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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 Your Down Payment Affects Your Bottom Line Return

When apartment investors evaluate a potential new property, they have many points to consider. If their preliminary analysis looks promising, they’ll eventually start figuring how to finance the project.

At this point they will check with various lenders to discover their current loan parameters. What loan-to-value (LTV) percentage will they honor? What debt service coverage ratio do they look for? What interest rate do they offer, and for what length of time before the balloon? For how many years will they amortize the loan?

In addition to the debt side of the equation, the sponsor must look to his or her investors for equity to cover the down payment, loan and acquisition fees, and reserves for known or anticipated capital expenses. They will poll their potential investors to discover how much they might contribute, as well as their tolerance for risk. They might also ask if any of them need to do a 1031 exchange, or need help setting up a self-directed IRA.

Once all this is done, they calculate how much equity to raise to complete the purchase. Most often, a sponsor hopes to raise just enough capital to meet the target LTV their favored lender is looking for. Currently, most lenders require a minimum of 25-35% down. So for a million dollar purchase, an investor group might look at raising a minimum of $250,000 to $350,000 for the down payment. However, not all groups want to get in for the minimum amount down. For their own reasons, they may prefer to put half down, or even pay all cash. How do these decisions affect the bottom line return after the holding period and subsequent sale?

In order to determine the answer, we’ll compare the internal rate of return (IRR) for three different scenarios. The IRR reflects the total return on investment, taking into account annual cash flows and final profit at the sale. All the following numbers reflect pre-tax dollars.

Assumptions

  • Purchase price (all-inclusive) = $1,000,000
  • Buy at 8% cap rate ($80,000 net operating income first year)
  • Vacancy rate = 7%
  • Rent income escalators = 3% per year
  • Expenses = 50% of gross operating income
  • Expense escalators = 3% per year
  • Expense of sale = 7%
  • Loan interest rate = 6%
  • Amortization period = 25 years
  • Loan term = 7 years
  • Sell at end of year 5
  • Sell at 8 % cap rate

If you’d like to see how the following numbers were derived, the spreadsheets are included below.

Down Payment

Year 1 cash flow Year 5 cash flow Sale @ 8 cap Sales Proceeds

IRR

$1,000,000 (all cash)

$84,600 $95,218 $1,225,932 $1,140,117

11.17%

$500,000 (50% LTV)

$45,942 $56,560 $1,225,932 $690,457

15.66%

$250,000 (75% LTV) $65,271 $75,899 $1,225,932 $915,287

24.16%

Upon close inspection, you will see that compared to putting 25% down, buying with all cash will give you better cash flow, but an overall smaller return. Putting in an intermediate amount gives intermediate results.

So why doesn’t everyone go for the maximum return? In these variations, putting in the smallest amount gives the biggest bang for the buck because you’re leveraging your money with the loan. It must be easier to raise $250,000 than a million dollars, so why do some folks buy for all cash?

One reason might be the ability to get a discount for an all cash purchase, where the seller doesn’t have to wait to see if your loan will go through in time, if at all.

It might also have to do with the mindset of the investors in the group putting up their cash. Younger investors with many years to go before retirement usually have a steady and growing income from their job and are often looking to work for a big payday down the road. Their risk tolerance may be relatively high since they have a long time to make up for any errors they make now.

People approaching retirement or already retired may place a higher value on a more robust cash flow today to supplement their fixed income. They may also be worried about that balloon payment a few years down the road when the loan term expires. They simply don’t have as high a tolerance for risk as they did in their younger years.

Many of the deals we see today are the result of projects not being valuable enough in the current market  to refinance the loan to pay off that debt coming due. So, paying with cash means there is no loan, so there is no balloon. As with all investments, the greater the return, the greater the risk. Therefore, successful sponsors will match the equity required with the risk-tolerance of their investors.

All Cash

50% Down

25% Down