One of the favorite parts about my role is spending time with new or experienced passive investors to answer questions about real estate syndications.
After vetting operators, markets, properties and business plans, the most important part we play is helping investors understand why we’re excited about an opportunity and what their role in it will be.
Below are the questions we get asked most frequently. They are not in any particular order, and replies may be different based on the type of property or structure on a particular deal. Since most investors’ first experience with syndications is with apartment complexes, many of these answers will skew towards that asset class.
- What does syndication mean? Honestly, syndication is just a fancy word for a group investment. Instead of one person or family coming up with the down payment (and rehab budget) to qualify for a loan to purchase a property, a group of investors comes together to acquire a large property with the intent to profit from it. Investor money is pooled together as part of a legal entity, such as an LLC. Most of the equity money comes from the limited partners (also called passive investors). That’s you. The group who put the deal together, will sign the loan documents, and execute the business plan is called the general partner. General partners are also called operators, syndicators, and sponsors. You’ll hear those terms used interchangeably.
- What is a limited partner? This is the same thing as a passive investor. “Limited” refers to limited liability, which stems from having limited control of the project. A limited partner’s risk is strictly limited to the amount she invests in the deal, and nothing no more. A limited partner cannot be sued, is not obligated by the loan, and is not responsible for the active management of the property.
- What are the typical returns? We’ve been really pleased that to date all of our deals have met or exceeded projected returns. Projections for cash on cash returns are generally in the 8-10% range with an internal rate of return (IRR) in the 16–20% range. While we’ve had many deals far exceed those projections, we’ll never tout that as typical. Projecting or reporting an average rate of return is also common, which is simply dividing total return over the number of years of the projected hold time. Our projects have all been “value-add” projects (meaning, there is work to be done to the property and management operations to increase the value of the property). This means that the majority of the investor returns occur upon the sale of the property. With that in mind, the average annual return will likely be higher than the IRR (Internal Rate of Return).
- What is a preferred return? A preferred return is a percentage return (accounting for distributions from operational cash flow or capital events such as refinance or sale proceeds) that must be obtained by the limited partners before any distributions can be paid to the general partners. It ensures that incentives are aligned since the general partners cannot receive distributions until the LPs achieve a meaningful return. It should not be looked at as a guaranteed return, but perhaps the next best thing. A preferred return of 7-8% is fairly typical.
- What does the investing process look like? After we put a property under contract we begin our full due diligence. This normally 30-60 days. During that process we begin the equity raising process with limited partners, with the investment window being open for about 5-6 weeks. We send out a high level one page summary, generally within the body of an email. Those who request more information will receive the full investment summary slide deck. We hold a conference call with the operators so you have hear more details about the property and how the operators are thinking of the business plan. If this all sounds good to you, you submit a “soft reserve” with a dollar amount you’d like to invest. Then you’ll receive a copy of the PPM to review. If you’d like to move forward, you sign the PPM and wire in your funds to the operator. We close on the purchase of the property about two to three weeks later and which time you’ll receive an email announcing the purchase. You’ll receive your first distribution and monthly report about 60 days later.
- What is a PPM? This stands for private placement memorandum. The PPM is the official offering document and is required by the SEC. It outlines the property, the ownership structure, associated risks, the partnership agreement, the distribution structure, as well as the investment summary and subscription agreement. Buckle up, it’s long! This is a formal legal document written in legalese. This document must be signed by all parties involved. It is the lawyers’ job to disclose all potential risks, including the fact you could lose your entire investment. This is where the strength of the operator team, their track record, the property and the market, must be considered. Also keep in mind that a bank is loaning millions of dollars to purchase the property and has thoroughly vetted the team and the property. Insurance is required to be in place before the loan is closed, as well as a third party property condition report. While a private placement is not evaluated by public markets, it has certainly been analyzed thoroughly by many parties.
- What is the minimum investment? Most common is $50,000 with additional amounts in increments of $5K, though this may vary per deal. We often have fund opportunities with minimum amounts as low as $25,000.
- Do I have to be an accredited investor, and what the heck does that mean? Most individuals who meet the accredited investor status do so by meeting the annual income (a person earning $200K per year or a couple earning $300K per year over the past two years and expected to do so going forward) or net worth (at least $1m, excluding your primary residence) requirements. There is no test you have to take or certification you have to achieve. You will self-attest to your accredited status, and perhaps supplemented by a form completed by your tax or investment advisor. Most of our opportunities do require the investor to be accredited, however we do have a few opportunities each year for non-accredited investors. Keep in mind that the number of non-accredited investors in any deal is limited by regulation, and we must have a pre-existing relationship with you (we can’t meet for the first time on Tuesday and take your money on Wednesday).
- Can I use a self-directed IRA or 401K to invest? Yes. This is actually really common among our investors. Due to the extra paperwork involved a few of our operators impose a higher minimum investment amount, but that’s the exception and not the rule. When using an IRA account you need to need to e aware of UBIT, which basically says you need to pay tax on the gains you receive that are attributable to leverage used (ie you bought an asset worth $x but you only paid x% of it, with a bank covering the rest). We strongly encourage you to speak with a tax advisor who is well versed in this topic. Be aware that UBIT is tied to IRAs and is not a concern for 401k accounts.
- How long do these projects take? When will I get my money back? Most of our single asset opportunities project a 4-7 year hold period. The fund structures commonly project 7-10 years. During the recent hot real estate market, some of our deals have had amazing exits after just a couple of years, but we want to set the expectation of a longer hold in case of a market downturn. Your original contribution is generally returned upon the sale of the property. Sometimes a portion may be returned early in the case of a refinance.
- What happens if I have a hardship and need to get my money back before the property is sold? There is nothing in the PPM outlining a possible early withdrawal scenario. Your contribution needs to be looked at as an illiquid investment, for good and for bad. That said, we’re partners with you and decent humans. We’ll visit with the general partner to review your issue and see if there is a potential solution based on your situation.
- When do distributions happen? Most of our projects offer monthly distributions, which begin after the first full month after we take over ownership of the property. Distributions are most often deposited directly into the the investor’s bank account. We do have projects that do quarterly distributions, which is made clear in the investment marketing materials.
- What reporting and updates will I receive along the way? Along with the distributions we send updates via email on how the project is progressing. We update on units renovated, occupancy rates, rent increases, etc, and include pictures that may be of interest. We also provide quarterly management financial reports for your review.
- What is an equity split and a distribution waterfall? The equity split refers to what portion of the returns go to the limited partners vs the general partners. Most of the deals feature a 70/30 split. This means that after the preferred return has been paid to the LPs, the remaining proceeds from operational cash flow or capital events are split 70% to the LPs and 30% to the GP. If a water fall is in place, that split will change after a certain hurdle has been achieved. For example, it may start at 70/30 then go to a 50/50 split once the LPs have received an 18% return. Returns higher than 18% would be split 50/50. This keeps incentives aligned (GPs are rewarded by doing a fantastic job), and all these details are fully disclosed in the investment summary and PPM.
- What are the tax implications of passive investing? As an investor, your are a member or partner of the entity. You will receive a K-1 statement by March of the following year. It is common to have received cash in your pocket through distributions while showing a reported passive loss on your K-1 statement. The paper loss is reflective of your portion of the entity’s deductions. We do a cost segregation study on every property we buy which allows us to accelerate depreciation. Depreciation is shown on financial statements as an expense, and in properties of this size, it’s large enough to offset cash flow received during the year. Refinances, which may result in a distribution to the investors, are seen as return of capital, not a taxable gain. Keep in mind that upon sale of the property depreciation is “recaptured,” which may entail a significant tax consequence for that year. We always seek to provide you with an opportunity to do a 1031 exchange into another property with the same operator, which allows you to defer your taxable gains even further. If a 1031 isn’t available or you elect not to roll your proceeds forward into that 1031, you may then be responsible to pay long-term capital gains tax.
- Can I use a 1031 to invest? Technically this is possible. But it requires extra effort and expense on the part of the operator, so the minimums are generally quite a bit higher ($500k to $1m is common). Also consider that you can expect a large passive loss in the first year of ownership of a syndicated asset, which may help to offset gains from your prior sale. After the sale of the syndicated property, should the operator have a 1031 opportunity available, rolling your funds forward into that next deal, and continuing to defer your capital gains is easy to accomplish.
- What risks should I be aware of? The initial one page summary, the investment marketing slides, the webinar, those are designed to show high level details of the opportunity and to get potential investors excited to learn more. Then we send out the PPM (private placement memorandum) which describes every which way the deal can go wrong, including losing up to every dollar invested, and a second Noah’s flood. All that said, the maximum extent of the limited partners’ risk is the loss of their invested capital. Less extreme, returns could be lower than projected, the hold period could be longer than expected.
A few things to consider: at the peak of the financial crisis in 2009, the delinquency rate of single family homes was 5%, where multifamily delinquencies topped out at 1%. Additionally, concessions (loss of revenue) in Class A apartment buildings (new buildings) are common in a downturn. Class A saw vacancies rise to 15%. Class B and C buildings (older apartments with value-add opportunities) remained steady at 8%. We buy properties that are already doing ok with steady cash flow (ability to pay the bills), and then improve upon to make them excellent. - Why are you buying a property with such bad online reviews? Because that smells like money! We love taking over a poorly run property, rebranding it, improving the management and adding new amenities, then solicit new reviews. That is all part of the “value add” process, and turning around poor reviews is cream on top. If the reviews were already all five starts, there may not be an opportunity for us to improve the property and force appreciation. This turn around can happen surprisingly fast.
- How are apartment units upgraded with people living in them? An apartment complex is never 100% occupied. (That would mean rents are too low!) When we assume ownership, we’ll start renovating the currently vacant units. Each month a certain number of leases are up for renewal and some of those tenants will choose not to renew. We’ll renovate those units before re-leasing them. In some cases, we’ll show those expiring tenants a recently renovated unit and invite them to move into it, which would be at a new current market rental rate for an updated unit. We’d then renovate the unit they moved out of before putting it back on the market. This process is repeated month after month until our turnaround business plan has been successfully achieved.
- What is a supplemental loan? After a number of renovations have been completed, operations have improved, and rental increases have been achieved, the value of the property has likely risen significantly. We then have the opportunity to go back to the bank with the same property now at a higher appraised amount and refinance the property if we’d like to obtain better loan terms, or take out a second (“supplemental”) loan if we already like the terms on the first loan. The refinance or the supplemental loan is an opportunity to increase the cash reserves and distribute equity to the investors. This also increases the cash on cash returns (investors are receiving the same returns on less capital invested) and IRR.
- How do you as a capital raiser make money and what are your fees? First, keep in mind that all of the projected and actual returns reported are net of fees. Common fees in syndications are an acquisition fee that is a percentage of the purchase price paid to the operator at closing. This fee essentially reimburses the operator for all of the expenses incurred to find a deal and perform the necessary due diligence. Our compensation at Sugarhouse is paid to us from this acquisition fee. You as the investor don’t pay any expense to us, and your returns are the same as every other investor in the deal. You simply receive the added time and attention from us by investing through our firm. The general partner is also paid an asset management fee during the life of the project, which is a percentage of the monthly revenues. This keeps them operationally sound and covers their time to “manage the managers.” Industry average for acquisition and asset management fees is 1-3%.
- How do you ensure your forecasting is conservative? We always seek to outperform our forecasts. (Under promise and over deliver.) There are a number of important assumptions that are made when buying these projects…rehab costs, rental rate increases, occupancy rates, market cap rates, etc. These numbers need to make sense to you. If you see an operator projecting a $200/month rental increase based off of rehabbing a unit for $5k, is that realistic? Does that local market really support that? That’s why checking neighborhood comparables and actual construction costs is so important. If costs exceed projections, and rental rates increases and occupancy rates are below projections, the actual investment returns will suffer. We go into every deal assuming not a worst case scenario, but close. And then we pressure test it using a sensitivity analysis.
- Wait, what’s a sensitivity analysis? It’s simply a chart to show you what returns will be under different scenarios, changing some of the variables like occupancy and rental rates. It shows you the breakeven point (where cash flow is just enough to pay the mortgage, taxes, utilities, staff, and basic upkeep) should we suffer a significant decline in occupancy or market rents. This is another area where multifamily properties shine. Our deals typically show a break even point somewhere around 75% occupancy. Looking at data from during the Great Recession in 2009, of all the markets we invest in the lowest occupancy rates dropped to was 85%. By buying the right properties in the right markets, we put ourselves in the best position to always be able to cover costs, weather any unforeseen storms, and even keep making money.
- What happens if there is another big economic recession? The biggest impact may be an extension of the hold time. We don’t want to sell in a bad market, so as long as we’re still operating well, covering our obligations, and generating a return (even if smaller than desired), we’ll keep marching forward until the market recovers for us to obtain a more favorable sales price. Your preferred return continues to be paid or accrued.
- Does the operator put their own money in the deal? Yes, this is most often the case so that the individuals within the GP also have a seat right next to all of the LPs. When they invest their personal money, those funds to in the same bucket with all of the passive investors (70% of the equity split). Keep in mind that the GP stands to make a lot more money from the GP slit (the 30%) which they can do by doing a great job for the LPs and exceeding the preferred return and waterfall targets. Their GP position is more important, and more motivating, than their LP position. By taking an LP position, she increases her exposure in the deal primarily as a token of comradery with the rest of the LPs.