Capital Markets

Class C, D properties find wealth of capital

By John Zipperer

(Apartment Finance Today, November/December 2004) — Too much capital chasing high-end apartment projects has helped the market for Class C and Class D properties get access to a greater variety of lenders.

Lenders have become increasingly comfortable with Class C, and even Class D, apartments since the early 1990s, according to Paul Daneshrad, CEO of developer StarPoint Properties. “There is so much capital … looking for multifamily product that as some of that debt has not been able to find a home in the A and B market, it has gone into the C and D market,” he said.

That’s a big change from a decade ago, when lenders felt distinctly uneasy about older properties that might have problems with crime or poor maintenance. Developers say that the only likely option for a developer that wanted to buy and revamp one of these properties used to be hard-money lenders, such as Kennedy Funding or Mountain Funding, LLC.

Today, hard money is not the only option for these properties, though it can sometimes be the only realistic option for Class D properties, especially if a developer has credit problems or a lack of experience with the property type. Hard money, sometimes called private money, is based on assets: If a borrower has assets the lender can use to back the loan, then hard-money lenders consider that their risk is covered.

These lenders also tend to be entrepreneurial: “Hard money typically embodies a very fast process from initial phone call to close, coupled with minimal documentation,” said Thomas Connolly, director of capital markets for Cohen Financial.

Hard-money lenders require a higher yield for taking the greater risk of financing Class C and Class D apartments: Interest rates can begin at 12% and can move above 25%.  Kennedy President Jeffrey Wolfer said his company was dropping its rates to 10% plus two points in a bid to continue its expansion; he said it may even go below 10%.

“The thing about hard-money lending is that it’s often presumed to be high leverage, but in general I believe it’s not,” said Connolly. He said the hard-money loan-to-value (LTV) ratio for a Class D property can often be 65% to 70%. Mountain Funding’s terms for hard money include an LTV of 60%; Kennedy Funding will go up to 75%.

Lenders such as Avatar Financial Group, LLC, play in much the same market, but Avatar is funded by public institutional investors. Its rates also tend to be lower than hard-money lenders but higher than bank loans.

Q10 | Kinghorn, Driver, Hough & Co. is another capital provider that gets its funds from institutional players. President Gary Hough said Q10’s Denver office finances Class D properties with LTVs as high as 75%. In some regions, such as the Midwest, it lends 80% of acquisition cost; the interest rate floats for six months (at about 3.4% at press time) followed by a 15-year, 6.2% fixed rate; amortization is for 30 years.

Lenders have followed developers into the Class C and Class D market because these properties can have significant upsides if the rehabbing and repositioning is done well. StarPoint recently sold a portfolio of 1920s-vintage apartment buildings in Los Angeles that it had purchased for $6 million in 2002 as Class D assets. After spending about $400,000 on rehab, it was able to increase rents from $475 to $650. It sold the portfolio in September to a group of local investors for $12.7 million.

Class C and Class D properties have more defaults than Class A or Class B properties, Hough said. But of the deals he’s seen go bad, the cause was poor project management, not real estate fundamentals.

Houston-based developer Michael McQuay, president of Principal Equity Investments, Inc., has a lot of experience with taking down-and-out properties, making conservative levels of investment in them and outperforming his local competitors. Class C owners and redevelopers need to be ready to spend time reassuring underwriters who may be scared off by an iffy neighborhood or by underperforming properties located nearby, stressed McQuay. He added that the most successful developer of these properties is going to be someone who knows the local market, how to manage Class C and Class D properties, and can do “massive amounts of due diligence.”

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