case study

Case Study Scenario

In this case study you will be analyzing a property from the perspective of an analyst at Moorage Capital Partners.

Moorage Capital Partners is a 25-year-old private equity firm that was born   of the wreckage of Boston’s housing bubble and bust in the late 1980s. The founding partners had been veterans of earlier real estate cycles and retained a great deal of confidence that the long-term fundamentals warranted continued investment. In the small world of real estate, the founding partners of Moorage had known each other for years, partnering or competing over numerous real estate deals in New England. All of them had seen cycles before and saw that the downturn was the right time to buy. But in 1991 each of their own firms had decided to slow their acquisitions until there were more obvious signs of strength. They had been frustrated having to watch good real estate trade at what they felt were below their “true” value. So they left their respective firms and formed Moorage Capital Partners to act on these beliefs.

Raising capital for a new firm in a downturn was a challenge, so they devel- oped an approach that could be described as “solid investments in stormy seas.” The firm’s name followed the business plan: a mooring is a safe place to anchor a ship, and Moorage was able to raise funds by acquiring well-located apartment buildings that were largely occupied. These investments were marketed as “shelters from the storm” because they had demonstrated a durable history of high occupancy. What had been marketed as a defensive strategy proved to be quite successful when the recovery brought both higher rents and higher asset values. Happy with their results, Moorage and their partners began to reinvest their returns back into more multifamily properties.

Twenty-five years from that start, Moorage Capital has replicated this strategy through every cycle. They sell assets when they feel prices are high enough, but otherwise remain interested in holding good assets for the longer-term. While they have expanded to units along the eastern seaboard and select submarkets inland, the same conservative mindset kept them from heading west. But for so many reasons, this year senior management has finally decided to test the waters of the West Coast. Gil was one of two people hired to run Moorage’s new office in Los Angeles. Moorage Capital is a firm that few brokers will know west of the Rockies, but one that has an exceptional reputation among national lenders and a lot of expertise with operating apartments. While they would be new play- ers to these markets, Moorage would not be seen as rookies.

Vista View Apartments

The Vista View Apartments are in Mission Viejo, California on Los Altos Drive. They consist of 15 separate buildings and 148 seperate units across 8 acres. The property is located in Orange County, this vibrant submarket has long since shed its earlier reputation as a bedroom community for Los Angeles. Indeed, where once the majority of real estate in Orange County was residential, providing housing for commuters to the major employer to the north, a significant motivation for this investment   is the fact that now there isn’t enough housing for the employees who have come to Orange County for jobs here. While Orange County benefits from be- ing part of the most vibrant metropolitan areas in the United States, its local economy has evolved into a unique and thriving submarket unto itself. The Orange County office market now has over 1.6 million employees and an un- employment rate of less than 3.5%. The Orange County office market stands at approximately 100,000,000 sf and is growing. Near the Vista View Apartments, the Irvine Spectrum and surrounding South County office markets total close to 20,000,000 sf and vacancy here has fallen to below 8%.

One of the constraining factors to this growth is the cost of housing, which has been rising well above rates of inflation in recent years. In fact, prices and rents now surpass the peak pricing of the housing bubble years in 2006 and 2007. This is impressive given the size of the downfall then, when unemploy- ment rose past 10% and office vacancy was approximately 25%. Orange County had been one of the primary centers for the subprime mortgage industry, which had been devastated with the housing bust. There was pain from 2008 to 2010 as deals unwound, development stopped, and extend-and-pretend was a dominant strategy for many owners.

Orange County has since found other economic engines and has succeeded in bringing jobs and incomes back to the region. The County now hosts some of the largest names in tech, design, automotive, and biotech, among other in- dustries. The attractive weather, high-quality schools, ample open space, and diversity of amenities can equate to an extraordinary quality of life if one can find housing at a reasonable cost. For a variety of reasons, state and local policies have left the state underhoused for decades. This has allowed owners of housing to charge ever-increasing rates; those with particularly good locations have been able to charge much more. And while there has been some devel- opment and redevelopment, it has been mild relative to a typical recovery in which housing leads the economy back. Certainly housing supply has not kept up with to the economic growth in the region. There have been numerous efforts at “solving the housing crisis,” but these aren’t serious and are unlikely to lead to a strong housing supply response that might be a source of falling rents in the foreseeable future. Gil could only find two similar projects in the surrounding area built in the past 20 years. To him, the primary risk in investing in Vista View is overpaying for it.

Beyond the larger fundamentals at work in the region, there are plenty of additional reasons to believe that bidding will be aggressive. Vista View is located in a strong submarket with regard to demographics, and there are few apartment complexes nearby. In some of Moorage’s east coast markets, single family homes have been a serious competitor to apartment owners. This is something the investment committee will want to know about. However, median household annual incomes here are approximately $100,000 (higher than the Orange county median of $78,000), but houses around the Vista View apartment nearby averaging prices of about $900,000. Gil would need to run the numbers but thought there is good reason to assume that no new direct competitors will arrive soon even if rents rise. Importantly, the Vista View Apartments are largely designed as townhomes and are likely to attract households that aspire to own in the same neighborhood at some point. Indeed, all of the two- and three-bedroom units are townhome style with two car direct access garages; the one-bedroom units are flats that have either direct access or detached garages in each unit. While a little dated, these units are not the generic boxes typical of earlier housing booms.

Gil has just received a phone call from the property broker saying the sellers are entertaining final and best offers of at least $57 million.

Despite the high pricing for the Vista View property, the broker had marketed it as a value-add deal. His pitch rested largely on the interiors of the units, which are mostly original with laminate countertops. Some of the units have stainless steel appliances, but most of the units still retain the legacy of what was trendy when they were built in 2002.

Options

The broker had been smart to market the property as a value-add deal. While inflation showed some signs of picking up, treasuries remained quite low and there is a lot of capital looking for safe assets that could earn a reasonable spread over them. The broker had also been smart about being vague as to what “value- add” would mean. He would, of course, want as many bidders as possible to “see the dream.” He had been right to be vague because this would allow all the prospective bidders to find their own optimism about what constituted a successful and optimal renovation program.

The broker provided his own underwriting of the cash flows and, not surprisingly, Gil found hopeful assumptions in key places in the broker’s pro forma. Gil started with the broker’s numbers but then considered assumptions he thought more realistic, refining his own model as he went. The broker had baked in some optimism looking forward, but mostly created an attractive cash flow by rolling forward some of the favorable trailing numbers from the property’s cash flows over the past months. At the same time, there might be some reason to be optimistic: both Gil’s sense of the market and the rent comparables suggested there was room to push rents higher. Once Gil had built his estimated current cash flows, he did not even download the rest of the broker’s pro forma numbers, preferring to work from his own assumptions about rent growth, vacancy, and operating expenses.

Should the deal happen, the property closing date will be August 1, 2020. Gil knows his company prefers to invest in NPV positive projects with after tax IRRs greater than 7.50%. 

Option #1:

Moorage Capital had a long track record of such renovations but they were entirely based on properties thousands of miles away. While they understood the principle of it, they knew that the cost-benefit economics must be local. That’s why they hired Gil—they would be looking to him to put together a business plan for the renovation. Gil assumed that he would have to renovate 100% of the units at an average cost of $8,700 per unit (interior renovations). He also intended to invest funds in modernizing the common areas and landscaping. There had been a significant swing toward interest in and use of shared space in last 10 years as key amenities for residents. At Vista View, the current common areas were tired and seem to be wholly unused. The total cost for the renovations of the units ($8,700) and common areas ($2,000) came out to $10,700 per unit. Gil thought he could get through the renovations over the course of 2 years (24 months). Renovations will begin in month 1 and run for 24 months. The contractor performing the renovations recommends a 10% construction contingency.

The outcome of these renovations would be an updated and current property in a great location. Gil thought he was being conservative in assuming that the renovated units would justify a premium rent of 15% over the current rents. And from there Gil expected high occupancy (similar to comparables after the renovation is completed) and relatively robust rent growth. Project rent growth in the model where appropriate for the next 10 years. Moorage wanted a good return, but more than that they wanted to buy a piece of property that would outperform when the market turned down. With the renovation, the Vista View Apartments would be the best product in the submarket while charging a rent that Gil thought was more than fair given the amenities both inside and outside the units.

Along with solid underwriting, Moorage avoided using too much debt. Gil had an ongoing relationship with a lender who would be happy to provide up to 60% of the total purchase price. In exchange, the lender would charge a 1% origination fee and offer a 30 year fixed 4.25% annual interest rate loan after the initial interest only loan. As with many standard loans, it would amortize over 30 years but be due at the end of 10 years. The lender also offered an initial interest only loan at a slightly higher rate to allow for better cash flows during the first 24 months renovation period. This loan would have a term of 24 months, interest only period is 24 months, interest rate of 6.00%, origination fee of 0.75%, and a loan to value of 57.50%.

This option would have an investment holding period of 10 years. After 10 years the property will be sold.

Option #2:

Currently the property contains supplementary parking that does generate garage income of $48/unit. However, in option number two some additional will be spent on exterior renovations that construct a $2,500,000, 150 parking spot garage. The garage will rent up to 1 spot per unit. It is expected this could generate an additional $50 per unit per month in garage/storage income. In scenario 2, an additional $2,000 per unit will be spent on bathroom upgrades and Gil projects this will result in an additional 5% increase in rent the property can generate.

In order to calculate the NPV information Gil had to find a market discount rate. For his inputs he used the equity risk premium computed by Aswath Damodaran and the 10 year UST yield. The 10 year is relevant because this project has a 10 year holding period. 

Risk Premium website: http://pages.stern.nyu.edu/~adamodar/

You will use this scenario to generate two separate scenarios based on the two options the analyst is discussing. 

Submit two Excel files one for each scenario and one Microsoft Word document.

Discuss the two scenarios. Compare the rates of return on both.

What assumptions is Gil making about the project’s risk by using the equity risk premium as an input into the market discount rate?

Could it cause trouble having such a low exit cap rate 10 years from today? Why? What about the current global environment makes it particularly risky?

If you raise the exit cap rate to 5%, what does it change about the deals? What about 6%? At each of these cap rates, does the current purchase price present a good return opportunity when comparing the project to other available investments such as large cap US stocks?

What do you suggest the investment firm do? Do you recommend the investment as is? Should they attempt to negotiate a lower sales price? If so, how large of a drop would provide the return necessary to justify an investment (keep in mind the return offered by other comparable investments)?