Student Housing Mezz Loan

<Executive Summary>

From the opportunity presented, I would recommend pursue the mezzanine loan investment in A Apartments presented by A Bank. With some recommended changes to sizing and pricing, the mezzanine loan would provide attractive returns with mitigated risk. This mezzanine loan opportunity to generate strong risk-adjusted yields in a tight market. Please see below a summary of the opportunity in terms of specific capital and headline loan terms that would need to be authorized, an overview of the counterparties, property, and business plan, the deal’s drivers or rationales, the deal’s risks and mitigants, and overall feedback.

<A summary of the opportunity in terms of specific capital and headline loan terms

that would need to be authorized>

The subject property consists of five-buildings, 290 beds in a 85 unit student housing located in A and located less than 0.3 miles from A building (student housing building). The property is is in the main downtown district where students can easily access campus and walk to main retailers, grocery stores, and night life. Our firm, A Capital is seeking to acquire A Apartments for a price of $23.5MM ($81K/bed). In-place master lease with the school expired in 2024 at $497 per bed per month, and it is about 50% below market. A plans to acquire the value-add opportunity through spending $4.45MM on renovations, and the rents will be at market to $1,057 per bed, and the construction will be completed by after all units are vacant by July 2026. Our firm has a mezzanine opportunity from the senior lender, A Bank based on the value-add business plan.

<An overview of counterparties, property, and business plan

 along with the deal’s driver’s and rationales>

The property is well-located in demand driven market that the students enrollment number is 105,000 across all its modalities and locations with 50,000 in person on the A campus. The Purdue’ 2023-2024 freshman class was 9,285 due to a lack of housing. In response, A trustees approved a resolution confirming their support for development by the A Research Foundation of a 1,000-bed student housing project at A. Because of this lack of housing supply, the private residential rental buildings have been marketing to students. Their building’s amenity includes study rooms, fitness centers, lounges, community kitchens, coffee bars, bike storages, and so on, entailed to a student life.

For the subject property, in-place rent generates a stable cash flows providing 1.70x DSCR on proposed debt in years 1 and 2. In addition, there is a substantial mark-to-market opportunity that currently, in-place rents are 20-50% below market, and A can achieve 60% premiums on releasing the rent.

A Properties is a mid-sized private owner and operator focusing on value-add student housing opportunities, with 9,000 beds under management across the U.S. It has been well performing in their assets and portfolios; however, the current debt environment from the Fed’s increased rate had them in a difficult situation. In here, A, the company’s Head of Acquisition had found the opportunity to deliver equity-like returns to investors via debt instruments in this subject property. From this investment, A can achieve two-digit returns like an equity investment with a proper loan sizing and intercreditor agreement with the senior lender.

The property will be vacant in year 2, and from year 3, the occupancy will be fully achieved with the conservative prospect of the vacancy rate at 5%. The exit will happen in year 4 with 2% rent increase in the forward year, which affect to a light inflated NOI upon sales. Our company will assume the property at $23.5MM ($81,034/bed), and at exit the sales price will be $41,773,606 for the next buyer ($144,047/bed).

At the exit year, the senior DSCR based on NOI will achieve at 1.04x and Mezz DSCR will be achieved by 0.92x. As a typical lenders require DSCR at a 1.25x, this case is significantly low from the lender’s perspective. Since the loan is Interest Only, the exit proceeds will result in shortfall if the property is refinanced at exit year of end 4. However, the overall property level IRR achieves at 15.9%, and which is expected to be higher IRR for the operators and lower IRR for the lenders and investors. Here, the Mezz lender is seeking for an equity-like investment opportunity, their IRR must be assumed at about a limited partner’s projection on returns. The senior loan lender’s IRR in this same deal will be 13.8%.

The current cap rate was achieved at 10.37% due to the significance discount on the asset happened from the Fed’s interest rate hike, and there is much less opportunity to borrow an additional capital from the owner’s standpoint. Here, A can obtain the opportunity by issuing the mezz debt, and to be an owner stake holder. At exit year, the cap rate will be 6%, and the net proceeds will be $39,796,386 with the equity return of $15,096,386. From this perspective, the lenders are protected by its subordinates, which are the equity holders, and have no issue to return their capital.

<The deal’s risks and mitigants>

After the renovation, there will be a lease-up period that will require a year long time to be fully leased at a projected level. I will take place after year-2, and there can be a possibility to a market fluctuation. In addition, before the Year-2, the construction completion date is guaranteed, but it has to be confirmed when it is actually completed. To mitigate this risk, the property can communicate with the school in terms of pre-leasing offering new incoming students providing perks and promotions such as complimentary amenity uses and flexibility on the dates to movein by giving them a key in advance to actual movein date.

Construction supply’s price can be increased due to inflation. Even though the construction supplies are contracted prior to actual construction, the labor and etc. can be increased. A proper cushion from the mezzanine loan can mitigate this issue. In this deal underwriting, the Mezz loan’s LTC is 75% at $2MM, the equity shortfall will less likely be happened.

The Fed can hike the interest rates in the future dates, and since the loan is based on the floating rate, there could be a default or re-negotiation risks. In this case, since the student housing is based on one-year contract, not like an office or retail leases, the rent can be adaptive to the environment. Moreover, the property will be the latest new development with offering the student-focused amenities and modern features, the sensitivity on demand will not be as sensitive as other existing properties near the subject property.

The school admits new incoming students at an increasing rate as long as the housing issue is resolved. Due to the locational and structural advantage in demand, this investment will be a well-risk adverse opportunity even it is a value-added investment.

<The overall opportunity>

The mezzanine loan terms will be 48 months from the closing date of May 16, 2024, and will be floating rate based on SOFR plus 10% spread (current coupon is 10.91%) with standby fee at 2%. The loan will be interest only, and total interest rate at current will be 15.32%. Since this is not a development opportunity, the property can obtain a senior loan for $15MM, Mezz loan for $2MM, and Equity for $8,354,500 initially. Then the additional senior loan will be obtained for $7.7MM, total $22.7MM in senior loan in year 2 (after 48 months). After 48 months Mezz loan issuance, the mezz loan can be extended or called from the equity investors. Here, the intercreditor agreement between the senior lander and mezz lender will need. The mezz lender is a direct subordinate to the senior lender with a shared collateral rights. In case, capital shortfall (actually in this case, until year 4, there is a capital shortfall), the equity investors’ call is required written in provision. At the end year 4, there will be cash flow after the sales deducting all costs for $15,778,607.

The property either can be disposed or refinance. If the capital market situation at the beginning of year 5 as similar as the current situation, there will be a shortfall in refinancing. The next buyer’s strategic projection on acquisition will be the main player in this deal.

However, this next buyer and refinance risk can be mitigated by the detailed market research on the external economic environment. The nature of the student housing structure is based on one year contract, and the revenue can be effectively adjusted to the market. Since the collateral is a 100% property, and is valuated based on income, in the next buyer’s situation, the collateral (asset)’s inflated price will lower down the LTV and LTC to the lenders, or vice versa when the interest rate environment is much down below the current market’s indicators.

Thus, I would recommend this deal to be pursued since it yields a strong risk-adjusted returns in a tight market as demand goes high and supplies are below the market needs. I would like you to communicate with A Bank in terms of our opportunity on mezzanine loans with a strong inter-creditor agreement along with the solid equity investor’s rights and responsibilities.