Weighing solo investment(s) vs syndicated deals

[Jacob Vorreuter]

Background: I'm an accredited investor with some cash I'd like to put to work in real estate. My goal is to build up passive income generating assets over the next 5-7 years to achieve financial freedom. Although I've studied and learned a lot, I have no applied experience investing in real estate.

I'm pondering three strategies to get started:

1. Portfolio of turnkey SFRs
2. Invest in a small apartment building
3. Invest as an LP in syndicated deals

Strategies

Below is my analysis of each option, followed by my conclusion. I'd love to hear some of your perspectives and input though!

1. Portfolio of turnkey SFRs

This option would entail building a portfolio of turnkey, professionally managed SFRs. The emergence of turnkey providers unlocks markets outside my home market and makes it easy to find and purchase cash flowing properties with management already in place. I'm looking primarily at the non-gateway markets (Southeast, Midwest, Southwest).

Below I've modeled a representative investment based on several rules of thumb, including:

• income 1% of purchase price
• 3% vacancy
• expenses 50% gross income
• income, expenses and property value increase at 3%/year

Estimate:

• Purchase price: $150,000
• Income: $1500/mo
• Expenses (including professional mgmt): $750/mo
• Capex/reserves: $45/mo
• Debt service: $644/mo (80% LTV, 5% interest rate, 30 yr)
• Cap rate: 5.6%
• Year 1, 5, 7 CoC return: 1.30%, 4.40%, 6.09%
• Year 1, 5, 7 IRR: -26%, 11%, 12%
• Year 1, 5, 7 Equity Multiple: 0.71, 1.39, 1.70
• Year 1, 5, 7 DSCR: 1.13, 1.27, 1.35

I'm intentionally using an optimistic estimation to give this option the best chance at competing with option #3.

2. Small apartment building

This scenario entails buying a small commercial multi-family building in a nearby West Coast market. I'm sticking to nearby markets because this option is the most labor intensive. There are no turnkey providers for commercial multi-family, so I'd have to invest in building relationships with market-local realtors, property managers, contractors, wholesalers, build my own team and source my own deal.

I pulled two examples off Loopnet in Portland and Sacramento:

Portland 7-unit

• Gross income: $103,130
• Gross operating income: $100,036
• Total operating expenses: $30,159
• Net operating income: $69,877
• Capex/reserves: $3,094
• Cap rate: 5.6%
• Projected purchase price: $1,247,804 ($1.4M list)
• Debt service: $59,513 (70% LTV)
• Year 1, 5, 7 CoC return: 2.32%, 4.48%, 5.67%
• Year 1, 5, 7 IRR: -17%, 9%, 10%
• Year 1, 5, 7 Equity Multiple: 0.81, 1.28, 1.50
• Year 1, 5, 7 DSCR: 1.17, 1.36, 1.44

Sacramento 8-unit

• Gross income: $143,114
• Gross operating income: $138,821
• Total operating expenses: $51,170
• Net operating income: $87,651
• Capex/reserves: $4,293
• Cap rate: 4.87%
• Projected purchase price: $1,799,813 ($1.9M list)
• Debt service: $73,578 (60% LTV)
• Year 1, 5, 7 CoC return: 1.68%, 3.12%, 3.90%
• Year 1, 5, 7 IRR: -14%, 6%, 7%
• Year 1, 5, 7 Equity Multiple: 0.86, 1.20, 1.38
• Year 1, 5, 7 DSCR: 1.19, 1.39, 1.47

Similar to option #1, option #2 is probably overly optimistic. I used the sellers' income and expense actuals/projections and only tweaked vacancy rates and capex reserves.

3. LP in syndicated deals

Below is a snapshot of a few commercial multi-family syndication deals currently available on a crowdfunding platform:

$12.5M primary market new condo development

• Hold period: 2.5Y
• Target IRR: 22%
• Equity Multiple: 1.65
• Year 1 CoC return: N/A

$4.7M primary market apartment community light rehab

• Hold period: 2-5Y
• Target IRR: 16-20%
• Equity Multiple: 1.5-1.9
• Year 1 CoC return: 2.9%

$18M tertiary market apartment community value add

• Hold period: 3-5Y
• Target IRR: 18.2%
• Equity Multiple: 2.11
• Year 1 CoC return: 7%

$34M tertiary market apartment community value add

• Hold period: 7Y
• Target IRR: 16.5%
• Equity Multiple: 2.43
• Year 1 CoC return: 7.4%

Observations

Risk

In a vacuum, the types of projects being carried out by the syndication sponsors are inherintly riskier (new construction and varying levels of renovation). However, in practice, the investor probably has as much, if not more influence on risk. Compare large syndication sponsors with tons of experience to a newbie investor and the risk scale shifts hard in favor of experience.

I'm sure there's a decent chance that a sponsor encounters a complication and drops a few percentage points on the IRR to their investors. On the other hand, what's the likelihood of a first-time investor making a small or large mistake that has a severe impact on their bottom line? I'm guessing pretty high.

This, of course, highlights the importance of a new investor finding a good mentor :)

Diversification

Investing in multiple properties (options #1 and #3) offers the opportunity to diversify across multiple markets. Option #3 additionally offers the opportunity to diversify across different types of projects and different (and shorter) hold periods.

Returns

The syndication deals provide substantially higher IRRs and equity multiples.

As cap rates compress and interest rates rise it seems to have become very difficult to find stable, performing investments (residential or commercial multi-family) that produce high teens or above IRRs on a 5-7 year timeline. Many savvy investors are probably still achieving these returns and I'd guess they're doing it in two ways:

Fix and flips

Buying depressed properties, rehabbing and re-selling/refinancing (BRRR) is risky and time intensive. This sounds fun and exciting, but the time commitment really kills it for me.

Forced appreciation through improved operations

I've heard many success stories from investors that have generated great returns by finding a commercial multi-family property that's underperforming and/or mismanaged. Bringing such a property up to market rents, tightening up expenses and completing some light improvements can have a substantial impact on net operating income. Unfortunately, sourcing these opportunities is tough because they probably never hit Loopnet/MLS and would require lots of active investment in relationship building in specific markets.

Conclusion

The risk profile and projected returns of these large syndication deals makes them the most attractive option for a newbie investor in my position.

Add in a potential looming economic downturn and uncertainty of where we are in the current real estate market cycle and that only increases my anxiety as a newbie investor trying to get into the market. I trust that the sponsors managing these projects can navigate upcoming turbulence better than I can on my own.

I'd love to hear other perspectives and feedback on my estimates/assumptions.

Looking forward to hearing from you all!

[Brian Burke]

@Jacob Vorreuter you have done a very pragmatic analysis of the various options and have come to a very sensible conclusion based on realistic facts that a lot of people overlook.

I agree with most everything you said except in your returns section, "The syndication deals provide substantially higher IRRs and equity multiples."

My disagreement is with the word "provide".  That word should be "project".  

The big risk with investing in syndications is picking the wrong sponsor.  This requires as much due diligence as it would if you were acquiring a property directly, or a portfolio of turnkey rentals, if not more.  

Which is one of the reasons why I don't think that selecting investments in the point-and-click environment of a crowdfunding portal is the best approach.  In my opinion, and others will disagree, is that the best syndicated offerings are found by researching the best operators and investing in deals directly with them.  This allows the investor to do extensive due diligence on the sponsor and dig deep into their character, strategy, tactics and underwriting.

Going back to IRRs and multiples, the projections made are only as good as the underlying assumptions used in underwriting the asset.  Actual performance varies widely among sponsors so digging in to historical actual performance versus projections can provide some insight into how realistic the sponsors are when they form their assumptions.

And as you astutely pointed out, as we navigate from sunny weather and into potential storms forming on the horizon, it is only experience that overcomes the forces of nature. You are far better off investing with groups that have a deeply experienced bench and a realistic underwriting approach versus the one projecting the highest IRR or multiple.