Today, we’re examining a deal for an industrial building with value-add opportunity. The investors are a group based in Denver who are buying in Indianapolis. Strategic Partners William Foy and Marcus Davis of Spearhead Commercial Capital did the debt financing on this transaction and joined me to talk about why this was a great move for their clients. I found this deal fascinating and learned some new concepts, too!
- Listen to the podcast “#392: Why Denver Investors Are Moving from Multifamily to Industrial Properties ” Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
Who Are the Investors?
This is a pretty experienced investor group with a $20MM portfolio. They’ve mainly focused on value-add multifamily properties but are starting to build out the industrial side of their portfolio. William estimates that since it’s getting harder to chase yield on multifamily properties around Denver, they’re opting to transition to a triple net industrial class. They’ll get more meat on the bone in terms of return and already know the market well.
For those of you who remember our episode on the triple net asset class, it may seem jarring to put triple net and value-add in the same sentence. Generally, people look to triple net properties as a way to park cash, say with a Little Caesar’s or CVS retail space. The tenants are responsible for paying their own taxes and insurance. However, it’s actually pretty common to have value-add in this asset class.
What’s the Property Profile?
This property is a multi-tenant industrial building located in a strong industrial market where there’s not much vacancy. The tenants are below market in terms of rent, which presents an immediate opportunity to go in and raise rents, similar to a multifamily scenario.
Another value-add opportunity for this building is that 80K of the 320K sq ft of the building is currently used as office space for a tenant who vacated. The investors can convert this space back into industrial use and bring in a new tenant that will drive the upward momentum of rents when the other leases are up for renewal.
Assessing Value-Add Opportunities
There are three facets of this property that present opportunities: existing vacancy, below market rents, and a separate parcel pad site that can be developed or sold.
We’re not going to focus on the parcel, which sold separately for $1MM. It’s part of the deal, but was quickly picked up and sold by the investors in order to help pay down the loan.
They purchased the building for $6.15MM and needs about $600K-650K in tenant improvement dollars to convert the office space to industrial space. The rest of the building is fully occupied by multiple tenants. For the seller, this property is a smaller asset and wasn’t given much attention. This is a great opportunity for the clients to put some TLC into the property and increase rents.
Will the tenants swallow the rent increase? The tenants need to look at the cost to move when they already have everything in place in their current building. The vacancy rate in this market is about 2%, which means that there aren’t a lot of options for relocation. It will likely cost them more to move their operations, which gives the investors an opportunity to negotiate the rents.
Structure of the Deal
The lender knew there would be tenant improvement that wouldn’t require existing tenants to move out, which means the work could begin right away. The lender structured the deal at 70% loan to cost, including the cost of the building and total rehab. In total, the cost was around $6.8MM, with a loan amount of $4.665MM.
This deal was done during the first part of 2022, just as interest rates started rising. The investors solidified their rate at the end of 2021, and William and Marcus worked hard to protect their clients’ rate through the 70-day closing period.
In the end, they were able to hold onto the 3.5% interest rate, but it didn’t come cheap for the borrowers. They had to pony up a deposit to ensure that the loan didn’t get re-traded to another lender. This was an acceptable tradeoff for the borrowers because they understood how quickly rates were climbing.
They’re paying 24 months interest only on a 5-year note, which allows them plenty of time to build out and lease the space. They expect full stabilization in 3 years, which entails rehabbing the space and gradually negotiating rent rates with existing tenants.
What Is an Earnout?
The lender built in an earnout. This means that upon stabilization, the investors can draw out more cash without having to do a refinance. The lender got an appraisal of the property in as-is condition as well as when it’s stabilized. Based on what the rents will look like, the building appraised at $7.5MM. The investors can go back to the lender and get their earnout when they reach that point. This allows them to recoup tenant improvement dollars and keep the same loan terms, including their 3.5% interest rate.
The benchmark of the earnout for the investors is investing the money into tenant improvements, completing the improvements, and getting an appraisal that puts the stabilized value at 90% occupancy and a particular net operating income figure.
This is an admittedly rare product. Essentially, the bank is earmarking funds for the investors. When they perform at the expected level, they’re earning their earnout, which allows for a loan modification. The modification will be at the same terms as the original, just bumping the loan amount.
Allowing the investors to take advantage of an earnout shows that the lending world is trying to fit value-add investors into their conventional underwriting world.
What Comes Next?
Between years 3-5, the investors are going to reevaluate the deal. They bought the building at a cap rate of 7% and anticipate an exit cap rate of 11% if they perform on their pro forma. Most likely, they’ll exit the property between years 5 and 7, though they have the option to refinance at that time.
How Spearhead Facilitates Deals
The lender in this deal didn’t have a relationship with the borrowers until William put together the package. Since Spearhead underwrites everything, banks have greater confidence in the deal. He facilitated the relationship between both parties, and now the lender and borrowers have a great relationship with each other.
Knowing the borrowers’ goals ahead of time helped tremendously when William presented the deal to the lender. He was able to explain what the end result would be, which made the lender comfortable moving forward.
Spearhead’s clients are both the borrowers and the lenders. They have long standing relationships with both sides, which is why it’s so important for the deals to work out and why they put so much effort into each deal.
Connect with William and Marcus
Interested in a commercial loan? Reach out to Spearhead. Fill out their online form so they can schedule a time with you to sit down and have a conversation. They want to know who you are, what your goals are, and what you want to do now.