Multi-Family Advice

The Great Debate: Class B vs Class C Assets

By November 25, 2019 No Comments

If you follow the Value-Add Multifamily space you’re sure to have heard about, or been sold, the dream. It’s the reason everyone wants to get into and invest in this space. So what is the dream? 

Buying a C-Class property and “converting” it to a B-Class property. 

The narrative goes something like this: By identifying and purchasing a rough and under-performing property, you can come in, renovate units, add amenities, shift your tenant base and, voila, you have elevated that property into a whole new category–the celebrated B-Class. Along the way, you’ve created huge value for your investors as the property is now worth twice what you paid for it a short 18-months ago.

We’ve never really bought that narrative, nor have we attempted to execute that plan.  We believe there is simply too much risk in that strategy–especially at this point in the market cycle. 

In today’s article, we will highlight why we don’t pursue this strategy in our markets, and the challenges we see in executing it. 

First though a caveat–we have plenty of friends and other operators that have successfully executed this strategy, a few even continue to do so.  We tip our cap to those folks, but stay unwavering in our Wildhorn beliefs that it’s our duty to find and deliver the best risk-adjusted returns for our investors.  And the key focus of that sentence is risk-adjusted. What’s the safest possible strategy to execute that removes the most risk?  For us, it’s simply not the C-Class Conversion. 

Here’s Why:

Macro Economic Shifts

Over the last ten year boom, the Value-Add space has been the en vogue and delivered huge returns to investors. Thousands of assets have been bought, renovated and repositioned.  The B-Class space has been the most sought after. During that process, at each asset, a number of the residents living there have been pushed out of that asset, and that neighborhood overall, as the rents simply got higher than they could afford.  In our Texas markets, rents have been growing faster than wages increase. The displaced residents who can’t afford the new B-Class rent are forced to move to C-Class apartments. As this has played out over and over, the concentration of lower-income folks have been pushed into smaller areas and specific assets.  Today’s C-Class properties are occupied by residents without much choice, and they’ll simply be unable to pay higher rents demanded by a Value-Add business plan. If there is no where else for them to go, the chances of successfully moving a C-Class asset to a B-Class becomes much more difficult to execute. While this was easier to do 6 or 7 years ago, the macro-level success of this business strategy has created an environment where its harder and harder to execute at the individual deal level. 

Limited Supply

Another symptom of all the success seen from this strategy?  Finding B-Class assets that haven’t been touched, or truly have any Value-Add left on them, has been increasingly difficult.  We were able to find one and close on it earlier this year, but in general most of the B-Class assets have been bought and sold 2, 3 and even 4 times over the last 10 years.  As the market has run up and the Value-Add category has gotten hotter and hotter, more deals have traded hands.  

What’s left today is hardly any B-Class Value Add, but a ton of C-Class product.  The thing about C-Class Product? It’s usually in a C-Class neighborhood–especially today as everything’s been picked over.  The key to the “Value Add Dream” is finding that C-Class Asset in a B-Class area. If you wind up with a C-Class asset in a C-Class neighborhood that’s “in the path of progress”, you have a somewhat high chance of being left holding the bag. 

Cost-conscious

Speaking of the residents ability to pay higher rents, you also need to think about the higher fees associated with any value-add strategy.  We employ a variety of value-add strategies on our deals. Things like adding Private Pet Yards, Covered and Reserved Parking, Valet Trash, Washer/Dryers, Package Delivery Services, High Speed Internet, etc.  While we position all of these as benefits to the residents–and we believe they are–there is still a cost to the resident for each of these options. Some of them are optional, some of them are not–but in either scenario you have to think about the total check size you’re asking residents to pay, and what they can afford. 

Most of these strategies have a fixed cost to them.  Valet Trash is going to cost $20/month. Reserved Parking is going to run $20-$30.  Those fees are pretty standard in the market, and they don’t vary much between Asset Classes.  At the end of the day, the business plan could call for anywhere from $50 – $150/month in additional “fees” being charged to the resident, all on top of the premiums you’re charging for the renovated unit.  

If you think about a C-Class property, where the average income may be $30,000 – $45,000, vs a B-Class property where incomes are $50,000 – $75,000 it’s only logical to realize the higher income, higher quality tenant can afford to pay those fees more easily than the lower income. While the dollars are the same and the impact to your investor returns are the same, the percentage increase on the rent they are paying is lower, and the percentage of their income is also lower. To us, this is a big added risk to the C-Class property that not many people talk about.

Long Term Horizon

Any short-term business plan is inherently more risky.  You are able to market higher returns when you return capital back to investors sooner, but you also have less time to solve any issues that come up you weren’t expecting.  In the 2-3 year business plan, a 6-month period is 20-25% of the total investment period. If you have a hiccup with your renovation plans, or your occupancy dips below where you want it, or the rent premiums aren’t being achieved there is no time to fix that.  And if the plan is to completely renovate and reposition a 200-unit community, that’s going to take a year or more to get those units renovated. 

Our business plans call for 5- or 7- year hold periods.  We usually plan to spend 24 months to complete the renovations on the interiors.  It’s more of a slow and steady approach that allows us to keep occupancy higher (rather than forcing people out early) and continue to produce cash flow during the renovations.  It also gives us flexibility to pause renovations if necessary during slower winter months, and overall takes more risk off the table.  

Financing

In the Classic C-Class to B-Class transition, we’ve typically seen these executed with short term bridge debt.  Again, the thinking here is you’re trying for a quick-win business strategy and turn this over very quickly. To accommodate that, you sign up for a bridge loan with a 3-year term.  If you go that route you’re also going to borrow some of your renovation dollars, pushing your Loan to Cost as high as 80%. This, again, adds risk to the deal. It certainly helps promote a higher return to your equity investors, but it does add risk. 

To be fair, we have used a bridge loan in the past, and there’s a good chance we’ll do more in the future.  It’s a great tool for the right project. But when thinking about those C-Class asset conversions, we see most of them executed with a Bridge loan, and you simply need to be aware of what that means from a risk standpoint. 

As we continue to canvas the market for deals, study up on the macro economy and make plans for 2020, we’ll continue to be looking for value-add opportunities with the best risk adjusted returns.  Just don’t look for Wildhorn to be buying any C-Class deals anytime soon.

Leave a Reply

The Wildhorn Capital Leadership Team offers small group training to existing or aspiring real estate investors. If you are interested in learning from our team please fill in the following information and we will get in touch with you.

Wildhorn Capital needs the contact information you provide to us to contact you about our products and services. You may unsubscribe from these communications at any time.*

Wildhorn Capital has investment opportunities for accredited AND non-accredited investors. An Accredited Investor is an individual with annual income of $200K ($300K joint income) for the last two years or with a net worth exceeding $1M per the SEC.

Wildhorn Capital needs the contact information you provide to us to contact you about our products and services. You may unsubscribe from these communications at any time.

Yes

Thanks for your interest!

Schedule a call with
Andrew Campbell

Schedule on Calendly