I’m a licensed real estate agent, an investor & managing partner of a multifamily investment firm. Every week, I have people ask me questions about how to get started investing in real estate. They believe that it involves the purchase of properties to flip or hold as rentals. In most cases, these individuals don’t know about the many forms of passive real estate investing. My favorite is multifamily syndications.
As a passive investor in a multifamily syndication, my money is pooled with money from other investors. The sponsor of the syndication uses this “equity capital” to acquire and reposition the multifamily asset. The passive investor becomes part of the ownership team along with the sponsor. Distributable cash from operations and refinance or sale of the asset is shared with investors at some pretty attractive rates without the ups and downs of the stock market.
Think of it like investing in a business. In this case the business is the apartment community, and the income comes from rents and other possible sources like an on site laundry facility, storage units, etc. Each month or quarter, the sponsor calculates the net operating income then net cash flow and cash distributions are paid to the passive investors after all the bills are paid.
Assets are typically held for five years, but it varies with each specific deal. At the end of the hold period, the asset is sold or refinanced with the passive investor sharing in the equity gain. I like assets where the appreciation can be forced through improvements because the appreciation can be controlled. There is also market appreciation, but this is not guaranteed.
Cash distributions are split between the passive investors and the sponsor. The amounts vary with each offering with the most common split sending 70% to the passive investors and 30% to the sponsor. The passive investors further split the 70% (or other amount) proportionate with the equity they invested.
It should be noted that the sponsor will charge fees that are paid before the cash is distributed. For example, it is typical that a sponsor takes a 2% acquisition fee and a 1% or 2% asset management fee. These fees are typical, and, when evaluating an opportunity, you should make sure the sponsor is not charging excessive fees.
Also, you may see “waterfall” distributions where the sponsor takes a higher percentage as the distributable cash increases. This type of distribution is intended to put investors first and incentivize the sponsor to provide higher returns. They do this by giving the passive investors a preferred return. Basically, the passive investors get all the distributable cash up to a certain percentage (usually 7%). However, at higher returns, the sponsor may take 50% of the distributable cash instead of 30%.
Syndications are a great way to diversify a portfolio, and there are syndications for all types of commercial real estate deals (office, industrial, self-storage, etc.). My goal is to educate potential investors about multifamily (apartment) syndications. Since most individuals are more familiar with stock investing, I thought it would be helpful to compare passive multifamily investing with stock market investing.
In general, stocks and multifamily investments provide the investor with income through cash flow and appreciation. Only stocks that pay a dividend have the cash flow component. The typical dividend pays about 2%.
In a syndication, investors also capitalize on cash flow. The distributable cash from operations makes up the cash flow component. When underwriting deals, most sponsors target an 8% cash-on-cash return. Basically, an average of 8% annually to be returned to the investor’s account from operations. This is an average, and the cash flow usually starts out lower than the average in the first year. As the asset is repositioned, the cash flow increases year over year.
Stock investors are usually familiar with historic market returns. A quick search will reveal various sources indicating an average return of 8% to 11% excluding fees. This is the appreciation component and is recognized when a stock is sold. Since its inception, the value of the stock market increased year over year about 70% of the time, which means it has had an annual decrease in value about 30% of the time.
Passive multifamily investors benefit from both forced and market appreciation. Like stocks, the appreciation is recognized when the asset is sold. Distributable cash from the sale or refinance is divided up between the passive investor and the sponsor similar to the cash flow described above. If the property was repositioned according to the business plan, the total returns will equal or exceed the planned rate of return. Most syndications underwrite their deals to provide investors with a 15% internal rate of return (IRR).
Another way syndications look at returns is using a factor called the equity multiple. If you double your investment over a 5-year hold period, the equity multiple would be 2.0x. Most 5-year multifamily syndications are underwritten with an equity multiple in the 1.75x to 2.2x range. Of course, if you hold the asset longer, the equity multiple should be higher. I like deals that are 1.9x to 2.0x, which basically means I am doubling my investment in five years.
Barrier to Entry
You can get started investing in stocks with very little money, so stocks have low barriers to entry. However, most invest hundreds if not thousands of dollars. You can also consistently buy stocks over time to build your portfolio.
To get started in Syndications, there is a minimum investment, which is usually between $25,000 and $100,000. The minimum investment eliminates the sponsor from the administrative burden of managing distributions and communications to a significantly higher number of investors.
The stock market is known for being very liquid. Stocks can be bought and sold on the same day. Day traders look for these short-term opportunities. However, success with the stock market is proven to have a time component, and most people do not “day trade.” Investors usually intend to keep their money in a stock or mutual fund for months if not years. Regardless, if you need your money in a pinch, you can liquidate investments with relative ease.
Multifamily syndications are not as liquid. You need to make sure the money invested will not be needed throughout the life of the deal. This is not a place for your emergency funds.
We all know that the government likes to use our hard-earned money. Over the years, tax deductions and credits have been written into the tax code. Many of these deductions and credits benefit real estate investors. Stocks, on the other hand, have minimal tax benefits.
One of the biggest tax benefits associated with multifamily properties is the depreciation benefit. Apartments can be depreciated over 27.5 years (office and industrial depreciation over 39 years). This depreciation reduces the investor’s tax liability without impacting the cash available for distribution. This is recognized on the K-1 provided by the sponsor to the investor each year.
I also ask if the sponsor is conducting a cost segregation study. The process is used to depreciate certain items faster. For example, personal property, such as a microwave, can be depreciated over five years. The cost segregation has the effect of “front loading” or maximizing the depreciation. Remember, these assets are only held for about five years, so front loading the depreciation is a real benefit to the investor.
A stock is a paper asset. It has a value on paper, but has no physical, tangible value to back it up. Real estate is a physical, tangible asset. There are cases where a stock’s value has plummeted due to changes in the market, an outdated product/service, or mismanagement of the company.
In a multifamily syndication, you own a tangible asset, the value of which is extremely unlikely to go to zero. Even in extreme cases where, for example, an investment in a single apartment building burns to the ground, the investment is covered by insurance.
Whether investing in the stock market or multifamily syndications as a passive investor, you do not have any control over the performance of the asset. However, in all my syndications, but one, I actually know the sponsor. And in all cases, I receive frequent updates including monthly reports, Zoom calls and other forms of communication. It feels like I have a seat at the table. Sponsors also set up an online account where you can view the private placement documents, distributions, tax forms, and other items.
Hedge Against Inflation
Stocks are not very well known for being a hedge against inflation. In inflationary times, the stock market tends to react negatively and volatility increases.
Multifamily real estate is an excellent hedge against inflation. In inflationary times, property values and, more importantly, the rent paid by tenants increase. I have read many articles where, during these Covid times, large private venture firms or wealthy, intelligent investors are looking to place their investments into commercial real estate to protect their investments against inflation.
The bottom line is that there are pros and cons to each form of investing. My goal is to make you aware of an attractive option that I discovered and have had success. In fact, I like it so much, I’m now working on the active side of these deals.