Month: December 2022

Many real estate investors get their start in single-family real estate before they graduate to larger deals.  The values of single-family homes are pretty easy to calculate – basically, the home is worth about what every other home in the neighborhood is worth.  Commercial real estate is much different.  The value of commercial real estate is tied to two variables – the cap rates of properties in the area and the property’s net income.  

Net Operating Income (NOI)

NOI is the net cash flow that is left over after paying the property’s expenses.  Note – we calculate this number before subtracting out the mortgage payment.

Cap Rate

Cap rate (short for capitalization rate) is the expected rate of return that investors demand in a certain area if buying a property with cash. Like everything in the world of finance, expected rates of return (cap rates) will vary based on investors’ perception of risk. A “Class A” property in a booming city will have a lower cap rate than a “Class C” property in a city whose economy is struggling.

Calculating the cap rate is easy.  We simply divide the property’s value by the net income.

Cap Rate = Net Operating Income / Current Market Value

If a property worth $10,000,000 and has NOI of $500,000 then the cap rate is 5%.

Cap rates are somewhat arbitrary and are determined by the price investors are willing to pay for a property. Things like interest rates, future rent growth projections, and future economic growth projections will all influence how much investors will pay for a given property’s cash flow.  If investors think that the property’s cash flow will decrease in the future then they will pay less for the property, pushing the cap rate up.  Conversely, if they think that the property’s cash flow will increase significantly then they may pay far more than $10,000,000 which would push the cap rate down.

 

Valuation Formula

Commercial Real Estate: Value = Net Operating Income / Cap Rate.

If the property produces $500,000 in NOI and the cap rate for that area is 5% then the value of the property is $10,000,000.

As you can see from the valuation formula above, if we choose our properties correctly then we we may be able to increase the property’s value by raising the income. Strategies like renovating dated units and/or operating the property more efficiently will all increase the NOI and boost value. We invest in states like Texas, Florida, and Arizona that all have strong population growth.  This increases demand for affordable housing and rents tend to rise.  All of these strategies may increase the NOI and build up equity.

In the above example, if the NOI increases to $600,000 then based on a 5% cap rate, the value moves up to $12,000,000!

 

If you are an accredited investor and would like to explore passively investing with Leap Multifamily on future deals, fill out our investor application here.

 

Real estate syndicators raise investment capital by issuing securities to investors. Ordinarily, sales of securities must be registered with the SEC (for example, when a company goes public via an initial public offering). However, the SEC provides several exemptions to the registration requirement, including the 506(b) and 506(c) exemptions that Leap Multifamily uses.  While these exemptions aren’t the only pathway to a securities offering that is not required to be registered, they’re the ones most commonly used by VC firms and syndicators.  This type of fundraising may also be referred to as a private placement (hence the private placement memorandum (PPM) that accompanies each offering) or an exempt offering.

All of our offerings for the foreseeable future will be either a 506(b) or a 506(c) so we’ll focus most of this article on the key differences between those.  

Investor Types Allowed (accredited versus non-accredited)

506(b) Offering:  Investors may be accredited or non-accredited. Up to 35 non-accredited investors may be accepted per offering and they must qualify as “sophisticated” investors.  See below for the definition of accredited investors and sophisticated investors.

506(c) Offering:  Investors must all be accredited.

Accreditation Documentation

506(b):  Accredited investors may self-attest to their accredited status.  No 3^rd party verification needed.

506(c):  Accredited investors must be verified by a 3^rd party.  There are several different ways that this may occur and a few of those are listed below.  Some investors don’t like the extra step of providing this information but the good news is that this only has to be done once every 5 years as the verification is good for that length of time.

Types of verification to prove accredited investor status:

1. Attestation from investor’s CPA
2. Reputable 3rd party vendor such as verifyinvestor.com
3. An investor can provide specific documents such as a W2 or bank statements to the sponsor

An investor can choose any of these methods for verification, but the first two methods are the most common.

General Solicitation

506(b) offerings are sometimes known as “friends and family” deals as the sponsor must have a pre-existing relationship prior to accepting an investor’s funds into the deal.  However, 506(c) offerings may include investors who don’t already have that relationship and as such, the sponsor may use general solicitation as part of their marketing campaign to raise money for the deal.  Any type of solicitation is fair game, from social media postings to TV, radio, and newspaper ads.

Glossary

Pre-existing Relationship:  A “pre-existing” relationship must be formed before the start of the offering or is established through a broker-dealer or investment adviser prior to that investment professional’s participation in the offering.

Sophisticated Investor:  While there isn’t a black and white rule on what constitutes a sophisticated investor, most definitions dictate that investors have sufficient capital, experience, and net worth to judge the merits of potential investments.

Accredited investor:  Unlike the definition of a sophisticated investor, there are hard rules for qualifying as an accredited investor.

• Financial Criteria
  • Net worth over $1 million, excluding primary residence (individually or with spouse or partner)
  • Income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, and reasonably expects the same for the current year

Or

• Professional Criteria
  • Investment professionals in good standing holding the general securities representative license (Series 7), the investment adviser representative license (Series 65), or the private securities offerings representative license (Series 82)
  • Directors, executive officers, or general partners (GP) of the company selling the securities (or of a GP of that company)
  •  Any “family client” of a “family office” that qualifies as an accredited investor
  • For investments in a private fund, “knowledgeable employees” of the fund

Did you know that you can use your IRA or your 401k from a former employer to invest in real estate syndications?

Most IRA custodians only allow you to invest in the typical stocks, bonds, and mutual funds.  Many of those providers are closely aligned with Wall Street and they make money by selling Wall Street’s products.  But you always have the choice of moving your IRA or 401k to a custodian that allows you to “self-direct” those funds into any investment vehicle of your choice.  A self-directed Individual Retirement Account allows the IRA owner (you) the flexibility to select the best investments for your future. 

 

Why haven’t I heard of SDIRA’s?

Self-directed IRAs have been around since 1974. SDIRAs are not well known because most banks and brokerage firms prefer traditional investments.

 

What is the transfer process?

There are many custodians that allow you to self-direct your IRA.  If your account is invested in stocks, bonds, or mutual funds, it is important to liquidate some or all your holdings to ensure the cash is available to transfer. The transfer process typically takes 2-4 weeks depending on which custodian you choose.

 

Are there tax consequences?

Money that sits in an IRA typically grows tax free and this is a wonderful benefit of this type of account.  When you invest outside of traditional stocks and bonds, it is possible that you will incur some additional tax.  Unrelated business income tax (UBIT) and unrelated debt financed income (UDFI) taxes may potentially come into play.  The IRA account will receive the standard depreciation benefits too but it’s possible that there will be taxes due at some point.  Even if the IRA incurs some amount of tax, this is typically far less than if you invested with cash not in an IRA. This article has more details if you are interested. 

 

A good investment is a good investment!

Regardless of the possibility of paying some amount of tax out of your SDIRA’s investment earnings, there are options outside of the traditional investment world that are far better on a risk-adjusted basis.  Cash flowing real estate is one of the very best!