Two Different Ways to Passively Invest in Multifamily Syndications
I’ve always believed that cash flow helps you quit your job and equity gain creates wealth. This is why your investment strategy has to fit with your current and future life goals. In this article, I would like to share two different ways to passively invest into a multifamily syndication project.
Multifamily Syndication in a Nutshell
When you are driving by a very large apartment site or towering skyscraper, have you ever wondered who actually owns it? Maybe you have, maybe you haven’t. The answer is, all sorts of institutions own these properties. Often they are owned by REITs or Real Estate Investment Trusts. They are companies that own or finance income-producing real estate across a range of property sectors. They can also be owned by insurance companies or other private investment firms used to generate yields for investors. So if you are invested in REITs, which are usually publicly traded or have a whole life insurance policy, you might be indirectly invested in something like this without knowing. However, the returns you get from REITs are very similar to stocks, at a 4-6% range for whole life insurance.
If you are invested in single family homes, then you know that there is something magic referred to as “depreciation.” Depreciation will help you pay less tax on your rental income and in some cases even your active income. We went in-depth on this topic that many folks may benefit from knowing more about, especially during tax season. Click on this link for the full write-up.
If you are investing in real estate through REITs, you might be wondering why you don’t receive the tax benefit of depreciation. This is because you are not investing in real estate directly but rather investing in the trust controlled by the REIT. There is a big difference. You may want to pause and ask yourself who gets the bigger benefit inside the REIT investment vehicle. If it’s not the investors, then learning about different types of investment vehicles is wise.
Going back to our example above, when you drive by a huge apartment and wonder how you can start investing in something like that, different questions may come up for you. “How can I invest in these apartments directly? Don’t I need truck loads of money to do something like that?!” Despite what most people may think, passive investors do not need truck loads of money to be involved. This is where apartment syndication comes in.
There are a lot of legal implications and structures behind apartment syndication which we can save for a future article. Putting into an overly simplified definition, apartment syndication is when people are pooling money together to directly purchase one or more complexes.
Here is a two-part guide that I have created for you to understand more about the passive investing criteria into apartment syndications to propel your Financial Independence.
Part I: Get Your Mindset Ready
Part II: Six Steps to Get to FI (Financial Independence)
Two Ways to Invest in an Apartment Syndication
Let’s talk about two common ways to passively invest into an apartment syndication to give you an idea how these fit into your overall investment strategy.
Equity Partners
The syndicators, AKA “general partners, syndicators or sponsors,” are the ones that acquire the asset, raise money for its purchase, operate, guarantee loans and have control over the apartment complex itself. Passive investors, AKA “limited partners,” are those who invest their money with the syndicators. Passive investors usually don’t have a lot of control or decision-making rights because they do not participate in the operation of the property. This is how they achieve earning passive income, generated by these investments while the sponsors work hard on the project.
Equity Partners, as the name suggests, usually shares some amount of equity with the syndicators. At the time of this writing, I have seen splits ranging from 40% of the profit to passive investors to 90% of the profit to passive investors. The most common split structures I have seen are 70% profit share to passive investors and 30% profit share to the syndicators. This can include some sort of performance based bonus for the syndicators.
An example of these bonuses is that when the project goes beyond certain returns, the top portion gets split 50/50 between the two parties, sponsor team and passives. This type of position usually comes with a cash flow return as well during the holding period. It ranges from 1% to 10% annually with a typical offer around 6-8% annually, at the time of this writing. Typically, the more experienced the syndicator is, the more likely they will get paid a higher portion of the profit because it is considered “safer” to invest with them. They usually have more investors than average sized or small syndicators, thus, they can ask for more.
Equity Partnerships have a lot of upside in terms of wealth creation. The cashflow during the holding period is fantastic, but often, the equity gain is what really makes it a sweet investment. When investing in this asset class, you don’t want to just focus on the cash flow aspect of the deal, but also equity gains. Make sure you have a good understanding of analyzing apartment investments and look out for upside potentials in these deals.
If the syndicators are credible, they will usually project the returns very conservatively and focus on providing transparency and education for their investors. As such, investors should have more upside from what is projected on the equity side. After passively investing in more than 1,000 units myself and being an active syndicator on more than 1,000 units, I’ve realized that while an immediate economic down shift may impact the annual cash flow by a few points, the equity gain is what really makes a difference in these investments. As long as the sponsors budget plenty of buffers and have healthy cash reserves, the apartment projects can ride out any potential economic lows and emerge a winner on the equity side.
If you are looking for building wealth, look for value-add deals where there are improvements to be done on the project to increase its valuation. Look for projects that are located in emerging markets or markets that have strong population growth. Equity gain in a smaller market is harder to achieve as there should be significant management or physical improvements planned for the project that can help the property achieve higher rents.
Equity partnership structured deals are great for high paying professionals who typically have a steady stream of income and can withstand fluctuations in cash flow. These investors are typically aiming at building wealth for 5-7 years in the future.
This type of class typically comes after the Preferred Equity positions mentioned below. It does carry slightly higher risk and is also awarded with higher potential yields. Standard offerings that I see in the current economy is between 13-14% IRR (Internal Rate of Return) with more upside for a value-add project if the syndicator projects conservatively.
The equity partners not only share the equity and cash flow profit, but they also share the tax benefits according to their shares. The depreciation we mentioned before on the buildings will get passed down to the investors through a partnership return issued to them. For the holding period of the project, one typically does not pay much in taxes.
2. Preferred Equity
Preferred Equity is another class of investors inside an apartment syndication project. Preferred Equity is not to be confused with Preferred Return, which means that unless a certain amount of return is achieved, the syndicators do not get paid.
A Preferred Equity Investor usually has higher priority of being paid than Equity Partners. This class of investors are typically offered a fixed rate return that is higher than the offering to an equity partner. A typical annual cash flow return is between 9-10% for Preferred Equity compared to Equity Partners at 6-8%. The downside of this class is that they usually are not sharing the equity upside. This group of investors is provided a relatively lower risk income stream than equity partners. This is because they are usually getting paid before equity partners and any other classes,or groups of investors, in the same deal. Less risk generally leads to less reward.
Preferred Equity partners also have the ability to get their invested amount back sooner. By cashing out that class using excess cash flow returns of the project or a cash-out refinance mechanism, this class of investors may enjoy a faster return of their capital, which increases their return. Think about the idea that a dollar today is not the same as a dollar tomorrow.
This class of investors also enjoys tax benefits as they split it with equity partners. This is a better alternative than investing in debt funds with a fixed rate of return. Debt funds profits are taxed at ordinary income tax rates. Preferred equity class investors are able to partake in depreciation and thus, might get taxed on rental income.
Finding the Best Fit for Your Investing Needs
The Preferred Equity class is perfect for people nearing retirement, a career change or quitting their full-time jobs, who are counting on steady income streams.
Due to the fixed rate return nature of this class, typically UDFI/UBIT taxes are not applicable if one uses their Self Directed IRA account to invest. Yes, you can use your retirement accounts to invest in apartment syndications. Read about it here.
I hope this brings you a good understanding of two of the most common ways to invest into multifamily deals. Based on the nature of the return and risk level, I hope you can make a sound choice that fits with your overall financial and life goals. It’s all about exploring and understanding the details of each investment vehicle, such as apartment syndications vs. stock market, that helps you identify qualities of those investments that fit into your current and future financial needs. If watching the news and refreshing your stock market feed is something you find exciting in regards to what your money is doing, then stock investing is most likely already in your portfolio. If handing over your money to a team of experienced professionals so they can do all the work and provide returns to you as you carry on with life as normal, then passive investing may sound more attractive to you. These qualities of an investment vehicle must be considered for your personal situation. Each investment vehicle has its own personality. Finding one that is a match, that resonates with your desires as an investor, is valuable.
In those examples above, there is also differing inherent risk involved. A passive apartment investor could be more averse to risk than a day trading stock market investor. Again, personality plays a part in which vessels we choose to invest. The nature of the return on investment is another factor that should be part of the decision-making process when investing. If you’re an investor who needs more cash flow, you may be allowing for minimal equity gains. If you’re a partner who prefers equity growth for long-term wealth building, you will most likely not see a steady stream of income from your investment.
The multitude of options in apartment investing alone reminds us of how diversified we can be inside of one category of real estate investing.
Which investment “personality types” are you most aligned with? Tell us in the comments. We’d love to hear from you.
If you’re ready to take your investment education to the next level, join us as a student at EZ FI University where real estate learning comes to life.
Those of you ready to start your journey as a passive investor and want to know more, schedule a call with one of our team members today.