Apartment Syndication vs. Turnkey Single-Family Rentals

[Mark Koster]

I know this has been asked in the past. I've read through those posts and am looking to update the discussion based on current market conditions and get some advice based on our specific circumstances listed below.

We are looking to diversify our stock-heavy portfolio into more passive, cash-flowing real estate and are analyzing our options. Our current real estate holdings consist of a few large-scale class B value-add apartment syndications in markets around growing major metro areas (with a very experienced sponsor), as well as a couple class C turnkey single-family rentals in the Midwest. We're looking at buying more of one or both of these asset classes and want some help comparing the two.

Some more background: we are accredited investors who are busy professionals and don't have time (right now) to learn how to find, and manage our own rental units without the help of a third party like a syndicator or turnkey provider. All else being equal, we prefer a more passive approach, but we realize some "work" is necessary for any investment, at least upfront. Rental properties in our local market are overinflated and the numbers do not make sense as long-term rentals from a cashflow perspective, which is why we are looking at investing out of our local area. We budget well and are ok with the irregular cashflow from the apartment syndications.

Here are some of the pros and cons of each option that we've identified so far. We'd love to hear others' thoughts on the risk/reward profile of each and anything we haven't yet considered:

Value-Add Apartment Syndications
PROS

• Higher return potential (most pro-formas I've read aim for 13-18% IRR over the life of the investment) due to value-add component
• Specific market and asset risk is short-term (most funds aim to sell properties in 3-7 years, after value-add is complete)
• Can fairly easily spread risk across multiple assets and markets using a syndication fund
• Investment opportunities (at least at the moment) seem to be readily available from many different syndicators
• Portfolio risk from individual unit vacancy is minimal (although nationwide eviction moratoriums and neighborhood/regional factors can still present a risk)
• No impact to personal credit. Leverage is baked into the investment at the GP level
• No decisions to make once investment is made (until the assets are sold and you need to find another investment)

CONS

• No control over investment
• Illiquid
• Some syndications have high initial investment requirements
• Short-term nature of investment requires identifying new investments as assets are sold
• Risk/return is more reliant on competence of syndicator - more due diligence needed upfront to vet them

QUESTIONS

• What unique risks are there with the value-add apartment syndication model that go along with the higher returns? How to mitigate those risks?
• What is the long-term outlook on value-add apartment investing? Are current IRR numbers sustainable over the long run? Is the "value-add" component creating a more speculative component that could be riskier if the market shifts?

Turnkey Single-Family Rentals
PROS

• Medium return potential (seems to max out at 7-10% CoC currently, using leverage)
• Full control over investment
  Long-term investment - most of the "work" is front-loaded. With good property management in place, it can be fairly hands-off after that
• More liquid than syndication investments - at least as long as there is a market for the property. Caveat is that turnkeys sell for the high-end of market value, so disposal in the first few years will likely lose money

CONS

• Specific market and asset risk is long-term (per property - mitigate by diversifying across different markets and property types)
• Spreading risk across multiple assets and markets requires multiple investments and quite a bit of due diligence
• Turnkey properties (along with most other single-family homes) are becoming harder to acquire and thus more expensive, compressing returns and making it harder to find properties to buy with solid cashflow
• Portfolio risk from individual units is high (until sufficient number of doors achieved to mitigate this risk)
• Using leverage requires qualifying with personal credit - may become harder/more expensive with recently-announced changes at Fannie May
• Requires some effort (to "manage the property manager") and decisions required at some point for capital expenditures

QUESTIONS

• What unique risks are there with the turnkey single-family rental model? How to mitigate those risks?
• What is the long-term outlook on class B/C turnkey rental investing? Will CoC numbers continue to compress or will they level out/rise over the long run?

Overall, we are leaning more towards adding more value-add apartment syndication investments, mainly due to the higher return potential, more plentiful opportunities and lower barriers to entry at present, as long as we feel comfortable selecting a competent syndicator. We'd like to know if there are factors we are not yet considering in the above analysis and if there other options we should be looking at for real estate exposure in a mostly "hands-off" fashion. Is there a higher risk of loss of capital in one of these two options? Are there any different tax benefits to holding one or the other?

[Ian Ippolito]

I'm an investor and support myself and my family from my investment income. And I invest in both direct real estate (via residential rentals) and syndication/crowdfunding passive investments. In my opinion, both have their pros and cons and neither is 100% superior to the other. And I feel the ideal portfolio can benefit from the diversification of both. But I also feel directly owned properties that are turnkeys are kind of a hybrid with unique risks (that I myself am not comfortable with).

1) Directly owned properties are great because they give you maximum control and the ability to tweak them exactly how you want. So for example I'm very conservative and don't want any debt on them because I feel this hardens them in case of a severe recession. That's unusual and it would be very difficult to find a passive investment like that.

Also direct control means you know exactly what's going on. And, for those people who have more time than money, they can put in sweat equity into directly owned real estate. This will increase the return above what can be obtained on a passive investment.

The flipside of having the power to control everything is that can be alot of work (and a full-time job if you are putting in sweat equity). Not everyone wants that or is willing to put up with that. It also requires gaining a level of sophistication and knowledge that not everyone has the time, inclination or ability to do. And someone jumping into this as a complete newbie can expect that they have a decent chance of making some expensive newbie mistakes.

2) On the other hand, one of the main advantages of passive investments (via syndication/crowdfunding) is that you can hire a manager who has years more experience than you can ever hope to obtain yourself. And once you finish the due diligence, your work is done: it's completely passive. Also, rather than taking a large amount of money and investing into one single directly owned property, you can split it up into much smaller chunks across many different passive investments. This can allow a person to get much better diversification protection across geographies, asset types, strategies, investment subclasses etc. Versus putting all the eggs into one basket.

The downside is that someone has to be comfortable with turning over control to someone else. That means learning how to vet a manager. Not everyone can do that and not everyone feels comfortable turning over control. So it's not a fit for everyone. Also there is a management fee to pay for all of the above. So someone who is looking purely to maximize potential return (and has unlimited time) is unlikely to find this a good fit.

3) Turnkey operators are kind of in-between. However I would not consider them to be truly passive because they do not put any skin into the game like a good passive investment does (via a sizable coinvestment). This coinvestment is what mitigates the risk of the other party taking risks that could be a detriment to the investor. Turnkey operators don't work like that and they are more like a broker collecting a fee for their work (regardless of the long-term performance). So they are financially misaligned on long-term performance (and I think this is why there are so many people who have had bad turnkey experiences)

And, as someone who has done lots of rehabs directly myself, I have seen hundreds of ways that turnkey operator could take shortcuts (to the detriment of the investor but beneficial to their bottom line) which investor could never detect (or not until years later when it's too late). So personally I don't trust reviews from investors saying there turnkey operator is great (because really they have no way of knowing). And personally I cannot pull the trigger on a turnkey operator. However there are other investors who feel very differently and love turnkey operators.

Hope this helps.