An Underfunded Rehab Can Create Serious Rent Problems, Analysts Find
By A. J. Johnson & Caitlin Jones
5 min read
Tax Credit Advisor January, 2006: Developers who skimp on spending when rehabilitating affordable housing properties may face serious problems in renting those properties post-rehab, according to a recent study from Paramount Financial Group.
The study was based on an analysis of rent and occupancy data for 25 properties conducted before and after rehabilitation. It was authored by Paramount’s David Ross, vice president of underwriting and head of market research, and Tom Jones, a construction analyst, and presented at the 2006 Winter Meeting of the National Council of Affordable Housing Market Analysts held in Washington, D.C.
Ross and Jones found that the properties faring the poorest in terms of marketability post-rehab were those in the “moderate” rehabilitation category, where the change in rental rates ranged from a 17 percent decline to a 4 percent increase.
By comparison, properties that had undergone “substantial” rehabilitation experienced rent changes that ranged between a 5 percent decline and a 7 percent increase. The study included one example of a “gut” rehabilitation, where marketability increased by about 3 percent.
Paramount Financial defines moderate rehabilitations as those involving less than $15,000 per unit in hard construction costs, with replacement of one or fewer major structural systems, such as a roof. Projects undergoing substantial rehab incur between $15,000 and $30,000 per unit of hard construction costs and replace more than one major system. Gut rehabs spend more than $30,000 per unit in hard construction costs and replace more than two major systems.
For both moderate and substantial rehabilitations, residents remain in their apartments during the rehab period, while residents are moved out during a gut rehab.
The Problem with Moderate Rehabilitations
Ross said that moderate rehabilitations are often problematic because, given the limited construction spending involved, they do not provide the improvements needed to retain existing tenants, or entice prospective ones.
“All of our rehab problem properties are moderate rehab properties,” he said. “If you are not making major changes to the marketability, you can’t expect an increase in rent, and chances are you are going to have to expect a decrease in rent because of increased turnover.”
Jones presented a series of case studies illustrating why some rehabilitations are successful and others aren’t. One unsuccessful example was a $14,000 per-unit rehab of a property built in 1966. Although in the high end of moderate rehabilitation expenditure, the rehab was unsatisfactory, he said, because given the property’s level of deferred maintenance, most of the spending went into exterior repairs, leaving the interior virtually unchanged.
“This property should have been a substantial rehabilitation,” he said.
On the other hand, Jones cited a successful moderate rehab where $12,000 per unit was spent, mostly on interior renovations, that resulted in new kitchens and bathrooms that furthered the marketability of the property.
One of the most common mistakes made by developers, the researchers said, is to defer maintenance. When this happens, the rehab is apt to be more expensive, making it difficult to spend on improvements to interior spaces where the tenants actually live.
“The issue is how much deferred maintenance there was, and how well the owners maintained the property prior to the rehab,” said Jones. “That is how some developers got away with spending less and how some really needed to spend more than what they did.”
Substantial rehabs, he said, do not typically have this problem because adequate spending has been allocated both to improving major systems as well as interior improvements.
“I don’t have a bad example [of a substantial rehab] because they are spending more money, they are doing the things that need to be done to bring the property in line,” he said.
Recommendations
The analysts provided several recommendations based on the results of their study.
- Developers should budget rehabilitations at $1,000 per unit per year of age.
- Before the rehab occurs, market analysts should press developers to provide detail about budgets, and not accept a vague commitment to rehabilitate checklist items on an “as needed” basis.
“If they say they are going to replace countertops as needed, I say no: “what percentage are you going to replace?” said Jones. Ross advised analysts to request construction documents. “Outlining the assumptions in detail that go into what this property is going to look like is essential,” he said.
- When the rehabilitation is complete, market analysts should follow up with a walkthrough of at least 10 percent of the units.
- In assessing a rehabilitation, market analysts must understand the needs and preferences of tenants, both existing and prospective.
“Most of us market analysts are very well grounded in real estate principals, but we often forget the market research side which is consumer behavior patterns and understanding demographics,” said Ross. “One of the most critical things to understand is who are your tenants.”
He said that this market research should include a review of current tenant profiles that detail tenants’ income, household size, workplace, and what type of unit the tenant has moved from. In addition, market analysts should determine how much rent tenants are actually paying.
