Have you ever looked up at a large apartment complex or a beautiful office building and wondered about what kind of people have enough money to own those? You may be surprised to know that most of those properties are owned by people just like you and me! These assets carry less risk than smaller properties and as a result, the largest institutions in the world love to lend on these properties. While large firms issue the debt, most of the equity (down payment) comes from regular people. Leap Multifamily helps accredited investors just like you own a piece of those assets!
Let’s spend a few minutes talking about the basics of what a real estate syndication is and then we’ll get into the meat of it – how to choose the right deal to invest in.
What is a Real Estate Syndication?
In simple terms, a real estate syndication is a group of dozens, sometimes hundreds, of investors coming together to buy a much better piece of property than they could purchase on their own. There are two groups of people in a syndication – the active sponsors and the passive investors. The sponsors, also known as general partners (GP’s), do the hard work of locating and managing the property. The passive investors, also known as limited partners (LP’s), contribute capital but don’t carry any financial or legal responsibility beyond the amount of money they choose to invest. Passive investing at its finest!
GP’s can put together a syndication to purchase almost any type of asset, but this article will focus mostly on multifamily investments.
The 5 Major Benefits of Multifamily Syndications
There are some incredible benefits that come with investing in multifamily syndications and many real estate investors utilize these investments as a tax shelter and to build their wealth. In fact, prior to the JOBS Act of 2013, syndications were available only for the wealthiest people. You had to “know” somebody to get in.
1.) Passive Cash Flow: Most multifamily syndications throw off rental income each month. Some deals will pay out distributions starting in the first month and others may require major rehab prior to having enough excess cash to pay out to investors.
2.) Cash Flow: Most multifamily syndications throw off cash flow each month. These passive investments will pay out distributions starting in the first month and others may require major rehab prior to having enough excess cash to pay out to investors.
3.) Equity Growth: One of the beautiful things about investing in commercial real estate is that the value of the property is based on how much cash the property generates. Unlike single-family houses, we may be able to force our properties to appreciate based on increasing the property’s income. This means that if we choose properties in cities where rents are rising, we may have significant equity growth that we can distribute to investors once the property sells.
4.) Less Risk: I’ve managed tens of thousands of single-family houses and I’ve seen every single type of issue you can imagine. Tenants pushing concrete down pipes, wild animals breaking into houses, major foundation issues, flooded properties, roof replacements, etc. You name it, I’ve seen it. The problem with owning a few rental houses is that the sample size is very small and one bad event like a broken HVAC can cost you an entire year’s cash flow.
With 100+ unit apartments, there are always 1 or 2 evictions happening and HVAC’s break down every month, but the vast majority of the other tenants keep paying their rent.
5.) Major Tax Advantages: Real estate is perhaps the most tax advantaged investment you can make. These investments throw off significant depreciation that you can use to offset other passive gains and when it comes time to sell, you can often parlay your equity into a new deal via a 1031 and defer your gains for many years. This allows your money to compound even faster!
The 4 Disadvantages of Real Estate Syndications
Many people believe that real estate syndications carry the best risk/reward profile of any investment out there. However, this type of investment isn’t for everybody. Here are the reasons why a multifamily syndication might not be a good fit.
1.) Illiquidity: Most syndications tie up your money for 3-5 years and withdrawing your money may not be an option. Read the private placement memorandum for your investment carefully to see what the rules on an early exit are. P.S., the illiquidity may actually be a benefit for all of you stock-market-timing-types out there.
2.) High Minimum Investment: Many syndications require a minimum investment of $75,000 to $100,000.
3.) Lack of Control: Passive investors in multifamily syndications don’t have any control over how the property is operated. Many people love this aspect because they can leave the hard work to the experts but if giving up control is difficult, this may not be the best option for you.
4.) Must be an Accredited Investor: Depending on the type of security offered, you may have to be an accredited investor to participate.
Ok, we’ve talked about what a multifamily syndication is and isn’t. Now it’s time for the fun stuff – figuring out which syndication to invest your hard-earned money into.
Choosing the Right Multifamily Syndication
Asset Class
Almost any type of real estate can be “syndicated”. Multifamily, self-storage, mobile home parks, office, retail, etc. You will want to spend some time researching exactly which asset you want to invest into. Each have their pros and cons. Leap Multifamily has traiditionally focused on, you guessed it, multifamily syndications. However, there are other great asset classes to choose from and we’ve expanded into industrial real estate and other asset classes with great growth potential.
Geography
After deciding on an asset class, investors will want to narrow down their focus to specific geographic areas. Our advice is to invest in high growth states where people are moving to. We have an interesting situation in the U.S. right now where domestic migration patterns are solidifying and there will be states that benefit from these patterns and states that lose. These trends are unlikely to change anytime soon and this type of economic growth can be a nice tailwind for your investment.
Leap Multifamily focuses on three states in particular – Arizona, Texas, and Florida. Each of these states is likely to continue to benefit from strong population and economic growth for many years to come. There are other great places to invest but developing a great base of operators and expertise in a market takes a lot of time and we want to invest with people and markets that we know very well.
The great thing about multifamily syndications is that if you live in a state where you don’t want to invest, you can still get money into other states where the odds of success are higher.
Great Operators
One of the most important pieces of the puzzle is picking the right operator. There is a lot of expertise needed to identify, underwrite, close, and operate a $50,000,000 asset. You should spend most of your research time on this piece of the puzzle. Your due diligence should include pointed questions about the operator’s track record, investment philosophy, underwriting guidelines, and operational expertise.
Which Deal to Invest in?
Ok, now you’ve identified an asset class, geographic market, and found several good operators to work with. Most operators with solid track records will close on 3-10 deals per year. The problem is that every operator is going to pitch each and every deal as the best one they’ve ever done. Taking the time to sift through all these deals and find the gems is really important because not all deals are worthy of investing in.
Due Diligence Questions to Ask the Sponsor
Question: What is the business plan for the property?
- Is this a buy and hold?
- A quick flip?
- Will there be minor/major renovations?
- How long will the renovations take?
- How will the operator manage the renovations?
Question: What does the debt look for this property? It’s 2023 and the Fed has been raising interest rates for the last year. The type of loan may be the most important thing to look at today. There will be some high-leverage adjustable-rate loans that will get operators into trouble and force a sale of their property. You will want to ask specific questions about the type of debt the operator is putting on a property.
- What is the loan-to-cost ratio? All things equal, lower leverage equals lower risk.
- What is the debt service coverage ratio (DSCR). Many lenders require at least a 1.25 DSCR. This means that after paying all of the property’s bills, there is excess money left over as a cushion. The higher the DSCR is, the more cushion the property has if there are unexpected expenses.
- Is the interest rate fixed? Or adjustable? If adjustable, is the operator purchasing a rate cap to limit how much the rate can rise?
Question: What is the preferred return* and how does the GP/LP investor split work?
- What kind of returns are you projecting for this investment? Some investors don’t care about cash flow and are content with a big lump sum upon sale. Others want consistent cash flow with less risk.
- What are the fees that the operator is going to charge? Do they sound fair? Are the fees at “market” rates?
- What does the cash flow waterfall look like? Is there a preferred return?
- How much of their own money is the operator putting in? Generally speaking, the more the better, as it shows their conviction in the deal.
Question: How much future rent growth are you projecting? This one is a biggie! Because commercial real estate is valued based on its net cash flows, if future rent increases come in at 2% instead of the 3-4% projection, that will make a large difference on the valuation in a few years.
Question: What kind of expense growth are you projecting? Same thing here. Inflation is causing expenses to rise. How are operators accounting for this?
Question: Cap rates – this one is huge because changing an exit cap rate by just .5% makes a big difference in the property’s value. What’s the going-in cap rate? What’s the exit (reversion) cap rate?
Question: How will the property be managed? Is the operator vertically integrated and runs their property management in-house? Or do they use a 3rd party property manager? If so, who is the PM? What kind of experience do they have with this type of property?
Question: What is the average houshold Income in a 1-mile radius of the property? This shows us how easily the average tenant can pay the rent and gives a good indication of how stable the tenant base will be in an economic downturn. Most PM’s require tenants to have income of 3x the monthly rent. If they are averaging 4x or 5x then that’s even better.
Crime Rates
High crime areas typically show higher returns on paper since prices are low. But there is also higher risk with this type of area too. Look up the crime stats for that zip code on google.
Rent Comps
Look closely at the rent comps that the operator has chosen. Are the properties truly comparable? Are the other properties superior in location, age, or amenities? Assuming they are comparable, are the projected rents at the top of the comp list? If so, that’s not as conservative as if the projected rents fall in the middle of the list.
Operating Reserves
Things go wrong sometimes. How much cash does the operator plan to raise for contingencies?
Sales Comps
Can the operator justify the price they paid for the property based on recent sales comps?
What about the exit price?
These are just a few of the questions that you should ask before investing in a multifamily syndication. The operator should be able to answer these questions satisfactorily and you should feel comfortable and confident in your decision. Never invest into a deal unless you are 100% confident. Being able to sleep at night is worth a lot more than getting money into a so-so deal. There will always be another deal to invest in!
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.
*Preferred returns are part of the deal structure and indicate the sequence of how distributions (from operations or a capital event) are disbursed. They are not guaranteed and should not be considered a financial projection. Actual cash flow projections and distributions from the sponsor may differ from the preferred return.