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Should You Be a Passive Apartment Investor?

Many people today are unhappy with the returns they’re getting from their current investments and are looking for alternatives. Of course CDs and savings accounts don’t return enough to keep up with inflation and the stock market is such a roller coaster that it’s hard to feel comfortable putting your entire retirement nest egg there.

With so many homes in foreclosure, some folks have tried buying a house to fix up and resell. If you know what you’re doing you may be able to work on it for a few months and sell at a profit. This strategy does come with obvious risks, but with proper training, mentorship and a good team, you can make a tidy sum on each property. However, unless you want to make a career of it, doing fix and flips requires a lot of time away from your regular job.

If you’ve been looking for alternative investments you’ve probably read about the opportunities in commercial real estate. One way to get in on these investments is through a Real Estate Investment Trust, or REIT. Investing in a REIT is a lot like buying a mutual fund, but the managers are acquiring portfolios of apartments, office buildings or shopping malls instead of stocks. You can get quarterly distributions based on the cash flow produced and are a part owner of the properties.

In today’s economic environment, both offices and retail centers are dealing with high vacancies. Since all real estate is cyclical, these property types should rebound sometime in the future, but apartments are doing well now, since everyone needs a place to live.

One reason investors favor apartments right now is the continued growth in the 18-34 year old age group, which makes up the bulk of apartment residents. In addition, houses are no longer viewed as the great investment people thought they were a decade ago. Not only have thousands lost their home during the economic downturn, but the banks have tightened up the lending requirements so much that even people with decent jobs are having trouble qualifying for a loan.

Even if you believe apartments may be a good place to invest, you may not be attracted to the returns and control of a REIT. Unless you’re very wealthy, it’s not practical to buy an apartment building yourself. Is there another way to participate safely and wisely in this current boom without having to deal with tenants and toilets?

As a matter of fact there is. You could pool your money with other investors to buy, manage and sell an apartment property. But what if you don’t personally have the knowledge, experience and team to pull this off? Now what?

You may be lucky enough to have a friend or family member who does these kind of deals who can offer you a spot in one of their syndications. A syndication is a group of investors who go in together on a project that none could pull off by themselves. Hollywood movies are often the result of a syndication, but they can be assembled for many purposes, including the purchase of commercial real estate.

Before putting your money into Uncle Bill’s syndicate, there are several things to consider. First of all, do you already believe in commercial real estate as an investment tool? Specifically, do you think the need for affordable housing will continue to grow? Have you seen that new construction has not been able to match the current demand, leading to lower vacancy rates and rising rents? I’d suggest that you don’t let anyone fast-talk you into this model if you don’t already believe in it yourself.

Once past this hurdle, there are several more to go. First of all, do you feel comfortable with the promoter/sponsor of the deal? You will be partners for several years, so you absolutely must not only trust, but actually like, this person. You will be putting some substantial cash into their hands, so pay attention to your gut feelings. Sometimes the best deal you ever do will be the one you avoided. At the same time, they will be judging if they want to be tied to you for the length of the project. If you’re hard to get along with, or are a micro-manager, they may well decide it’s not a good match to have you in the group.

You also want to consider the sponsor’s experience with this type of project. If they’ve done similar deals and they’ve worked out well for the investors, that’s all a plus. Everyone has to do a first deal, so if that’s the case, you need to feel that their experience in smaller real estate endeavors has prepared them for this specific offering. If they’ve owned and operated several fourplexes, you may feel comfortable trusting them to pull off a smaller apartment complex, but maybe not one of several hundred units. It’s your call.

Make sure they have a professional team in place. No one does this alone, so they should let you know about their real estate attorney, securities attorney, management company, commercial broker, accountant and title company. Feel free to call them as a reference.

Consider your timeline for this type and size of investment. Most apartment projects will need you to commit your funds for several years. If you think you may need your cash back sooner than the projected holding period, this is not a good investment for you.

Once you feel good about all these considerations, it’s time to get more information about the specific offering being presented to you.

If you are looking for current cash flow, make sure the property is throwing off enough cash to provide your required return. The sponsor will probably provide you with a spreadsheet that projects expected gross income, less all the operating expenses. This number is the net operating income, or NOI, and it’s the basis for figuring the value of the property. After that, the mortgage payments are subtracted and the result is the before tax cash flow. This should be greater than what has been promised to the investors so that you can feel comfortable that even if things don’t go exactly as planned, you will still get your promised return.

The group of investors will most likely be promised a percentage of ownership in the deal. You will collect your pro-rata share of this once the property is sold. The combined result of distributions from ongoing cash flows, plus the chunk you receive at the end is called the Internal Rate of Return, or IRR. You’ll want to make sure this number is substantially higher than what you are getting with your current investments.

Even though apartments seem to be a great investment today, all investments come with some risks involved. Don’t invest any money you can’t afford to lose, and whatever you do, don’t take out a loan to put into any investment, including the “can’t fail” deal Uncle Bill has for you.

Before you send in your check, be sure to read any and all legal documents the sponsor provides. Most apartments are purchased via a Limited Liability Company, or LLC. You will be a member of the LLC and will actually own a membership in the LLC, not a portion of the real estate itself. Be sure to read and understand the LLC’s Operating Agreement, as it spells out in great detail how the project will be run from start to finish. I recommend you have your accountant, attorney or financial advisor review it and answer any questions you have. If you’re not comfortable with the risks and benefits, don’t do the deal.

If you go to a luncheon put on by a promoter, or are otherwise introduced to one you don’t know personally, proceed with caution. Most likely putting a group purchase together creates a security, so SEC regulations must be followed to the letter. They require the sponsor to have a substantial personal or business relationship with you before presenting you with an offer to invest, so make sure you’ve had enough time to get to know them and their history, and they know enough about you to feel good about your ability to participate in this kind of opportunity.

Real estate syndications can be a great way for a sophisticated or accredited investor to participate safely and profitably in a commercial real estate deal. If you understand and follow the suggestions put forth here, you’re well on your way to a successful investment.

How to Pool Investor Funds Without Running Afoul of the SEC

Since commercial real estate often requires a larger down payment than most individuals can come up with, investors usually pool their funds in order to raise sufficient cash to cover the down payment and other acquisition costs. Doing this incorrectly can lead to huge fines from the SEC, not to mention potential liability from lawsuits.

Anytime money is pooled with the expectation of making a profit, a security is created. After the Great Depression, the Securities Acts of 1933 and 1934 were enacted to protect the public against fraudulent securities. It was at this time that the Securities and Exchange Commission (SEC) was created to oversee the implementation of these laws.

The person who pools investor funds creates a syndication and is known as a syndicator or a promoter. This person must be very careful to follow all the SEC regulations because the fines for violations are very stiff. The laws are not difficult to understand and follow, but claiming a lack of knowledge about them will not be a suitable defense.

The syndicator must ensure that all the potential investors are given enough financial and other important information regarding the security being offered for sale so that they can make an informed decision about the suitability of this particular deal.

In 1946 the Supreme Court heard a case called SEC v WJ Howey. The Howey Company sold land in citrus groves in Florida and also offered to plant, harvest and sell the fruit for the new landowners, who were mostly out of state people looking for a passive investment. When things went bad, it ended up going through the courts, and resulted in what became known as the Howey Test. This test determines what qualifies as a security and has four main points, all of which must be true.
1. There must be an investment of money, and
2. There must be a common enterprise, and
3. There must be the expectation of profit, and
4. This will be managed soley through the efforts of the promoter.

If all four of these are true, a security has been created which falls under the SEC guidelines. The most critical part of the law for our purposes is called Regulation D, usually just called Reg D. Reg D describes a private offering made only to accredited or sophisticated investors. When this is done correctly, it allows full exemption from registering the security with the federal SEC. Since registration can cost upwards of $250,000, avoiding it is a worthy goal for most of us.
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