Passive Investing in Multifamily Real Estate Part Three

Part Three: 4 Steps to Get Started

In this part, we’re starting our deep dive into the multifamily real estate deal process. We’ve covered the fundamentals in part one and generating passive income in part two. If you are ready to learn the steps to take to land your first deal, this is the part for you.

As a quick refresher, our goal is to generate passive income through investing in multifamily real estate. Passive income – and passive investing in general – means we won’t be materially engaged with the property: no property management and no day-to-day duties. In practice, this means investing with a group of investors, often in multifamily real estate syndication, through limited partnerships and limited liability corporations.

Multifamily Real Estate Investing in 4 Steps

I’ve created a template for those ready to get started investing in multifamily real estate. These four steps will take you from preparation through deal selection and on to closing your first multifamily real estate investment. They are:

1. Create your investment strategy
2. Choose your equity position: cash flow or appreciation
3. Understand syndication and sponsors
4. Get a list of sponsors and deals and vet both

Step 1 – Create Your Investment Strategy

Like many investments, multifamily deals offer many options for investors to consider. My first recommendation for any investor is to create a plan that outlines an investor’s preferences. The foundation of any plan is built on these four pillars:

• Available capital
• Risk tolerance
• Property type
• Property class

If this is your first multifamily real estate deal, I strongly recommend you consider your position within each of these categories.

Available Capital

How much capital are you able and willing to invest? Multifamily deals have a wide range of capital requirements, from $5,000 to $500,000 or more. Some syndicates will stipulate that only accredited investors can invest. Accredited investors, as defined by the U.S. Securities and Exchange Commission (SEC), are those with a net worth over $1,000,000 or an annual individual income over $200,000.

Risk Tolerance

You may have heard of real estate’s four asset categories: core, core plus, value add, and opportunistic. These categories describe the asset type and provide some idea of the overall risk of an investment.

1. Core (low risk profile with 8-10% IRR) – luxury apartments and other upscale multifamily dwellings. Considered best-in-class with full occupancy, and needs little renovation. Often in primary markets.
2. Core plus (low to moderate risk profile with 10-14% IRR) – similar to core, and can be located in primary or secondary markets. Location tends to be less desirable than core. The property may need to improve its vacancy rates. Usually an opportunity to raise rents and improve the property.
3. Value add (moderate risk profile with 15-20% IRR) – less desirable than core and core plus. These properties usually have lower rental incomes, require renovations, and have lower occupancy rates. Sometimes the properties aren’t professionally managed. Value add means the property requires capital to improve, but which can increase appreciation and generate significant returns.
4. Opportunistic (high risk profile with 20%+ IRR) – ground-up developments or major renovation overhaul. Often times these properties won’t have cash flow, but offer investors much higher appreciation rates and therefore better overall returns.

Property Types

There are a wide variety of different multifamily real estate property types. We won’t go into the specifics of each, but they all have different pros and cons depending on your investment needs.

• Apartment buildings
• Duplex
• Triplex
• Quadruplex
• Condominiums
• Mobile home parks
• Co-ops
• Fraternity and sorority houses
• Dormitories

Property Classes

The class of a property determines its investment potential and is based on a combination of its physical attributes, demographic characteristics, and its location. There are three main classes most real estate professionals recognize: Class A, B, and C.

• Class A – low risk, high-end properties with high income, low crime rate, and good amenities nearby. Often a high percentage of owner-occupied properties and are located outside of major cities.
• · Class B – generally older, but still have strong management and good tenants. Restoration is a main differentiator, as these buildings can improve to Class A with improvements or renovation. Located in and around first- and second-tier cities, and are often 15 or more years old.
• · Class C – usually more than 20 years old and located in less desirable areas, including high crime areas. These properties have substantial room for improvement, both in terms of renovation and building management.

Step 2 – Choose Your Equity Position: Cash flow or Appreciation

For many, the beauty of passive investing is generating passive income. In multifamily real estate, this comes in the form of regular cash flow, which we discussed in part two. But cash flow isn’t the only aspect of a multifamily real estate deal. Some deals offer lower cash flow but more long-term appreciation. As a passive investor, you’ll want to answer this question before investing:

• · Is my passive investing goal to generate periodic cash flow or capital appreciation?

Investors looking for periodic cash flow are what I call cash flow minded. These can be retirees or investors looking to transition out of full-time work, who require regular cash dividends to live on. Investors with short time horizons, from 5 to 10 years, may value cash flow over appreciation.

Investors looking for capital appreciation are what I call growth minded. They are a varied group, but sometimes include young or middle-aged investors with a time horizon of 20 or more years.

Importantly, some investors will want to consider how liquid their position may be. Real estate investments are often illiquid investments, so make sure you consider the length of your investment.

Step 3 – Understand Syndication and Sponsors

Choosing the best investment vehicle for your first multifamily real estate deal could easily be an entire article itself. I won’t go into many of the specifics and will focus primarily on syndication. Why? Syndicates tend to be the most reliable way for investors to get started in multifamily real estate. There are a few important things to know about syndication and syndicates.

Syndicate Structure

Here I want to talk about what you should know about syndicates, including those listed as a limited partnership (LP) and those listed as a limited liability corporation (LLC). Both LP and LLC syndicates have different structures and rules, which you should read carefully. The rules outline voting rights, distribution rights, and fees. Some have a waterfall structure, which means certain investors get paid before others. An LLC is often used to protect the sponsor by limiting liability, a good thing to note when selecting a syndicate. Profits are often split 50/50 or 70/30 between passive investors and general partners.

More common is a syndicate formed as an LLC. The LLC will have multiple classes of members, often Class A investors and Class B investors. Class A usually is preferred, meaning investors in this class receive returns before Class B. The returns can be cumulative, accruing even if no cash is on-hand to pay. Preferred returns are calculated annually put often paid quarterly. Class B, on the other hand, is subordinate to Class A shares, and is paid after Class A. The advantage of Class B is that distributions are often paid and taxable at capital gains rates, not income rates as in the case of Class B.

Syndicate Fees

You’ll want to be aware of the types of fees syndicates charge. They are:

• Acquisition fees – cost to find the deal, organize, purchase the property, and close funding
• Financing fees – fee for acquiring a loan or other financing
• Asset management fees – how much the sponsor is paid to manage the corporate assets
• Property management fees – how much the sponsor is paid to manage the property
• Disposition fees – how much the sponsor receives when the property is sold

Step 4 – Get a List of Sponsors and Deals and Vet Both

Once you’ve defined your investment strategy, equity position, and have researched syndicates, it is time to start searching for sponsors and deals. As a rule of thumb, I recommend selecting sponsors that have committed some of their own capital to the deal.

Finding Deals

Syndicates often require investors to be accredited and that they receive an invite to participate. Invitations come from the head of the syndicate, the sponsor, or from other investors. Connections here are important. If you are new to real estate, contact me and I can help you find syndicates in your market.

In the 21st century, some sponsors have turned to real estate crowdfunding as a way to attract investors. While not a bad way to find sponsors, keep in mind that there may be additional fees associated with the crowdfunding marketplace. Also, many of these sites will list multifamily opportunities alongside commercial real estate. I’ve found too that most of the multifamily deals on these sites are either value add or opportunistic, and may not represent the full breadth of options.

Top real estate crowdfunding platforms include:

• Realty Mogul
• Fundrise
• CrowdStreet

Vetting Deals

This is another section that could easily fill an entire article (or eBook). Here are the broad strokes from my personal experience. Make sure to vet deals based on three factors: the deal, the market, and the sponsor.

In part one we discussed a few of the parameters to consider when assessing a deal. They are:

1. Net operating income (NOI)
2. Cap rate (NOI / sale price)
3. Cash-on-cash ratio
4. IRR
5. The equity multiple (2x, 3x, etc.)
6. 1% rule – monthly rent is 1% of the sale price of the property

You will also want to consider the market you are investing in, including macroeconomic conditions and the particulars of the area around the multifamily unit.

Last, and probably the most important, is the sponsor. I recommend investors rank sponsors on these ten elements:

1. Sponsor team and background
2. Investment strategy and record
3. Investor relations
4. Underwriting assumptions and forecasting
5. Property management strategy
6. Asset management strategy
7. Payout structure
8. Fees
9. Investment duration
10. Exit strategy

Don’t forget to ask for references after you’ve found a sponsor you think is good. Good sponsors with strong track records shouldn’t have any problem providing references.

Part 4 next......