YOUR 4 ELEMENT CHECKLIST

What is needed for a good deal?

INTRODUCTION

Come with me on an analysis of a motel-to-apartment conversion idea.

We will walk through a four-point checklist, kind of up at 30,000 feet, if you know what I mean.

Here is how we at Attune Investments tend to think about a property being a good deal or not.

There are four elements to this checklist – (1) buy right, (2) finance right, (3) reposition right, and (4) manage right.  Here goes.

BUY RIGHT

You may think “buy right” is about buying the property at the right price.  And, it is.  But price is only one small part of buying right.

Buying right starts with your understanding of the market.

For our purposes, not just any motel will be the right property.  It has to be a motel in an area that has the right population.  To be more specific, who is our motel to apartment conversion going to serve. 

One way of looking at this is by thinking of a problem and a solution.  Is there a problem that converting a motel to apartments will meet?

We have been looking at college towns, specifically ones in Southern states like Georgia, Alabama and Florida.  Ones with large universities, say over 30,000 students, where there isn’t enough student housing.  For example:  University of Central Florida in Orlando with 68,475 students, University of Florida in Gainesville with 52,218 students or Auburn University in Auburn Alabama with 30,440 students.

Is there demand for what we hope to create, small, studio or efficiency apartments near the campus?  Is there a problem which we can solve? 

This “buy right” step works were we to be looking for other kinds of apartments for potential purchase.  It is the right market, with population and job growth, with a path of progress, good schools, low crime, etc. 

Now, for our example, it has to be cheaper to renovate a motel in this college town than it is to build from the ground up. 

There are a number of operators who are building student housing, often 4 bedroom units, renting by the bedroom, with pools and clubhouses and lots of activities.

We have a different idea, serving students who don’t want all that noise and distraction, students who are serious about getting a good education and want a small studio apartment and don’t need a lot of amenities, close to the campus.

Now that we have considered the market we want to serve, we need to see if there are any current motels which we might buy.  Can we negotiate a purchase and buy the property at the right price?

Determining what the right price for a particular property is can be a challenge.

The “right price” is a somewhat subjective decision.  Different people might decide on different prices that seem right to them.  We will have to run some numbers related to each of the four elements.

As the buyer, we have to determine why we want this particular property.  Is there something we know or think about the property that would lead us to be willing to pay a certain price?  We might consider what other properties are selling for, or whether the local market is growing well, or whether the government is investor-friendly.

What is our system for determining what the right price is for a property?

We have been looking at a variety of motels that lend themselves to being converted to apartments.  We have studied a number of these that have worked quite well for other operators. 

One of the big factors with a motel conversion is the city or county requirements where the property is located.

If we run into expensive or complicated requirements or roadblocks for the renovation, a very low price may not be the right price.  It might be too difficult to convert.

Mike Jacobson shared a good article last week on the various ways of determining the price for a property, including a per-door price for apartment complexes.  With a motel to apartment conversion, this might give an idea of the after-repositioning-value for the property, which might, with a little math, help us determine an appropriate purchase price.

For this article, based on what the rents might be for studio student apartments in the right location, let’s say we think a $1.5 million purchase price might be a good starting place, perhaps a right purchase price for a 50-unit motel converting to efficiencies.  We might, after looking at the other elements of our four-point checklist come back and decide this is too high or too low.

Although I have put “buy right” as the first check box, I will wait to settle in on the right price until I have worked though through all four elements of this checklist.  I put it as the first point in the checklist because folks like us usually think of a potential purchase price first.

But, ultimately my purchase price will have something to do with my exit strategy and the cost of money and whether I will be doing any capital improvements or implementing any management systems that will have an effect on the value after I purchase it.

And remember, buying right includes not only the price but the terms of the purchase.  If I can get seller financing or the right financing, I can pay more up front, perhaps.

So, let’s look at these other elements and come back to buy right later.

FINANCE RIGHT

Our second element is “finance right”.  We will seek the right leverage at the right terms for the particular property and concept.  We will look at institutional financing and money from private partners and our own funds in this finance right element.

We note that all four of these elements must come together.  Once we find a particular potential property, we will still need to project what the conversion costs will be to know how much it will cost to both purchase the property and renovate it.  Some properties will cost too much to renovate, our next element.

Assuming we can reposition the property from a motel to studios at the right price of purchase and renovation, how will we finance it?

With our motel to apartment conversion concept, we will likely have an empty motel, with no income, and therefore will have to get a bit creative about financing.  We will not yet be able to get a more traditional long-term loan, which usually requires a 90% or so occupied complex.

So, what is available for financing?

We might have enough available cash of our own to do everything, and self-finance.

We like to use the bulk of our funds from banks or traditional lenders or private partners. 

So, what might be available with a bank-type lender? 

Very likely it will be what is called a bridge loan and or a construction loan.  We will assume we need to come up with a down payment on the purchase of the property.  Let’s assume our down payment will be 30% of the purchase price.  So, we will get 70% financing of the purchase.  Very often we can get 100% financing on the construction or repositioning costs.

A couple of lenders we have contacted have said they would be willing to lend for 24 months at about 9% interest and 2 points up front.  Seems pretty high, doesn’t it? We might shop around or simply realize is the cost of the money and deal with it.

This bridge financing would be a temporary loan to help fund the purchase and the construction costs.  As soon as we get the apartments in place and leased and stabilized, we would secure a new long-term loan at much lower rates and pay off this bridge and construction loan.

We would need to anticipate paying interest only during the life of this loan each month and would figure that into our calculations.

We have talked with several potential private partners and have discussed them making 24 month loans until we have completed the repositioning and get leased up and can secure more long-term traditional financing on a stabilized property.  We might agree to pay back these loans, with interest in about 24 months.

We would need to syndicate or form a group of private lenders in accordance with Security and Exchange Commission rules.  Let’s say we offer 12% simple interest per year for 24 months with principal returned and interest paid when we secure the new loan.

I hope I haven’t confused you too much thus far.

In our example, let’s say we need 30% of the purchase price ($450,000 based on a $1.5 million purchase price) of private money for the down payment.  We will plan on securing additional private money which would add additional funds for closing costs and to provide some operating or capital reserves during the construction period.  The total we might need from private partners might be $750,000

Our investors would prefer we have some of our money at risk along with their money, so we will include about $150,000 of our own money in the $750,000

But, we still need to get through the next element to see if these numbers work.  The repositioning costs are critical to the viability of any proposed purchase and conversion.

All four elements need to be right.

REPOSITION RIGHT

So, we looked at two elements that are related to this third element.

We looked first at “buy right”.  We are making sure we are in the right market, solving a real problem with an appropriate solution.  We are considering available properties which might be available at the right purchase price with the right terms for the purchase. 

Then we looked at “finance right” and realized our financing might come from two sources, a bank and some private partners.  We would negotiate terms such as interest rates and length of financing.  And both of these needed to take into consideration this third element “reposition right”.

What might be some factors in doing the repositioning right?  We are taking an empty motel and turning it into an apartment complex.  For our example, we have decided to make each of the motel units into a studio apartment. 

This means a full bathroom and a full kitchen along with closets and room for living.  Our kitchen might have a smaller refrigerator and stove and oven and limited counter spaces.  We need to consider if we will keep any of the current bathroom fixtures or replace them with new ones.  We will also consider the kinds of floors we will put in and the quality of the cabinets and light fixtures and more.

The city might require us to put in a fire-suppression system and even “firewalls” between units, which we would need to include in our cost estimates.  Will there be any exterior costs – replacing roofs, parking areas, landscaping?  Will the electrical wiring need to be replaced?   How about the plumbing?

We will figure in some holding costs – the interest on the bridge and construction loans, electricity and other utilities, taxes, and insurance, for example.

The financing possibilities put a likely time limit on us of 24 months to complete the renovations.

Let’s assume our original estimates put the total repairs at around $1 million. 

So, it is possible we can purchase for $1.5 million and have an additional $1 million in renovations for a total of $2.5 million for a 50 unit motel converted to studios.  This comes out to $50,000 per unit, not counting the holding costs (closing costs, utilities, taxes, insurance, interest payments on the bridge loan, etc.)

Let’s say the holding costs are another $1 million, so $3.5 million all in or $70,000 per unit.

Will this conversion work?  We still don’t know yet.

As with the first two elements, this third element relies on the fourth element, managing right, as we will see in a moment.

MANAGE RIGHT

The final aspect of “manage right” actually depends on why we want to do this conversion.  We will explore our purpose.  Are we in this for the cash flow or for the appreciation or both?

A part of “manage right” for us is having a good idea early in the process of what we expect the rents to be for our efficiency units.  Will the conversion produce large enough rents to justify the purchase price, the repositioning costs, the holding costs, and loan costs?

We want to know if the property will cash flow once it is operating well.  We will work out some “pro-forma” numbers to see what will work.

We will also need to think about how we will manage the complex once it is up and running.  We will be anticipating what the eventual long-term loan terms might be after we complete the renovations and stabilize the complex as apartments.  We will make some assumptions, based on our research of the market area where our motel is currently located.

We might secure an after-completion appraisal from a professional to see if we have made the right assumptions.  This will help us see if our numbers work.  Does another expert think we will create appreciation with our conversion? 

In our example, let’s say the appraisal comes back at $5 million.  We have spent $3.5 million (purchase plus renovations plus holding costs) and created something worth $5 million.  Is that good enough?

We will also want to consider what our exit strategy will be.  Are we planning on holding this new apartment complex for a long period of time, for five to seven years, or will we be “flipping” it once we get it stabilized?

Managing an apartment complex has a lot of moving parts. 

Let’s say we think the efficiencies will generate around $800 per month in rent.  The numbers may say this deal will work.  Or perhaps it doesn’t work.

Once we have our decisions or assumptions about our apartments after we have converted them from motel rooms to apartments, we will go back through all of these four elements again and make adjustments.

We might seek better interim or bridge financing terms.  We might negotiate with our private lenders.  We might offer equity positions rather than just have our private lenders make loans.  We might adjust the extent and quality of our renovations.

Only when all four of the elements are making sense, particularly economic sense, will we know what will work. 

We will know what we can offer to buy right, how we can structure to finance right, what the standards will be to reposition right, and how we will manage right through construction and into the property stabilizing and running well.

What do you think your decision would be?

CONCLUSION

When you are considering getting into a deal on a property, whether as an operator or as a passive investor, take a look at these four elements.

If you buy right, finance right, reposition right, and manage right you have a deal.

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