Why repositioning your commercial property may make dollars and sense
Recently, a borrower came to First National for a mortgage loan to purchase a 60-unit townhouse complex in the Greater Toronto Area for $7.7 million. The purchaser, an experienced real estate investor, targeted the property because the units were rundown and producing well below market rents.
Some lenders would pass on this opportunity because the property featured a great deal of deferred maintenance. Many borrowers would pass on the property because the cash flows were insufficient to support a loan that provided an acceptable amount of capital.
First National chose a different path. Working with the purchaser, we provided both a conventional loan to acquire the property and additional capital to fund a property turnaround strategy. The initial financing package featured leverage at 85% of the purchase price. An additional $500,000 was available to fund property improvements. With this financing, the buyer purchased the property for $7.7 million and invested approximately $675,000 in improvements ($500,000 provided by First National) to renovate a number of units. The property was sold about 24 months later for slightly more than $12 million.
Property repositioning of this kind is something First National’s commercial team offers as part of its solutions platform, but even so, turnaround strategies are not as widely used as they could be, in our opinion. Because much of Canada’s multi-unit, purpose-built rental housing stock is aging and in need of capital reinvestment, and tenant demand for units is strong and growing in many urban markets, we believe more property owners should consider the merits of repositioning in order to drive net income and produce higher-valued assets.
The Value of Repositioning
To learn more about employing such a strategy, we asked Dru McAuley, Assistant Vice President, Commercial Financing at First National to explain the basics.
“There are two primary, inter-connected catalysts for repositioning: the physical condition of the asset and the financial condition of the asset,” said Dru. “When a property is in rough physical shape and needs either structural or aesthetic enhancements, it is often underperforming financially – there isn’t enough cashflow to either improve the asset as a desirable place to occupy or improve the asset as a desirable investment. The operating costs are often too high, the rents are too low and the property does not command the value that it could. A repositioning, executed properly, drives higher net income and, as a consequence, a higher value. The end game is the goal of increasing revenues, reducing expenses and improving its marketability to both users and investors.”
Cap rate compression has been a feature of all real estate asset classes over the last few years. The upshot is that prices for all buildings have increased, notwithstanding their physical or financial condition. The key factor in an acquisition is often less a case of what a purchaser is paying and more a case of what a purchaser can do with the asset – which ties into a repositioning strategy.
First Steps in Any Turnaround
As with most property acquisitions a Building Condition Assessment (“BCA”) is required in order to develop a repositioning strategy. Conducted by a professional engineer, a BCA identifies and documents physical deficiencies in electrical, mechanical and plumbing systems, roof, wall, parking and balcony structures and then itemizes the costs to rectify them. BCAs provide a blueprint for remedial action on the physical structure.
In addition, the interior condition of the structure (common areas and suites) needs to be reviewed and the borrower must decide how much to spend, per suite, to improve the units. Is $5,000 sufficient? What about $10,000? This is where the expertise of the borrower becomes paramount. Experienced borrowers will make the call after assessing how much extra revenue they can realistically generate once the improvement plan is completed.
Given the competitive environment, a borrower’s assessments and the resulting investment decisions should be supported by market data. Since First National has a substantial bank of information applicable to several local markets, can offer guidance that supports the chosen approach and has capital to lend that leads to a viable exit strategy for the borrower, we are well positioned to offer effective financing solutions. First National’s commercial team shares its assessments on all aspects of the financing package with borrowers in its role as turnaround advisors.
A key consideration in lending to fund a repositioning is the future cash flow and value achieved once the program is complete – which determines the exit strategy. For the borrower, an exit strategy is either a sale or a refinance of the property with long-term capital once the program is complete. In order for the loan to work well for both the borrower and First National, the exit strategy has to be clearly articulated and embraced by both parties.
“As you would expect of a lender, we satisfy ourselves that the renovation plan and associated costs are realistic,” said Dru, “taking into account the proposed construction schedule and the projected timeframe for generating improved value. We also validate the financial aspects of the plan through our own exhaustive local market data because if the sought-after uplift in cash flow falls short, it imperils the viability of the financing. But we don’t do research just for our own sake. We share this information with our clients along with lessons learned in working on other turnarounds with the clear purpose of helping borrowers make the best decisions and achieve the most desirable outcomes.”
Management expertise is important in every successful turnaround. Experienced owners keep renovation costs realistic without sacrificing quality and maintain relationships with tradespeople and building material suppliers – all of whom are ultimately relied upon as part of the team.
Sometimes, the choices of where to allocate turnaround capital are easy: a roof must be fixed because it leaks, or a parking garage repaired because damaged concrete is threatening building integrity. Incurring these expenses may not generate higher rents, but is unavoidable in the case of older rental stock and definitely preserves property value.
Other times, spending choices are not as clear cut, such as when a building’s common areas and suites both feature deferred maintenance and need improvement. By applying the experience amassed by working on other turnarounds, First National helps owners determine which ‘fix’ will provide the best value for money. This advice takes into account savings that may be realized through a combination of renovating or attacking costs – such as measures that reduce electrical, water or energy expenses.
During the renovation of the townhouse complex referenced at the beginning of this case study, the owner made several smart decisions that enabled monthly rental rate increases for each of the renovated suites in the $400-500 range, which produced additional revenues that corresponded to forecasts. The borrower’s decisions also kept renovation costs functional and efficient as spending on items that would not generate additional cash flow or value was avoided. Although the borrower chose to divest the property after completing the turnaround, the option was also available to refinance it with a standard conventional or CMHC term loan and continue to enjoy the financial benefits of much higher cashflow.
In a turnaround strategy, financial solutions are determined by a variety of factors that feature a number of moving parts. It can all get complicated quickly. As a result, it’s important to choose a lender that understands the process, and the nuances, involved in realizing your goals.
Repositioning with First National’s help is a great way to access capital for improvements, renovations or repairs that is not typically available in standard financing scenarios. While it requires active management, the financial payback can be significant, and the loan approval process is not materially longer than for any standard commercial transaction.
To learn more about how repositioning can make dollars and sense for your property portfolio, contact your First National advisor.