All Forum Posts by: Ellie Perlman

There are numerous advantages to investing alongside a syndicator, such as having access to more investment opportunities, diversification, enjoying high returns at a lower risk, etc. But as a passive investor, you need to make sure that the syndicator’s interests align with yours.

Alignment of interest is crucial, since syndicators receive fees or managing the deal and managing investors’ money part of their compensation. The most common fees are:

~ acquisitions fee (paid to syndicators once the deal closes)

~ asset management fee (paid yearly/quarterly from property’s net income)

~ disposition fee (paid once the property is sold)

This fee structure can bring a conflict of interest between the syndicator and you, the passive investor. You want to make sure that the syndicator purchased the property because it was a great deal, or sold it at the right time to maximize investor’s returns, and not because the fee was tempting. Sometimes it’s not black and white; I’m not saying that syndicators buy or sell properties just to get fees, but they will be more careful if they had some skin in the game. The question is…how do you make sure of that?

In one of my previous blogs I wrote about syndication and how it works, but before you get to that, there are a few things you must pay attention to. When you are looking to take the leap into a new investment venture and invest passively, choosing the right syndicator is key.

Here are just a few ways you can make sure the syndicator’s interests are in line with yours.

1. The Syndicator Invests His/Her Own Money in the Deal

Always ask the syndicator if he/she is investing in the deal. When a syndicator invests his/her money in the deal — you know their interests are aligned with yours; after all, they put money from their own pockets in the deal and have the same risks as you. This is how REITs are different than some syndicators — they only take fees and never invest their own money in the deals. Their interests are to maximize their fees and that has a potential for a conflict of interests.

2. Make Sure You Have a Preferred Returns Mechanism

Not all syndicators give preferred returns, but as a passive investor, having such a mechanism is in your best interest. The preferred return is a return on investment that the syndicator offers to investors with the purpose of mitigating the risk associated with investing capital in the deal. Typically, you, as a passive investor, will be promised to get first dibs on profit at a rate of X%, as long as the partnership generates enough cash flow to pay it. Preferred returns are usually 6%-8%. The preferred returns is paid BEFORE the Syndicator receives any fees associated with the investment. Hence, the syndicator is extremely motivated to work hard to make the investment as profitable as possible.

3. The Syndicator Signs on the Loan as A KP (Key Principal) and Becomes a Loan Guarantor

By doing this, the syndicator is putting their balance sheet on the line, since even though most commercial real estate loans are non-recourse, they will become recourse if the syndicator commits a fraud. In that case, the lender is able to collect 100% of the loan balance from the syndicator’s personal wealth. As such, signing onto the loan is a way for the syndicator to vouch for their character. They have a lot to lose, and their interests are aligned.

To conclude, I cannot stress the importance of making sure you end up with the right syndicator and looking at these three ways will guide you in the process. Once you do choose the right syndicator, it is up to you to oversee the investment. 

Generally speaking, there are two main strategies when buying multifamily properties: Turn Key and Value Add. These strategies are very different and both have pros and cons.

In a turn key investment, the buyer does not plan on making any significant changes to the property. They might change the property management company, but the property simply changes hands and everything else stays the same: the rents, design, amenities, etc. Turn Key deals usually provide lower returns. Value-Add, on the other hand, is a very popular type of investment today, and I usually do not consider deals that have no value-add component. In a value-add deal, the buyer is looking for a way to increase the property’s profitability. It can be done by applying any of these methods:

1. Renovating the amenities, property exterior or units and increasing rents.Syndicators conduct a market research and analyze nearby buildings with similar vintage (age), amenities and renovation level. If they find that a property is charging rents that are lower than the comps, then it is a great opportunity to renovate the building and increase rents to match the nearby, nicer buildings. The gap between the current rents and the new, higher rents is called the “premium.” Some of the most popular value-add strategies are:

a. Renovating the unit’s interiors (kitchen, floors, bathrooms, paint throughout the unit, etc.)

b. Adding washers and dryers to the apartments

c. Adding reserved parking

d. Renovating or adding new amenities (gyms, package distribution center, dog parks, etc.)

2. Finding a property that has below market rents and increasing them to match market rents. Some properties are charging lower rents than similar competing properties that have similar amenities and renovation level. It usually happens because of one of the following reasons:

a. An inexperienced property management company who does not understand the market.

b. Mom-and-pop operated properties where the owners are afraid the vacancy will drop due to increasing rents.

3. Applying a RUBS plan to charge tenants more for a more accurate use of utilities.Ratio Utility Billing System (RUBS) is a system through which the owner can bill back the tenants for their utility usage based on formulas that take into account the unit size and number of occupants. RUBS is a more accurate way to bill tenants on their utility consumptions and helps to increase income and reduce expenses.

4. Bringing in a new property management company to manage the property more efficiently and reduce costs. In multifamily properties, the income to expense ratio is anywhere from 45% to 55% (for 100 units and above). A great value-add opportunity is a property that is mismanaged and its expenses are higher than they should be. If an investor can find a property that is managed on a 60% expense ratio and can lower it to 55%, they can increase the cash flow from the property and the building’s value as well.

Since a multifamily property’s value is mainly based on the property’s income, by adding value and cutting costs syndicators can sell the property for a higher price after holding it for several years. That is the main reason why many investors, including myself, are focused on value-add deals.

A final word of caution: not every property is suitable for a value-add plan. Even the nicest apartment cannot guarantee that someone will want or be able to pay the premium to live in it. A good value-add candidate is one who is in a strong area where people with sufficient income live and can afford to pay for the upgraded unit.

So Which Strategy Is Better?

When investing in renovated units and amenities there is always the risk of not being able to charge higher rents (a shift in the economy, mistake in pricing, etc.). This risk does not exist in a turn key deal. However, your value-add deals provide higher returns than turn key deals, and for good reason. An investor that is willing to put the time, money and effort to improve the property will be rewarded, as long as they know the area and the property well.

The COVID-19 pandemic has caused an upheaval in almost every industry, and that includes real estate. Many real estate investors are scrambling to determine whether their investments will be able to withstand the impact that the pandemic has on the economy. There is no right answer, as there are many different types of real estate investments, including commercial, retail, and multifamily.

While there will certainly be some real estate investments that will have adverse effects due to the pandemic, not all will be struggling. In addition to the type of real estate involved, the location where the investment is located might also play a key role as to whether or not the impact will be more or less severe.

Property Type 1: Those in COVID Hot Zones

You don’t have to be an expert to realize that real estate assets located in pandemic hot zones will not perform well. Originally, the hot zones were located in New York along with cities in the Northeast corridor and the Midwest. Today, those hot zones have shifted (to California for instance), and will continue to shift. However, one thing is clear: many people in the hot zones are moving either to other states, or to the suburbs where it’s less crowded and exposure is minimized.

I like to review reports, and in doing so I found an interesting correlation between last year’s performance and this year’s. One report in particular showed that over the past 12 months, the average return on multifamily properties was around 5%. If you look at markets that were in the hot zone like New York, the average return was around 1%. In Los Angeles, the average return was 3.75%. This shows the correlation between areas that were struggling with COVID-19, and their average returns over the past 12 months. It also shows that you want to avoid investing in assets located in hot zones, because they’re simply not performing that well thanks to the pandemic.

Property Type 2: C and D Asset Classes

The asset classes that are struggling the most right now are Class C and Class D properties. Class A properties are the luxury multifamily properties with all the amenities and are usually new construction or built within the past 7 to 10 years. Class B properties are somewhat older than Class A and may have some deferred maintenance. I like to buy Class B properties, as they’re the ones that we can renovate and upgrade in order to increase rents.

Class C properties are much older, usually built in the ‘60’s, 70’s and 80’s, and are located in areas that are not ideal. Class D properties are the oldest ones and have the most deferred maintenance. They’re often located in areas that are the least desirable, and have trouble attracting tenants.

The reason that Class C and D properties are struggling now are because the tenants are usually employed in the service industries, which have low paying jobs. These are the people who have lost their jobs due to the pandemic and are having the most trouble paying their rent. Currently, Class B are the highest performers, followed by Class A. Only then does Class C show up, followed by Class D as the lowest performing asset.

Property Type 3: Hands-off Sponsors

Even though I live in Southern California, most of the properties I own or manage are located in Texas, Georgia and Florida. Part of our process in managing our assets is to contact the property management company to review reports that include occupancy rates, vacancy rates, rent collections, and other metrics that show how the property is performing. Since COVID-19 began, we’ve been having these talks on almost a daily basis in order to stay on top of our property’s performance.

We’ve found that assets with hands-off sponsors are simply not doing as well as assets that have aggressive sponsors who are in constant contact with their property management companies. By having daily contract with property management companies, we can look at numbers and see when properties are moving in the wrong direction and adjust our approach on the spot, rather than waiting for a period of time to pass. This quick response is what helps to keep our assets performing well. If a sponsor is “hands-off,” it may take time to see that there’s a problem with the numbers, and if too much time elapses, it may be hard to fix the problem.

Property Type 4: Downtown Locations

Other assets that are not performing well in this post-COVID-19 market are those located in downtown areas of large cities or in a very crowded submarket. The reasons is that tenants are concerned about being infected with the virus based on how crowded the market is, and they’re moving in with family and friends in other states or less crowded areas. This eliminates having to share an elevator with 300-500 tenants, minimizing their exposure.

This impacts the properties with reduced rent collections, increased vacancies, and often requires property managers to offer different types of rent concessions and move-in specials in order to attract or retain tenants. That is why these types of properties are not performing well. The more frequently the property is reviewed and implemented with needed intervention, the better the asset will perform.

Property Type 5: Overpriced Properties

The final type of properties that aren’t doing well are those that were overpriced when purchased. Prior to COVID-19 , the market was strong, prices held steady and sponsors were projecting growth to investors. The problem was that prices were driven up by the strong market, and sponsors and their investors were overpaying for properties because there was a shortage of multifamily properties in strong markets. Another reason for overpaying was that many new sponsors wanted to get in on the growth of multifamily properties. They pushed aside running numbers and good judgment and overpaid.

For example, prior to COVID-19, investors were paying $135,000 per door for units that should have sold for $120,000. The sponsor figured that if he or she renovated 10 to 12 units per month and increased the rents by a $200 premium per unit, they would have enough cash flow to pay for the higher prices. But then the pandemic came along and many sponsors and investors found themselves holding on to properties that they overpaid for and realized that they weren’t going to be able to do value-add and renovate their properties in order to justify the premium they had anticipated.

Sponsors who did overpay for multifamily properties before the pandemic hit are finding that they are paying a very large portion of their monthly income to the lender. Those payments don’t leave much money at the end of the month for anything else. Sponsors who overpaid and still anticipated 9% cash-on-cash returns for the year aren’t coming anywhere close to that number.

The COVID-19 pandemic has caused an upheaval in almost every industry, and that includes real estate. Many real estate investors are scrambling to determine whether their investments will be able to withstand the impact that the pandemic has on the economy. There is no right answer, as there are many different types of real estate investments, including commercial, retail, and multifamily.

While there will certainly be some real estate investments that will have adverse effects due to the pandemic, not all will be struggling. In addition to the type of real estate involved, the location where the investment is located might also play a key role as to whether or not the impact will be more or less severe.

Property Type 1: Those in COVID Hot Zones

You don’t have to be an expert to realize that real estate assets located in pandemic hot zones will not perform well. Originally, the hot zones were located in New York along with cities in the Northeast corridor and the Midwest. Today, those hot zones have shifted (to California for instance), and will continue to shift. However, one thing is clear: many people in the hot zones are moving either to other states, or to the suburbs where it’s less crowded and exposure is minimized.

I like to review reports, and in doing so I found an interesting correlation between last year’s performance and this year’s. One report in particular showed that over the past 12 months, the average return on multifamily properties was around 5%. If you look at markets that were in the hot zone like New York, the average return was around 1%. In Los Angeles, the average return was 3.75%. This shows the correlation between areas that were struggling with COVID-19, and their average returns over the past 12 months. It also shows that you want to avoid investing in assets located in hot zones, because they’re simply not performing that well thanks to the pandemic.

Property Type 2: C and D Asset Classes

The asset classes that are struggling the most right now are Class C and Class D properties. Class A properties are the luxury multifamily properties with all the amenities and are usually new construction or built within the past 7 to 10 years. Class B properties are somewhat older than Class A and may have some deferred maintenance. I like to buy Class B properties, as they’re the ones that we can renovate and upgrade in order to increase rents.

Class C properties are much older, usually built in the ‘60’s, 70’s and 80’s, and are located in areas that are not ideal. Class D properties are the oldest ones and have the most deferred maintenance. They’re often located in areas that are the least desirable, and have trouble attracting tenants.

The reason that Class C and D properties are struggling now are because the tenants are usually employed in the service industries, which have low paying jobs. These are the people who have lost their jobs due to the pandemic and are having the most trouble paying their rent. Currently, Class B are the highest performers, followed by Class A. Only then does Class C show up, followed by Class D as the lowest performing asset.

Property Type 3: Hands-off Sponsors

Even though I live in Southern California, most of the properties I own or manage are located in Texas, Georgia and Florida. Part of our process in managing our assets is to contact the property management company to review reports that include occupancy rates, vacancy rates, rent collections, and other metrics that show how the property is performing. Since COVID-19 began, we’ve been having these talks on almost a daily basis in order to stay on top of our property’s performance.

We’ve found that assets with hands-off sponsors are simply not doing as well as assets that have aggressive sponsors who are in constant contact with their property management companies. By having daily contract with property management companies, we can look at numbers and see when properties are moving in the wrong direction and adjust our approach on the spot, rather than waiting for a period of time to pass. This quick response is what helps to keep our assets performing well. If a sponsor is “hands-off,” it may take time to see that there’s a problem with the numbers, and if too much time elapses, it may be hard to fix the problem.

Property Type 4: Downtown Locations

Other assets that are not performing well in this post-COVID-19 market are those located in downtown areas of large cities or in a very crowded submarket. The reasons is that tenants are concerned about being infected with the virus based on how crowded the market is, and they’re moving in with family and friends in other states or less crowded areas. This eliminates having to share an elevator with 300-500 tenants, minimizing their exposure.

This impacts the properties with reduced rent collections, increased vacancies, and often requires property managers to offer different types of rent concessions and move-in specials in order to attract or retain tenants. That is why these types of properties are not performing well. The more frequently the property is reviewed and implemented with needed intervention, the better the asset will perform.

Property Type 5: Overpriced Properties

The final type of properties that aren’t doing well are those that were overpriced when purchased. Prior to COVID-19 , the market was strong, prices held steady and sponsors were projecting growth to investors. The problem was that prices were driven up by the strong market, and sponsors and their investors were overpaying for properties because there was a shortage of multifamily properties in strong markets. Another reason for overpaying was that many new sponsors wanted to get in on the growth of multifamily properties. They pushed aside running numbers and good judgment and overpaid.

For example, prior to COVID-19, investors were paying $135,000 per door for units that should have sold for $120,000. The sponsor figured that if he or she renovated 10 to 12 units per month and increased the rents by a $200 premium per unit, they would have enough cash flow to pay for the higher prices. But then the pandemic came along and many sponsors and investors found themselves holding on to properties that they overpaid for and realized that they weren’t going to be able to do value-add and renovate their properties in order to justify the premium they had anticipated.

Sponsors who did overpay for multifamily properties before the pandemic hit are finding that they are paying a very large portion of their monthly income to the lender. Those payments don’t leave much money at the end of the month for anything else. Sponsors who overpaid and still anticipated 9% cash-on-cash returns for the year aren’t coming anywhere close to that number.

There are many misconceptions about investing in multifamily real estate during the pandemic, but I’ve highlighted the top 3 for you to consider. These are the ones many colleagues and investors are talking about.

Misconception #3: The asset classes that performed well during the “great recession” are the ones you want to invest in now.

During the great recession, a lot of homeowners lost their homes. Many of those homeowners purchased their homes without having the necessary resources, income, and down payment, and ended up losing their homes. But people still (and will always) need a place to live. Those homeowners couldn’t afford to rent in Class A multifamily properties, and for many, Class B was expensive as well.

So, how did this impact the market during the great recession? The asset class that was in high demand post the 2008 recession was Class C properties. Many investors purchased Class C properties during that time, thinking that if another recession were to occur, they would have the ideal property to rent. After all, it was the most resilient asset class during the great recession. However, the current pandemic changed that, as the those who lost their jobs and fueled the 13% unemployment were mostly service workers with low paying jobs – the classic Class C and D property tenants.

Unfortunately, it meant that many of those tenants couldn’t afford Class C properties and could only look to rent Class D properties. Class D properties became the leader in rental demand during the pandemic, not the Class C properties that investors had thought would take the lead. While Class D properties are in great demand, they do have many challenges with rent collections and more deferred maintenance.

Sadly, for many investors, Class C properties didn’t turn out to be the “winning asset class” that they thought they would be. This shows me you can learn new things from each recession, and that you simply can’t replicate the same thinking and strategy each time, as it might not protect you during the next downturn.

Misconception #2: Deals today should have high returns because you’re buying in a down market.

During the great recession of 2008, the market was down, and real estate investors who were able to purchase properties at the right time in the right market were able to generate high returns. While we’re now seeing a down market due to the COVID-19 pandemic, conservative investors and sponsors like myself should actually expect lower returns, not higher.

When purchasing a property, the property value is based on Net Operating Income (income minus expenses) divided by the cap rate. When it comes to estimating the IRR, the resell price has a major impact on the profits. So, if you estimate a very high exit price, you will see a high IRR and cash-on-cash.

The higher the cap rate, the lower the price, and to be on the safe side, we always assume a higher cap rate when we sell the property, because we are assuming that the market will be worse than it is now. If you assume there will be a higher exit cap when you sell your property than the current cap rate, your returns will be lower, and it’s always better to assume worse market conditions and lower returns. If you got it wrong and you were able to sell the property at a much higher price, then your returns will be higher, but assuming the worst means lower returns, and a much more conservative approach.

Rent growth is another reason that returns may be lower. Before the pandemic, we would assume that there would be rent growth of 3% to 4% each year. Now, we’re assuming rent growth of 0% to 1%, especially during the first year of operations. It’s due to the uncertainty of rent collections, occupancy rates, and fluctuating employment numbers because of COVID-19. Nobody really knows what rent growth will be, so it’s best to estimate low.

Another reason returns may be lower since the pandemic is that renovations are being done slower and premiums might be lower than expected. Our business model is to purchase properties and do value-add renovations in order to increase rents. Though we haven’t stopped renovating during COVID, we have adjusted our model to Renovations on Demand. When a new prospective tenant shows up to see some available units, we show them a classic (non-renovated) unit and a renovated unit and let them choose which one they want to rent. The choice is theirs, and surprisingly, over the past three months, over 70% of new tenants chose the renovated unit.

However, this slower renovation pace does certainly impact the returns, which are lower. Prior to COVID-19 we assumed that we would be able to rent every available unit, which might amount to ten to twelve per month. Post-pandemic, this is being done at a much slower pace, which ultimately impacts returns.

Lastly, we underwrite a higher delinquency and vacancy, just to be on the safe side. Taking all these factors into consideration, it’s easy to see why, at least on paper, returns should be lower.

Misconception #1: It’s risky to invest in real estate now.

Realistically speaking, there were bad deals before COVID-19, and there were good deals as well. There are bad deals now, as there are good deals. It might be slightly riskier now due to some uncertainties, like employment, occupancy rates, and lower rent increases, but most can be mitigated.

To better understand how risky an investment is, you can look at the break-even point of the property. So, for example, if the break-even point is 60% occupancy, that means that if 40% of your tenants are leaving or not paying rent, only then are you breaking even. And remember, that’s just breaking even – it’s not losing any money. That’s a very extreme scenario, even during the pandemic, considering that current occupancy rates are 92% to 95%.

While there is some risk investing during a pandemic, if you assume it’s too risky to invest in multifamily real estate now, you’ll be missing out on some potentially profitable deals. Each market is different, and tenants are different in different areas as well. You have to do your research; a good starting point is www.citydata.com. You can find employment figures, comparable rents, crime statistics and so much more. By doing your due diligence on specific areas, you’ll have a better idea of which markets are considered a strong real estate market.

The first type of investor is The Appreciation Investor. This type of investor is someone who is not looking to make money on the short run, but rather, expects the property’s value to SIGNIFICANTLY increase over time. These are speculative investors, because let’s face it – nobody has a crystal ball. Yet if investors know the market well, how it behaved in the last recession and have a strong belief that it will improve significantly, they invest in this market. They are not looking for immediate returns. Amon those investors you will find foreign investors, who need to park their money somewhere, and any alternative is better than what they have right now in their hometown. Another type are REITs and large real state companies.

The second type of investor is The Cash Flow Investor. This investor is more conservative than the Appreciation Investor and look for short term returns. This investor doesn’t put a large emphasis on the future appreciation of the property, and will never invest in a property that does not produce positive cash flow (money left after all expenses and debt have been paid). Some Cash Flow Investors are willing to accept no or little cash flow during a rehab period if they invest in a value add deal – because they expect to get a much higher cash flow once the rehab period is over.

As for me? I am a classic Cash Flow Investor. When I look at a deal, I always assume that when I plan to exit (in 5-7 years from the purchase date), the market is not strong and that real estate prices are falling. If the property is not cash flowing from day 1 – I pass on the opportunity.

There is no right or wrong here. It’s a matter of personal preference, appetite for risk and investing philosophy. What type of investor are you?

The Exit Cap

I chose to start with the Exit cap because it seems like a small factor in the syndicator’s underwriting and is often overlooked by many passive investors. However, it’s one of the most important factors in any underwriting that can significantly affect returns and can be the difference between a failing investment and a successful one.

The Cap or Cap Rate is the ratio between the Net Operating income (NOI) and the purchase price. The lower the cap rate – the more you pay for a property, relative to its NOI, and vice versa. Sellers always aim to sell their properties at the lowest cap rate, and the buyers' interest is to buy properties with the best cap rates.

The Exit Cap is the cap rate that the syndicator assumes they will be able to sell the property for by the end of the holding period (at time of exit). If you only change the Exit Cap by, say, half a percent, that can increase the IRR and CoC significantly. Yet the Exit Cap is the most speculative part of the underwriting – none of us have a crystal ball and nobody knows how the market will behave in 3-5 years from now, when it's time to sell, or even a year from now. Hence, two syndicators can look at the same deal and share similar assumptions when it comes to putsches price, rent, expense increases and even premiums (the increase in rents achieved by implementing a value-add plan – rehabbing the property and renovating the units). If they assume different Exit Cap rates, the more conservative syndicator – the one who assumes a higher Exit Cap than the cap rate at purchase – may pass on the deal, since the underwriting will show low returns, while the other syndicator – who assumes a lower cap rate – might end up buying the property, since their calculations will show much higher returns.

Actionable Advice: always ask the syndicator what cap rate they purchased the property at, and what is their assumed Exit Cap. Then try to assess if the gap is reasonable. For example, I usually assume an Exit Cap that is 0.5% to 1% HIGHER than the cap rate at purchase. I am very conservative in nature (something I inherited from my years of practicing law) and assume that in 5-6 years the market will not be as strong as it is today, and property prices will DROP. If the deal still works with conservative assumptions – then it’s a great deal.

Expense to Income Ratio

As a rule of thumb, and it changes based on the market and property size, expenses should be around 50% of the income. Many syndicators find deals where the income-expense ratio is higher (say 65%) and optimize expenses, usually by bringing an experienced property management company to manage the property. As a passive investor, you should look at the NEW income-expense ratio closely and ask yourself: is the ratio reasonable? If the syndicator assumes a 33% ratio, that might not be realistic.

Additionally, examine by how much the syndicator predicts they can narrow that ratio. Does the syndicator assume they can bring that ratio from 70% to 50%? It’s a pretty significant change and could be hard to achieve in some cases.

If a syndicator assumes they can manage the property better than the seller, it's important to understand their experience in managing multifamily properties, and the same goes for the property management company that will manage the building.

Actionable Advice: look at the current income-expense ratio and the one that the syndicator is aiming to achieve (as indicated in the pro forma). If the pro forma ratio is lower than 50% or if the syndicator assumes they can significantly lower expenses, ask the syndicator how they arrived at those numbers.

Renovation Plan

Many value-add syndicators, like myself, buy multifamily properties that need some work. They will improve the amenities, add new ones, and renovate the units. By improving the overall look and functionality of the building, they’ll be able to increase rental rates as well as making the property more attractive to the next buyer.

Passive investors who examine a new opportunity should inquire about the renovation plan and understand the specifics, instead of simply evaluating a high-level plan. A good passive investor will ask:

- Can local demographic pay for the renovated units? A syndicator can turn an old unit to a state-of-the-art apartment – but if the building is in a bad neighborhood – not many will be able to pay $200 more for a nicer apartment. Now, the situation might not be that extreme, and yet, even in a decent neighborhood, some syndicators struggle to find tenants who will pay a higher price for a renovated unit. Look at the rent comps if provided by the syndicator or ask them for the information. Understand if there are other nearby buildings with similar vintage (age) and amenities that charge higher rents – this will be a good indication that it’s possible to increase rents.

- How many units does the syndicator plan to complete every year? Does the syndicator assume they can complete a large scope renovation in a short period of time? Renovating a 200-unit apartment building can take 24 months, and sometimes longer. As a passive investor, try to assess if the time frame for a complete renovation is reasonable, and ask the syndicator how they plan to complete it within the anticipated time frame.

- How experienced is the syndicator and the property management in rehabbing properties in this market? An experienced team would know what features are popular among the locals, where to buy high quality materials for the best prices, and whether, as I mentioned earlier, the locals will be willing and able to pay premiums for the upgraded units.

- How high are the premiums? Generally speaking, bumping rents by $400 for a renovated unit might not be easy. Most premiums fall into the $75-$150 range and are considered reasonable. It depends on the specifics of each deal and the market (if rents are under market, for instance, it can be achieved). A passive investor who sees a projected high premium should inquire about the achievability of new rents.

Demand Drivers

Demand drivers are key in every investment. It’s what draws people to a specific market/area/neighborhood. Look for demand drivers in the syndicator’s materials – is there any reference to job growth? Population growth? Is there a new and promising project nearby – such as a new shopping center, employment center, or even a major road? All these factors will strengthen tenant’s demand for the property. If this aspect is missing in the summary – ask yourself why? Is it because the area is not desirable or strong enough? Is it because the syndicator does not know the area that well? Or it is something else?

Actionable Advice: look for demand drivers and understand them. Always talk with the syndicator about the demand drivers and try to assess how familiar they are with the area. You obviously want someone who knows the location very well.

Refinance and Bridge Loan

Many syndicators project a refinance after 2-3 years, after they improve the NOI. Similarly, if the property is not eligible for an agency loan (if it's not 90% occupied for the last 90 days), then many syndicators take a bridge loan – which is often, if not always, at a higher rate than an agency loan, hoping to stabilize the property and take an agency loan then.

This strategy can definitely work, but there's also some risk involved. What happens if the syndicator won't be able to stabilize the property and get an agency loan? What if in two years interest rates rise even more and a refinance will not be attractive? Or if the syndicator will not be able to improve the NOI? As a passive investor, you need to understand that when a syndicator assumes a refinance event or a bridge loan, it can significantly affect the returns calculation. Without getting too technical, a sensitivity analysis can reveal returns you can expect if a refinance event will not happen, or if it would take longer to stabilize the property and get out of a bridge loan.

Actionable Advice: make sure to ask the syndicator to show you the returns WITHOUT refinancing or with a longer period of a bridge loan. This way you can make sure that your money is more likely to be safe, even if the financing plan doesn’t go as planned.

 That’s a great question Tim. I normally assume that the real estate market is worse than it is now, which means higher cap rate at exit. My rule of thumb is 10 to 15 basis points higher per year of holding.

Here are 5 steps you should follow when considering an opportunity to join a syndication as a passive investor.

Step 1: Determine the Exact Nature of the Opportunity

Ostensibly, this is the very first step that one should take before considering a real estate opportunity. It is imperative to determine the nature of deal;

• Location: is the property located in an area you feel comfortable with? Is it in a market that you are familiar with or at least comfortable with. Some investors like to invest in their ‘backyard’ and some are comfortable investing out of state. Additionally, make sure you understand the location’s demographics profile – is the property located in a decent area or in a crime zone? If you are unfamiliar with a certain city or neighborhood, look up the crime rate on Trulia and Google the city/neighborhood name to gather more information that will help you assess whether the property is located in a decent area or in a crime zone. Some investors have a higher appetite for risk, where returns are high, but the risk is high as well. Knowing your preference when it comes to property’s location can help you save time and focus on the right deals for you.
• Hold period: take a close look at the business plan – does the syndicator plan to hold the property for 3-5 years? 10 years? Longer? Every investor is comfortable with a different time frame, and knowing your ideal hold period will help you screen the numerous investment opportunities out there and focus on the ones that fit your needs.
• Risk Profile: is the deal low risk (core or core plus, no renovation or raising rents needed) or a high risk (repositioning of a Class B apartment building in a Class D neighborhood). Make sure you understand your appetite for risk before making a decision to join a syndication. Don't be tempted by high returns! The higher the returns, the higher the risk, so make sure you are comfortable with the risk associated with the deal.
• Return Driver: is the opportunity based on appreciation (low cash flow throughout the hold period and high appreciation factor), cash flow (high cash flow during the hold period with a modest appreciation projections), or both. Finding opportunities that have strong cash flow and appreciation is ideal, but very hard to find these days. It’s a balancing act and you should know in advance if you favor cash flow or appreciation as a main driver for returns.

Step 2: Evaluate the Sponsor’s Experience

Once you decide that an investment opportunity is the right opportunity for you, the next step involves evaluating the experience of the sponsors. Consider the experience level and competence of not only the sponsor, but of the sponsorship team as a whole. A sponsorship team with a well-balanced backgrounds and experiences in real estate and outside of it can be a great asset and will add unique value to the deal.

Step 3: Look for Your Ideal Return

The most experienced and seasoned players in the realm of passive investment provide effective clues and guidance, when it comes to looking for an appropriate and most preferred return. In fact, in their book it’s not feasible to consider any passive opportunity unless and until it does not include a preferred return for them. It’s best to take a leaf out of their book as a preferred return essentially guarantees receipt of the first installment of the profit amount, before it’s split for the manager’s share. When this happens, it helps in recouping the original investment amount on a priority basis. The amount of return definitely depends upon the level of experience at the end of the day.

Step 4: Review the Profit Distribution

Profit distribution is one of the most critical factors in any investment as this determines the ROI at the end of the day. Thus, it's extremely important to review this factor before considering any opportunity of passive investment. Profit distribution ironically depends upon the managers' experience and their share of contribution in terms of work and labor throughout the lifespan of the investment opportunity. Some sponsors offer an equity spilt that ranges between 5%-95% and 30%-70% (where 95% and 70% goes to the investors, respectively). Generally speaking, the more experienced the sponsor, the higher their share. In this scenario, the sponsor will receive an agreed portion of the profit regardless of their performance (with the exception of a preferred return payout).

Another format of profit distribution is waterfall. Waterfall distribution is directly related to the sponsor’s performance and allocates a higher portion of the profit the higher returns the sponsor provides. Today, however the vast majority of sponsors don’t offer this option.

As a passive investor, you should decide which profit share mechanism you are most comfortable with.

Step 5: Evaluate the Pro Forma Assumptions

One of the most effective mechanisms to ascertain whether one is dealing with an aggressive management or a conservative one is by reviewing the assumptions used in Pro Forma. These assumptions provide a first-hand feel of whether the opportunity is going to perform as ascertained. However, the goal should be to look for a conservative manager, who will be using the conservative assumptions to make sure that they are able to under-promise as well as over-perform for setting up long-terms relationship with the investor. The main assumptions you should review are the rent growth trajectory, the occupancy and the exit cap rate. It is advised to have a conversation with the sponsor and ask how they arrived at the assumptions.

When investing in real estate in general, and multifamily in particular, selecting the right market is critical. I personally like multifamily because this asset class outperform all other asset classes. According to CBRE, “Over the past 25 years, multifamily investment has had the highest average returns of any commercial real estate asset class. The 9.8% average annual return is slightly ahead of industrial, and more than 100 basis points greater than office.” But, not all markets perform the same, and knowing which markets are performing well and still generating strong returns, even in a pandemic, is very important information to consider when committing to a potential investment. The reality is that we are now in a recession, and while 9.8% return might not be a realistic expectation in many markets these days, many markets are still capable of achieving solid returns.

Another factor to also pay close attention to is cap rates. Cap Rate indicates the investment risk and calculates what your return could be if you paid for it with 100% cash (no leverage or financing involved). Cap rates are used to value commercial properties in relation to other comparable properties (“comps”) in the area. As a rule of thumb, an attractive investment is to purchase a property with a higher cap rate than its comparable properties in the area, and sell it at a lower cap rate than the one you bought it for. The reason for this is because the lower the cap rate, the more the property will be worth.

Finally, above all else, is demand. Being aware of the percentage of renters within each market, as well as the number of competitors, including new development, is another key factor to take into consideration. After all, even if you get a great deal, without a stable tenant base, the property will not be profitable.

Here are the 2nd quarter of 2020 top 12 markets for US multifamily total returns:

12. Boston, MA

Annualized Total Return: 3.7%

2020 Average Cap Rates: 4.6% - 6.0%

Renter Percentage: 38.16%

11. Palm Beach, FL

Annualized Total Return: 4.0%

2020 Average Cap Rates: 4.6% - 6.0%

Renter Percentage: 30.52%

10. Seattle, WA

Annualized Total Return: 4.1%

2020 Average Cap Rates: 4.5% - 6.1%

Renter Percentage: 40.01%

9. Atlanta, GA

Annualized Total Return: 4.2%

2020 Average Cap Rates: 4.5% - 6.1%

Renter Percentage: 37.04%

8. Fort Lauderdale, FL

Annualized Total Return: 4.7%

2020 Average Cap Rates: 4.6% - 6.0%

Renter Percentage: 50%

7. Minneapolis, MN

Annualized Total Return: 5.0%

2020 Average Cap Rates: 4.5% - 6.1%

Renter Percentage: 28.43%

6. Tampa, FL

Annualized Total Return: 5.2%

2020 Average Cap Rates: 4.5% - 6.1%

Renter Percentage: 35.62%

5. Denver, CO

Annualized Total Return: 5.5%

2020 Average Cap Rates: 4.5% - 6.1%

Renter Percentage: 35.86%

4. Austin, TX

Annualized Total Return: 5.8%

2020 Average Cap Rates: 4.6% - 6.0%

Renter Percentage: 42.29%

3. Orlando, FL

Annualized Total Return: 6.8%

2020 Average Cap Rates: 4.5% - 6.1%

Renter Percentage: 40.68%

2. Charlotte, NC

Annualized Total Return: 6.9%

2020 Average Cap Rates: 4.5% - 6.1%

Renter Percentage: 47.10%

1. Phoenix, AZ

Annualized Total Return: 10.5%

2020 Average Cap Rates: 4.6% - 6.0%

Renter Percentage: 36.33%

Sources:

Newmark Knight Frank 2Q20 US Multifamily Markets Report

www.Apartmentloanstore.com

Department of Numbers