Deconversions, Adaptive Reuse Drive Chicago Multifamily Investment

by Kristin Harlow

Resilience in the Chicago apartment market amid a historic construction boom is creating opportunities for multifamily investors, particularly those who are willing to go the extra mile — sometimes literally — to capitalize on rent growth outside the downtown core.

David Goss, Interra Realty

Across the city in outlying neighborhoods like Uptown, Rogers Park and Pilsen, value is being discovered in vintage buildings due to their high appreciation potential. In addition to circumventing rising material and labor costs, buyers of existing buildings are benefiting from their ability to collect rents now, while there’s still room for growth, rather than going through the time-consuming development process that has cast a shadow over some pipeline projects.

Jon Morgan, Interra Realty

Wave of deconversions
Condo deconversions have been a popular choice among investors in recent years, with nearly 2,000 units deconverted at a combined market value of approximately $437 million since late 2016 in Chicago, according to data from CoStar Group and Interra Realty. When executed well, these transactions create a win-win for both parties involved.

Condo owners, some of whom are still trying to recover value lost during the recession, can usually sell their units at a higher price than they would have achieved on their own, particularly in older buildings with deferred maintenance that could have resulted in a special assessment. At the same time, buyers are able to acquire assets below replacement cost, adding value through strategic capital improvements that enhance the marketability of the property.

A recent example is Interra’s $30 million deconversion sale of 445 W. Wellington Ave., a 15-story condominium building in Chicago’s Lakeview East neighborhood. The buyer, a local private real estate investor, plans to turn the 65-year-old building’s 117 condos back into rental apartments.

Many of the units feature condo-quality finishes, including hardwood floors and modern kitchens with granite countertops and stainless steel appliances. The building also includes a rooftop deck, laundry room, parking, storage and a bike room — all must-have amenities in today’s rental market.

For the investor, deconversions present an opportunity to inherit a relatively stable tenant base of owners-turned-renters, as it’s not uncommon for sellers to turn around and lease their unit — at least until they’re ready to buy again. This aids in initial carry costs since the investor doesn’t have to start with an empty building, or worse, a neglected tenant base leftover from a prior owner. The latter can pose initial management problems, particularly if those residents are paying below-market rents.

Despite the upside they offer, deconversions can pose significant challenges for investors. Among them is getting at least 75 percent of owners to sign off on a sale, as required under the Illinois Condominium Property Act.

In the largest Chicago deconversion deal to date, the owners of the River City condominiums in the South Loop voted to sell the 448-unit complex to an investor for nearly $100 million. Just over 79 percent of owners voted in favor of the sale in December 2017. But they had previously declined two lower offers from the same buyer — approximately $92 million and $81.4 million — in votes dating back to 2016.

Older buildings underutilized
Another option for investors looking to avoid the challenges associated with a deconversion is the adaptive reuse of existing buildings. Today’s buyers are much more adept at looking at zoning and figuring out the highest and best use for structures that are underutilized in their current state.

In Chicago, former industrial neighborhoods like the West Loop and River West have seen factories and warehouses converted into new uses, including office, retail and mixed-use.

Perhaps the biggest benefit of adaptive reuse is the attractive, infill location many properties offer. Competition is even steeper for assets with adjacent parking, which can allow for a ground-up component.

An example is the $4.3 million sale of 2501-11 N. Southport Ave., a three-story, mixed-use building and adjacent parking lot located in Chicago’s Lincoln Park neighborhood. The 10,000-square-foot, limestone-fronted building previously housed a family-owned funeral home. In addition to renovating the building’s interior, the buyer plans to develop the adjacent 9,300-square-foot parking lot, which offers approximately 75 feet of frontage along a popular city street.

In more extensive adaptive reuse projects, investors are not only applying high-end finishes to interiors, but also carving out amenity spaces like those offered in newly built Class A properties — fitness centers, lounges and rooftop decks, to name a few. Yet these buyers are also taking care to preserve original design features. For example, exposed brick and timber add authenticity and differentiate buildings from the competition.

For some multifamily investors, buying existing or building new is not an either-or proposition, as demonstrated by the recent $13.7 million sale of a property located at 3264-70 N. Clark St. in Chicago’s Lakeview neighborhood. The buyer intends to convert the mixed-use building’s 30 condominiums back into rentals, retain street-level commercial space and develop a five-story, 22-unit apartment building on an adjacent surface lot.

Looking ahead, the appetite for multifamily properties appears to be healthy despite historic unit deliveries. According to Integra Realty Resources, last year 4,348 rental units were completed downtown, more than any year on record. Another 3,000 are slated to deliver in 2018 and 4,200 in 2019.

Those are big numbers, but the influx of jobs from the suburbs to the city has helped absorb much of the new supply, and factors like the city’s Affordable Requirements Ordinance (ARO), as well as higher land and construction costs, are expected to keep the market from getting too frothy. The ARO mandates that 10 percent of the units in any new development be set aside for affordable housing if there is any city assistance, it involves any city property, or it requires any zoning change.

Faced with low cap rates downtown hovering around 4.75 percent, investors, including institutional-level buyers, are targeting older, value-add investments that offer both immediate cash flow and upside potential. The trend of deconversions will be especially noticeable in North Side neighborhoods flush with young workers looking for housing that is relatively affordable compared to downtown.
As long as demand continues to outpace available supply, investors willing to weather some turbulence in the form of rising interest rates should be sailing on relatively calm seas.

— By David Goss and Jon Morgan, Co-Founders, Interra Realty. This article originally appeared in the June 2018 issue of Heartland Real Estate Business magazine.

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