Experts Share Secrets for Avoiding Pitfalls Of Housing Rehab, Conversion Projects

• Consider economies of scale and unit configurations
• When and how to schedule the inspector’s visit
• Improving disabled access
• Minimize unwanted surprises

Rehabbing older apartment buildings is a big business that’s destined to get even bigger in this decade, if projections from the National Multi Housing Council (NMHC) in Washington, D.C., prove accurate.

Growing household demand for apartments, shifts in public policy and an aging apartment stock should spur the pace of rental rehab, according to NMHC’s report, “Capital Improvements to Apartments: Projections for States and Metro Areas.”

“This research suggests that renovating and improving the nation’s 17 million existing rental apartments likely will be one of the multifamily industry’s major business opportunities in the coming years,” said NMHC President Jonathan L. Kempner.

Given the opportunity, how can the savvy builder turn an aged apartment building into a prime multifamily housing community? The first step is to identify and evaluate rehab-worthy properties. Knowing the area, developing relationships with landlords and real estate brokers and keeping one’s eyes open are all part of the process.

Rehab-oriented builders say brokers (and occasionally sellers) bring potentially rehab-ready apartment buildings to the attention of companies that have a good reputation for purchasing and revitalizing such properties. Networking and favorable publicity about successful projects are good avenues to future deals.
The next step is to ascertain the extent of a candidate building’s damage, dilapidation and deferred maintenance. The best opportunities are buildings that require substantial rehab, but not extensive structural repairs. “If the building is literally falling down or some of the units have been condemned and boarded up by the local authorities, [that building] may not be worth rehabbing. If you can tear [a building] down and build a new one for the same price [as a rehab], you’ll end up with a better asset by [starting from scratch],” said Steve Lawson, president of The Lawson Cos. in Virginia Beach, Va.

Some buildings are teeming with serious structural problems, for example wood rot, that are far too costly to fix, while others aren’t run down enough to warrant a major rehab. “Our goal is to find a sow’s ear and turn it into a silk purse. We’re not interested in buying a silk purse,” said Dick Knapp, senior vice president of KSI Services, Inc., in Vienna, Va. “There are some extreme situations where a property is too [run down], but more often than not, what we look at is too good.”

KSI’s rehab projects cost $26,000 per unit on average for complete replacement of major systems and components, including HVAC, electrical, plumbing, roof, kitchens and bathrooms, windows, landscaping, lighting, signage, parking lots and amenities.

Consider economies of scale and unit configurations

Other considerations include economies of scale and unit configurations. “We don’t like to buy [a building with] 50 units. We prefer to buy 180 units or more for operational efficiency. We don’t want to buy a project that is all studios or one-bedrooms. What’s available usually has two-bedroom, one-bathroom [units], so the more of those, the better,” Knapp said.

Among the most costly aspects of a major rehab project is the task of bringing an older building into compliance with modern-day building codes. That means a building code review is a crucial component of the pre-purchase stage of a rehab project. “You have to spend a lot of time up front. You need to hire a consultant to do a thorough existing conditions survey. You need to hire another consultant to do a code check to make sure the uses you [have in mind] for the building will work,” said Jon Wallenmeyer, vice president of Forest City Residential Group in Cleveland, Ohio.

The code check includes building codes, zoning, the Americans with Disabilities Act (ADA), fair housing design requirements, fire sprinklers, parking requirements and other items.

Developers then have to meet with the local jurisdiction to make sure they agree with the code consultant and the rehab plans. “You do all that before you decide to proceed, and there are a lot of costs involved,” said Wallenmeyer. It’s not unusual for him to pass on a dozen or more buildings before selecting one that presents an attractive opportunity.

Building codes inject a degree of uncertainty because they vary from one jurisdiction to the next and are subject to interpretation. “Each area has a different interpretation of how the codes and historic buildings should be adapted. The first priority is to work with the local building code officials hired by the city or locality because the final word is always [from] a local inspector,” said Wallenmeyer.

If the inspector’s view is unfavorable for the project, there is no higher authority to which the builder can appeal. Soliciting a third-party opinion, however, can prove fruitful. “We will bring in other building code experts and get their interpretation. Sometimes, you get lucky. But you can’t be confrontational. In most cases, the inspectors want to see the old buildings reused,” Wallenmeyer adds.

When and how to schedule the inspector’s visit

The building inspector’s visit should be scheduled before the building is purchased. Many jurisdictions will inspect a building at no charge, but others assess a nominal fee for the inspector’s time and effort. Any sticky discussions that could cause trouble after-the-fact should be documented in writing. If need be, the builder can write a letter confirming the conversation and ask the inspector to initial and return a copy of it.

In some cases, a variance or waiver might be granted to facilitate the reuse of a dilapidated property. These variances and waivers can enable a project to go forward. However, the catch is that the lender or insurance carrier might object to the variance or waiver and refuse to finance or insure the project without that component. And, of course, any project might not merit adequate financing or insurance on an economic basis even if the building code and other consultations go well.

Improving disabled access

Looming behind every discussion about building codes is the federal Americans with Disabilities Act (ADA), which, in essence, mandates that public accommodations, including most rental housing, must be made accessible for people with disabilities. The ADA can be a decisive factor in a rehab project because there are no variances or waivers, and gray areas can be financially treacherous. Some local inspectors may comment on ADA requirements and compliance, but it’s important to understand and remember that the ADA is a matter of federal law. Some architects specialize in the ADA, but again their opinion is merely one interpretation of the law. “You can’t negotiate the ADA,” Wallenmeyer warns.

It may become easier to reuse buildings because of a move toward consolidating and standardizing building codes over larger geographical areas. There are now three code-writing organizations that comprise the International Code Council – namely, the Building Officials and Code Administrators, the International Conference of Building Officials and the Southern Building Code Congress International. Until recently, they each had their own model code, but now they plan to phase out the three regional model codes in favor of the combined International Building Code (IBC). The next step in this process is for more localities to adopt the IBC in lieu of homegrown building codes.

Beyond building codes and the ADA, builders would do well to investigate any environmental hazards lurking in older buildings. First-time renovators typically underestimate the environmental issues. Old properties often have lead paint, asbestos and underground storage tanks. “We typically spend $1 million per project on environmental testing, monitoring, consulting fees and remediation. You must hire a special abatement contractor for asbestos or lead [paint] removal,” Knapp said.

Lawson said asbestos and other environmental concerns aren’t necessarily deal-breakers, but their presence certainly warrants a lot of scrutiny in determining whether the cost of remediation will make the asset a poor rehab candidate.

Rehab isn’t nearly as predictable as new construction. “It’s a constant process of recovering from problems and mistakes that you can’t avoid. There are huge risks relating to concealed conditions, and change order budgets are often 15% [of the construction costs]. Rehabs are not a way to get rich quick. You have to have money and be willing to visualize the long-term turnaround of an area,” Knapp said.

Peter Siegel, vice president of Landex Corp. in Baltimore, Md., echoes that view. “In rehab, you’re buying damaged goods. You can do exploratory surgery, interview the maintenance staff and stick your head behind the walls, but you won’t see everything.” For example, you may discover that a building actually has more or less units than are shown on the architectural drawings because an owner or tenant has added or removed walls or reconfigured one or more units.

Minimize unwanted surprises

One way to minimize surprises is to conduct a more than thorough investigation of the building prior to acquisition. This process usually is very costly, but Knapp said some savings can be achieved by asking subcontractors to check out a building for little or no compensation. In return, they’ll get a shot at getting on board early with a reputable builder’s rehab project.

Lawson stressed the importance of doing a full unit-by-unit assessment, instead of making assumptions after a cursory investigation of a few units. “Suppose I tell a sub to put new vinyl [flooring] in every kitchen. [In one kitchen], the sub finds the floor is rotted out under the sink area because of a leak that was never repaired. That contractor can’t do his job [because] someone else needs to repair the floor. That’s not only a cost overrun, but also a significant delay,” he said.

Building plenty of flexibility into the budget is a smart idea. “In the early days, we under-budgeted the contingencies. We had a 5% contingency, instead of 15%. The key to rehab is to have contingencies on your contingencies on your contingencies,” Knapp said.

Experience counts, too. “Experience tells you the types of problems you might run into, how to build in contingencies and how to get out of [problems]. We have had many situations when we had to redesign something right there on the site. You need a team that’s knowledgeable and visionary enough to be able to do that on the site,” Siegel said. “You have to know that everyone will step up to the plate when things go wrong. The team [must be] flexible and responsive and have good communication.”

Another area ripe for under-budgeting is tenant relocation costs and rent losses. “Most jurisdictions require the filing of a voluntary relocation plan, for households that are being relocated. You don’t want to get into an adverse situation with tenants about displacement,” Knapp warns.

“The rent loss [on a rehab] is absolutely astronomical,” he added. “The time during which the units are [vacant] is often vastly underestimated. At the midpoint, occupancy often is as low as 40%.”

Tenants can’t be expected to come flocking back to the building after the rehab either, especially if the property was stigmatized prior to its renovation. Knapp said it’s normal for half or more of the tenants to have permanently moved on. Re-leasing the units depends on a thorough rehab of the building’s exterior, including landscaping, lighting and signage, as well as the interior.

A classic error to avoid is under-renovating a building. “If you’re expecting a rehab to last 20 to 25 years, you’d better make sure you’re doing it right. If all you do is put Band-Aids on it, that will come back to haunt you in seven or 10 years. If you need $10,000 per unit of rehab and you put only $5,000 per unit into it, you’ll pay for that down the road,” he warned. “Trying to make the project work when the market or the circumstances don’t warrant it can be [unwise].”

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