As an investor, there are various ways you could put your money to work. When you’re in the world of private placements, you may have heard of preferred returns. These refer to the order in which profits from a project are distributed to investors. Preferred return indicates a contractual entitlement to distributions of profit. Those who were promised preferred returns are given priority when the distribution of profits happens. This is maintained until a predetermined threshold rate of return has been met.
Preferred returns are usually expressed as a percentage of return on an annual basis. For example, if in an agreement you were promised a preferred return of 8% for a $100,000 investment, then you would receive $8,000 ($100,000 x 0.08) in annual return if available from the net revenue.
As an investor, the rate of preferred return is a vital component in checking the health of a particular investment, as it reveals the intent of your partners in returning your money. When you have preferred returns, you’re given priority over the company’s income before the general shareholders. That means the people running the company should work hard enough to not only meet the promised preferred returns but also generate enough excess income to be profitable.
In short, the operators will be focused on reducing the time spent before you get your return on investment, to increase your overall return. This will ensure that your goals as an investor and the goals of those running the company are in sync, and no one is out to cut the other short.
By the nature of preferred returns, it is indeed more advantageous to the one with the capital. Thus, when you’re offered an investment, it pays to look for this clause. An operator may choose not to offer preferred returns because doing so will delay their split of the profits. While this is acceptable, as an investor, you may see this as a misalignment of interest. Another reason why operators may not offer preferred returns is if they are not as well-capitalized and need the proceeds from the cash flow to fund their syndication operations.
Types of Preferred Returns
Now that we’ve talked about preferred returns, let’s discuss their types.
The first is cumulative versus non-cumulative. When you’re tasked to review a private placement memorandum (PPM), you will want to make sure that you take note of whether it’s a cumulative preferred return. Cumulative preferred return is ideal because it will help protect your overall return and here’s why.
Remember our example earlier? Let’s say you’re given a preferred return of 8% per annum. In a non-cumulative preferred return, if you do not receive your total preferred return for one year, then you lose the difference. Say, in year 1 you receive back 6% (rather than the 8% that was anticipated). With a non-cumulative return, youforfeit the right of getting the difference after that year has elapsed. Every year the preferred return resets and does not carry forward.
A cumulative preferred return gives you the right to add the difference and roll it over to the next year. For example, if your preferred return was 8% and you only received 6% one year, then your preferred return the following year would increase to 10% (8% + 2%).
In the normal business cycle, cash flows are expected to increase year to year as operations begin to stabilize and become more profitable. Thus, while the promised return in percentage is fixed, the actual value of such will be bigger since the number where it’s computed from also gets bigger as the years pass. This can lead you to get a return on investment sooner.
As a reminder, always read your documents carefully to be aware of whether you are investing in projects with a cumulative preferred return.
Another type of preferred return is the preferred return with catch-up. This setup is considered the second position in the waterfall distribution schedule. Here, once your share of the profit is achieved and is set aside, the operator receives all or most of the profits until the operator “catches up” and reaches the same portion of equity you received. This type of catchup provision allows the operator to receive its entire equity split as originally agreed by both parties.
What Else To Know
Another aspect that you should know about concerning PPMs is the difference between Preferred Returns and Preferred Equity. To differentiate both, let’s go back to the life cycle of the investment. Assuming that funding is already secured, your investment can either be with a preferred return, preferred equity, or both. We discussed how preferred returns work. When it comes to preferred returns, the actual return of your overall capital is not in the picture.
When you have preferred equity, you’re prioritized to get your returns during the hold period and also have a priority treatment to get back your initial capital when the asset is sold.
So it is a good business practice to consider adding an equal amount of preferred equity and preferred returns in your portfolio for risk management purposes. Preferred returns help you with a steadier, consistent cash flow; while as a preferred equity investor, you would receive your specified return and your initial capital back before any of the other investors.
When Do Preferred Returns Go Away?
Preferred returns are often calculated based on how much capital you contributed times the interest promised. However, there are distribution structures where your payouts are deducted from your capital. Thus, every payment you receive means a return from the capital you invested. This will also mean that since your returns are based on your unpaid capital, then it’s safe to assume that you will get smaller payments over time.
Some operators will say that this is a good idea because you are not paying taxes on the cash flow. However, since your preferred returns are based on unreturned capital contributions, your preferred returns will gradually diminish. Some operators prefer this structure because it allows them to achieve profitability quicker.
As an investor, It’s generally better to choose preferred returns that are distributed from profits alone and not deducted from your initial capital so that your payouts will not be diminished. Typically you do not have to worry about the taxes right now anyway, since the depreciation each year should offset all the distributions you receive.
You also do not have to worry about the return in the capital, as preferred returns are not the most efficient way to get it back. Usually, to reduce your unreturned capital contributions or get it back completely, you need to go through a capital event such as a refinance or supplemental loan. Through these events, you would receive a portion of your initial capital back and this amount would reduce your unreturned capital contributions.
To make the above example less confusing, let’s pick up from our last scenario. You invested $100,000 and because of this, you will be getting an 8% preferred return rate (or $8,000 a year). Instead of deducting this amount from the initial capital, treat it as a dividend gain. In year three, when the operations have stabilized and the company is ripe and due for refinancing, that’s the time you can lobby to get a portion of your capital back. Your preferred return would then be based on the remaining unpaid capital. Thus, if during the said refinancing you were able to get around $40,000 back, then you will still be able to enjoy the fruits of the 8% preferred return rate on the $60,000.
With this example, it is important to note that even though your unreturned capital was reduced, this does not reduce your equity position in the overall deal. This amount is only used to calculate your preferred returns. However, some operators will reduce your equity position during a refinance or supplement loan, so be very diligent in reading the PPMs to make sure you know exactly what you are getting yourself into from the start.
Conclusion
Remember that just as with any venture you may get into, always protect your capital first. That’s the basic rule of risk management. Do not look so far ahead, especially to the potential gains, and overlook the red flags and risks that might be lurking in the PPM. Look at preferred returns as a powerful tool for you to protect your capital. It allows you to have preferential treatment in getting back your capital (and more) and eventually helps you grow your portfolio as a passive investor. By carefully choosing preferred returns, you reduce your risk when putting your money in private placements, since you are prioritized to receive the proceeds of all cash flows first.
Apartment syndication has been a strong buzzword in society, especially since the JOBS Act passed back in 2012 that boosted real estate crowdfunding. All in all, apartment syndication is an inked transaction between a general partner/sponsor and a group of passive partner investors to adequately fund a property that holds high credibility to drive optimal financial gains. Now, as clear-cut as this process may seem on the surface for all parties involved, there is one leading and fully justified question that arises amongst potential passive investors – how do general partners make money from this deal?
In summary, the answer to this question is quite dynamic, as there are several ways general partners can (and do) make money from apartment syndication. To offer more insight and clarity within this area, below is a comprehensive overview of the diverse streams a general partner has that allows them to get compensated for their role.
1. Distributions
First are distributions, which is an umbrella term that consists of operations, refinancing, and the sale of the property. Depending on the written contract and how much everyone invested will determine what the split and payout will be. For instance, the profit split could be a clean 50/50 between a passive partner and the general partner, or it could be as tilted as 90/10. As long as everyone agrees, the profits can be split equally, or each person could obtain a different return based on the X/X ratio listed.
Example: If a passive partner with an 8% preferred return invested $2,000,000 into a property that earned an annual cash flow of $200,000, they would receive $160,000 along with an additional $20,000 if the contract was a 50/50 split. That scenario would leave the general partner with $20,000 to take.
2. Percentage Ownership
Another primary way, which is also linked to the distribution point above, is making money through percentage ownership. Again, depending on how much personal investment the general partner chose to invest and how much the property refinanced or sold for will determine the outcome of this profit. An example for this one is the general partner owning 30% of the property and the passive partners owning 70% of it. The only underlying issue with this one is that it does not usually offer steady cash flow over time, but it could deliver large lump sums in the end if the value of the property rose significantly.
3. Fees
Next involves general partner fees. In short, there are typically a few different fees involved in an apartment syndication agreement, one of which is an acquisition fee. Almost all general partners will charge this one-time upfront fee, usually around 1-5% of the total purchase price. This profit will again be strongly determined on the potential of the property, the qualifications of the team, and the scope of the project as a whole. Why do you, as a passive partner, need to pay this? Because it covers the time and money spent by the general partner on their efforts involving deal development, team building, marketing analysis work, finance securing, and other aspects involved to make the project a successful and seamless one. Other fees that a passive partner can expect to pay and how general partners get paid for their time include:
Asset Management Fee: An annual per unit fee ranging from about 2-3% and is used to cover aspects within the business plan such as interior/exterior renovations. An important thing to note here is that this percentage is based on what the collected income is, meaning the lower the income, the lower the percentage will be.
Organization Fee: The majority of the time, most apartment syndication contracts do not list an organization fee as it is built into the acquisition fee. However, if it is separate, then a general partner will likely ask for a 3-10% upfront fee based on the total money that has been raised to organize and orchestrate the project team fundamentals.
Refinance Fee: A refinance fee goes to a general partner for their time involved in refinancing a property. Perhaps the value increases as time goes on, and they are able to refinance with a better interest rate and terms. Refinancing is not always applicable, but if it is, there may be a 1-3% fee collected based on the total loan amount.
Loan Guarantor Fee: This is another one-time closing fee (that a general partner may or may not ask for) which is collected to guarantee the loan. This one had a larger percentage range falling anywhere from .5% to 5%, depending on the risk involved and if it is a recourse loan or not. Diving deeper into the risks, a recourse loan is red on the risk chart because it allows the lender to collect the general partner’s assets (home, car, credit cards, etc.) even after the collateral has been taken to collect the debt owed. On the other hand, a nonrecourse does not allow the lender to collect assets other than the collateral. In those circumstances, the loan guarantor fee will be lower since there is less risk on the general partner.
Loan Interest Fees: Regardless of the size of the loan being taken on to carry out the property renovating objectives, there is going to be interest involved. Because of this, there might be an 8-12% loan interest fee as part of the apartment syndication deal. This fee is to help cover that said interest incurred from the loans made to the company.
Construction Management Fee: Lastly, a construction management fee is typically an on-going 5-10% fee to support the general partner in optimizing the project pipeline efforts. This percentage is calculated on the total renovation budget, but keep in mind that it is often intertwined with the asset management fee to maximize passive partner returns.
4. Brokerage Commissions (If Licensed A Broker in The Same State as The Property)
If a general partner happens to be a licensed real estate broker in the same state as the property they are investing in, then they could earn compensation for that area of business as well for performing brokerage activities to the syndication. For instance, they may earn a commission for purchasing the property initially and potentially a resale commission if selling the flipped property is part of the big picture agenda. As a final comment here, if a general partner is not a licensed broker, then onboarding one will be part of their team building process, as they are the main link between the buyer and seller and helps ensure that the entire acquisition process will go smoothly.
Conclusion – Ready to Invest Passively?
From finding and underwriting deals, securing finances, negotiating, executing business plans to investor communications, general partners are essentially the drivers when it comes to apartment syndication. Because of that, it stands to reason why many people looking to invest passively stop and ask how do general partners make money as their role significantly differs from theirs. After reviewing the list of streams above, hopefully you now have a better understanding of how the process works on that side of the spectrum and have a concrete idea of what to expect if you choose to opt for this investing avenue yourself.
With that being said, passive investing is one of the leading ways to obtain the advantages of owning an apartment property without having to put in the full time, commitment, and funding needed to execute the project. Now, this is certainly not a get rich quick scheme, but it is one that can hold monumental value that builds over time. Remember, when a multifamily property you invested in earns a profit, so do you! Overall, if you are ready to have your money work for you and invest passively in multifamily real estate, then contact us today, and we will be happy to help you get the process started.
What is meant by the multi-family property classifications A, B, C, and D?
In investment terms which of these property types are classified as core assets and which can be considered core-plus assets?
If you are looking to pursue a conservative investment strategy or if you prefer a more aggressive one that has the potential to deliver a higher yield in which class of multi-family property should you be looking to invest?
All these questions and more will be clearly answered in this article.
Classification – Class A
Class A multi-family properties are buildings that are less than 10 years old. If they are more than 10 years old, they will have been extensively renovated.
The fixtures and fittings will be of the very best quality.
The amenities will be comprehensive and of a luxury standard.
While Class A properties tend to generate a lower yield percentage, they can grow exponentially and they tend to hold their value even in major economic downturns.
In terms of their investment profile, they are considered to be core assets.
An article on multi-family investing at millionairedoc.com explains why Class A apartment buildings, with a ‘core asset’ risk profile, offer a lower yield percentage:-
“Owners purchase these properties using lower leverage, therefore with lower risk. REITs and institutional investors purchase these assets for income stream. The lower risk profile results in lower returns in the 8-10% IRR range.”
A property in the Class A category would not likely have a “core plus” risk profile unless it were slightly downgraded in some way perhaps by a less favorable location, housing type or a number of other factors.
Classification – Class B
Class B properties are older than class A properties. Usually, class B properties have been built within the last 20 years.
The quality of the construction will still be high but there could be some evidence of deferred maintenance. The fixtures and finishings will not be as high quality and the amenities will be limited.
Classification– Class C
Class C properties are built within the last 30 years. They will definitely show some signs of deferred maintenance.
The property will be in a less favorable location and it will likely not have been managed in an optimum way.
Fixtures and finishings will be old fashioned and of low quality. Amenities will be very limited.
Both Class B and Class C properties can be candidates for a ‘value add’ investment strategy.
By bringing deferred maintenance issues up to date or by upgrading the property by means of an interior and/or exterior renovation there is an opportunity to increase the tenant occupancy and receive a higher return on your investment.
In his article, ‘what are the 4 investment strategies?’ Ian Ippolito explains why pursuing a value add investment strategy is a higher risk:- “Much of the risk in value-added strategies comes from the fact that they require moderate to high leverage to execute (40 to 70%). Leverage does increase the return, but also increases the risk, and makes the investment more susceptible to loss during a real estate cycle downturn.”
Classification – Class D
Class D properties are generally more than 30 years old. The property will be showing signs of disrepair and will be run down.
The construction quality will be inferior and the location will be less desirable.
The property may be suffering due to prolonged and intense use and high-level occupancy.
Both Class C and Class D properties can be candidates for an ‘opportunistic’ investment strategy.
Because these properties require major renovations they are the highest risk investments but they can also yield the highest returns.
Summary
In overall terms, the US multi-family real estate market continues to give excellent returns for well-informed investors.
This article has clearly explained how different types of multi-family properties are classified. The article has also given an overview of how each class of property fits the different types of investment profiles. We trust that this information will assist you in assessing your multi-family real estate investment goals.
For further assistance please connect with our team.
The demand for rental accommodation continues
to significantly outpace supply. The current status quo is that rental housing
supply is falling short by hundreds of thousands of units each year across the
United States. This situation, according to The National Multifamily Housing
Council and The National Apartment Association, looks set to continue for many
years to come.
Current demographic preferences reveal a trend
at both ends of the age spectrum for renting as opposed to owning. The younger
demographic are finding it more challenging to get the financing for property
ownership and the baby boomer generation favor downsizing and the increased
freedom that allows. The result is that the demand for rental property is
increasing.
The combination of these two market factors
gives a strong positive indication for sustained revenue growth in the
multifamily sector. The conditions look
set to remain positive for multifamily investment in most locations for the
foreseeable future.
Let’s take a look now at four more reasons why
investing in multifamily makes good financial sense.
#1 Economy
of Scale
The basic meaning of the economic term, ‘economy
of scale’ is that there is a fundamental cost-saving benefit to being bigger.
To quote Investopedia, an ‘economy of scale’ is
an advantage “that arises with increased output of a product. Economies of
scale arise because of the inverse relationship between the quantity produced
and per-unit fixed costs.”
How does this concept apply to the argument
that multifamily investing is more advantageous than investing in single-family
property?
To give a simple example, if you have been
collecting 10 rents for 12 months from your multifamily property and then the
roof needs fixing, that’s a much better scenario than collecting 1 rent for 12
months on your single-family property and then the roof on it needs fixing.
The rationale applies even more if you add more
single family properties to the equation. The cost of managing 10 individual properties,
which could be spread across multiple states, and the cost of hiring different
contractors to care for each one would be punitive. The cost would be much
greater and the management less efficient and less cost-effective than caring
for one multifamily property of 10 units in one geographic location.
#2 Greater
Control of Property Value
With a single-family property, you are almost completely
at the mercy of market forces.
If you need to sell in a down market your hands
will be relatively tied. The value of your property will be determined by what other
properties have sold for in the local area at that time.
A multifamily property is perceived somewhat
differently because of its commercial nature. It is managed and run as a
business and therefore a significant part of its value is determined in the
same way as a business. This means that the value is much more in your own
hands.
Businesses are valued largely on their
profitability and, in a similar way; a multifamily property’s value is
determined by its net operating income.
Something as straightforward as adding a
laundry facility or some paid parking are two examples that can very positively
affect the profitability of your multifamily property and in turn, its value.
With a multifamily property, there are many more
ways that you can bring your management and entrepreneurial skills to bear to
increase the value of the property independently of the surrounding property
market.
In a nutshell, you have the ability to raise
the value of your multifamily property by decreasing expenses and increasing
income.
#3
Positive Cashflow
In addition to the ideas mentioned previously, namely,
adding laundry facilities and paid parking, there are lots of amenities that
could be added to your multifamily property to keep positive cash flow.
In addition, the old adage of not having all
your eggs in one basket applies here also. A tenant vacancy in a single family
rental property will bring your cash flow to a grinding halt. In contrast, if
one of your units in your multifamily property is vacant, the impact on your
cash flow will be minor because you will still be collecting rent from all the
other units.
#4 Tax
Benefits
One of the great things about supplying housing
for the populace is that in doing so you are helping the government fulfill one
of their important responsibilities. Not surprisingly, in return, the
government offers you certain tax advantages.
One of the most significant tax advantages for
multifamily property owners is something called ‘depreciation deduction,’ in
effect it can allow you to deduct a large amount of the income your property
generates. For details on how it works, take a look at the following Investopedia
article, How
Rental Property Depreciation Works.
Another way multifamily property tax laws
benefit you is that you are permitted to use some of the cash flow from the
property itself to pay down the mortgage.
It is permissible to collect revenue but show a
much smaller amount of income on your taxes. This allows you to take a portion
of that rental income and use it to pay down your debt on the property, which
will steadily increase the equity.
With the help of a good tax advisor, you may
find that there are many other legitimate ways to capitalize on the tax
deductions and incentives and even grants that the government makes available
to multifamily property owners.
Summary
In the present fluctuating economic climate
multifamily properties are tangible assets that represent a sound focal point
for your investment and wealth creation strategy.
Due to shorter lease terms that give room for
regular increases in rent, multifamily assets represent less of a risk than
other commercial real estate investments.
The prevailing demographics are also favorable.
The steady increase in the number of professionals in the workplace, families,
and empty nesters looking to downsize and simplify their lifestyle means that
focusing on the multi-family market makes sense.
Multifamily is and will continue to be a solid strategy
for investors looking to achieve financial freedom by means of strong investment
returns that are attractively low risk.
Of the two types of investing, investing in stocks and shares seems more accessible to many than the world of property investment.
So, why would you consider investing in real estate?
Both types of investment have their pros and cons but the beauty of investing in property lies in the low risk, stability, and predictability of the investment.
You can also add, tax advantages, hedge against inflation and control of investment to the list of positives when it comes to investing in tangible bricks and mortar over stocks and shares.
Let’s take a brief look at some of the pros and cons.
Stocks – Positives and Negatives
When you invest in stocks you effectively own a portion of the company that you are investing in. If that company manages to thrive then the value of your stock rises and you win. When the company struggles, you lose.
Positives
Passive Income The entire process of investing in stocks can be automated. Of course, when it comes to investing in property, you don’t have to be the one dealing with tenants’ problems. When you invest in a property deal that is syndicated by someone else then this means that your real estate investment income will effectively also be 100% passive. You are several steps removed from the day to day management of the property.
Liquidity Buying and selling stock is a relatively straightforward and speedy process with low transaction costs. No tangible asset is being exchanged so the transaction is quick and inexpensive. The process of actually buying and selling stocks is obviously much more straightforward than buying and selling a property which often takes two or three months or more.
Diversification Due to the relative ease of buying and selling stocks, it stands to reason that it would also be fairly simple to spread your capital across different stocks. This is a way to combat the volatility of the stock market where the prices of individual stocks fluctuate daily. Clearly, it would take a much greater investment of capital to diversify your real estate portfolio in the same way.
Negatives
Volatility During a dip in the economy, you may be subject to the disappointment of diminishing funds as the profitability of the company drops. Stock prices experience extreme short term volatility, depending on the day’s events. Most smart traders do not react to these volatile market cycles but take a long term approach; however, the unpredictability of stocks can take its toll emotionally.
Risk Stocks are volatile by nature because they depend greatly not only on the economy but also on the performance of a company and more importantly on the performance of the flawed individuals that run those companies. If a company goes bankrupt then the money that you have invested in those stocks is completely dissolved. This is a bigger risk than many are willing to take; many investors prefer to have their capital tied up in an investment over which they have a greater degree of control.
Ambiguity Accurate stock analysis calls for a great deal of study. Even many honest experts admit that they are barely scratching the surface when it comes to accurate in-depth analysis.
Real Estate – Positives and Negatives
Real estate is a tangible asset and as such for many investors, feels more real. A great appeal of this type of investment is its stability.
For many millions of people, this kind of investment has generated consistent wealth and long-term appreciation.
Real estate investment provides a very consistent and stable rental income. Having a home is a vital necessity for all people, and as a result, rental investors are relatively protected even during economic downturns.
Positives
Cash Flow Property investment provides an opportunity to invest for cash flow which means buying a rental property for the income it generates each month. With skillful management, this cash flow income can be increased significantly after your investment. The passive income from your real estate investments can dramatically improve your quality of life. Rental properties give a steady source of cash that keeps up with inflation. With smart investment advice, real estate investing will bring a consistent stream of passive income. Many investors are often able to earn cash flow completely tax-free.
Tax Advantages The government gives many tax advantages to those that effectively help them with their responsibility to provide suitable housing for the populace. Owning real estate brings many tax advantages, not least of which is depreciation. Depreciation is a key tax advantage with real estate investment. Real estate investors earn back the cost of depreciation over a period of time after the initial purchase. Because you are depreciating an asset that increases in value, you receive a tax credit accordingly. This tax credit is received in addition to property maintenance and other costs that you can take away from the rental income you receive.
Hedge against Inflation Depending on the type of securities you hold, Inflation can be problematic. Real estate investing serves as a hedge against inflation. The value of the property is tied to inflation as replacement cost goes up and the rent of the tenant is adjusted upward.
Negatives
Lack of liquidity With property, you can’t just sell it at the end of the trading day. You can’t go back on your decision to invest in a property at the click of a key on your keyboard. It may be necessary to hold the property for several years to realize the anticipated big returns.
Lack of diversification If you’re putting all of your money into real estate you might be limiting your diversification. In contrast, with stocks, by means of an index or mutual fund, you can have easy diversification. However, diversification can be achieved in real estate investing; well-qualified advisors can help you to spread your investments across different communities and different types of property.
Transaction Costs As we have seen, stock trading has much lower transaction costs than real estate. Real estate is a longer-term investment and transferring property is expensive. There are title fees, attorney fees, agent commissions, transfer taxes, inspections, and appraisal costs.
Summary
Investing in multifamily properties brings excellent returns with low volatility. But we are not saying that you should not have other types of investment in your portfolio.
If you work with the right people, rental income will mean an immediate return on your investment.
On the other hand, the stocks you buy today won’t produce significant income for perhaps decades.
Why not have a portfolio of passive income from rentals and dividends.
We look forward to supporting you in your desire to expand your wealth and reach your goal of financial reedom by means of multifamily real estate investment.
