Episode 29: Multifamily Case Study: Westlake Apartments
Joe and Ryan dive into a recent multifamily deal in Sacramento, CA. What worked? What didn’t? They cover it all.
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Ryan Swehla:
The sale decision is never an obvious. "Well, sell now." Unless someone comes up to you and just gives you an obscene offer. It's always a nuanced decision about how much more return can I get over time, versus what I have right now.
Speaker 2:
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Ryan Swehla:
So today we're talking about a case study, Westlake Apartments and how that ended up the investment that it has, and both speaking to the dynamics of the property, the market, and then also what went well, what didn't go well.
Joe Muratore:
Yeah.
Ryan Swehla:
And maybe if you could start by giving a little background on the property.
Joe Muratore:
Sure. Well, Westlake Apartments, 148 units in the pocket neighborhood of Sacramento. We bought it a little over a year ago at $23,500,000, which is $158,000 a unit. And we are scheduled to close escrow on the sale in about a month at 38,050,000. So that's $257,000 a unit sounds. That sounds good. Let's talk about today like the setup for that, the numbers we ran, our intuition on it, the market, what went well, what's next, that sort of thing. So the setup on it, what started it out was we'd been active buying value-add office buildings in Sacramento. We purchased one, our first deal in Sacramento, actually, 1651 Response. And that broker was working with a family that had an office building and apartment complex coming to market. And there was quite a bit of competition around apartments at that moment.
Joe Muratore:
And we'd done a fair number of apartments before, but it wasn't a major focus for us at the time. But at a recent board meeting, we had been pushed to add more multifamily into the portfolio and this property came up and we looked at it seriously and ultimately decided to purchase two assets at the same time, 2101, Arena, 80,000 square foot state-occupied office building. And that at the same, and ultimately we got sort of a bulk discount. So we got both properties at slightly more favorable pricing than if we purchased them individually. And that worked out pretty great.
Ryan Swehla:
Well, I think what adds to this a little bit is kind of the relationships around how the deal came to be. I know originally that push toward, "Let's figure out how we can do more multifamily" was a impetus for us to start looking or to add, I guess, emphasis to where we were looking. But if you could kind of talk a little bit about the timing and the relationship and how that happened, because it certainly wasn't, "Hey, there's a property on the market. Let's put an offer in." And this is kind of almost years in the making.
Joe Muratore:
Yeah. So virtually everything we buy is off-market. That works well for our timing. We tend to get better deals that way. This came from one family that had reached a generational shift and they were selling off various assets. So we bought three of them ultimately. And Ali Nadimi with Newmark Knight Frank, helped us with the first purchase and we kept sort of looking at other assets and ultimately, these two came up as a pair. I think we paid $36 million for both. And at the time that was a very large purchase for us. And it was a very large sale for them. And it was dramatic. It was a larger family, struck me as a little bit more disorganized. They were very fixed on their particular contract. It was a little bit of more of a... There was hair on the deal so to speak. You had to deal with this contract, you had to deal with the family in this way. And I knew it was a great deal and we-
Ryan Swehla:
Yeah.
Joe Muratore:
Went for it.
Ryan Swehla:
And I remember when you first brought it up in the Sacramento market, that property is a fairly desirable asset in the sense of its location and its amenities. And that kind of brought a little bit of margin of safety as we're stepping into a large purchase for us. What is that margin of safety that we have? So a little bit about the proper, it's located in the Green Haven or the pocket neighborhood in Sacramento. This is a fairly isolated neighborhood because it has the river wrapping around three sides of the neighborhood. And because of that, it is a desirable neighborhood. I think the mayor lives in the neighborhood and it's about a 10 minute commute to downtown in Sacramento. The property backs up to a lake, Green Haven Lake. So it's pretty exceptional to be able to buy a lakefront property. And it was built in the sixties, but the property had been very well maintained. It hadn't been invested in, so the units weren't upgraded, there were still popcorn ceiling-
Joe Muratore:
But the roof were new.
Ryan Swehla:
But the roofs were new.
Joe Muratore:
The grounds were nice.
Ryan Swehla:
The grounds were well maintained. The owner did everything to maintain the assets well. So we weren't going into a property where we expected to have a lot of deferred maintenance that we were going to have to deal with as well.
Joe Muratore:
Yeah. There's some controversy at the moment, I remember we were about 23% IRR, and then we got sort of whittled down on the price a little more. We ended up at maybe an 18 or 19% IRR. And we weren't sure about our exit price per unit. It seemed high, but at the end of the day, there's like a mix of where the math meets intuition. Like there's a piece of magic in our business where the numbers are what they are based on the competition in the market. And you have to look within yourself and within your firm and think about, "Are we the right group to execute on this? Does this fit our larger strategy? And is there that spark of belief that this is the right thing to do?"
Joe Muratore:
And I remember there was a sort of fierce conversation at that moment. We had an analyst with us at that time that was opposed. And we looked at it as principals and had to make a call. And that's why we're principals.
Ryan Swehla:
Well, and it's interesting because, speaking of the market dynamics too, we went into this, we purchased this in the fall of 2020.
Joe Muratore:
Yeah.
Ryan Swehla:
So at that point, and frankly, when we went into escrow and due diligence, many months prior to that, it was at the really stages of COVID, and nobody really knew what the outcome of this pandemic was going to be and what the outcome would mean for that asset in that market. And certainly, I think that helped contribute to our ability to acquire it, the price that we acquired it at. But we look back now and very shortly out of the gate, we were achieving rents that were our third year proforma rents.
Joe Muratore:
Yeah.
Ryan Swehla:
And what happened in the meantime, and I think this is important to speak to, is the market was a huge tailwind to our success. That's not to say that the market created this success because at the end of the day, you have to buy right and execute right. But the market was definitely a favorable wind [crosstalk 00:07:48] for that asset. So we were exiting now at 38 million and change on a cost basis of about 26 million. And had the market not been on our side, maybe that would be 32 million or something like that. But the market certainly played a factor in the outcome that we received.
Joe Muratore:
I think if it had been on-market and maybe not in that moment in COVID, it would've sold for 25 or 26 million and we would've passed, it wouldn't have hit our IRR threshold. We would've thought it was too rich. Of course, it still would've been a great deal. Of course, right at that moment, you should have bought every apartment building-
Ryan Swehla:
In retrospect, yep.
Joe Muratore:
In the country, like all of them all at once
Ryan Swehla:
In secondary markets.
Joe Muratore:
But nobody [crosstalk 00:08:37].
Ryan Swehla:
Do you want to little bit about execution and how we executed the value-add strategy and what we planned to do?
Joe Muratore:
Sure. So we planned to renovate about 70% of the units because very few of them were renovated, virtually none of them were renovated. In reality, we renovated about 35 of the units. If I have to look at a part we didn't do well, we didn't renovate quickly. We didn't have the... Frankly, we didn't have the competency in our firm to execute quickly and at speed and we should have been faster. What we got done in six or eight months. I had originally thought we'd do in three or four months. And maybe that's normal, maybe that's due to COVID, whatever. As a firm, since then and currently we are doing a bunch of things to make sure that as soon as we close, renovations starts at speed. And the market was on our side. That was great, it sort of helped us. But if I have to look at something we could have done better, it's renovate faster and with more precision and-
Ryan Swehla:
Yeah. And I would describe this as kind of maybe a little bit between a heavy lift and a light lift in the sense that we went in budgeting about 15,000 a unit, is that right?
Joe Muratore:
Budgeting 18,000, we ended up spending about 21,000 per unit.
Ryan Swehla:
Yeah. So going in, we knew that we were going to be scraping popcorn ceilings. We were going to be doing new flooring, new carpet, new cabinet, or refinishing the cabinetry, new counter tops, new appliances. And that certainly added to the delta and rent that we received as, as those units turned.
Joe Muratore:
Well, the neighborhood warranted it, there's other complexes in other neighborhoods where we're not scraping popcorn ceilings now, but at the time we made the call and I agree with it that this was a classy neighborhood and it was on the lake and it was worth it. And it proved to be so.
Ryan Swehla:
What about exterior improvements or common area upgrades?
Joe Muratore:
Yeah. So most of it was landscaping. We spent about half a million dollars in landscaping and it looks incredible now, but that's a lot of new plants and park and hummus and that sort of thing. We certainly improved the pool area that was mostly cosmetic new furniture, new paint. We re-did the clubhouse dramatically, it looks amazing. We repainted the whole complex.
Ryan Swehla:
Barbecue
Ryan Swehla:
Areas too, I remember two barbecue areas [crosstalk 00:11:17] curious. And new signage, because the signage was from 1960s. Yeah. So maybe let's talk a little bit about, where we are today and also-
Joe Muratore:
And why sell?
Ryan Swehla:
Yeah. Why sell?
Joe Muratore:
Yeah. Let me ask you that. I mean, that was-
Ryan Swehla:
Yeah. Well, that's an interesting one because the sale decision is never an obvious, "Well, sell now." Unless someone comes up to you and just gives you an obscene offer, it's always a nuanced decision about how much more return can I get over time versus what I have right now.
Joe Muratore:
Yeah.
Ryan Swehla:
And I think for us, we were on the fence a little bit because we've owned it now for 15 months. And we've turned about 40 of the 148 units. So there's certainly plenty of upside. What informed our decision making is a few things. Number one is the market dynamics.
Joe Muratore:
Yeah.
Ryan Swehla:
And I'll speak to that a little bit. But then the second thing that I would say is we put out trial balloons on where we thought we could sell and they ended up substantially higher than our expectations. And those trial of balloons are kind of what will tell you, how strong this market really is. To be frank, we never anticipated that this property would sell for 38 million right now, but this is the fundamentals of this market. When we took the property to market, we received 50 signed confidentiality-
Joe Muratore:
70.
Ryan Swehla:
70.
Joe Muratore:
70.
Ryan Swehla:
And I believe over 15 offers, is that correct?
Joe Muratore:
Thereabout, yeah.
Ryan Swehla:
So just an incredibly competitive frothy market. And I think that speaks a little bit to how the market has moved since we bought that property. Number one, huge additional emphasis on markets like ours. Secondary markets were outside of the Bay area, people are moving to a more affordable place to live. Secondly, the capital environment that we're in. We see a tremendous amount of capital chasing very few opportunities. And we were bringing to market an opportunity that still had meat on the bone, so to speak. And that brought a lot of interest because people are looking for any way that they can to have additional return.
Joe Muratore:
So we bought it at a high four cap, which seemed crazy at the time. We're selling it in the mid two caps.
Ryan Swehla:
Yeah.
Joe Muratore:
But that speaks to the value-add still to happen. When we bought it, the average rent was $1,200 a month currently it's about 1850. So we proved out $600 in rent growth. And now we've handed off this business plan to the next person. Who's going to be able to just harvest this business plan. But they're at a two and a half cap we're getting paid. We're splitting the deal so to speak. They get the upside, they're still paying as a premium for what we proved out.
Ryan Swehla:
Well, and to speak a little more about, why sell now. Obviously, if we step back, we're our gross IRRs, like 91% are gross equity multiples, 2.01. So we've essentially done money over that period of time. So, that speaks to itself. But the other thing that I'd say is, we look back and our job is to create an exceptional returning portfolio, right?
Joe Muratore:
Right.
Ryan Swehla:
It's not just one property, not just two properties, but the portfolio. And as we look at that, we have assets that have longer time horizons. We have assets that have shorter time horizons and to be able to take an early win in the portfolio now, as we continue to work the business plans on the rest of the property, it's kind of the adage take money off the table. We've seen a tremendous increase in value. Let's take us some of that money off of the table, as we continue to work the rest of the portfolio, including one property that has a seven-year time horizon from now.
Joe Muratore:
Mm-hmm (affirmative). Let's talk about, what's next, since the purchase of that, we've purchased about 500 more multifamily units and we're in escrow currently on another 200 or so and kicking tires on another 2, 3, 400 units that I hope we'll go into escrow. So-
Ryan Swehla:
What does that look like? You said kicking tires in and putting offers.
Joe Muratore:
Yeah. Putting offers. So we have offers in, in a large complex on the East Bay. One in Manteca, one in Turlock and one in Modesto. So-
Ryan Swehla:
I'm curious [crosstalk 00:16:08].
Joe Muratore:
And escrow on 40 units more in Sacramento.
Ryan Swehla:
So I'm curious what the process of finding these properties. Obviously, we were the beneficiary of a very hot market as a seller.
Joe Muratore:
Yeah.
Ryan Swehla:
Where we had 15 offers and 50 interested parties. What does that look like now that we're being in the buyer position?
Joe Muratore:
Right. So the market's so hot right now that on-market, so we recently competed and didn't win in Madera for 109 units. But the market's so hot that you cannot buy something these days and have a due diligence period. Like you have to waive due diligence at offer acceptance. That's about par these days. and we got beaten in Madera because multiple groups were willing to waive due diligence at signing of contract. So, that's the environment we live in. That's not an environment we're quite comfortable with yet. And again, most everything we buy is off-market. We tend to work with sellers and brokers that we've done multiple deals with. There are a portion of sellers that are happy to do off-market deals for various reasons. And it's their style, or they don't want to go through an on-market process or-
Ryan Swehla:
Well, and a lot of times what we've seen like with this property and others is, the market has moved so much, the sellers aren't particularly, "Hey, I'm in the mood to sell." But the broker, the relationships that we have, they may know, "Hey, this is a seller that might sell." And then we do our underwriting, and because the market has moved so much, we're comfortable with a price that the seller receives and says, "I can't believe the property's worth that much." And there is a shock value there because of how much the rents have grown and how much the market has moved.
Joe Muratore:
But it's our job to see the next few years, because people have been saying what you just said for the last five years. In 2017, people said, "I can't believe rents have gone up this much. In 2018, I can't believe prices." 2019, 2020, 2021. Well, guess what? I believe, and it's for debate. We talk about it, but I think 2022 and 2023 are going to continue to see rent growth. And it probably won't be as dramatic as we've seen in the last year. But for the most part, what we do is, we cure the loss to lease and improve the assets from groups that haven't been aggressive enough. We're not riding the top of the market. We're not saying, "Hey, this thing's already at par, and par is moving here." We're saying, "Oh, we do think pars moving from here to here. But meanwhile, as we buy this asset, rents are here. We're going to get them to par and meanwhile take them to here also." But-
Ryan Swehla:
Yeah. And I think that's a big part of how we underwrite things, because even though we're seeing 20% rent growth year over year, in some cases, we're still underwriting future rent growth at a more conservative 3 to 5%. The biggest value-add that we're doing is that loss to lease is, current market rents are here and our current property rents are here. and our job is to bring those property rents to market, not to rely on some sort of future rent growth. And obviously there's a modest factor in there, but that's not the reliance of our business plan.
Joe Muratore:
Yeah. But we're still excited about apartment, certainly excited about the apartments. What's great about them is that they're very dynamic. You have hundreds of leases, not one or two or three like you might see in an office building or an industrial building. And each one of those rollovers is a major event that requires great effort and strategy. With multifamily, it's the markets here, current rents in the complex are here. We're going to go on this plan to get to here. And we can run that with our team at scale and with precision, and that's amazing.
Ryan Swehla:
Yep.
Joe Muratore:
So what's next? I think these next couple of years we'll continue to invest in multifamily in addition to the other asset classes. But with everything we buy tends to be with an eye for the exits within two or three years. We seek to move in quickly, add value, make our mark and move on.
Ryan Swehla:
Yeah. Let's talk a little bit about, what's interesting and multi for only in our market in particular, because I do think it's generally recognized that multifamily is a strong asset class. There are some market fundamentals across the country that make multifamily compelling, particularly in secondary and tertiary markets. But just kind of zeroing in on our market, the Central Valley Market. It was probably one of the biggest beneficiaries of COVID-induced changes in preferences.
Ryan Swehla:
Because you have people that moved away from urban markets and our area tended to be one of the first areas that they would move to. And the reason is, if you feel like you still need to be back in the office, some amount of time, you're not going to move to Boise, Idaho. The Central Valley is immediately adjacent to the Bay Area. And so we saw a tremendous amount of people moving where they could buy a home, where they could have their kids in a school district, where they could have a quality of life that they wanted.
Ryan Swehla:
And that pent up demand onto the multifamily market as well. Because when you have new entrant into the market, you end up having more demand for all housing types. And then I'd say to speak to the supply side, our market, the rental rates had been climbing pre-COVID, but the construction costs had also been climbing. Obviously, there were demands on construction materials as other parts of the state had fires, our area doesn't have that issue. And so construction costs kept going up while rental rates were going up and we only maybe a year or two prior to COVID, did we start to get to a point where it made sense to add new inventory to the market. Then COVID hit, the supply issues that we've had, construction costs have gone up further. And we really haven't had a new amount of supply added to the market. So, that just amplifies the issue.
Joe Muratore:
Yeah. I like to think of it like a COVID... Like a dust cloud of sorts. So during COVID, the rules changed. Like work changed, family life changed, feelings about whatever changed. America, the world, whatever changed, it all just got sort of thrown into the air and it sought and continues to seek a new equilibrium. How everything would play out. And some of those things are three days at work and two days from work from home, which we're seeing more commonly.
Joe Muratore:
Some of that was millennials wanting to leave primary markets. So they could do family formation, purchase houses, maybe do something more like how they were growing up. And I think our area in that supply-demand dust cloud was a winner. A secondary market around the Bay Area, one of the largest and most important markets in the world, people moved and a lot of them moved our direction. So, that pushed apartments, that pushed housing. And I think we were a beneficiary of that and I think that's still playing out.
Ryan Swehla:
Yeah. And I think something that a lot of people don't know is that, more people migrated within California than out of California.
Joe Muratore:
Yeah.
Ryan Swehla:
It's a kind of a common belief that people are moving out of California and people have moved out of California from the primary markets within California. But more people decided to make the secondary markets of California home than decided to move to Austin, Texas, or Salt Lake City. So we don't see... And that trend is sticky because these are people making very existential decisions about what's important for them and their life and their family and that sort of thing. So we don't see that trend shifting.
Joe Muratore:
Yeah. Goldman Sachs had a headline or there's a headline about Goldman Sachs two weeks ago that said they expect home prices to rise another 16% this coming year. I mean that's amazing, and that's... It's hard to believe the demand's going to keep growing that much. So there's like a ripple effect from COVID in that some people move to one place which raised prices, which caused other people to move, who were there before to move to other places. There's just a whole bunch of just disruption and chaos in all of that. But-
Ryan Swehla:
Yeah.
Joe Muratore:
And there's opportunity.
Ryan Swehla:
And that opportunity and to the extent that we can continue to see where those trends are going. I think we're well served going forward.
Speaker 2:
Thank you for listening to, Durable Value: An Investor's Podcast, where we demystify commercial real estate with safe down investment strategies to help you balance your portfolio. If you enjoyed this podcast, be sure to rate it on iTunes or wherever you get your podcasts. To learn more, visit graceadagartners.com where you'll find more information, investors tools, case studies and more. This podcast is hosted by Joe Muratore and Ryan Swehla. It's produced, edited and mixed by Melodic with intro music by Ian Post. Thanks again for listening. And we'll see you next time.