating income from a property by the cost total cost of buying and renovating it… in other words, treating the project like it will be done all-cash, with no debt.

It’s a good question, because a lot of other people in the business look at levered yields (in other words, they assume there will be a mortgage on the property).

We have two main reasons for ignoring debt when we’re under-writing a project:

  1. Using lots of leverage can make a so-so project look ok or even great, particularly if you forecast rent growth in the future and/or an exit (sale) at an aggressive cap rate. We don’t forecast rent growth, we don’t forecast exits, and we don’t want to do so-so deals.
  2. Using leverage to make your deal work puts you at the mercy of the debt markets, and we try to avoid putting ourselves and our investors at the mercy of forces we can not control.

To expand on point 2 above: When we completed the repositioning of our first batch of deals via our old company, Better Dwellings, in 2011-12, we knew that we have created a TON of value. We thought for sure that we would be able to get banks to underwrite our stabilized rent rolls and then cash us out on refinances with cheap debt.

They refused. Banks were extremely gun-shy after the crash, and, despite all of the numbers showing that the buildings could easily handle the leverage, they simply refused to make the loans.

This had a HUGE impact on my thinking. Once you see that banks can/will behave irrationally, you realize that you don’t want to base your business model on them behaving rationally.

How do you avoid leaning on the banks? Well, you make sure that you do deals where the unlevered yield is sufficiently high that you and your investors would be ok with just holding the deals all cash. That way, if the banks want to loan on terms that make sense, great. If not, you’re still ok.

The broken refinancing process

We’re currently in the process of refinancing three properties, with another due to begin shortly.

Think we will end up refinancing another 8-10 during 2018.

Over time, as our portfolio grows, I expect we’ll be rolling refis constantly.

And, I have to tell you: The prospect terrifies me.

The financing process is broken.

It’s totally chaotic and opaque and, because you’re “exclusive” with one bank for ~60 days, the bank feels free to re-trade the terms (ooohhhh, yeeaaaah, about that rate we promised…).

All of the other participants (banks and loan brokers) are fine with this situation, because a fragmented / opaque market creates information asymmetries which benefit the most active participants.

As a borrower, it’s a disaster.

I would absolutely love to find a bank that has a streamlined application process, understands borrowers who syndicate equity, offers competitive terms and won’t re-trade.

That bank would get a ton of business from me and, I expect, a lot of other borrowers.

The math behind what we do

At this point in the cycle, when we consider a new deal, we spend a lot of time thinking about leverage.

Mainly, we’re looking at how our pro forma unlevered yield (eg the cap rate we’re trying to hit post renovation) compares to the projected interest rate on the refinance we’ll do at that point.

I know this is a little boring, but stay with me!

Let’s look at three scenarios, all $5MM all-in deals.

Scenario 1: 7% unlevered yield

  • Invest $5MM
  • Hit 7% unlevered, so $350k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $7.8MM (divide $350k by 4.5%)
  • Borrow 65% LTV at 4.5%
  • That’s a $5.1MM loan, with annual debt service of $309k
  • So, we’ve got all the money invested back out of the deal and we’re earning $350k-309k = $41k / year
  • Levered yield of $41k / $0 = Infinity!

Scenario 2: 6.25% unlevered yield

  • Invest $5MM
  • Hit 6.25% unlevered, so $313k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $7.0MM (divide $313k by 4.5%)
  • Try to borrow 65% LTV at 4.5%, but can’t, because the NOI won’t exceed the debt service by enough to make the banks (or us!) comfortable
  • Instead, borrow $4.3MM (61% LTV), with debt service of $260k
  • Leave $5MM-$4.3MM = $700k in the deal
  • Receive free cashflow 0f $313k-260k = $53k
  • Levered yield of $53k / $700k = 7.6%

Scenario 3: 5.75% unlevered yield

  • Invest $5MM
  • Limp into a 5.75% unlevered, so $288k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $6.4MM
  • Borrow $3.95MM (ouch), with debt service of $239k
  • Leave $5MM-$3.95MM = $1.05MM in the deal
  • Receive free cashflow 0f $288k-239k = $49k
  • Levered yield of $49k / $1.05MM = 4.7%

As you can see, in Scenarios 1 & 2, the more you borrow, the better the deal gets. That’s because the unlevered yield exceeds the cost of the debt (which is the total debt service divided by the loan amount). In Scenario 3, because the cost of the debt exceeds the unlevered yield, the more you borrow, the worse the deal gets.

The above is, in a nutshell, why our business exists. We get paid to deliver unlevered yields that are in excess of the cost of the debt, allowing investors to benefit from leverage, rather than get killed by it.

Another successful Adaptive deal

We just closed on the refinancing of an 11 unit apartment building.

We bought the building two years ago for $2.65MM, then spent another $900k renovating it, bringing the total investment to ~$3.55MM.

Our net loan proceeds on the refi are $3.54MM and we’ve accumulated ~$250k in cash from operations since lease-up.

So, today we’re going to be able to return a bit more than 100% of the capital invested in the deal to the investors.

Since this is beautifully renovated (to the studs!), non-rent control building in a prime area, we’ll hold it forever, with a levered yield that is, literally, infinite.

The refi was delayed by 2-3 months due to some wrangling with the bank, so I wouldn’t say this is literally the perfect Adaptive deal.

But it’s close.