Small Properties, Sizeable Challenges
Small rental properties come with increased risks that make them difficult to develop and underwrite. Depending on the market, a “small” property may be up to 50 units or up to 30 units. However, both come with the same problems of higher per-unit costs.
Regardless of the size of the property, there are some standard costs involved in the development and underwriting process, including the market study, staff time, site visit, environmental review and application fees. Small properties also require ongoing servicing at the same level of staff time and resources as a larger property. However, because the properties require smaller loans, they have a smaller rate of return.
In addition, smaller properties carry more operation risk. “In underwriting rural deals you find that they tend to be smaller and thus do not benefit from economies of scale,” said Tony Lyons, regional vice president of the northeast acquisition group for National Equity Fund (NEF). “The vacancy rate can spike well above the typical 7 percent (used as a rule of thumb). A 10-unit building with one vacancy can have significant fluctuations in NOI (net operating income). Rents tend to be lower than in urban and suburban markets and consequently often cannot support fixed operating expenses let alone any meaningful, conventional hard debt and because smaller, rural properties often can’t support the expense of a full-time, on-site manager, property management can often be challenging.”
All of these issues are enough to steer many lenders away from small properties. They are typically financed by local banks and credit unions or specialty lenders such as NEF and Mercy Loan Fund.
“Small rental properties offer real affordable housing opportunities for low income people and communities,” said Julie Gould, president of Mercy Loan Fund. “Rural areas, veterans, people with special needs and seniors [are] a few important vulnerable people and communities that are currently served and could be served in the future with small rental properties.”
Gould said the biggest obstacle for small rental properties is developing a financial structure that produces positive cash flow. She noted this is one of Mercy’s strengths. “Mercy Loan Fund finances small multifamily rental properties because our primary purpose is to provide innovative financing for credit-worthy projects for which conventional financing is not available or affordable,” Gould said, “and these projects often find difficulty obtaining loans from traditional lenders.”
Mercy has a minimum loan amount of $500,000, which helps minimize some of the cost and risk associated with these smaller projects. In addition, they have tightened lending standards in recent years. “We learned to say ‘no’ to deals that are underwritten too tightly without any margin for error or slippage,” Gould said. “For example, deals that have unrealistic assumptions for debt coverage based on historical numbers, are underwritten at maximum LIHTC rents, or have little or no contingency for cost overruns are difficult for Mercy Loan Fund to move forward with.”
Mercy also works with the properties in their portfolio when they begin to have cash flow issues. It provides technical assistance on how to improve marketing efforts, how to apply for project or tenant-based housing choice vouchers, and how to receive a tax abatement. It also works to restructure the debt.
Mike Rush, director of housing programs for People Inc. in Virginia, identified the original financing structure as the key to successfully developing a small property. “It would be characterized by having either forgivable money or grant money in it,” Rush said. The lower the debt financing costs, the lower the overhead to maintain a healthy cash flow during the life of the property.
People Inc. recently completed a small 14-unit property, Toms Brook School Apartments, in Shenandoah County, Va. The property involved eight funding sources: historic tax credits, low-income housing tax credits, HOME funds from the local HOME consortium, HOME funds from the state consortium, a low-interest Sponsoring Partnerships and Revitalizing Communities (SPARC) loan from Virginia Housing Development Authority, Federal Home Loan Bank of Atlanta funds and a grant from the Southeast Rural Community Assistance Project to assist with infrastructure such as water, taps and fees. Rush said they typically have six to eight funding sources for each property.
Lyons agreed that the key to a successful project is how it is structured from the beginning. “The National Equity Fund, working with many knowledgeable and understanding partners such as Rural LISC, the local USDA-Rural Development offices and developers with solid track records in doing rural transactions, has successfully completed 293 projects totaling 12,655 units in rural locations throughout the country, many of which were made possible by the inclusion of additional soft subsidies and/or rental assistance,” Lyons said. “The key to getting these projects done is to work with all the partners involved, early on and often, to ensure their long-term success.”
For long-term success, Rush recommends other aspects of the development that should be considered from the beginning: location and amenities. People Inc. works primarily in rural southwest Virginia where incomes are low. This translates to low rents and extremely limited cash flow. To make the most of its limited dollars, a property must maintain a strong occupancy with limited turnover. A location near amenities to reduce travelling costs for tenants is one part of this. People Inc. also builds to Virginia EarthCraft standards to improve energy efficiency and save tenants money on utilities. A focus on strong property management and maintenance round out their efforts to maximize cash flow. The company’s successful design and management has led to a waiting list of 300 people for one 20-unit property in Abingdon, Va. With such a waiting list, management is able to limit the amount of time units sit vacant and do not produce revenue to strictly the amount of time required to clean and repair the unit during turnover.
A strong, comprehensive market study will be an important part of the development process. When evaluating the market study, the key areas to consider will be the demand analysis and the rent comparison.
With regards to the demand analysis, a small property can rely more heavily on anecdotal evidence of demand in the face of an undesirable capture rate. However, if that is the case, it is important that the source of demand be ongoing. A nonprofit that has a list of 50 people in need of housing is not sufficient for underwriting standards. To rely on such a demand, you would need to know the source of that waiting list, whether those people are likely to meet income qualifications, and if the demand can be replaced as those households find housing. Ideally, there will be both a low capture rate and strong anecdotal evidence of demand for such a property. When there is no margin for error with lease-up and ongoing occupancy rates, demand must be strong and supportable.
Rent comparison also needs to show strongly in favor of the subject property. A larger property with more units can bet on charging higher rents to offset potential losses from vacancy and turnover. A smaller property does not have that luxury. Therefore, rents and amenities need to be competitive. Location is key among the amenities. A beautiful new project 20 miles from the nearest grocery store is going to have trouble attracting tenants regardless of whether or not it offers stainless steel appliances and a garbage disposal.
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