The majority of potential investors I meet with have not invested in apartments before. Some have friends who have invested with me or in other syndications and are experience good results, but many are being exposed to this investment vehicle for the first time. Everyone of course knows about stock and bond investing (mostly because of their 401k exposure). But current regulations prevent companies likes ours from advertising our deals to the general public, as well as place restrictions on who can invest, so most individuals have fairly limited understanding of how commercial real estate syndications work.
While some of our investors have their own rental properties, even small apartment complexes (10-20 units for example), most of our investors aren’t interested in the active management of those types of properties. They’re successful in their other endeavors, so they want the benefits of owning real estate without the hassles. That’s where passive investing via syndications can provide a fantastic opportunity.
Borrowing an acronym for an apartment syndicator (thank you Brian Adams) here are a few reasons I like investing in apartments any why they make an an IDEAL investment for those not wanting to be active property owners.
I = Income
D = Depreciation
E = Equity
A = Appreciation (especially forced appreciation)
L = Leverage
Income – We buy performing assets that are already generating respectable cash flow from the existing tenant base. That means that from the first month after we take possession of the complex, we’re able to distribute income (most often monthly, sometimes quarterly) to our investors.
Depreciation – When we invest even as passive investors, we have direct ownership of the property, and thus receive full benefits of depreciation, which can then your taxable income. Because of the size of the properties we invest in, in almost every case we’re able to generate accelerated (or bonus) depreciation as well. (This is done via a cost segregation study, which we’ll cover fully in another article.)
Equity – Just like what happens with your home, when you pay down your mortgage balance you create equity. However, with apartment complexes, as we improve the property and optimize the management of the complex, we’re able to generate higher rents (income) and reduce expenses, which increases the net operating income, which then also increases the value of the property. We then all benefit from increased equity.
Appreciation – This is a consideration where commercial properties (defined as 5 units and above) really shine above residential (1-4 units). With your home, or duplex, or 4-plex, you can improve the property significantly but it’s appraised value is still very dependent on what neighboring properties have sold for (comparables). With commercial properties, the value is primarily tied to how the property is performing, as measured by its Net Operating Income. This mean that as we increase the properties revenue (generally done via increased rents which are justified after property improvements) we can significantly increase the market value of the property with less regard to what the neighbors are doing. With your house you have to wait for neighbors to sell their houses to drive appreciation of your property. With commercial properties, we can force appreciation by optimizing the operations of the property which are under our control. It’s a powerful concept that can drive significant returns.
Here’s a real world example of how this can play out. After we purchased a 320 unit complex we surveyed the residents for their ideas of improvements. Over two-thirds said they’d accept an increase of $25 in monthly rent if we provided options for covered parking. Take roughly two-thirds of the units, 200 of them, paying an extra $25 per month, that’s an extra $5,000 in monthly revenue ($60,000 per year) at that property. The cost of the parking structures was roughly $90,000, which puts the breakeven point at 18 months. However, more important is what that extra revenue does to the value of the property. The value is simply an equation: Net Operating Income / Market Cap Rate. (Cap rates are worthy of their own article, but simply put it’s the return an investor would receive if she paid all cash for a property.) In this example, the market cap rate was 5%, so the extra $60k in revenue increased our equity position by $1.2 million ($60,000 / .05). Of all the reasons I like investing in apartments, this concept of appreciation by optimizing elements within our own control may be my favorite.
Leverage: This concept isn’t particular to apartments, or even just real estate in general. It applies to any investment you can participate in without having to provide the entire purchase amount. Essentially, by borrowing part of the purchase cost, you’re able to decrease the amount of cash needed to execute the purchase, as well as increase your calculated returns significantly. Here’s an example: You buy an apartment building for $1 million all cash. If that building generates Net Operating Income of $60,000 per year, you’re earning a 6% return on the money you invested. If you implement a business plan that costs $50,000 and increases your NOI by 50% ($90,000), your new annual return is 9%.
Now let’s say you bought that same building with a loan from the bank providing 65% of the purchase price, and you put down 35% cash. Your value-add business plan costs $50,000 and increases your revenue by 50%. Now you’re earning $90,000 per year, minus the monthly mortgage payment – let’s say $45,000 per year, based on a $650,000 25-year mortgage at 5%. Your new NOI is $45,000, but after only putting $400,000 into the deal. $45,000 / $400,000 is an annual return of 11%. This is compared to the 9% return of the all-cash scenario. That’s the power of leverage. Your able to preserve cash by bringing less to the table, and increase your calculated returns at the same time.
Let’s talk about a couple more advantages.
Here’s a big one: taxes. For whatever reason, Congress has decided to provide numerous incentives for purchasing, improving, and operating real estate. While generating and distributing positive cash flow, we’re able to report paper losses due to significant deductions like depreciation. (Yes, at the time of sale we have to consider depreciation recapture, but keep in mind that the gain will be classified as long term capital, and we’ll also seek to provide our investors with a 1031 exchange option.) Also, in many of our properties after just a coupe of years of ownership we’re able to do a “cash out refinance” where we acquire a new loan based on the new value of the property once improvements have been made. The proceeds are returned to the investors categorized as “return of capital,” and is not taxable. This decreases your invested equity while the returns remain the same, significantly increasing your calculated returns.
Finally, we have to mention scale. When it comes to the cost of maintenance, supplies, occupancy decline, and property management, more units equals lower per unit cost. If you lose a tenant from your duplex, all the sudden you’ve dropped to a 50% occupancy while all the operating costs have not decreased. With a 200 unit building, you can buy supplies like paint, carpet, tile, appliances, etc, in bulk and receive favorable pricing. Sometimes we’re able to buy these things directly from the overseas manufacturers. You just can’t do that with small properties.
In our experience, by all considerable measures, investing in large properties outperforms smaller properties. But buying them requires a focused team with a lot expertise. Unlike owning a rental or two, you can’t properly operate large complexes while holding down a day job. Participating in syndications as a passive investor enables you to participate in all of the advantages of commercial real estate with none of the hassles.
Most of these deals require investors to be accredited, though each year we have several opportunities that do no require that status. For those who do meet that requirement, you have access to one of the best investment vehicles that exists, requiring no more work than signing a few documents and wiring in your funds.
Schedule time with our team to review some of our previous deals to get a sense of who we are, how we operate, and what our investors experience. If you haven’t invested in syndications before, you’re going to be excited at how this asset class can help you achieve your financial goals much faster than you thought possible.