Passive Investing in Multifamily Real Estate Part Two

Part Two: Generating Passive Income

In part one, I introduced you to what will become more popular in the years to come: passive investing in multifamily real estate. For some, either passive investing, multifamily real estate, or both are new topics. When combined, the two make for a powerful way to build long-term wealth. Historically, real estate has offered more up years compared to popular investment options like stocks and bonds.

If you didn’t get a chance to read part one, I recommend you read through it before continuing, as part one forms the foundation for this entire series. In that article, we discussed the fundamentals of passive investing, passive investing advantages, the benefits of multifamily real estate over single-family, and multifamily investor syndicates.

This article will explain how passive income works in multifamily real estate. Remember, the goal as a passive investor is to generate strong, consistent returns with minimal day-to-day effort. We will answer the following question: How does passive income for multifamily real estate work?

Passive Income for Multifamily Real Estate

As we learned in part one, passive investors will invest in multifamily real estate as part of an investment group, partnership, or a syndicate. In later parts, we will discuss the different investment vehicle forms, such as Limited Partnerships (LPs) and Limited Liability Corporations (LLCs). The important point here is that you are investing in a portion of a multifamily real estate investment, and leaving the day-to-day management to others. With a syndicate, you will likely pay a sponsor fee, which covers the administrative overhead of the sponsor.

The goal of a passive investor is to generate a stable, consistent source (or sources) of passive income, all with little day-to-day effort. As an asset class, multifamily real estate is an excellent way to access stable returns. Consider the yearly returns on apartment complexes, from 1984 through 2017.

But more than just returns, multifamily real estate offers three distinct options for generating wealth over time:

• Monthly cash flow
• Appreciation
• Tax benefits

Read on as we dig into each of the three ways you can generate passive returns with your multifamily real estate holdings.

Periodic Cash Flow

Periodic cash flow forms the cornerstone of a multifamily passive investing strategy. What attracts many to real estate is the opportunity to receive regular cash flow distributions. A multifamily dwelling will collect rent from tenets, which go to running the property, paying off debt, and providing monthly or quarterly distributions. These periodic payments will vary greatly, depending on the investment amount and property profitability.

You may have heard of cash-on-cash return (or yield). In short, this metric tracks the relationship between the original equity investment in the property and its cash flow. From the perspective of a syndicate, this is the profits after paying debt and operating expenses. As an investor, knowing the cash-on-cash return is the most useful way to estimate how much income you will receive. Importantly, when investing with a syndicate, the total cash paid out may be less than the cash-on-cash return. Let’s look at an example.

An investor invests $20,000 in a multifamily apartment building that offers $2,000 per year in cash flow. Cash-on-cash for the year would be 10%. However, a syndicate may restrict distribution to 5%, leaving the investor with $1,000 per year, a 5% return. The withheld $1,000 may be distributed later or re-invested into the property.

Appreciation

In the previous example, 5% or $1,000, of the investor’s yearly cash flow was potentially reinvested in the property. This highlights the second way to generate passive income with multifamily real estate: appreciation.

While some investors will strongly prefer a monthly, quarterly, or yearly distribution, others prefer lump sum returns at a future date. Part of building wealth is having your money accrue value over time. Investing in multifamily real estate does just that – invest in property that will sell three, five, seven, or nine years later for a solid return.

As a passive investor, you are generating income from the appreciation of a property. That extra $1,000 of your income that the syndicate reinvests is used to grow the value of the multifamily dwelling. When the property is sold, you as the passive investor will have gained both the income distributions and the total return of the property over time.

This rate over time is called the IRR, or internal rate of return. The IRR gives an investor a big-picture view of the expected return on the property over a period of time. This is different than the cash-on-cash return, which is a measure of periodic yield.

In our earlier example, our yearly cash return was 5% (with 5% withheld for growth purposes). Let’s say the investment period on our multifamily property is 6 years. The IRR for this would include the 5% cash yield plus the expected growth of the investment. Depending on the property and market, the IRR could range from as low as 10% to 21% or more.

Tax Benefits

I’ve written in an earlier blog post on the tax advantages of multifamily real estate. Any method that reduces your yearly taxable income burden is effectively income in your pocket. While taxes may not be the first aspect investors consider when investing in multifamily real estate, it is heavily influences how high of a return any given investment yields.

When investing in a syndicate, you are pooling money with other investors, which is run by a sponsor. Surprisingly, this gives you access to a wealth of tax benefits. Income distributions can be treated as a return of capital, making the distributions tax free. It is also possible to receive distributions and still have a tax loss for the year, provided the property is cash-flow positive but negative income.

Importantly, tax implications are similar to if you owned the property. However, there will be differences in terms of the limitations on deductions for passive losses, as stipulated by the IRS.

Not Quite Passive Income But Still Valuable

While passive investing and passive income are the focus of this series, I want to touch on briefly a few additional advantages of multifamily real estate. Any strategy focused on true wealth creation will naturally tend towards the big three – periodic cash flow, appreciation, and tax advantages – while offering a host of other options. They include:

• Risk reduction: through investing with other investors as part of an LP, LLC, or syndicate
• Consistent returns: the proven value of real estate as an asset class over time
• Inflation hedge: rents rise with inflation, making hard assets like multifamily real estate a good investment

Now that we’ve covered the basics of passive investing in multifamily, part 3 tomorrow will discuss how to get started with your first deal.