Before I begin explaining the details let me get the financial disclaimer out of the way. Multifamily Investing, like any other type of investment, has risks. Sometimes you win and sometimes you lose. But as the old saying goes in life only two things are certain death and taxes. As real estate investors, we try our best to avoid the latter. Don’t hate the player, hate the game!
Making money by investing in an apartment complex is really not that different from renting out a house. It’s just on a much larger scale. While buying a house to rent may cost you $100,000 – $200,000 for the purchase and another several thousand dollars to renovate the house, an apartment complex is going to cost millions of dollars to purchase and several hundred thousand dollars to renovate. Most people don’t have millions of dollars available for a down payment on an apartment complex which is where a syndication comes into play.
At this point, if you are a newbie spend a few minutes reading and understanding the terminology below. If you’ve already got some basic knowledge skip right past the Terminology section and get to the good stuff.
Some Basic Terminology
Syndication – A real estate syndication is the process by which investors pool their money and expertise to invest in real estate projects that would be too expensive or complicated for an individual investor
Passive Investor – A passive investor is one who does not participate in the day-to-day decisions of running a company
Deal Sponsor(s) – The person or group of people that organize the investment and handle the daily operations
Apartment Class (A,B,C,D) – This is a grading assignment given to properties based on their age, quality, and location of the property
A Class – Very high-quality apartments typically built within the last 10 -15 years
B Class – Slightly older than A class and a step down in quality and amenities. Generally, there is some deferred maintenance but overall the properties are in good shape.
C Class – Typically these properties are 20 years or older. There can be a lot of deferred maintenance depending on the current owners. Stabilized properties can cash flow well yet there is more risk associated with these investments.
D Class – These properties are rundown properties on the “other side of the tracks” if you know what I mean. Typically they are neglected and need lots of repairs. Often times these properties are described as a war zone. Cash flow can be higher on these properties and section 8 often helps with the majority of rental income.
Hold Time – A holding period is an amount of time the investment is held by an investor, or the period between the purchase and sale of the investment
Projected Return on Investment (ROI) – The targeted return on investment is based on the deal sponsor’s business plan. Projected ROI is calculated by dividing the projected profit by the initial investment.Underwriting – This is the process in which a person or entity conducts research and assesses the degree of risk associated with the investment. For multifamily investments, this includes things like: borrowing rates and terms, purchase price, projects sales price, in-place rents vs. projected rents, in-place expenses vs. projected expenses, etc.
The Basic Concepts of Apartment Investing
At a 30,000 ft. view when you are investing in an apartment complex you are actually investing in a business. The sponsorship team comes together with the expertise and works with passive investors to help fund the deal. The sponsors get fees to compensate them for the work they are putting in and the passive investors get paid so long as the property is making money. It is the deal sponsors who will be running that business and making business decisions. As a passive investor, you are not involved in any of the business sides of the investment. You hand over your money and let the professionals do the rest. What you are searching for are business-savvy deal sponsors. You want to find someone who is taking calculated risks, not just hoping to get lucky.
You are investing in the sponsor’s ability to execute their business plan
Let me say that again, you are investing in the sponsor’s ability to execute their business plan. The deal may pencil out beautifully on paper but if the deal sponsor can’t execute on what’s been laid out then it will be a bad investment. I’ve been a passive investor in this situation and the outcome was miles away from what was put in the business plan.
Making Money as a Passive Investor
You can make money in two ways:
1) Cash flow
2) Sales proceeds
Cash flow is the extra money the investment is making after paying all the expenses. Cash flow happens during the life of the investment. Most properties don’t cash flow on day one. Some do, and most don’t. The reason these deals make sense as an investment is that the previous owners left some room for improvement. The room for improvement is broken out into increasing revenue and decreasing expenses. It’s that simple. If the Net Operating Income (NOI) is large enough then everyone receives checks in the mail known as mailbox money. The business plan put together by the deal sponsors should outline target timelines on when the property will start to cash flow. It could be from day one, six months or it could be longer than that.Sales proceeds happen at the sale of the property. If the property is sold for more than any remaining debt and sales fees and didn’t lose money during the life of the investment then there will be a capital gain. Capital gains can happen in a couple of different ways. The first way is through forced appreciation. If the deal sponsors can operate the business to make more money than the day it was purchased then the property has more value and can be sold for more. Very simply put, raise rents and reduce expenses and you’ve created forced appreciation. The second way is through market demand. This topic can be very complicated but it truly is driven by the laws of supply and demand. If there is a shortage of housing, the economy is doing well or other investment types aren’t being sought after then demand will be high and sellers can ask more for the property. This is actually quantifiable as something called a Capitalization Rate or more commonly referred to as a CAP rate. Don’t worry, I will get into the details and math behind CAP rates in a future post. Just know that it exists and it’s really important to understand if you are going to be investing in apartments.
Understanding the Investment
I’m going to be very honest here, understanding what goes into these deals is not easy. You can really dive deep into these deals as a passive investor. I saw a recent survey posed to an investment group I belong to and several of those passive investors are spending up to 12 hours analyzing a deal before they invest. These are people who have spent tons of hours educating themselves on these types of investments. Honestly, 12 hours isn’t very much time before making a commitment on this level. Once you know what to look for then it is a much quicker process. Minimum investments are typically $50,000 and I’ve seen deals with a $100,000 minimum. To truly understand an apartment investment opportunity there are three key components:
- The deal
- The deal sponsor
- The deal structure
Since we are sticking with the basics of apartment investing I’ll keep this post simple but will break this down in much more detail in subsequent posts.
The best way to understand the deal is to get something called an offering package from the deal sponsor. The offering package should be a one-stop shop for making an educated decision for the investment. The deal is comprised of things like market details, location details, the business model, property details, underwriting details, and projected returns. Think of this as the business plan. The offering package is very important. This is what you need to spend your time reviewing before making an investment. If a sponsor doesn’t have one, my recommendation is to walk away and move on to the next deal sponsor.
The Deal Sponsor(s)
The deal sponsor or sponsors are the people who will be running the business. As stated before it’s the deal sponsor who will make or break the investment. Find a deal sponsor with a good track record. Join networking groups, get their business cards, and be their friend on Facebook or LinkedIn. Also, don’t be afraid to ask them for things like their resume. Ask other people for their opinions of the sponsorship team. The bottom line is if you don’t trust them then don’t invest with them.
The Deal Structure
The deal structure is things like will the business be set up as a Limited Liability Corporation (LLC) or Limited Partnership (LP), asset management fees, how financial reporting details will be shared, holding period, ownership split, etc. A lot of these details will be found in what is called a Private Placement Memorandum or PPM.
Bringing it All Together
Remember that this article is just the tip of the iceberg when it comes to fully understanding apartment investing. While it’s true you can just hand over your money and hope for the best, you’re much better off taking the time to learn as much as possible. Apartment investments are nothing more than investing in a small business. What I love about apartment investing is that it’s something tangible and I get to have a relationship with the sponsors. When I have questions I send an email or make a phone call and get to speak with the actual person managing the asset. Try having that experience with your 401k investments. The best you can do is talk to a financial advisor who doesn’t know you from Adam and has zero influence on the success of your investments.
If you’re tired of feeling helpless every time you check on your 401k and feel like you’d rather have more control of your money then maybe apartment investing is for you!