The Bascom Company Looks to Operational Value-Add in Rent Lagging B and C apartment sectors.

Like most seasoned apartment renovators, The Bascom Group has seen little opportunity across its portfolio of 32,051 units to invest in serious physical renovation projects over the past three years. Sure, labor has been cheap, and most nonpetroleum building products can be had at a discount to prerecession prices. Economically stressed renters even still show an interest in newly renovated apartments—but here’s the rub: Virtually none of those prospects is willing to pay a premium to rent an upgraded unit.

In the B and C markets, which make up 80 percent of the Bascom portfolio, pushing rent increases for any reason remains challenging, resulting in a renovation docket that precludes action on all but the most critical deferred maintenance issues. While bringing so-called “down units” back on line as a value-add play remains doable, large-scale asset upgrades still have to wait out a larger market recovery. Until then, if you’re funneling cap-ex into a value-added physical renovation play, you might as well be throwing your dollars into a black hole.

“I don’t see how spending money on traditional value-add renovation is going to get you any bang for your buck right now,” says Jerome Fink, one of three managing partners (including David Kim and Derek Chen) who founded Bascom in 1996 with a vision of buying physically distressed apartment assets, investing in functional and operational renovations, and reselling the assets after a three- to five-year hold. “In a lot of our markets, renters are still too price-sensitive. Yeah, the resident demographic likes a renovated unit, but they are not yet willing—and, in many cases, not yet able—to pay for it.”

So what’s an apartment renovator to do when renovation opportunities are on economic pause? If you’re The Bascom Group, you find more creative ways to pull value-add returns out of the acquisition market by targeting purchases with distressed rent fundamentals, often due to an owner’s financial or professional inability to keep pace with regular asset maintenance and management. Bascom did just that across three deals consummated in 2010. For an inclusive total of $65.4 million, the purchases crossed asset classes and came via ­receivership, foreclosure, and trustee sales. (For more on these acquisitions, see “Triple Play.”) The one thing all three assets had in common: They were operationally dysfunctional.

Indeed, what seemed like an insurmountable hurdle—the turnaround of long-neglected properties—has become a profitable niche opportunity for Bascom. And until the greater economy has improved sufficiently to justify traditional repositioning efforts, this strategy is one that Bascom, which is eyeing a $300 million pipeline of potential investments, plans to pursue for the remainder of 2011.

Survival of the Fittest

Today’s renovations have a different purpose: “The value-add now isn’t going in and upgrading all of the units to granite; it’s about getting units up to a functional par,” Kim explains. “Today’s concept is locating a property with 30 down units, where you spend $150,000 to bring back the inventory that is off line because of functional neglect, deferred maintenance, and lack of replacement capital. All we are doing from a value-add standpoint is bringing the asset on line and getting it to market so it can be rented.”

Such was the case at The Maples at Crestwood Apartments, 300 units of Class C rental stock in a blue-collar Denver neighborhood where a nonprofit community development corporation was unable to continue renovations and even began cannibalizing vacant units as leases turned. Fink says the practice of essentially highjacking vacant units for spare parts in order to upgrade other apartments during the turn has been an all-too-common practice during the recession—and one that can quickly lead to property distress in the absence of capital reserves.

“You take a stove from here, a microwave from here, and you don’t have to put in any money, but the problem is that you then increase the number of down units,” Fink says. “All of a sudden, the owner doesn’t have any money, and the bank of cannibalized and unrentable units starts growing and growing and growing. It’s robbing Peter to pay Paul, without the thought that eventually you have to pay somebody.”

Kim says unit cannibalization is a death spiral that few Class B and C operators are able to recover from. Bascom was able to acquire the Maples in an off-market deal for $7.9 million and plans on executing a total repositioning budget of approximately $420,000 to get off-line units in rentable shape, as well as to make overall cosmetic improvements at the property. It’s a business model that the firm could logically apply elsewhere as secondary markets continue to stagnate, despite broader improvements in Class A and higher-­barrier-to-entry markets.

“The Bs and Cs are where the private owner has been starving it out, and the mid-’90s [glut of deteriorating apartments] is happening all over again because of deferred maintenance and the penny-wise, pound-foolish strategy of living from quarter to quarter,” Kim says. “Well, we’re three years into that now, and capital equipment does not have an infinite useful life. Just about every owner has deferred capital improvements, and the assets are long in the tooth in terms of renovations—falling apart and looking dated. It’s a boost for our business because it has built an incredible pipeline of deferred maintenance issues.”

Just Get the Rents

The difference between The Bascom Group’s current acquisitions strategy and traditional buy-it, better-it, sell-it-for-more value-add plays is that the company is not singularly focused on raising rents via improvements in design and product selection. Instead, today’s renovation mind-set commands an understanding of how to achieve an occupancy improvement and/or shrink rent disparities compared with market averages. In short, Bascom is looking for properties with lower occupancy and rents versus their comps, where the primary reason for that disparity involves deferred maintenance and a lack of cap-ex investment.

“The metric is not that complicated. We buy where rents are in the first quartile, and, through capital improvements and investments, our end rents have to be in the second quartile,” Kim says. “If we can create newer inventory and newer product where the community is priced in the middle, but the functional aspects and service aspects are in the 90th percentile, we can always make that equation work. It’s not that sophisticated.”

Not that Bascom is oblivious to the higher risks of owning and operating in the B and C markets, where rent and occupancy distress is more prevalent. With unemployment still prolific among renters in these asset classes, buyers “need to make pretty realistic assumptions of how long it will take to shore up occupancy and see a return to revenue growth,” says Bascom Group senior vice president of business development Chad Sanderson. “Unemployment continues to be a very real issue for apartment operators in those markets. You see it in increased delinquencies, and you see it in increased turnover.”

Indeed, Bascom itself has experienced difficulty with some of the toughest assets in the firm’s history. In June 2009, five Phoenix properties held by the firm’s Bascom Arizona Ventures subsidiary fell into foreclosure. Those properties, however, were the only Phoenix assets that the firm wasn’t able to unload via disposition in a 2007 move to vacate the market via a 12-property, $427.5 million portfolio sale.

Those types of risks are exactly what have kept the vast majority of apartment investors and their institutional equity away from the B and C deals that Bascom finds attractive. With challenging rent fundamentals and no clear rent-lift-for-cap-ex parity, assets not firmly in the flight-to-quality, Class A space aren’t the kind that most fund managers are bringing to acquisition committees. Bascom itself is witnessing the reticence in institutional investor psychology among its own equity partners, and is consequently doing more deals with its high-net-worth equity providers versus pension fund partners and like-minded money managers.

“The new equity investor is high net worth, sitting on a lot of money and looking at a down market as a place to jump in and buy a property at 50 percent less than it traded for three years ago,” Kim says. “A lot of times, the private investor doesn’t even look at internal rates of return (IRRs); they look at discount and what is a ­decent 5 percent to 7 percent cash-on-cash return even without improvement.”

Such underwriting requirements open a large spectrum of deals for Bascom acquisition executives but also require flexibility on debt placement as well as the confidence that merely meeting the market will be good enough for the significant NOI and asset value improvement necessary to profit on disposition. “We’re not trying to hit a rent level that no one is achieving,” Sanderson says. “We are looking to move rents within our markets as they exist today, but with the range of deals that we buy, we cannot be reliant on any singular line of financing on either the debt or equity side. We need to match the right capital with the right deal in the right market.”

Operation: Outsource

Bascom’s strategy of matching its partners with specific real estate also extends to the construction and management side of the firm’s operations. At its core, The Bascom Group is an apartment investment advisory firm with a GC’s aptitude for managing the renovation and repositioning of real estate assets. It also hires best-in-class regional management and construction firms as partners for the on-the-ground execution of the Bascom game plan.

“We assist on the front end with design and budgeting, and then we help them execute the contracts once they purchase the property,” says J.R. Bolos, director of client services for Carrollton, Texas–based construction management and apartment renovation firm United Renovations, who is working with Bascom on the repositioning of The Maples in Denver as well as assisting on cosmetic improvements at The Retreat at Canyon Springs Apartments, a Class A property in San Antonio. “Every deal is distinct. Denver has a pretty heavy renovation plan, and we’re about halfway through that, where in San Antonio, we’re making something nice even nicer. But regardless, they are cutting edge and really on the front end of what they do, and they aren’t always playing it safe: They’ll swing for the fences.”

On the management side, Bascom maintains a visible presence on site, often playing a necessarily larger hand in operations during renovations. That hands-on approach helps ally them with more flexible regional managers as opposed to national fee-­management shops with prescribed management M.O.s. “They are very involved at a high level, and a lot of operators might view that as a negative, but we certainly don’t,” says Greg Wiseman, founder of Salt Lake City, Utah–based Apartment Management Consultants, LLC., which has 52,000 units under management in the Western United States, 13,000 of which are Bascom units in Colorado, Washington, Utah, and California.

“One of the things Bascom does really well is stick to its concept,” Wiseman says. “Too many times during renovations, the message isn’t communicated really well to property management, and they do a great job of getting in front of everyone, from our maintenance technicians to our leasing consultants. Getting on-site buy-in to a renovation program requires a single sustained message repeated over and over again, and no one does that better than Bascom does. Our team wants to jump on their back and glide through a renovation program. People want to work for them, and they definitely reap those rewards.”

Bascom takes advantage of that fee-management popularity by hiring two to three management firms in any given market and pitting them competitively against one another to produce best practices and solid property fundamentals. This year, the firm even asked all of its fee managers to come up with four new ideas for resident social outreach as a way of improving community cohesion and underlying property performance (see “Candy Wrappers,” on page 26). “We want to create competition not just on fees but also on performance,” Fink says. “We want to get away from the excuse that the market is soft and also apply best practices across our portfolio.”

Renovation Guns for Hire

Fink says the resulting operational model aligns with both the specific market-to-­market and property-to-property repositioning needs while also matching up with internal and external investor return expectations. “We’re not in this for a fee-revenue business; we are really in it for the gross dollar profit return,” Fink says. “That’s consistent with our investors, who want to harvest the gains eventually—they are looking for total return and not necessarily month-to-month yield.”

And while investor competition in the B and C renovation sector remains muted, Bascom is prepared—and perhaps even hopeful—for a larger volume of dealmaking in 2011 and beyond. Consistent with the firm’s model since it invested in its first $2.2 million property 208 deals ago, Bascom will continue to partner with institutional and high-net-worth investors, typically on a 90/10 equity split arrangement and preferred profit returns with a targeted mid- to high-teen IRR. Historically, the company has averaged an unleveraged property IRR of 13.32 percent.

“We think the institutional equity is moving that way,” Fink says. “In 2010, all they wanted was As, and in 2011, they are already looking for B-plusses. Our sense is that later this year or early into next year, people are going to be looking for higher returns, and looking for distressed Bs and Cs that can be repositioned. They’ll do that by finding operators like us to develop ventures for targeting those assets.”

Bascom also thinks the volume of deals with deferred maintenance and financial distress likely to come out of the Class B and C markets over the next five years will be more than healthy enough to satisfy investor demand. Success, the company’s executives contend, will depend on familiarity with the renovation process and hardiness when it comes to the hairier side of reposition-ready ­assets.

“It’s tough to bring us a deal that we have not seen ­before, whether it is an operational deficiency or a physical deficiency,” says Bascom vice president of acquisitions Jeff Fuller. “We’re looking at an acquisition right now that has major sewer problems that are going to scare away a lot of buyers,” he continues. “But we have the ability, the capital sources, and the expertise to do it. We can also do Class A value-add. It is the same business plan for As, Bs, and Cs. We don’t do condo conversions, and we don’t do ground-up construction: We just buy and reposition existing apartments.”

This year, Bascom will focus on the continued renovation of the firm’s 2010 acquisitions while looking for new deal opportunities. Only 451 units are scheduled for full-on renovation (mostly at The Maples) this year, meaning the company will continue to tighten occupancies, expenses, and collections to position the portfolio for revenue growth in 2011 and, eventually, traditional cap-ex renovations beyond.

Meanwhile, Bascom will look to land more assets out of an already identified $300 million pipeline of possible deals while reaching out feelers for additional opportunities to shine where capital-constrained owners have failed.

“There are a lot of people hanging on, thinking they’ve gotten through the worst of it, and yes, rents are going up, but the reality is that rents are not going to go up fast enough for them to get out of that hole,” Fink says. “The repositioning of B, B-minus, and even C assets is a phenomenon that has to happen before the cost-to-replacement equation makes ground-up development pencil out.

“We think we are entering the most amazing period in our generation for our business plan, which is acquiring and repositioning value-add distressed apartment communities in the United States.”