Converting student housing properties to traditional multifamily has become a more noticeable trend as ever compressing cap rates pressure conventional multifamily investors to seek higher yields. And as many markets seek more affordable and market rate rental housing, converting non-performing student housing properties to conventional multifamily has become popular among a subset of traditional multifamily owners.
Berkadia Senior Managing Director of Student Housing Kevin Larimer points to a National Multifamily Housing Council/National Apartment Association study released in July that supports why conversions are on the upswing. The study shows that the United States needs approximately 4.3 million new apartment units by 2035. The study also points to a deficit — underbuilding — of 600,000 units caused by the 2008 financial crisis.
“Additionally, there has been a decline of 4.7 million affordable units between 2015 and 2020,” says Larimer, citing the study. “All of these factors have led conventional multifamily capital to look for creative ways to fill the supply gap. Conversion of student housing properties has been a very effective and efficient way.”
The draw to conversion developed as investors sought more yield in new acquisitions and flips.
“This trend largely started due to the significantly compressed cap rates and yields in the multifamily space that we have seen over the past few years,” says Sean Lyons, partner with Triad Real Estate Partners. “In certain growth markets, multifamily cap rates were trading below 3 percent for a period of time while interest rates remained at historic lows. The market demand was being fueled by this low-cost debt and higher projected long-term rent growth. Student housing has historically been more consistent and has offered a significant yield margin over multifamily in the recent run up.”
Smart investors — often with experience in value-add properties — looked at non-performing student housing assets in growing markets as a strategy to success in the conventional multifamily sector.
“We originally saw a lot of groups looking for yields, and who were looking at alternate strategy to gain those yields,” says Jaclyn Fitts, executive vice president with CBRE Capital Markets. “While cap rates and interest rates have risen, investors are still seeking higher internal rates of return (IRRs). In some instances, with these conversions, investors can still achieve a higher IRR than they can with a standard value-add multifamily property.”
According to Yardi, this trend has been around for some time. The real estate information services firm tracks the number of student housing to traditional multifamily conversions. Over the past seven years, Yardi has counted more than 100 student housing properties that have been converted to traditional multifamily. The trend has been steady since 2019, with about 10 to 12 properties per year being converted nationwide. So far in 2022, however, Yardi has tracked 13 properties that have been converted.
“The best assets that work for this are those that are not operating well as a student housing property,” says Fitts. “It is more difficult to get a conversion to make sense financially if the asset is fully leased and operating well as a student property. We’ve seen more success with conversions when the asset is distressed as a student housing property.”
Sean Baird, managing director of Colliers’ National Student Housing Group, provides the following example: “A student buyer may cap a deal out at $30,000 per bed or $90,000 per unit in value, whereas a multifamily buyer sees the value at $120,000 per unit because the market is 95 percent occupied for multifamily and stabilized assets are selling for $200,000 per unit. That leaves plenty of margin to renovate and sell for a profit.”
When seeking these assets for conversion, conventional buyers also tend to know what they are in for, says Douglas Sitt, co-head of student housing at Philadelphia-based Rittenhouse Realty Advisors.
“Conventional buyers are getting a little better pricing because they are getting a higher cap rate by acquiring a student property than they would with a traditional multifamily deal,” says Sitt.
“There are fewer bidders going after student assets as well,” adds Ken Wellar, managing partner at Rittenhouse. “In student housing, we know the usual suspects to go to; with conventional, there are a lot more players. It’s easier for a conventional player to compete for these properties.”
Conversions tend to do best in major markets or secondary markets where there is a lack of conventional multifamily product. Some markets that saw student housing built for a secondary or tertiary university are now seeing that product converted to traditional multifamily to satisfy housing demand. A number of sources pointed to the markets of Clarksville and Murfreesboro, Tennessee, two markets on opposite sides of the Nashville MSA that have small colleges, but have seen their overall population grow faster than their university enrollment.
“Both of these markets are 30 minutes from Nashville and both are tertiary student housing markets: Austin Peay State University in Clarksville and Middle Tennessee State University (MTSU) in Murfreesboro,” says Chris Epp, managing director with Walker & Dunlop. “Both of these are sleeper student housing markets with rents that are $500 less per unit than Nashville. We have a winner for conversion.”
Conventional renters are attracted to these exurban markets because of their affordability and proximity to Nashville. Fitts and her team recently sold a property in Bowling Green, Kentucky, that has similar characteristics, one of seven student housing assets the CBRE team has sold in the past 18 months that have been converted to conventional multifamily properties after the transactions closed.
Markets that have a strong need for multifamily inventory are most in demand for investors to convert a student housing asset.
“Especially at Tier 2 universities in markets that are strong for conventional multifamily assets, we are seeing acquisitions for conversions,” says Sitt. Rittenhouse recently sold a student housing property near MTSU in Murfreesboro that was quickly converted to a conventional multifamily property.
Sitt has also seen this trend take place in markets where student housing remains strong, including near the University of South Florida (USF) in Tampa.
“While the USF market is one of the strongest for student housing in the country, Tampa is also one of the best markets for conventional multifamily in the country,” he says. “Cap rates are lower for conventional properties, creating an arbitrage.”
Risk is most apparent in college towns, where demand may lag for conventional product.
“Investors need to make sure the demand is there outside the student population when looking at a conversion in a college town,” says Fitts.
There has been an unexpected benefit in many college markets where off-campus student housing properties have been converted to traditional multifamily assets — higher occupancy in dedicated student housing properties. In more than a few markets this improved the performance of the remaining student housing properties.
“There are many owners in secondary and tertiary markets that were absolutely saved by this conversion trend,” says Epp. “A few markets that come to mind are San Marcos, Texas; Tampa, Florida; Edwardsville, Illinois; Clarksville, Tennessee; San Antonio, Texas; and Murfreesboro, Tennessee.”
Another notoriously overbuilt student housing market that has benefitted is Tallahassee, Florida.
“You saw older, non-competitive student product being converted and doing very well as multifamily in a market that was starved for conventional assets,” says Baird. “Any time we can remove supply from a market — whether demand is flat or growing — the remaining student housing assets will benefit.”
Physical and Financial Transformation
But converting a student housing property to conventional is not an easy task. Most student housing properties were designed with a mix of two-, three- and four-bedroom units with bed-bath parity. Most conventional units max out at two or three bedrooms, many without bed-bath parity.
Investors who convert properties generally have a background with properties that need heavy renovation, such as value-add properties.
“They have to understand the nuances related to large renovations or construction,” says Fitts.
The majority of properties that are being converted from student to conventional are garden-style because they are the easiest to convert. Student housing units tend to have more bedrooms and less common area space. Conventional units need more common area unit space, like a dining area and larger living rooms. As such, walls are generally removed and relocated, creating more common space. Large student four-bedroom units can even be converted to create a one-bedroom unit and a two-bedroom unit.
“Properties that offer smaller, more conventional unit mixes are the easiest to convert to conventional housing,” says Lyons. “Heavy four-bedroom floorplan properties can be more challenging, creating two units is possible but often awkward and expensive. Projects that have bed-bath parity are also more challenging to convert as that is not an amenity you typically see in conventional multifamily product.”
Another issue that can come with conversion is parking. With more units, parking requirements can change depending on the municipality. However, garden-style complexes tend to have larger parking lots that can usually accommodate additional requirements.
Cottage-style student housing properties are also being considered by single family rental (SFR) owners for conversion. CBRE’s student housing team is marketing a cottage-style asset in San Antonio as a student property, while the firm’s multifamily team is marketing the project as an SFR asset.
“We put both scenarios out there,” says Fitts. “Ultimately, what we are seeing is the highest offers are coming from the potential converters to SFR.”
In addition to the physical transformation that usually has to take place in a conversion, there is also a change that takes place in operations. Aside from changing the leasing strategy and pricing model from by the bed to by the unit, there are other potential benefits to an investor who converts. For one, there are savings with fewer amenities. Cable and internet are usually no longer provided, nor is furniture. With SFR properties, all utilities are transferred to the tenant. If a shuttle service to campus is operated, that is generally halted.
There are a number of investment groups who are actively acquiring student housing properties and converting them to traditional multifamily as a business model. Some sell the assets into the conventional market after conversion, effectively flipping them for a tidy profit.
“Investors have to make sure operationally the net operating income from a conversion makes sense, and also the return on investment on the conversion is worthwhile,” says Baird. “If student rates are $1.50 per square foot and conventional rent is only $1.10 per square foot, there is most likely not an opportunity to convert if heavy renovations are needed, no matter what the occupancy bump will look like. Conversion is a heavy underwriting endeavor that requires a buyer to understand the full cost of conversion before making the jump.”
While conversions have been on the rise, many in the industry expect to see the trend slow down. Rising interest rates are causing many multifamily deals — conventional, student and otherwise — to be re-priced or held from the market. As well, the student housing sector is extremely healthy for the 2022-2023 academic year in most markets.
“The operating fundamentals for the 2022-2023 academic year are historically strong, and the industry has recovered from the impact of the pandemic,” says Larimer. “Pre-leasing velocity is 6.5 percent ahead of the 2019-2020 cycle (the last cycle pre-pandemic) and rents have increased on average 5.7 percent. Colleges have experienced record applications so we expect to see very strong enrollment numbers in fall 2022.”
While the old industry adage used to be that a great exit strategy for student housing assets would be to convert properties to traditional multifamily, investment sales professionals warn against that.
“I would not use conversion as an exit strategy, but more of an emergency parachute,” says Baird. “Not every deal will work for a conversion, nor will it pencil. You have to keep your pulse on the conversion costs and market rates, or you can end up in a bad position with a strategy that won’t pencil.”
This article was originally published in the July/August issue of Student Housing Business magazine.