Anatomy of an Underwriting — Our First Acquisition in SB3

Charleston, SC | June 1, 2024

As we launch our third Sunbelt Multifamily fund since Ballast Rock was founded in 2018, we thought it would be helpful to provide a comprehensive look behind the curtain at our underwriting process for new acquisitions. To that end, our Investment Director, Kyle Fitzgerald, offers insights into our underwriting “special sauce:”

“Underwriting for acquisitions is as much an art as it is a science, with the quantitative and qualitative inputs coming from years of experience reconciling hundreds of desktop underwritings with the reality of a site visit.”
Kyle Fitzgerald, Investment Director

When reviewing potential acquisitions for our Sunbelt Multifamily funds, our Atlanta based acquisitions team conducts an initial comprehensive desktop underwriting for every deal, making assumptions about revenues, expenses, capital expenditures, financing terms, etc. all based on a combination of the property’s historical performance and current market information.

The team begins with baseline assumptions for all our underwriting inputs, based on our own in-house operating metrics, as well as comparable operations from our competitors’ properties. However, every deal is unique and market conditions are continuously changing, so every underwriting requires further careful consideration of individual assumptions to make sure they reflect deal-specific characteristics.

If a deal passes our initial screen, both our asset management and property management teams go on-site to carry out further in-person diligence to enable us to refine the assumptions we used in our initial underwriting. Our first onsite visit also allows us to accurately assess the condition of the asset, understand the resident base better, and meet the current on-site employees.

In this piece, we offer some insight into the underwriting process we went through for the first asset we expect to acquire in Sunbelt Multifamily Fund III (“SB3”).

On Site

The asset we are acquiring was purchased by the current owners in mid-2021 and then converted from student housing to conventional multifamily. As it was an extensive conversion, they had to vacate most units before work began, which brought property occupancy down to ~10%. They then renovated every unit, improved exteriors by painting and light amenity enhancement, before they began re-leasing the property with conventional workforce tenants.

Given the conversion from student to workforce multi for this asset, going on-site was an opportunity to inspect the work performed and obtain more granular estimates for CapEx spend, interior and exterior scopes, etc. In this case, when we arrived at the property, we found that it was in worse condition than we had anticipated (given the extensive renovations that had been purportedly carried out). Some examples included:

• Unit renovations were of a lighter scope and with lower-cost materials than we had expected (e.g., cheaper “rolled vinyl-look” flooring was used rather than “plank vinyl” flooring, which does cost more but in our experience is easier to maintain and lasts much longer, so justifies the added cost).
• The leasing office’s A/C was non-functional.
• The workout room had outdated equipment and the TVs had been stripped from their wall-mounts.
• When we toured the model unit, the ceiling fan in the master bedroom was attached to the ceiling by a single wire and the ceiling paint appeared stained/damaged. The model unit allows prospective residents to do a tour before they sign a lease, so they are usually kept at a high standard.

Next, we are going to look at the impact on-site inspection by comparing pre-due-diligence vs. post-due-diligence underwriting estimates.

Capital Expenditure

As mentioned earlier, during our initial underwriting, we typically budget a benchmark amount for per-unit renovations and estimate exterior expenses based on expected condition, usually based in part on the broker report, pictures of the exterior, desktop review, etc.

In this case, we budgeted for replacement of 35% of the property’s HVAC and hot water heaters, $4k/unit for interior upgrades and a few major exterior categories, including property-wide roof replacements, plumbing contingencies, and some other miscellaneous exterior repair improvements.

Considering what we learned about the condition of the asset during our on-site due diligence visit, we adjusted our budget for interior renovations to $6.6k/unit for 75% of the units, with an additional $2k/unit contingency for 50% of the units.

For the exterior and common areas, after fine-tuning various line items like updating the fitness center, leasing office upgrades, bringing the fob system back online, repairing gutters/rotting wood/fascia, etc., we found that our pre-due-diligence estimate was remarkably close to our post-due-diligence figure.

The net result of these changes was a 19% increase in expected CapEx. But looking at CapEx is just part of the picture. Next, we looked at refining our estimate for market rents achievable at the property.

Rents

We believe one of our competitive advantages is having our own in-house property management company, so one of the qualitative aspects we consider when looking at an asset is the quality of the current property management team. There were several shortcomings we identified that we felt could be easily addressed and would help us improve the standard of the property and hence allow us to increase rents, such as:

• Given the property was largely vacant during renovations and occupancy took longer to recover than expected, the current owner was forced to complete repairs and maintenance with a focus on cost rather than quality. As a result, critical items such as HVAC replacements were being addressed with temporary and in some cases ineffective fixes, rather than fully addressing the issue.
• The property is gated, but the key-fob system is broken. Through a small spend, our team will bring the key-fob system back online, both improving resident safety through a functional gated community and increasing resident satisfaction by allowing access to the gym outside of the leasing office’s hours (9am–5pm).
• Management was not adequately monitoring quality control when turning units e.g. “Rent ready” units were often dirty and missing minor cosmetic finishes when being shown, reducing demand and leaving those residents that signed a new lease frustrated and dissatisfied from the moment they moved in.

In addition to spending time at the property, the team also toured nearby comparable assets so we can ensure we are comparing “apples to apples” when we estimate the market rents we are likely to achieve.

After going through this extensive underwriting process, the team is confident that this property can be genuinely differentiated from nearby comparable properties, and, given its age and potential for upgrades, we believe we can reposition it as a B+ asset, while nearby competitors are B- assets at best.

Additionally, where this asset has been operating at occupancy in the mid 80s for the last 12 months, since our initial bid, we have seen occupancy climb to the low 90s, while the current owners have pushed asking rents $100 higher. This continues to give us confidence that there is scope to push market rents, given the current sponsor achieved rent increases even with the shortcomings highlighted above.

For this first seed asset in Sunbelt Multifamily Fund III discussed above, we feel increasingly confident in our ability to reposition this asset, increase rents accordingly, and achieve the targets we have set for ourselves in our underwriting pro-forma.

The underwriting processes described above for this first asset acquisition is consistent with how we have analyzed every deal from a quantitative and qualitative perspective for our Sunbelt Multifamily funds over the past eight years of executing deals in the Southeast.

Prior Sunbelt Multifamily Funds

Ballast Rock launched Sunbelt Multifamily Fund I (“SB1”) in 2019 and between February 2019 and January 2021 acquired nine properties totaling 1,110 apartment units for $63,630,000. SB1 began dispositions in early 2022, generating gross proceeds of $60,450,000 from the first four properties sold. The 593 apartment units involved were acquired at an average cost of $53,583 per unit and sold at an average cost of $101,939 per unit. Ballast Rock anticipates exiting the remaining five assets in SB1 opportunistically over the next 12 to 18 months.

Sunbelt Multifamily Fund II (“SB2”), launched in 2021 and between February 2021 and January 2023 acquired nine properties totaling $101,408,000, with 1,039 apartment units.

In April of 2023 Ballast Rock launched Ballast Rock Capital, its broker-dealer. Ballast Rock Capital is a member of the Financial Regulatory Authority (FINRA) and the Securities Investor Protection Corporation (SIPC) and is registered with the Securities and Exchange Commission (SEC).