apartment deal syndication most frequently asked questionsAs part of a syndication team that spends ample time educating and answering investor questions I wanted to compile some of the most Frequently Asked Questions (FAQs) as part of a quick study guide for new folks who are looking to invest in this area. It’s also good for folks who are new to raising private equity what to expect most from investors in the way of questions. These are in no order and note that there are various types of deals and syndication structures so one size does not fit all. I’m going to focus on value add apartment syndications which is a very mainstream investment niche many investors get involved in as their first foray into syndication.

1) What is syndication? In its simplest form, syndication is the pooling of investor money where the investor is typically a passive, limited partner. The other partner to the deal is the general partner, or active partner that puts the deal together, manages the business plan to provide a return for the benefit of all investors. You will hear General Partner (GP), Syndicate and Sponsor often used interchangeably.

2) What are your return projections and how are your returns calculated? As of this writing, typical cash on cash returns are in the 8-10% range and an internal rate of return (IRR) of 16 – 20% range. You may also see an average rate of return which is simply the total return over 5 years divided by 5. In value add syndication, the average annual return may be deceiving (higher) than the IRR (Internal Rate of Return) as a large part of the investor returns come in the year of sale (modeled as year 5). IRR typically would be a better measure for varying cash flows over a set time horizon.

3) When will I get my original investment back and what is the holding period? Typically, at time of sale. For our deals, year 5 is the target. It could happen in year 3 or year 7 or longer if we have a long downturn but 5 is typically what value add syndicators have as a target.

4) What are the risks? They are outlined in the PPM. That said, I like to provide a few data points. In 2009, at the bottom of the financial crisis, delinquency rates on single family homes was 5% vs 1% on MF apartments. Additionally, in Houston when oil went from $100 barrel to $50 barrel Class A (new apt buildings) had to offer concessions and vacancies rose to 15% while Class B (older MF where value add syndicators play) remained steady at 8%. Lastly, we buy proven. Our typical apartment acquisition will have occupancy greater than 90% and usually higher than that and the previous owner was making good money (T12 – trailing 12-month audit will prove this out). We want to improve proven properties not buy on hope.

5) What is a limited partner? A passive investor in the deal. They have limited liability. Their risk is limited to the amount they invest in the deal, no more. Their other assets are protected. They cannot be sued, they are not on the loan and are not responsible for the active performance of the property.

6) What is the minimum investment? We set it at $50K and increments of $5K.

7) When will I get paid? We do monthly (after 30 days of full monthly operations upon closing of the property). That can be direct deposited into the investors account. Most syndicates do monthly or quarterly distributions.

8) How will you communicate with me? Monthly quick updates (email) on how the investment’s progress. Typical bullet points / some pics on how many units were renovated, rents we are getting, etc. Quarterly property management financials can be reviewed. Following March of each year you will receive a K-1 statement from us for your tax filings.

9) What kind of tax impact is there? Apartment syndications are very tax efficient. As a partner in our limited partnership, you will benefit from your portion of the investment’s deductions for property taxes, loan interest and depreciation which are the big ones. We like to use a cost segregation strategy as well to accelerate depreciation since we don’t plan on holding onto the asset for a long time. You will get a K-1 statement from the partnership in March of the following year for the current tax year. It’s not unusual on a $100K investment to experience a min 8% preferred return or cash in your pocket of $8K while experiencing a paper loss on your annual K-1. Additionally, any refinances or supplemental loans are reviewed as a return of equity so no tax impacts. At time of sale, there may be an opportunity to 1031 exchange into another property that the sponsor wants to buy to continue to defer your long-term gains tax. Keep in mind some depreciation recapture may occur at time of sale if a 1031 exchange does not occur in addition to the long-term capital gains tax you would be responsible for paying on the gains.

10) What is the process / timeline? Once we have a property under contract, due diligence is about 60 days. We start the equity raise process with investors which runs about 5-6 weeks end to end. Marketing deck goes out, investor conference call takes place, investors reserve a spot, review the PPM / sign and fund. About 2-3 weeks later we close on the property. About 60 days later first investor distribution.

11) Why would we purchase a property where the Yelp reviews were so poor? We believe that’s a good thing. As value add syndicators, if all news was good, there would be nothing to improve. The property is often re-branded (new name), new website, new property management team is brought in. Focus is on operational improvement and renovating the property. There’s a focus on intangibles such hosting monthly community gatherings to foster a sense of community that may have been lost which can improve retention, reduce turnover. This can be turned around faster than you think. Re-branding, re-positioning the asset is the focus.

12) How do you renovate with people living there? When we take over a property, even a 300-unit apartment will have 15 vacant units if occupancy is at 95%. We start there. Next month when 10-12 leases are up, we introduce the residents to their new renovated unit (move them in) and start renovating their vacated unit and keep repeating this process month after month. We expect that the improved unit will be so dramatic that retention / new lease signups will be high.

13) What is a supplemental loan? It’s very common to create a lot of value once the renovations are complete and the forecasted rent is being achieved. That is when the value is optimized in a value add strategy. You go back to the bank with a higher assessed property value and either refinance the property (if you had a variable rate loan) or you obtain a second loan on the property (called a supplemental loan) if you have an attractive fixed rate in place that you want to keep. This second loan allows you to pull equity out for the investors benefit which increases the cash on cash returns and IRR on the project.

14) What is a sensitivity analysis? We like to show investors under different scenarios if our forecasts are off, what is the breakeven point for profitability given a decline in occupancy or if rents don’t project where we expected. Surprisingly most of our scenarios allow occupancy to go to 75% to break even. During the 2009 financial crisis, third party data proved that in one the submarkets in Dallas where we have five apartment communities (Richardson) that the worst level was 85%. That is comforting to our investors to know this information.

15) Can I use a 1031? You cannot 1031 into our deals or out of our deals since you are technically purchasing units of our Limited Partnership and not actually the land itself. That said, there are mechanisms where we expect to be able to 1031 from one of our deals into another one of our deals, thus deferring the tax you would have normally paid on the sale of the first apartment.

16) Can I use a SD-IRA or solo 401K to fund the deal? As this time, you can but there is a UBIT tax to understand on the SD-IRA as the IRS does not want to see you take advantage of the leveraged portion of the investment. Interestingly, the solo 401K does not have this problem.

17) What happens if we have a hardship and want to get out before we sell the property? There is nothing in our prospectus for a workout or formula for such a scenario. The investment should be considered an illiquid investment. That said, as a partner with you, the general partner will review your issue and see if there is something that can be done based on your circumstances.

18) What are your fees? Most important is returns forecasted should be post fees. Most common two fees are acquisition fee (2% I see most often) based on purchase price and paid once to the sponsor at closing. This covers all the sponsors costs to find and put under contract this one deal. The second most common fee is the asset management fee (typically 2%) based on the monthly revenues. The asset management fee is for the sponsor to hold the property manager accountable and to ensure execution of the business plan. Industry averages are 1-3 % for both fees.

19) What is a PPM? The Private Placement Memorandum is required by the SEC and describes the offering, risks, includes the partnership agreement, investment summary and subscription agreement. It is a lengthy legal document well over 100 pages. The subscription agreement is what investors will review, sign and includes basic information as to number of units and amounts being purchased, accredited investor’s declaration form, etc. I like to pre-wire new investors if they have never seen a PPM before because the risk section is a bit heavy (like the Surgeon General’s warning) highlighting about every possible risk that could happen. I tell investors that there are risks to every investment, yes, you can lose your entire investment, but certainly I highlight the good track record MF investments have had in severe market down markets. Additionally, no lender is going to give us $10m to $30m unless we are experienced, have a good business plan, conservative underwriting (bank’s will underwrite the deal as well), have adequate insurance and have the property condition report completed by outside experts (often 100-pages) highlighting what fixes need to be made before we take over the property.

20) Are your forecasts conservative? It should be yes. Good sponsors will want to underpromise and overdeliver. You want to review all financial assumptions from the sponsor and ensure they make sense. Key ones to focus on would be rents (check the area comps for before and after renovation pricing – you want to be under where the market is before and after), rent growth and occupancy. Review the T12 (prior 12 months from previous owner). Does the value add improvements, increased income and timing of those improvements make sense to the forecast?

21) What if we have a downturn in the economy? We won’t want to sell in a down market. The goal would be to continue to pay the preferred return minimum and hold on until the market is healthier to achieve a better price at sale. Class B/C value add properties tend to hold up much better in downturns because folks need a place to stay and rents are more in line with the market / service economy demographic that is typically still employed in downturns versus the class A renter making $100K/yr. whose jobs are more at risk (i.e. Houston oil crisis example).

22) What is a preferred return? Typically, 8% is what I see most. This favors the limited partner. It essentially means that the first 8% return on an investment (distributions from cash flow or capital events such as refi proceeds or sale) will go entirely to the limited partner, nothing to the general partners. This is not a guarantee but the next best thing.

23) What is a split and what is a waterfall? The split is investment returns that go to the investors in the portion of the split. So, if the split is 70% to the limited partner and 30% to the general partner, after the preferred return is paid (if there is one), then the partners splits all other proceeds from distributions or capital events 70/30. That split can change if a certain hurdle (or waterfall) is achieved. Example: A split could by 70/30 then go to 50/50 once the IRR hits say 18%. Any returns higher than 18%, will then be split 50/50 LP/GP. That is a waterfall.

24) What is an accredited investor? We currently market our deals under SEC regulations 506 (b) meaning we can only share our deals with investor who are accredited and we have a relationship with. The definition in the U.S. is a person earning $200K per year or a couple earning $300K per year over the past two years and expected to do so in the current year; or a net worth of $1m (excluding your primary residence). Since we don’t advertise our deals the accreditation determination is by self-disclosure of the investor by a checkbox. If the deal is advertised to the public, then verification by an outside third party is required.

25) Do syndicates invest in their own deal ? You will typically see this being the case to align with investors. However, when the GP invests, that money goes with all other investors money into the LP investment bucket (70% split). In other words, the GP split of say 30% is what the GP wants to earn for doing all the work. If he puts money in the deal, he’s increasing his stake in the deal so it is going in on the LP side. That’s how it works.

Mobile home parks make great commercial multifamily investmentsIn my continuing efforts to identify some of the most alluring alternative real estate investment asset classes, mobile home parks continue to be near the top.  I like multi-family value add apartment investing as a core holding and self- storage and mobile home parks to provide some unique diversification around the edges.  The interest stems from long term demographic trends favoring more renters, need for affordable housing, our desires to keep things which all buffer these asset classes to some extent from economic downturns.  We’ll focus here on MHPs (often called Manufactured Home Parks).  I’ve outlined below the 7 reasons I like this asset class:

1) Demand for Affordable Housing Increasing – For many, the rise of housing costs and overall living costs keeps affordability of buying a home at bay for many.  More and more folks are retiring (10,000 baby boomers retire every day) with little savings and live primarily on social security to make ends.  Low wage earners also cannot afford the rising cost of home ownership so their only options are low rent apartment housing or MHPs.  MHPs are an affordable option for many folks who need a place to live. America as a group is getting poorer as the middle class is getting squeezed. There is a growing demand for affordable housing and this trend has long legs.

2) Limited Supply / Competition – There are only about 10 new MHPs built in the entire U.S. in a typical year against a total stock of 50,000 parks.  Cities and townships across America frown on MHP developments so getting permits and zoning approved to build new parks is difficult.  Hence, less supply increases the value of existing parks.  This benefits current owners also as there is virtually no competition from new MHP development.  It’s also costly to build new parks because the owner must then attract mobile home owners and moving them is costly.  As a result, most MH owners stay put forcing the MHP owner to not only buy the land and put in the infrastructure, but gradually buy and place new mobile homes on the lot.  That creates a longer road to profitability.

3) Lack of Mobility – The essential income generation makeup of MHPs come from renting the space to an owner of a mobile home.  However, the cost to move the mobile home for the owner can be $3,000 to $5,000 which is cost prohibitive.  For most manufactured homes, the trip from the factory to the mobile home park is the last move it will ever make.  The only choice really for the owner of the manufactured home is to continue to rent the lot or sell to the park owner.  Reasonable lot rent increases are more tolerable as moving the unit is cost prohibitive.

4) Cash Flow / Total Returns – MHPs throw off a lot of cash for investors and 10% cash on cash returns are achievable.  Add refinancing to pull out more investor cash at regular intervals on improved park valuations and total ROI can amp up to high teens to 20% annual returns over the hold period.  Cap rates for the sector are typically higher than both apartments and self-storage.  Costs are much cheaper since the owner of the MHP does not typically own the manufactured homes and just rents out the lots.  Lot rents can increase at a reasonable clip due to lack of mobility issue and high cost of other housing options.  Very little maintenance costs since the units are not owned by the MHP owner.  Rising property value also does good things for the owner of the manufactured home so it’s not a winner take all proposition which encourages lot renters to stay.

5) Fragmented ownership – Almost 80% of the 50,000 MHPs in the nation are not owned by large companies but by everyday folks who have owned these parks for years.  Many are ready to retire.  The opportunity for a new MHP owner is to look for parks in good locations that are underperforming and with professional management add value by improving the overall appearance and economic performance of the park.

6) Big money has committed to the space – The largest park owner in the U.S. is Sam Zell, the Chicago based real estate magnate and Warren Buffet, who owns Clayton Homes, the largest manufacturer of mobile homes.  Zell is chairman of Equity Life Style Properties and is the mobile home industry’s largest landlord with over 144,000 lots and 32 states.  Clayton Homes manufacturers and provides financing for new manufactured homes.

If you like this sector, one of the best ways to play it is through syndication.  Here, as a passive investor, one can invest with experts that know this space well, acquire and manage these properties to improve performance.  I like pooled investments even better, where instead of just buying one property, you are investing in several MHPs across different geographies.

why self-storage units have become popular commercial investmentsThe model for my real estate business focuses on alternative real estate niches.  I want to provide education and investment opportunities for investors to take advantage of the trends and attractive returns some specific niches offer.  I carefully select key trusted partners (sponsors) and help provide private equity investor funds to support their projects. In 2016, I spent all of my time learning the apartment investing business, hired a coach, learned how to do market and deal analysis so that I could vet deals before recommending them to my investor clients.  I forged a close relationship with Ashcroft Capital and as part of the SEC requirements to market deals, I earned my way into a general sponsor role to help acquire three properties and over 800 units.  Out of this grew a strong base of accredited investors that have seen solid performance in these investments to-date.  I still like this niche very much and this will remain my focus for my investor base again this year.  I expect to do many more deals with Ashcroft Capital as they indicate an active and robust pipeline of potential new projects this year.

As we move into 2017 however, I wanted to research and get a deep understanding of another potentially solid investment niche.  Down the road, this could provide my investors with more opportunities to learn and diversify into some other attractive real estate niches.  I identified early on in my research into commercial real estate investing niches, that self-storage was one area that deserved a serious look.  I attend a multi-family (multi-unit) meetup group in Austin and although most of the talk is around apartments, I found a small but vocal group involved in self-storage.  They talked about how the business model was more attractive than apartments because the CCR (Cash on Cash Return) was higher due to the relatively low cost to operate these sites.  That the future looked bright as the growing demand mirrored the growing demand for more folks renting.  That had always garnered my attention but I had to admit, it did not seem to be a very sexy niche.  I had visions of growing up seeing self-storage somewhat tucked away, out of site, not very attractive, places where folks just stored junk.  I also had never paid for one in my life and always thought if I ever came to that point, I have to seriously examine my material life of needs versus wants.

Wow, have times changed. Nearly 1 in 10 Americans is using a self-storage facility today.  These facilities are much more visible, clean looking, automated and professionally operated.  Sure, the industry is still very fragmented, lots of mom and pop operations and still a lot of leftover, dingy, shed-type looking facilities scattered around, but the big players are taking the game to a new level.  No, I’m not using one yet but in my research, I’m finding a lot more reasons why folks are using them.  Surely, the increasing demand for renting a storage unit parallels closely with the reasons why I still love apartment investing.  Simply, there are powerful trends underlying both types of niches.  Demographic trends favor more folks renting and hence, needing places to store their stuff.  With home price increases, millennials are renting longer as well. Back in the 70s, first-time home buyers rented only 2.6 years before purchasing their first home, now it’s 6 years.  But it goes beyond that.

I purchased a new investment home nearby to my home.  This was a new home mind you but storage was limited in all the models the builder was building and this was a national builder and a very nice home.  The A/C is in the attic and I wanted to show the renter how to replace the filters.  We essentially had to crawl on our knees to replace the filter because the ceiling and space was so limited.  What’s happening that makes storage an important factor in our lives?  More renters I get because millennials often delay buying, and boomers are downsizing.  But when folks do buy a home, the builders are not leaving much space in the two-car garage, attics nor inside the home.  In many parts of the country like Texas, homes lack basements.  Add to this situation stricter rules from the HOAs, and folks can’t store their boat, RV, etc. at home.  Many folks are forced to use self-storage beyond just storing excess stuff.

Businesses are also leveraging self-storage like never before.  They are finding it cheaper to use self-storage to store offsite—versus taking space in a more expensive office setting—for files, records, equipment, etc.  There is an even growing offshoot in building some store-front warehouse space near the front of the self-storage property where there is a lacking availability of business space for those needing a small 400 sf office and a larger warehouse for their storing, staging and shipping operations. I discovered this in Austin when I was looking for similar space with a friend of mine and we both came across the same conclusion: High demand, low supply.  I met with a builder and he told me that he found this niche of building a mini warehouse / office for small businesses and is making a killing off just building them and selling them, like 100% return in one year; they’re easy to build and sorely lacking in supply.  So, with space, one can add a lot of creative types of storage / revenue streams including simply offering everything from covered and uncovered parking spaces for boats and RVs to full retail operations in the main office where huge markups on locks, boxes, tape, utility hardware, etc. can be offered as a convenience factor to users ready to move into their new storage unit.

Ok, got it.  So, what’s the investment angle?  Several things were starting to get my attention.  In my research for this article, I came across a member of the Forbes 400, Wayne Hughes, who started a company called Public Storage and has a net worth of $2.8B. It must be an industry where one can make serious money I gathered.  It’s also a very recession resistant industry.  Simply, when the economy is growing as it is now, people buy more stuff to store and when the economy slows, individuals and businesses downsize and store more stuff.  Similar to apartment investing using a Class B value-add approach, folks have to live somewhere and offering reasonable rents and nicely renovated properties with excellent management will keep them there through ups and downs.  With storage, here is another niche that holds up well during good times and bad and is quite resilient.  In 2008 when the economy was getting crushed, the self-storage REITs (publicly traded companies that buy lots of self-storage properties) were the only real estate sector to generate a positive return at 5%.  Over 5,15, 20 and 25 years, these REITs have outperformed the S&P 500 so they clearly have a solid and consistent track record of good performance.

Why is self-storage so attractive from a business model?  The cost to build is much less expensive than your typical real estate property as we’re talking concrete, steel frames and garage doors. They’re also inexpensive to operate and maintain (maybe one on-site person, much is automated).  Plus, turnover (makeover) costs that are one of the things in apartments that drive-up expenses are almost nil in storage; sweep out the unit, provide a new lock and it’s ready to re-rent. Hence, the breakeven on self-storage is around 45% occupancy level where apartments are about 65%.  Tenants are relatively sticky as well, they often move in and never leave.  Estimates are that one third of users have stored their stuff in one of these units for over 3 years. Also, the short-term nature of the rentals (month to month) enables owners to turn units quicker and raise rental rates more frequently.  This, with the sheer number of units in these facilities, means the owner is not as subject to financial impacts from numerous vacancies hitting at one time.  This is another business with scale like apartments that has a very attractive appeal.

Up to 80% of the industry is still in the hands of small independent operators.  Its highly fragmented and ripe for consolidation.  Many owners have not kept pace with the changing times nor reinvested in modernizing their facilities, expanding their footprint or adding new revenue streams–that’s the opportunity.  It’s not uncommon to find locations lacking simple signage, websites or other amenities to attract users.  Climate controlled, biometric scanning access and other security features are lacking in older properties and becoming more popular.  Big players have moved in for sure and five dominate the space but there remains a lot of opportunity for the savvy syndicator looking to find solid, attractive properties that are underperforming.  Financing is relatively available and easy to get as the financials and strong history of this resilient sector plays well with lenders.

Further, many cities don’t like new building of storage units as many residents deem them tacky and they don’t create a lot of jobs.  That may prevent oversupply in some areas which would be a good thing from an investment standpoint.  Research shows that most users want a facility within 3 miles up to 5 miles of where they live.  Although data proves most don’t go to the facility as much as they think, psychologically the proximity to their residence is part of the buying decision.

Institutional investor interest is growing towards this niche, as evidenced by a recent article last week in the WSJ that self-storage facilities are getting a serious look.  With many real estate sectors seeing slower growth, think brick and mortar retail with the online threat of companies like Amazon and some concerns of rising interest rates, savvy institutional investors (think pension and private equity funds) are in a “risk off” mode.  Stable and resilient niche markets like value-add apartments and self-storage that have very favorable long term trends are continuing to gain favor with the smart money crowd.

Why I like investing in apartments

As a private equity capital raiser for a large apartment syndicator I’m very aware of the power of apartment investing. I meet potential investors on a daily basis who are interested in apartment investing but most have never invested in apartments before.  They may have heard from a friend who is involved and seeing good results or this may be the very first time they were ever exposed to this idea.  The primary reason this is fairly unknown is because most syndication groups operate under SEC regulations that prohibit advertising their deals to the general public.  They are only available to accredited investors, which provides a hurdle for many investors to participate.

Other more active investors get started investing in apartments by starting small with an 8 or 12 unit then gradually trade up.  That requires active investing (developing knowledge, time and skill) of which most of the investors I deal with are not interested in being.  They want the benefits of being a passive investor without the hassle of being active in it.  Hence, syndication groups provide just what they are looking for.  Syndicates pool money from passive investors to make these acquisitions, improve the asset and provide a very solid return to investors.  Syndicates are the “active” partner in the deal.  Most syndicate groups like to target older apartments (think 1980s) because they can add value in the form of renovating the interiors, exteriors and placing new more sophisticated property management companies on site to improve the operational efficiency of these apartment communities.  It’s not uncommon for “value-add” syndicators to target a 10% cash on cash return in the form of quarterly distributions and an overall IRR of 20% over a typical five-year hold period where upon the asset is sold. 

I recently completed reading a powerful book from my peer Paul Moore called The Perfect Investment.  I highly recommend it if you are an investor already investing in apartments or looking to invest in this profitable real estate niche.  I talk to Paul often and we share best practices.  He brought up some good points in the book around demographic trends leading to more renters for some time to come (millennials and boomers for instance) and shares with us that risk-adjusted returns on apartments are 4x the stock market (wow!).  During the 2008 financial crisis, Paul’s research indicates that the delinquency on residential mortgages was as high as 4-5% nationwide while multifamily loan delinquencies were 1% and almost nil if you excluded over exuberant markets (think Las Vegas, Phoenix and Miami) and had experienced operators.

I shared with him my experiences of an investment company in Houston that partnered with us on a few deals in the Texas market where they were the property manager.  They had their own properties in Houston (10 or so) and they have a chart showing how well their apartments (B/C value-add class – built in the 1970s and 1980s) held up during the oil downturn while Class A (newer built) apartment occupancies dropped 15-20% during that time showing the resiliency of the B/C value-add asset class to economic downturns.  Hence, I wanted to put something together for my investor base as well as prospective investors on why I think investing in large, value-add class B/C properties may be one of the best investments out there from a stand point of low risk and high return, a rare combination.

I’ll start out here with some basics on why I like this investment.  This comes primarily from another syndicator peer of mine Brian Adams in which he lays out why apartment investing makes for an IDEAL investment.  Where:

I = Income
D = Depreciation
E = Equity
A = Appreciation (especially forced appreciation)
L = Leverage

I’ll add a few more TIPS (benefits):

T = Tax advantaged
P = Performing Asset
S = Scale

We’ll explore this briefly here.

Income:  Apartments throw off income from the rents generated less expenses.  This can be paid out monthly or quarterly.  We often see distribution in the 8-12 % range and many syndicators offer a preferred 8% return meaning the limited partners get paid first up to 8% before the general partner gets paid.

Depreciation:  The building, not the land depreciates and hence, reduces your taxable income.  Many syndicates also utilize accelerated depreciation techniques as well.

Equity: As you pay down the loan and make improvements to the property and operational efficiencies to generate higher rents (income) your equity stake in the property increases.

Appreciation: This is my favorite and what makes apartments (commercial property valuation model) stand out over non-commercial (less than 5 units) and single family rental properties so I’m going to elaborate on this one a bit more.  If I can find apartments that need some work (value-add) and increase the NOI, I can greatly increase the market value of the property, even if the general market around me is stagnant.  Not so in residential where homes are valued based on what other comparable properties sold for.  In commercial valuation, the model is NOI/cap rate = market value. (A cap or capitalization rate is simply what an investor should expect to earn if they paid 100% cash for an apartment. Example: If an apartment costs $1M and the cap rate is 6, then the investor should expect to get 6% or a return annually of $60K from the investment).  So, assume the cap rate stays the same and I’m able to increase the NOI even modestly per the equation above, the market value will almost exponentially increase. This concept called forced appreciation is what makes apartment investing and commercial real estate for that matter so powerful and is little understood by the average investor.

Example:  At one of our 300+ unit apartment acquisitions this past year, we identified a desire for covered parking.  A survey of residents suggested about 2/3 would pay for covered parking for a modest $25/monthly fee.  If 200 units then paid $25/monthly fee, that generates about $5K/monthly revenue or $60K/yr.  The cost was $90K to build it so we would break even in about 18months.  But from a valuation model, we added $1M of equity.  How’s that?  We increased NOI $60K / 6 cap (.06) = $1,000,000.  That is the true power of value-add apartment investing and the concept of forced appreciation.  Keep in mind, we were not relying on comparable properties to drive appreciation so much as looking at what value-add opportunities our own residents would be willing to pay for and letting the valuation model take care of the rest.  Hence, more control in driving value than reliance on outside forces.

Leverage: This goes for real estate in general and we can answer this question best with an example that is a bit easier to think about.  If I bought a $5M apartment building for cash and the building generated a NOI of $300K/yr., then I’m getting a 6% return on my investment.  Now let’s say I purchased this property with a 20% down payment (or $1M) and added value improving the NOI by 50%, my new NOI would be $450K/yr. less new debt payment of $225K/yr. = NOI of $225K.  However, $225K / 1M down payment = 22.5% return on the investment vs 6% on the all-cash deal.  This is the power of leverage.  Pictorially, here is the comparison between an all-cash deal versus a leveraged deal.

Cash vs. Leverage

Tax Advantaged: Investing in real estate is a highly tax efficient investment.  It’s not uncommon for annual distributions to investors of 10% or so to be offset on paper as a loss on your annual K-1 partner distribution tax statement because not only depreciation (mentioned earlier) but property taxes and loan interest are significant deductions that offset gains.  This occurs generally over the life of a five year investment.  Additionally, value-add syndicators frequently do a “cash out” refinance after the renovations are complete in a few years after the property is purchased and property NOI is optimized.  This refinance is considered by the IRS as a return of the investors capital and is not a taxable event.  At time of sale, say in year 5, there is some depreciation recapture, but the expected gain at sale is considered a long term capital gain and is treated at a lower tax rate, currently 15%.

Performing Asset: In my experience, most of the value-add older apartments in the strong markets we acquire them are making money even before we make improvements.  Hence, its considered a performing asset and this reduces investor risks.  There are investors who like turnaround plays and will invest in apartments where the occupancy is less than 70% and not making money but that is a lot riskier.  We like to purchase apartments that have an occupancy of greater than 90% and want to build on that by improving the look and operations of the buildings.  This lowers investor risk.  We don’t buy on hope, we buy on proven and improve from there.

Scale: The more units typically in an apartment the more opportunity to gain economies of scale and lower your cost per unit expense of maintaining them.  There are certain thresholds in number of units where onsite property management and maintenance make sense. The cost of an onsite manager to manage 100 units versus 200 units are about the same cost but the cost per unit goes down as you move up the scale as an example.

So, in sum, there are many benefits to being an investor in large, multifamily apartments.  Focusing on value-add Class B/C is where we find the most opportunities for attractive returns for investors.  Get a hold of Paul Moore’s book to supplement what I’ve covered here and help you more fully understand the strong renter demand trends and understand more the relatively high returns versus lower risk of this powerful asset class.  Accredited status is required for many of these deals, but if you meet that criteria, you have an opportunity to put some of your money into what I believe is a very attractive investment niche.

Reach out to me and I can share with you some closed deals I have participated in as a general partner to help educate you further on what’s possible and if accredited, we can spend some time understanding your goals and objectives to see if future opportunities are an interest and fit to grow your wealth.  I think what you will find is an exciting asset class that can accelerate your financial goals much faster than you realized.

Vetting an Apartment Deal Sponsor - 10 Tips from an Insider

Investing in apartment deals can be a fantastic vehicle for growing your investment accounts. As a passive investor there are a number of potential upsides. But as with any investment, it’s imperative to know your risks. And of the best things you can do to ensure a successful outcome of your investment is to thoroughly vet the deal sponsor.

Click here to access our PDF report, Vetting an Apartment Deal Sponsor: 10 Tips from an Insider.