Dallas Beauty – B mine or C you later?

September 29, 2019

We had the opportunity to invest in a 120-unit 1980 construction B- apartment in Lancaster, a suburb in the Dallas-Fort Worth Metroplex, about 15 minutes from downtown. It is located near major thoroughfares, public transportation routes, shopping center, public park and library. The property is cashflowing from day 1 of ownership and has 95% occupancy rate. 80% of the units are 2BR or 3BR with washer/dryer connection.  It has 109,920 rentable sqft (floor plans averaging 916 sqft) on 7.66 acres so that the density is 15.7 Units per Acre.  It has a swimming pool and office/clubhouse.  The 2-story building has pitched composition shingle roof, concrete slab foundation, wood framing, brick veneer exterior and siding.  The units have patios or balconies and are individually metered (water and gas are RUBS; Tenant pays electric).

The economic drivers in the Lancaster area, per sponsor data: 12 month Rent growth of 4.2%, population growth 2019-2024 projected at 7.5% in 5-mile radius, diverse local job base with employers such as Amazon, L'Oreal, Wayfair, BMW Group, William-Sonoma and others in healthcare.  The sponsor data indicated a Median Household Income at $62,300 within a 1-mile radius though our findings suggest differently.  Calculating the minimum income requirement for housing which is yearly income/40, we get $1557 (using sponsor data) or $1236 (our data) suggesting rent below this number is affordable.

The deal is touted to be a value add opportunity with equity raise of over $3M granting the Class A investors 70% ownership of property with average unit cost of $97,750.  The business plan consists of repairing exterior and interior deferred maintenance items, and upgrading approximately 50% unit interiors to market level to achieve market rents through a third party property management company.  A water savings program will be implemented to replace toilets, faucets and shower heads with efficient models and to optimize operating cost. The interior unit upgrades will be new black appliances, two tone interior paint, gray wood look vinyl flooring, new kitchen and bathroom brushed nickel hardware, new lighting fixtures & ceiling fans.  The Office will also be remodeled.  The exterior upgrades will be new property signage in the main entrance, fresh paint on front doors, new building signs, parking lot striping and painting of exterior eves.  The landscaping will be updated and playground/pergolas/common area will be added.

The ownership structure is tenant-in-common TIC with 15% private entity, 70% Class A Investor LLC and the remaining 15% Sponsor entity through which they will receive their compensation.  The Sponsor fees are (a) monthly Asset Management Fee of two percent (2%) of gross quarterly receipts of the Property, (b) Refinance Fee equal to 1% of any new loan, (c) TIC Manager will receive 15% of the Net Cash Flow of the Property from operations, and (d) As TIC Member, they will receive TIC distributions 15% of Net Cash Flow of the Property upon any sale or refinance of the Property, after each of the other TIC Members have received the return of their Unrecovered Capital Contribution.  No acquisition fee charged.  Class A Members will receive 100% of Net Cash Flow of the Company from the Sale or Refinance of the Property from the Company’s 70% ownership of the Property. The  third party Property Manager will be compensated at market rate of (3%) of gross income.

The sponsor data provided apartment comparables in the area that showed that the proforma rents are competitive.  Even though single family homes/condos/townhomes are not customarily considered in an apartment acquisition analysis, we also looked at homes purchased in the past 3 months and nearby homes available for rent.  We believe renters in the B&C class are price sensitive and would consider other cheaper options if available.  Though our own apartment search validated the sponsor comparables, it should be noted that there are houses for rent that are cheaper and there are condos for sale at similar "wholesale" price.

Analysis on the zipcode based on 2016 data showed increase in population with renters accounting for 43% (vs State average of 39%) but still at low population density of 2,180 people per square mile.  Cost of living index is less than U.S. average and Residents with income below the poverty level is 20.1% vs 15.6% for Texas.  For population aged 25 years and over, 86.7% have High school or higher, 19% Bachelor's degree or higher (below state average), 4.5% Graduate or professional degree and 6.4% Unemployed.  The mean travel time to work is 31.0 minutes. For population 15 years and over, 39.8% are never married, 41.4% married, 3.2% Separated, 3.3% Widowed and 12.3% Divorced.  The Black race population percentage is significantly above state average; the Hispanic race and Foreign-born population percentage are below state average.  Length of stay since moving in above state average. The estimated median house/condo value in 2016: $121,535 vs. $161,500 for Texas.  The median resident age is 32.2 years vs. 34.5 years for Texas. The average household size is 3.1 people vs. 2.9 for Texas. The percentage of family households is 61.4% vs. 53.6% for Texas. 

The sponsors will have a cost-segregation study with bonus depreciation to determine tax benefits to investors.  They assume a five-year holding period, 5.7% income growth from actuals to projected year 1, exit CAP rate from 6.1% on T3 actual to 7.00% reversion CAP rate upon exit, T3 actual expenses lowered from $5,612 per unit per year to $5,190 per unit per year and 10% economic vacancy though historically it had 5% or less physical vacancy. Passive investors are projected to achieve 80% total return, 10% average cashflow and 14.8% IRR.  Assuming no rent increase or other income increase in the next 5 years (we assume that factors that enabled Texas to largely escape the economic distress experienced around the nation in the 2008 recession are still in place in case there is another recession during the 5-year hold.), our calculations indicate passive investors may still walk away with 16% total return, 10% average cashflow and 3.8% IRR. 

Based on the analysis we performed, the property appears to be a C+ than B-.  Though this property is not the most expensive apartment rental price out there, it seems that apartments are getting to the point where it is cheaper to rent a similar house/condo or even to buy.  This points to our scenario where there is no rent growth and possibly little capital appreciation over 5-year hold unless house prices increase. In conclusion, we passed on this deal.