One of the biggest decisions we can make in private equity real estate is the price we pay. That’s because it sets the stage for investment success. Everything else that happens the day after we close a deal is an assumption.
What makes everything else an assumption?
For starters, no one can predict the price a tenant will pay to lease space in three years, future rent growth, interest rates, capitalization rates or property tax rates, to name just a few. These are all inputs that have a large impact on projected returns and what price we are willing to pay today. Underwriting is an inexact science and our job is not to win every deal we try to acquire, but to acquire deals at a price where we can execute our business plan with confidence.
For example, if we believe that rents will rise by 10% over the next three years, we would be willing to pay a higher price than if the forecast were only for 2% rental increases. The key is to value a property as if it were only going to achieve 2% annual increases—and then benefit from 10% annual increases. This is how we price real estate at Origin, and it’s one of the main reasons why 96% of our deals have outperformed our initial projections.
But finding deals that pass our underwriting standards is not easy, even though we have talented acquisition officers who live in their markets and see every available deal, both on- and off-market.
Our ability to “buy right” has enabled Origin to acquire deals that deliver tremendous value while protecting our investors’ principal at all times. Two of our recent projects, in particular, show how having well-researched investment strategies for “buying right” is an essential part of creating value in private equity real estate.
Naperville, Illinois: Adding value in a thriving market
Last year we purchased Iroquois Club, a 264-unit multifamily property in Naperville, Illinois. The property had all the characteristics we look for: an infill location in one of Chicago’s most affluent suburbs, right off of the I-88 technology and research corridor and its thriving employment offerings; robust retail offerings a block away; low taxes; one of the area’s best school districts; and compelling amenities that include underground parking, a fully renovated fitness center, a year-round swimming pool and more. Its landscaped 16 acres are arguably the most attractive in the area. It is also nearby two Metra stations for an easy 30-minute commute to downtown Chicago.
More significantly, despite being in the state’s second-fastest growing city, there was no new apartment construction nearby. Naperville data shows the city issued no building permits for condominiums or apartments in 2014 or 2015.
Finding a high-quality property is our first goal. But we also look for properties where we can add value by focusing on solvable problems. And this property happened to have many, from outdated units and facilities to lax management. The property’s owner lived out of state and stopped focusing on rental operations after he executed a failed condo conversion strategy in 2006 and 2007.
Thanks to these issues, the property was underperforming the market substantially. Rents were 15% below market rates, and occupancy was 81% in a market where 96% occupancy was the norm. Unit interiors hadn’t been upgraded since the project was built in 1989.
The building was also quietly marketed, which kept competition to a minimum.
Today, we’ve owned the property a little less than a year and have raised occupancy to 93% with 15% or higher rent increases. Our business plan is tracking well above our original estimates.
When we are done with unit renovations, capital improvements and condo repurchases, we will have spent a total of $170,000 per unit. We underwrote a projected 2020 exit price of $190,000 per unit, well below today’s replacement cost of $240,000 per unit. Recently, a competitive property of the same vintage and location sold in an open market transaction for more than $215,000 per unit.
Based on this recent sale, we are confident that we not only bought right but also more than doubled our investment in less than a year. And we have room to increase these gains further. We will undoubtedly beat our projections for business plan execution time, internal rate of return and multiple on equity.
Dallas: ‘Jewel’ of an opportunity
In August 2016, we acquired One and Two Oak Lawn for our Fund III, a 120,000 sq. ft. class B office building in the Uptown submarket of Dallas. It is one of the country’s hottest commercial real estate submarkets. The building’s name comes from its proximate location to Oak Lawn Park, a 14-acre creekside oasis called the “jewel in the crown of the Dallas parks system” and named one of Dallas’ “best urban green spaces” by USA Today.
Oak Lawn Park was also purchased in an off-market transaction. We recapitalized the former equity owner, who needed to liquidate their position due to their exposure in the energy sector. In return, we had a rare chance to acquire a value-add opportunity in a prime location.
Rents and occupancy rates in Uptown are skyrocketing, according to The Dallas Morning News. In short, Oak Lawn Park is in an urban area that will continue to grow at a sustainable pace. Additionally, Dallas economic growth outpaces the rest of Texas, according to the Dallas Fed, and unemployment is near multiyear lows.
Negotiations with the existing ownership group took more than six months to complete. We finally settled on a price of $14 million, which we believed to be a great value considering that the land underneath the building is worth this much without the structure.
During the closing process, the new lender appraised the asset’s property value. Appraisals have tended to be very conservative since the real estate meltdown of 2008, which is why we were surprised when the appraisal for this property came back at roughly $18 million, nearly 30 percent higher than our negotiated purchase price.
We felt confident about our purchase at $14 million, but the third-party appraisal validated what we already knew: Our real estate acquisitions team put us in an incredibly favorable position to profit from the asset while assuming very little risk. This transaction benefits all shareholders in Fund III — including me and my partner, David Scherer, as we have committed more than $11.7 million to this vehicle.
Origin’s All-Encompassing Approach Facilitates Success
The foundation of our strategy starts with “buying right,” but it doesn’t end there. Our strategy is also about creating value from the bottom up by solving problems and building streams of stable cash flow at each property we acquire. It’s the intersection of these two strategies where we have found success — for us, our partners and our team — and we believe it’s a recipe that will enable us to maintain our position as a top-ranked asset manager in real estate.