apartment syndication taxes

The Five Tax Factors When Passively Investing in Apartment Syndications

In addition to the capital preservation and cash flow benefits, one of the main reasons that passive investors seek to invest in real estate opportunities, and apartment syndications in particular, is because of the tax benefits.

 

When a passive investor invests in a value-add apartment syndication, they will generally receive a profit from annual cash flow and the profit at sale. Being a profit, this money is taxable. However, for apartment syndications, there are five pieces of tax information that the syndicator and the passive investor need to understand in order to determine the tax advantages of investing. These are 1) the depreciation benefits, 2) accelerated depreciation via cost segregation, 3) depreciation recapture, 4) bonus depreciation and 5) capital gains tax at sale.

 

DISCLAIMER: THIS IS FOR YOUR INFORMATION ONLY. SINCE I AM NOT A TAX ADVISORY FIRM, I REFER ALL GENERAL TAX-RELATED REAL ESTATE QUESTIONS FROM PASSIVE INVESTORS BACK TO THEIR ACCOUNTANTS. HOWEVER, I WILL SAY THAT INVESTORS OFTEN SEEK REAL ESTATE OPPORTUNITIES TO INVEST IN DUE TO THE TAX ADVANTAGES THAT MAY COME FROM DEBT WRITE OFF AND LOSS DUE TO DEPRECIATION. BUT I DON’T INCLUDE ANY ASSUMPTIONS ABOUT THESE TAX ADVANTAGES IN OUR PROJECTIONS.

 

1 – Depreciation

 

Depreciation is the amount that can be deducted from income each year as the depreciable items at the apartment community age. The IRS classifies each depreciable item according to its useful life, which is the number of years of useful life of the item. The business can deduct the full cost of the item over that period.

 

The most common form of depreciation is straight-line depreciation, which allows the deduction of equal amounts each year. The annual deduction is the cost of the item divided by its useful life. The IRS considers the useful life of real estate to be 27.5 years. So, the annual depreciation on an apartment building worth $1,000,000 (excluding the land value) is $1,000,000 / 27.5 years = $36,363,64 per year.

 

Generally, the depreciation amount is such that a passive investor won’t pay taxes on their monthly, quarterly or annual distributions during the hold period. They will, however, have to pay taxes on the sales proceeds.

 

2 – Cost Segregation

 

Cost segregations is a strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes. A cost segregation study performed by a cost segregation engineering firm dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27.5 years, the useful life of a residential building. The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7 and 15 years

 

For example, my company performed a cost segregation on our portfolio for 2017. On one of the properties, we showed loss from depreciation of greater than 412% than we would have seen with the straight-line depreciation using the 27.5 year useful life figure.

 

To perform a cost segregation, the syndicator will need to hire a cost segregation specialist. This can cost anywhere between $10,000 and $100,000 depending on the size of the apartments.

 

3 – Depreciation Recapture

 

Depreciation recapture is the gain received from sale of depreciable capital property that must be reported as income. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is “recaptured” by reporting it as income.

 

For example, consider an apartment that was purchased for $1,000,000 and has an annual depreciation of $35,000. After 11 years, the owner decides to sell the property for $1,300,000. The adjusted cost basis then is $1,000,000 – ($35,000 x 11) = $615,000. The realized gain on the sale will be $1,300,000 – $615,000 = $685,000. Capital gain on the property can be calculated as $685,000 – ($35,000 x 11) = $300,000, and the depreciation recapture gain is $35,000 x 11 = $385,000.

 

Let’s assume a 15% capital gains tax and that the owner falls in the 28% income tax bracket. The total amount of tax that the taxpayer will owe on the sale of this rental property is (0.15 x $300,000) + (0.28 x $385,000) = $45,000 + $107,800 = $152,800. The depreciation recapture amount is $107,800 and the capital gains amount is $45,000.

 

4 – Bonus Depreciation

 

One of the major changes with the Tax Cuts and Jobs Act of 2017 was the bonus depreciation provision, where business can take 100% bonus depreciation on a qualified property purchased after September 27th, 2017. Click here for more information on the qualifications and benefits of the change in bonus appreciation.

 

5 – Capital Gains

 

When the asset it sold and the partnership is terminated, initial equity and profits are distributed to the passive investors. The IRS classifies the profit portion as long-term capital gain.

 

Under the new 2018 tax law, the capital gains tax bracket breakdown is as follows:

 

Taxable income (individual or joint)

  • $0 to $77,220: 0% capital gains tax
  • $77,221 to $479,000: 15% capital gains tax
  • More than $479,000: 20% capital gains tax

 

Annual Tax Statements

 

At the beginning of the following year, the syndicator will have their CPA create Schedule K-1 tax reports for each passive investor. The K-1 is a tax document that includes all of the pertinent tax information that the passive investor will use to fill out their tax forms.

 

DISCLAIMER: THIS IS FOR YOUR INFORMATION ONLY. SINCE I AM NOT A TAX ADVISORY FIRM, I REFER ALL GENERAL TAX-RELATED REAL ESTATE QUESTIONS FROM PASSIVE INVESTORS BACK TO THEIR ACCOUNTANTS. HOWEVER, I WILL SAY THAT INVESTORS OFTEN SEEK REAL ESTATE OPPORTUNITIES TO INVEST IN DUE TO THE TAX ADVANTAGES THAT MAY COME FROM DEBT WRITE OFF AND LOSS DUE TO DEPRECIATION. BUT I DON’T INCLUDE ANY ASSUMPTIONS ABOUT THESE TAX ADVANTAGES IN OUR PROJECTIONS.

 

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Secure Passive Investor Commitments

5 Step Process for Securing Passive Investor Commitments for Apartment Syndications

There are three main steps to take an apartment deal from contract to close. First, the apartment syndicator performs detailed due diligence to confirm or update the underwriting assumptions. Next, the apartment syndicator secures a loan to finance the deal. Lastly, and the focus of this blog post, the apartment syndicator secures financial commitments from passive investors in order to fund the deal.

 

For apartment syndications, and the value-add investment strategy in particular, the syndicator will get a loan to cover the majority of the project costs. Generally, the costs that are not covered by the loan are the down payment for the loan (which is 20% to 30% of the purchase price or the purchase price plus renovations, depending on the loan), general partnership fees charged by the syndicator, financing fees (which are approximately 1.75% of the purchase price), closing costs (which are approximately 1% of the purchase price) and an operating account fund (which is approximately 1% to 3% of the purchase price).

 

In total, a syndicator should expect to require 30% to 40% of the total project costs in order to close on the deal. These remaining costs come from a combination of the general partners (i.e. the syndication team) and the limited partners (i.e. passive investors), with the majority generally coming from the limited partners.

 

The purpose of this blog post is to outline the 5-step process for securing financial commitments from passive investors after an apartment deal is under contract in order to cover this 30% to 40% of the project costs and close on the deal.

 

1 – Investment Package

 

From the syndicator’s perspective, one of the first steps towards securing commitments from passive investors is creating an investment package. Before closing on the deal, the syndicator underwrote the property, conducted a rental comparable analysis, visited the property in-person and negotiated a purchase price. During this time, they become extremely familiar with the property and the surrounding area. The purpose of the investment package is to take all of this knowledge gained by the syndicator from initially qualifying the deal and consolidating it into a digestible form so that the passive investors can review the deal and make an educated investment decision.

 

The form of and the information included in an investment package will vary from syndicator to syndicator, depending on their experience and the business plan. At the very least, the investment package will include the main highlights of the deal that are relevant to the passive investor. These highlights include the purchase price, the projected returns for the project and to the passive investors, an explanation of the business plan including the exit strategy, and the partnership structure. However, ideally the investment package includes much more about the underlying assumptions behind these investment highlights.

 

For example, my company creates an investment summary package which includes the following sections:

 

  • Executive Summary: a summary of the information that is relevant to the passive investor, which is expanded upon in later sections. This includes things like purchase price, return projections and the business plan
  • Investment Highlights: an explanation on why this apartment deal is a solid investment. This includes things like our value-add business plan, the debt terms, the exit strategy and anything unique to the specific deal or market
  • Property Overview: an overview of the property details. This include things like the community amenities, unit features, a property description, the unit mix and floorplans, and a site map
  • Financial Analysis: shows the underlying analysis and assumptions of the return projections. This includes things like the offering summary, debt summary, projected returns to the investor and the detailed proforma
  • Market Overview: an overview of the submarket and market in which the apartment deal is located. This includes things like job growth, demographic data, nearby transportation of developments and the rental and sales comparables that were used to calculate the projected rents

 

Mostly everything that a passive investor needs to know in order to make an educated investment decision should be included in the investment package.

 

2 – Passive Investors Notified about New Deal

 

Once the investment package is created, which could take anywhere from a few days to a week, the next step is for the syndicator to notify their investor database about their deal.

 

I highly recommend that a syndicator gets verbal commitments from passive investors and creates an investor database prior to looking for deal (here are over 20 blog posts on how to find passive investors). In fact, understanding how much money they can raise will determine the size of deal a syndicator should pursue. For example, understanding the they will require approximately 30% to 40% of the project costs to close, a syndicator with $1 million in verbal commitments can look for apartment deals in the $2.5 to 3.3 million range.

 

For my company, once we put a deal under contract and creates the investment package, we notify our passive investors about the new opportunity via email. In this email, we include the top two to three highlights of the deal, include a link to the investment package and invite them to a conference call where we will go over the deal in more detail. We set up the conference call using www.FreeConferenceCall.com and include the date and call-in information in this email.

 

3 – New Investment Offering Call

 

A few days to a few weeks after sending the notification email, my company hosts a new investment offering conference call. Here is a blog post I wrote that outlines my 7-step approach to preparing and conducting a successful new investment offering call. Read this post for more details, but the 7-step approach is:

 

  1. Get in the right mindset
  2. Determine your main focus
  3. Introduce yourself and your team
  4. Provide an overview of the deal, the market and the team
  5. Go into more detail on the deal, the market and the team
  6. Questions and answers session
  7. Conclude the call and send the recording to the investors

 

This is my company’s approach, but it will vary from syndicator to syndicator. Some syndicators will structure their presentations differently. Some syndicators may host a video webinar. Others might just send the investment package and/or a recording to their investors.

 

4 – Secure Commitments

 

After the new investment offering presentation, however the syndicator decided to approach it, the next step is to secure financial commitments from the passive investors.

 

If you are a passive investor, if the deal aligns with your investment goals, you can verbally commit to investing in the deal. How you make your commitment will vary for syndicator to syndicator. For my company, we ask our passive investors to send us an email with their commitments and we hold their spot until they review and sign the required documentation, which I will outline in the next section.

 

If you are an apartment syndicator, this process will vary depending on your experience level. When you are first starting out, you will need to be more proactive when securing commitments. A good strategy is to send emails to your investor database every week or two, inviting them to invest in the deal and providing them a new piece of positive information. You don’t want to send them an email that only asks them to invest. You want to provide a new piece of positive information like a due diligence report came back clean, a new development that was recently announced down the street, the rental comparable report came back and the rents are higher than what you projected, etc. Then, as you gain more experience and credibility from passive investors, they will come to you. Your goal should be to have 100% of the funding 30 days before closing. And once the deal is fully funded, don’t turn away interested investors. Instead, tell them that the deal is fully funded but that you will put them on a waiting list.

 

5 – Complete Required Documentation

 

The last step is for the passive investors to make their investments official by reviewing and signing the required documentation. There are five main documents that the syndicator needs to prepare (with the help of their real estate and securities attorney) and the passive investors need to sign in order to make the investments official.

 

  1. Private Placement Memorandum (PPM)

 

The PPM is a legal document that highlights all the legal disclaimers for how the passive investor could lose their money in the deal.

 

Generally, a PPM will include two major components. One is the introduction, which includes a summary of the offering, description of the asset being purchased, minimum and maximum investment amounts, key risks involved in the offering and a disclosure on how the general partners are paid. The other section covers basic disclosures, which includes general partner information, offering description and a list of all the risks associated with the offering.

 

The PPM should be prepared by a securities attorney for each apartment deal.

 

  1. Operating Agreement

 

For each apartment deal, my company forms a new limited liability company (LLC). My company is a general partner (GP). Our investors will purchase shares in that LLC and become a limited partner (LP). However, every syndicator should speak with a real estate attorney to determine which approach is best for them.

 

The operating agreement outlines the responsibilities and ownership percentages for the GP and LP.

 

The operating agreement should be prepared by a real estate attorney for each apartment deal.

 

  1. Subscription Agreement

 

Simply put, the subscription agreement is a promise by the LLC to sell a specified number of shares to passive investors at a specified price, and a promise by the passive investors to pay that price. For example, a passive investor that is investing $50,000 would purchase 50,000 shares of the LLC at $1 per share.

 

Like the operating agreement, the subscription agreement should be prepared by a real estate attorney for each deal.

 

  1. Accredited Investor Qualifier Form

 

The accredited investor form required is based on whether the offering is 506(b) vs. 506(c). Most likely, the general partner is either selling private securities to the limited partners under Rule 506(b) or 506(c). One key difference is that 506(c) allows for general solicitation or advertising of the deal to the public, while 506(b) offerings do not. But the other difference is the type of person who can invest in each offering type. For the 506(b), there can be up to 35 unaccredited but sophisticated investors, while 506(c) is strictly for accredited investors only. That being said, a syndicator should have a conversation with a securities attorney to see which offering is the best fit for them.

 

If the general partners are doing a 506(c) offering, they must verify the accredited investor status of each passive investor, which requires the review of tax returns or bank statements, verification of net worth or written confirmation from a broker, attorney or certified account. The accredited investor qualifications are a net worth exceeding $1,000,000 excluding a personal residence or an individual annual income exceeding $200,000 in the last two years or a joint income with a spouse exceeding $300,000.

 

If the general partners are doing a 506(b), they are not required to verify the accredited investors status – the passive investor can self-verify that they are accredited or sophisticated. In addition, for the 506(b) offering, to prove that the general partners didn’t solicit the offering, they must be able to demonstrate that they had a relationship with the passive investor before their knowledge of the investment opportunity, which is determined by the duration and extent of the relationship.

 

This form should also be prepared by a securities attorney, but only on one occasion (unless the accredited investor qualifications change).

 

  1. ACH Application

 

Lastly is the ACH application. This document is optional but recommended. It will allow the passive investor to receive their distributions via direct deposit into a bank of their choice.

 

Once a passive investor has committed to investing in a deal, the general partners should them these five documents to make the partnership official.

 

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securing financing on apartments

How a Syndicator Secures Financing for an Apartment Deal

Once a syndicator puts an apartment deal under contract, concurrent with the due diligence process is the process of securing financing. Generally, debt is a part of the apartment syndicator’s business plan because of the benefits that arise from leverage. Rather than purchasing the apartment community with all cash, they obtain a loan for upwards of 80% of the value while benefiting from 100% ownership.

However, not all debt and financing are the same. The type of debt and financing an apartment syndicator puts on the asset is highly dependent on the business plan. Also, different types of financing bring different levels of risks. Therefore, as a passive investor or an apartment syndicator, it is important to understand 1) the different types of debt and 2) the different types of financing. In doing so, you will be able to identify which combination of debt and financing is in your best interests based on the business plan.

 

Two Types of Debt: Recourse and Nonrecourse

Before diving into the two main types of loans, it is important to first distinguish the two types of debt – recourse and nonrecourse. According to the IRS, with recourse debt, the borrower is personally liable while all other debt is considered nonrecourse. In other words, recourse debt allows the lender to collect what is owed for the debt even after they’ve taken the collateral (which in this case is the apartment building). Lenders have the right to garnish wages or levy accounts in order to collect what is owed.

On the other hand, with nonrecourse debt, the lender cannot pursue anything other than the collateral. But, there are exceptions. In the cases of gross negligence or fraud, the lender is allowed to collect what is owed above and beyond the collateral.

Apartment syndicators almost universally prefer nonrecourse debt while lenders almost universally prefer recourse debt. But, while nonrecourse is advantageous to the borrower for the reasons stated above, it generally comes with a higher interest rate and are only given to individuals or businesses with a strong financial history and credit.

 

Two Types of Financing: Permanent and Bridge Loan

Generally, an apartment syndicator will secure one of two types of loans: a permanent agency loan or a bridge loan.

A permanent agency loan is secured from Fannie Mae or Freddie Mac and are longer-term compared to bridge loans. Typically loan term lengths are 5, 7 or 10 years amortized over 20 to 30 years. For example, with a 5-year loan amortized over 25 years, the syndicator would make payments for 5 years at an amount based on a loan being paid off over 25 years. At the end of the loan term, the syndicator will either have to pay off the remaining principal, refinance into a new loan or sell the asset.

The permanent agency loan is an LTV (loan-to-value) loan at 75% to 80%, which means the lender will provide funding for 75% to 80% of the value of the apartment and the syndicator provides the remaining 20% to 25%.

Generally, permanent agency loans are nonrecourse. However, value-add or distressed investors likely won’t be able to have the renovation costs included in the loan. Additionally, depending on the physical condition and operations, the asset may not qualify for permanent financing.

Compared to bridge loans, the interest rate is lower, and you may be able to get a few years of interest-only payments. Also, since these loans are longer-term in nature, they are less risky. The permanent loan is a set it and forget it loan where you won’t have to worry about a balloon payment or refinancing before the end of your business plan.

The other most common type of loan is the bridge loan. A bridge loan is a short-term loan that is used until the borrower secures long-term financing or sells the property. This loan is ideal for repositioning an apartment, like with the value-add or distressed apartment strategy.

Typically bridge loans have a term of 6 months to 3 years with the option to purchase an extension of a year or two. They are almost exclusively interest-only. For example, with a 2-year bridge loan, the investor would make interest-only payments for two years, at which point the investor must pay off the loan, refinancing, purchase an extension or sell the property.

The bridge loan is an LTC (loan-to-cost) loan at 75% to 80%, which means the lender will provide funding for 75% to 80% of the total project cost (purchase price + renovation costs) and the syndicator provides the remaining 20% to 25%.

Generally, bridge loans are nonrecourse to the borrower and have a faster closing process. Also, since they are interest-only, the monthly debt service is lower. However, the disadvantages are that they are riskier than permanent loans because they are shorter term in nature. Before the end of the term, which will likely occur before the end of the business plan, the syndicator must refinance or sell. And if the market is such that permanent financing isn’t available or if the business plan didn’t go according to plan, the syndicator is in trouble.

When securing financing, the most important thing is that the length of the loan exceeds the projected hold period, which is law number two of the Three Immutable Laws of Real Estate Investing. In doing so, as long as the syndicator follows the other two laws (buy for cash flow and have adequate cash reserves), the business plan is maintainable during a down turn. This law will usually be covered with the permanent loan. However, if the syndicator secures a bridge loan that will come due in the middle of the business plan, they better have a plan in place well ahead of time, whether that’s an early refinance or purchasing an extension.

 

Overall, the type of debt and financing a syndicator secures is based on their business plan. Bridge loans can be great for value-add investors, as long as they buy right, plan ahead and have an experienced team in place. And permanent financing is great because it is less risky and is a set it and forget it type of loan.

But regardless of the business plan, the syndicator should always have a conversation with a lending professional before securing financing for a deal.

 

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18 Creative Ways to Market Apartment Rental Listings

One of the 11 responsibilities an apartment syndicator has as the asset manager of an apartment community is maintaining and maximizing the economic occupancy. For value-add investors, this involves renovating the units and upgrading the community amenities in order to increase the rents, thus increasing the cash flow and returns.

 

However, no matter how beautiful the newly upgraded apartment community is, the syndicator still needs to implement a marketing strategy in order to fill the units with high-quality residents. Ideally, the syndicator hires a property management company that already applies the best marketing practices. But it is still their responsibility to oversee the management company and make sure the marketing strategy is being implemented properly.

 

Therefore, whether you are an apartment syndicator or a passive investor in syndications, it is helpful to understand the main ways to effectively market rental listings to attract the desired resident – one who pays rent on time and is courteous to their neighbors – and increase overall economic occupancy.

 

Here is a list of 18 creative ways to market an apartment rental listing to accomplish the above stated goals:

 

  1. Create a landing page, either standalone or as a part of your website, that captures the information of potential residents
  2. Create a direct mailing campaign and send it out to people living in similar buildings, inviting them to move into yours by offering some sort of concession (i.e. reduced rent for the first month, reduced security deposit, waive the application fee, etc.) and highlighting the major selling point of your community compared to theirs (i.e. direct garage access, new fitness center, BBQ pit, etc.). This strategy could anger local owners, so if you decide to do this, don’t expect to be popular and expect others to do it to your residents
  3. Contact the Human Resources departments at all the major employers in the area, letting them know that you own an apartment in the area and asking if they can direct new hires to your community
  4. Create a resident referral program where you offer current residents a flat fee ($300 is standard) if they refer someone that signs a lease
  5. Set up an open house and invite members of the local community to attend. Having a model unit and offering refreshments is helpful
  6. Offer special pricing to soldiers, police and first responders, like 50% off the first month’s rent
  7. Design a “for lease” banner and put it near the entry of your property, or near an area that has high foot or car traffic
  8. Design and place flyers at local establishments that are frequented by your resident demographic, like laundry mats, hair salons, nail salons, gyms, coffee shops, etc.
  9. Purchase advertisements in the local newspaper
  10. Post “for rent” listings to Craigslist, Zillow, Realtor.com, Apartments.com and other free online rental listing services
  11. Partner with a real estate broker or agent and advertise your apartment community on the MLS
  12. Create a Facebook advertisement, which allows you to select criteria to hyper-target your preferred resident
  13. Create a Facebook page for your apartment community, posting weekly content to generate a following and posting your rental listings
  14. Pay close attention to the nearby landmarks to cater to that audience, like colleges, military bases, large corporations, etc.
  15. Provide good old-fashioned customer service. Be responsive and timely with requests and questions. If doesn’t matter if you are a marketing wizard and get hundreds of responses to your rental listings if you don’t pick up the phone or respond quickly to emails, politely answer their questions and get them one step closer to viewing the property and signing the lease
  16. Call all residents who have previously notified you that they plan on leave at the end of their lease, asking them about their reason for leaving to see if it is something that can be addressed
  17. Send marketing material or gift baskets to businesses and employers surrounding your community
  18. Follow-up with old leads that are older than 90 days

 

Some of the strategies are free and just require effort on the part of the syndicator and/or property management company. Others will require an upfront investment or result in a short-term reduction in income. Therefore, it is important that the syndication team understands the marketing strategy prior to closing on the deal so that they account for these expenses in the underwriting.

 

What about you? Comment below: What strategies do you implement to fill vacancies at your rental properties?

 

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due diligence on apartment

The Ultimate Guide to Performing Due Diligence on an Apartment Building

After putting a deal under contract, the due diligence process for an apartment building is much more involved and complicated in comparison to that of a single-family residence or smaller multifamily building. For the due diligence process on an SFR or smaller multifamily building, the lender will likely only require an inspection report and an appraisal report in order to provide you with financing. And then for your own knowledge, you’ll perform your own financial audit, comparing the leases and rent rolls with the historical financials to make sure the rental rates are in alignment.

 

When you scale up to hundreds of units, the increase in the number of potential risk points is such that the lender will require additional reports prior to financing the deal and you will want to obtain additional reports before deciding to move forward with the deal.

 

For the apartment community due diligence process, you’ll want to obtain and analyze the results of these 10 reports:

 

  1. Financial Document Audit
  2. Internal Property Condition Assessment
  3. Market Survey
  4. Lease Audit
  5. Unit Walk
  6. Site Survey
  7. Property Condition Assessment
  8. Environmental Site Assessment
  9. Appraisal
  10. Green Report

 

In this ultimate guide, I will outline the contents of each report, how to obtain them, the approximate cost of each (for apartment communities 100 units or more) and how to analyze the results.

 

1 – Financial Document Audit

 

The financial document audit is an analysis that compares the apartment’s historical operations to your budgeted income and expense figures you set when underwriting the deal.

 

For the audit, a consultant will collect detailed historical financial reports from the sellers, including the last one to three years of income and expense data, bank statements and rent rolls. The output of the analysis is a detailed spreadsheet of the asset’s historical income, operating expenses, non-operating expenses and net cash flow which are compared to the budgeted figures you provided.

 

The summary will take on a form that is similar to a pro forma, with the income and expenses broken down into each individual line item for an easy comparison on your end. They will also provide you with an executive summary document, which will outline how to interpret the audit, what data was used to create the audit spreadsheet and an explanation of any figures that deviate from your budget.

 

To obtain this document, you will need to hire a commercial real estate consulting firm that specializes in creating financial document audits. An approximate cost for this report is $6,000.

 

When you initially underwrote the deal, you set the income and expense assumptions based on how you and your team will operate the property once you’ve taken over. These assumptions came from a combination of the trailing 12 months of income and expense data and the current rent roll provided by the seller and the standard market cost per unit per year rates for the expenses.

 

Once you receive the results of the financial audit report, you want to go through each income and expense line item and compare them to the assumptions in your underwriting model. Ideally, the consultant that performed the audit already compared the results to your provided budget, made adjustments based on their expertise and any inputs you provided and commented on any discrepancies.

 

If any discrepancies were found or if the consultant recommended any adjustments, discuss them with your property management company to see if you need to update your budget. If you and your management company come to the conclusion that the budget needs to change, make the necessary adjustments to your underwriting model.

 

2 – Internal Property Condition (PCA) Assessment

 

The internal property condition assessment (PCA) is a detailed inspection report that outlines the overall condition of the apartment community.

 

A licensed contractor will inspect the property from top to bottom. Based on the inspection, the contractor will prepare a report with recommendations, preliminary costs and priorities for immediate repairs, recommended repairs and continued replacements, along with accompanying pictures of the interiors, exteriors and the items needing repair.

 

Being an internal report, you will be responsible for hiring a licensed commercial contractor to perform the assessment. An approximate cost for this assessment is $2,500.

 

During the underwriting process, you created a renovation/upgrade plan for the interior and exterior of the apartment community, which included the estimated costs. Once you receive the internal PCA, compare the results to your initial renovation budget.

 

The results of the internal PCA are preliminary costs, not exact costs. However, they will most likely be more accurate than the assumptions you made during the underwriting process. Therefore, if there are discrepancies between the contractor’s estimated renovation costs and your renovation budget, update the underwriting model to reflect the results of the internal PCA.

 

Hopefully, your initial renovation assumptions were fairly accurate. And ideally, if you made very conservative renovation cost assumptions, you discover that you over-budgeted and can reduce the costs in your underwriting model.

 

3 – Market Survey

 

The market survey is a more formal and comprehensive rental comparison analysis than the one you performed during the underwriting phase.

 

For the market survey, your property management company will locate direct competitors of the apartment community. Then, they will compare your apartment community to each of the direct competitors over various factors to determine the market rents on an overall and a unit type basis. A few key points on the market survey analysis is to make sure that your property management company uses apartment communities that are upgraded to a similar degree as how your apartment community will be post renovations and not in its current condition, that are in similar neighborhoods and that were built within a similar time period.

 

When initial underwriting the deal, you set your renovated rental assumptions based on a combination of performing your own rental comparable analysis and, if the sellers had initiated an upgrade program, proven rental rates. Compare the results of the market survey to your initial renovated rent assumptions. If there are any discrepancies, update your underwriting model to reflect the results of the market survey.

 

4 – Lease Audit

 

The lease audit is the process of examining the individual leases at the apartment community.

 

Your property management company will collect all of the leases of the current residents at the apartment community and perform an audit. They will analyze each lease, recording the rents, security deposits, concessions and terms. Then, they will compare the information gathered from the leases to the rent roll provided by the owner, recording any discrepancies.

 

Unless the current property management company was extremely incompetent, the discrepancies should be minor, if there are any at all, and it should affect your financial model.

 

5 – Unit Walk

 

A question my apartment syndication clients ask a lot is “when I am performing due diligence, do I need to walk every single unit?” The answer is a resounding yes! And that is the purpose of the unit walk report. It is the inspection of each individual unit at the apartment community.

 

During the unit walk, your property management company will inspect each individual unit. The purpose of the unit walk is to determine the current condition of each unit.  So, while conducting the unit walk, they will take notes on things like the condition of the rooms, the type and condition of appliances, the presence or absence of washer/dryer hookups, the conditions of the light fixtures, missing GFCI outlets, and anything else that stands out as a potential maintenance or resident issue.

 

Once you receive the unit walk report, compare the results to your interior renovation assumptions to determine the accuracy of your interior business plan.

 

Do the number of units that require interior upgrades match your business plan? Is there unexpected deferred maintenance that wasn’t accounted for in your budget? Are there a high number of residents who will need to be evicted once you’ve taken over the operations?

 

Using that data, you can create a more detailed, unit-by-unit interior renovation plan and calculate a more accurate budget. Make any adjustments to your interior renovation assumption on your financial model.

 

Most likely, your property manager will perform the market survey, lease audit and unit walk report, and they will usually do it for free. However, ask the property manager how much they will charge you for these three reports if you do not close on the deal. And if you have to hire a 3rd party to create these three reports, the cost is approximately $4,000.

 

6 – Site Survey

 

A site survey shows the boundaries of the property, indicating the lot size. It also includes a written description of the property. The report resembles a map.

 

There are a lot of third party services that can conduct a site survey. A quick Google search of “site survey + (city name) will do the trick. I recommend reaching out to multiple companies to get a handful of bids for your project. The approximate cost for the site survey is $6,000.

 

The site survey report will list any boundary, easement, utility and zoning issues for the apartment community. Generally, if a problem is found during the site survey, the bank will not provide a loan on the property. So, if something does come up, your options are limited and should be addressed on a case-by-case basis. If the problem can’t be resolved, you will have to cancel the contract.

 

7 – Property Condition Assessment

 

The property condition assessment is the same as the internal property condition assessment, except this one is created by a third party selected by the lender. The cost is approximately $2,000.

 

Analyze this reports the same way that you analyzed the internal PCA. Then, compare and contrast the results of the two PCAs. Maybe the lender’s contractor caught something that your contractor did not, and vice versa.

 

8 – Environmental Site Survey

 

The environmental site assessment is an inspection that identifies potential or existing environmental contamination liabilities. It will address the underlying land, as well as any physical improvements to the property, and will offer conclusions or recommendations for further investigations of an issue is found.

 

The environmental site assessment is also performed by a 3rd party vendor selected by your lender. The approximate cost is $2,500.

 

Similar to the site survey, if the vendor identifies an environmental problem, the lender will not provide a loan for the property. Again, these issues should be addressed on a case-by-case basis.

 

9 – Appraisal

 

The appraisal determines the as-is value of the apartment community.

 

An appraiser will inspect the property, and then calculate the as-is value of the apartment community. The two appraisal methods that will be used to determine the value of the property are the sales comparison approach (i.e. comparing the subject property to similar properties that were recently sold) and the income capitalization approach (i.e. using the net operating income and the market cap rate).

 

The appraisal report is created by an appraiser selected by your lender. The cost is approximately $5,000.

 

Once you receive the appraisal, you should compare the appraised value to the contract purchase price. The lender will base their financing on the appraised value, not the contract price. Therefore, if the appraisal comes back at a value higher than the contract price, fantastic! That’s essentially free equity. However, if the appraised value is lower than the contract price, you will have to either make up the difference by raising additional capital or renegotiate the purchase price with the seller.

 

10 – Green Report

 

The Green report is an optional assessment that evaluates potential energy and water conservation measures for the apartment community. The report will include a list of all measures found, along with the associated cost savings and initial investment.

 

The report is created by a 3rd party vendor selected by your lender. The approximate cost is $3,500.

 

The green report, which is the only document that won’t disqualify a deal, will outline all of the potential energy and water conservation opportunities. It will list all of the opportunities that were identified, the estimated initial investment to implement, the associated cost savings and the return on investment. Deciding which opportunities to move forward with should be based on the payback period and the projected hold period of the property.

 

For example, following energy efficient opportunities were identified at an apartment project my company had assessed:

 

  • Dual pane windows
  • Wall insulation and leakage sealing
  • Roof insulation
  • Programmable thermostats
  • Low-flow showerheads and toilets
  • Interior and exterior LED lighting
  • Energy Star rated refrigerators and dishwasher

 

After analyzing the investment amount and cost savings, the opportunities we implemented, and the associated savings and payback periods were:

 

  • Low-flow showerheads: 1-year payback, $16,827 annual savings
  • Exterior LED lighting: 14.4-year payback, $3,236 annual savings
  • Pool cover: 1.5-year payback, $409 annual savings

 

The reasoning behind the low-flow showerheads and pool cover was that we planned on holding the property for 5-years, so once we paid back the initial investment amount, it was pure profit. We ended up losing money on the exterior LED lighting project. However, we installed these lights to increase resident safety.

 

You will find that the green report will list ALL opportunities, even if the payback period is absurdly long. If we implemented all the opportunities identified in the example above, the overall payback period would have been 91.9 years, with the longest payback period being 165 years for the Energy Star rated dishwashers. Unless we decided to hold onto a building until we died or unit they’ve discovered an immortality serum, we will stick to the opportunities that either result in a payback period lower than our projected hold time or address a resident safety concern.

 

How to Pay for the Due Diligence Reports

 

Usually, the costs of the due diligence reports will not be due until closing. So, when underwriting the deal, make sure you are taking these costs into account when determining how much equity you need to raise.

 

Other times, you will need to pay for a due diligence report upfront. If this is the case, you can do one of two things. You can come out-of-pocket and reimburse yourself at close. Or, you can take a loan from a third-party (maybe one of your passive investors) and reimburse the initial loan amount with interest at close.

 

Review the Results of Your New Underwriting Model

 

Based on the financial document audit, market survey report, lease audit report and green program report, you either confirmed or updated your income assumptions. Based on the financial document audit, you either confirmed or updated your expense assumptions. Based on the two property condition assessments and the unit walk report, you either confirmed or updated your renovation budget assumptions. Based on the appraisal report, you either confirmed the accuracy of the purchase price or determined that you have the property under contract at price that is below or above the as-is value. And based on the site survey and environmental survey, you determined if there is anything that disqualifies the deal entirely.

 

Once you have received the results of all 10 due diligence documents and made the necessary adjustments to your underwriting model, you need to re-review your return projections. If you had to make drastic changes to the income, expenses or renovation budgets in the negative direction, then the new return projections will be reduced. In some cases, the return projections will be reduced to such a degree that the deal no longer meets the return goals of you and your investors. Also, if an issue came up during the site survey or the environmental site assessment, which is rare, it will need to be resolved prior to closing. If the seller is unwilling or unable to address these issues, your lender will not provide financing on the property, which means you will have to cancel the contract.

 

If the updated return projections fall below your investor’s return goals, adjust the purchase price in your underwriting model until the projected returns meet your investor’s goals again. Then, explain to your real estate broker that you want to renegotiated the purchase price and state the reasons for doing so.

 

If the seller will not accept the new contract terms, don’t be afraid to walk away from the deal. At the end of the day, it is your job to please your investors, which means providing them with their desired return goals.

 

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How a Passive Investor Qualifies an Apartment Syndicator’s Team

One of the three main risk points associated with passively investing in apartment syndications is the syndication team (the other two are the deal itself and the market). The best deal, from a projected returns standpoint, in the best market in the country may result in failure if the team cannot successfully execute the business plan. Therefore, prior to committing to a particular apartment syndicator or to a particular deal, a passive investor should qualify the main team members involved in the deal.

 

Before asking these questions, however, you need to qualify the actual apartment syndicator. Click here for a blog post for how a passive investor qualifies an apartment syndicator.

 

There are the 7 team members involved in syndication process: property management company, real estate broker, CPA, mortgage broker, real estate attorney, securities attorney and a consultant (optional). But the main team member is the property management company.

 

The property management company is the boots-on-the-ground force that is responsible for overseeing the ongoing, day-to-day operations of the apartment community. This includes marketing efforts to attract new residents, resident relations (like hosting resident events), managing turnovers, fulfilling maintenance requests, maximizing rents and occupancy levels, etc. If the syndicator is following a value-add or distressed investment strategy, the property management company will also oversee the renovation process.

 

Prior to investing with an apartment syndicator, you want to determine the credibility of the property management company, which you can accomplish by asking the following 8 questions:

 

  1. How long have they been in business?

 

A relatively new property management company might not have enough experience managing certain sized or types of apartments. Generally, the longer they’ve been in business, the better. For example, the property management company that we use has been in business for over 75 years.

 

  1. What geographic areas do they cover?

 

The property management company MUST have a presence in the market in which the apartment syndicator is investing. That means the company must be local to the market or, if they are a national property management company, must have a regional office located in the market.

 

  1. How many units do they manage?

 

Similar to the question 1, the property management company should manage multiple apartment communities in the same market. However, bigger isn’t always better, because if they manage too many units, they might not be able to provide the highest quality service. Also, if they have been in business for decades but only manage a handful of communities, that could be a red flag.

 

  1. How many units do they own?

 

If the property management company owns other apartment communities in the same market, it could be a conflict of interest. If the syndicator’s property and their property have a vacant 2 bed, 1 bath unit at the same time, which one are they likely to fill first? Not a deal breaker, but this is definitely something that you want to be aware of.

 

  1. What asset class do they specialize in?

 

The property management company MUST have experience implementing the same business plan that the syndicator is pursuing. For example, If the syndicator is following a value-add investment strategy, the property management company must have experience with value-add apartment communities.

 

  1. What are some of the names of nearby properties they are currently managing?

 

This proves that they are actually managing apartments in the local market. But it will also allow you to perform some research to see how the apartment communities are maintained. If you are local to the market, you can visit these properties in person. If not, you can perform online research by looking at the website and by looking at the property on Google Maps. Also, you can look up the apartment community on Google or Apartments.com to read resident reviews and see the overall rating.

 

  1. Have you worked with this company in the past?

 

Since you are ideally investing with a syndicator who has previous apartment experience, this shouldn’t be the first time they used their property management company. If the property management company doesn’t manage the majority of their portfolio in their target market, that could be red flag. So, if that is the case, a follow-up question would be to ask them why this management company doesn’t manage the majority of their portfolio.

 

  1. Is the property management company showing alignment of interests?

 

Alignment of interests are always important, but they are especially important if the syndicator doesn’t have a long, successful track record with apartment communities. There are five main ways that the property management company can show alignment of interest.

 

The lowest level of alignment of interests is the management company has a proven track record managing apartment communities that are located in the local market, has worked with the syndicator in the past and has followed the same investment strategy that the syndicator is implementing. Regardless of the experience level of the apartment syndicator, this level of alignment of interest should be shown.

 

The next level up is when the property management company has an equity stake in the general partnership.

 

The third level of alignment of interest is when the property management company invests their own capital in the deals.

 

The fourth level of alignment of interest is when the property management company invests their own money in the deal AND brings on their own passive investors.

 

And the highest level of alignment of interests is when the property management company signs on the loan.

 

Again: it is ideal that the syndicator has previous experience with apartments, but if they don’t, having alignment of interests with the property management company – or with other team members, like the real estate broker or a local apartment owner/consultant – can offset their lack of experience. If the syndicator does have experience, then the level two to five alignment of interests are less important.

 

 

Over the course of your communication with a prospective apartment syndicator, these are the eight questions you want to ask in order to determine the credibility and experience of their property management company.

 

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qualify an apartment syndicator

How a Passive Investor Qualifies an Apartment Syndicator

The syndicator, also referred to as the sponsor or general partner, is an individual or a group of individuals that puts an apartment syndication together. And, this entails a lot of responsibilities.

 

Their main responsibilities include creating the syndication team, selecting and evaluating a target market, finding a deal, qualifying or disqualifying the deal through underwriting, submitting an offer and negotiating the purchase price and terms.

 

Once a deal is under contract, their main responsibilities are to manage the due diligence process, confirm the underwriting assumptions, create the business plan, arrange the debt, secure the equity from passive investors and coordinate with the real estate and securities attorney to structure and create the partnership.

 

Once the deal is closed, they are responsible for the ongoing asset management of the project, which includes implementing the business plan, distributing the returns to the passive investors, communicating updates to the passive investors, visiting the property and frequently analyzing the competition and the market.

 

Essentially, they are responsible for managing the entire process from start to finish. Because of their heavy involvement in the process, the success or failure of the deal rests mostly on their shoulders. Therefore, rather than investing with the first apartment syndicator you find, you need to qualify them by asking questions.

 

The Business Plan

 

One of the first things you want to know is the general business plan they implement. Click here to learn more about the three apartment syndication options. This will segue into the next question, which is what is their past experience with this particular business plan? In particular, you want to know if they have taken a deal full cycle (from acquisition to sale) following this business plan and whether or not they were successful (which is determined by how the projected returns compared to the actual returns distributed to the passive investors).

 

Alignment of Interests

 

If the syndicator does not have previous experience implementing the business plan, that is not an automatic disqualifier. However, their lack of experience must be made up for by having a credible team and strong alignment of interests. And for the experienced syndicator with a proven track record of successfully implementing their business plan, having a partnership structure that promotes alignment of interests is the icing on the cake.

 

There are many other team members that are involved in the syndication process, but the three team members with the most involvement in the deal are the property management company, the real estate broker and – if the syndicator doesn’t have previous apartment experience – a consultant. And each of these team members bring different levels of alignment of interests to the deal. Generally, an experienced property management company results in the most alignment of interests, followed by an experienced syndication consultant or local owner who is active in the apartment industry, followed by an experienced real estate broker.

 

The syndicator themselves can also promote alignment of interests. For example, one of the common fees the syndicator charges in an ongoing asset management fee. If they put that fee in second position to the preferred return, that promotes alignment of interests. If you don’t get paid, they don’t get paid.

 

Additionally, they can promote alignment of interests by investing their own capital in the deal, whether that’s is their personal funds, company funds or by allocating a portion or all of their acquisition fee into the deal. By not having money in the deal, the syndicator isn’t exposed to the same level of risks as you are. If the deal performs poorly, they won’t get paid but they also won’t lose any capital either. Whereas, by having their own skin in the game, they are incentivized to maximize returns.

 

Another way to promote alignment of interest is for the syndicator, or a member of the team, to personally guarantee the loan as a loan guarantor.

 

Transparency

 

Another characteristic of a good syndicator is transparency. To determine the level of transparency, ask them about their ongoing communication process. How often do they send updates on the deal? Will they provide you with financial reports so you can review the property’s operations?

 

You also want to ask them what the communication process is when you have a question. Will they provide you with their cell phone number or direct email address? And if you do have a question, what will be the turn-around time?

 

You are trusting the syndicator with your hard-earned capital, so having transparency in regards to what they are doing with your money and how the deal is progressing is a must.

 

Credibility

 

A good question to determine the syndicators track record is to ask them how many of their passive investors have invested in multiple assets. Syndicators who have investors that continue to come back deal after deal is an indication that they have a proven track record of meeting and/or exceeding the projected returns. While the opposite may be true if the syndicator has a poor investor retention rate.

 

Similarly, ask the syndicator what percentage of their new investors come in the form of referrals. If they have a lot of referrals, that indicates satisfied investors who are motivated to share their success with friends and colleagues.

 

You can also gauge the reputation and credibility of a syndicator by their online presence. Are they easily found when you perform a Google search? Do they have a website? Do they create content in the form of a podcast or blog? You can learn a lot about a syndicator by performing online research prior to actually speaking with them.

 

 

The syndicator’s past experience with the apartment business plan, level of alignment of interests, transparency and credibility are important factors to understand when determining whether or not to passively invest in their deal.

 

If you are a current passive real estate investor, what do you think? Comment below: what do you look for when qualifying an apartment syndicator?

 

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How the General Partner Makes Money from an Apartment Syndication

The types of fees and the range of each fee will vary from syndicator-to-syndicator. But every fee that is charged should be directly tied to a task that is explicitly adding value to the apartment deal.

 

In order to identify the fairness and reasonableness of the GP compensation structure, you need to understand 1) the types and standard ranges of the general partnership fees for the industry, 2) what tasks they are performing in return for those fees and 3) if each of those fees promotes alignment of interests between the LP and GP.

 

There a lot of different fees that the syndicator could charge, but here is a list of the seven fees that you will come across most often. An important disclaimer to make is that this is not a list of the fees that every syndicator will charge every single time. Rather most syndicators will mix-and-match the types of fees that charge, depending on the project.

 

1 – Profit Split

 

Depending on the type of LP compensation structure, the general partnership may earn a portion of the remaining profits after the preferred return is distributed.

 

For example, the LP may receive an 8% preferred return and the profits thereafter are split between the LP and GP. This split can be anywhere from 50/50 to 90/10 (LP/GP)

 

If the LP invested $1,000,000 into a property that cash flowed $100,000 for the year, assuming an 8% preferred return and a 50/50 split thereafter, the LP would receive $80,000 as a preferred return, plus another $10,000 as a profit split. Then, the GP would receive the remaining $10,000.

 

The profit split promotes alignment of interests because the GP is financially incentivized to operate the apartment community such that the annual return exceeds the preferred return. Because if they don’t, they are missing out on an opportunity to make money. Then for the passive investor, when the annual returns exceed the preferred return, the LP receives a higher annual distribution and – since the net operating income is directly tied to the property value – a higher distribution at sale.

 

On a related note, you want to confirm that at sale, the profit split is calculated based on the remaining profits AFTER the LP’s initial equity is return. Also, when the GP is outlining the LP return projections, you want to confirm that those projections are net of the GP fees. This means that you want to make sure that the projections they show you are AFTER the GP has taken their fees, because if not, the actual returns will be less than what they are showing you.

 

2 – Acquisition Fee

 

Nearly every apartment syndicator will charge an acquisition fee. The acquisition fee is an upfront, one-time fee paid to the GP at closing. The acquisition fee ranges from 1% to 5% of the purchase price, depending on the size, scope, experience of team and profit potential of the project.

 

Think of the acquisition fee as a consulting fee paid to the GP for putting the entire project together. It is a fee that pays the GP for their time and money spent on market research, creating a team (lawyers, CPAs, real estate brokers, etc.), finding the deal, analyzing the deal, raising money, securing financing, performing due diligence and closing.

 

3 – Asset Management Fee

 

The asset management fee is an ongoing annual fee paid to the GP in return for overseeing the operations of the property and implementing the business plan. The asset management fee is either a percentage of the collected income or a per unit per year fee. The standard percentage range is 2% to 3% while the standard per unit per year is $200 to $300.

 

The range of the asset management fee is usually based on the business plan. If the plan is to perform interior renovations and exterior renovations/upgrades, a higher asset management fee may be justified, because the GP will be heavily involved in ongoing oversight of the business plan. But the opposite is true if the property is already stabilized and up-to-date from day one. In other words, the more effort and time required by the GP, the higher the asset management fee. And since the asset management fee is directly tied to the collected revenue, if the business plan isn’t implemented effectively, the GP doesn’t maximize what they could make, which helps with alignment of interests.

 

Additionally, there is a higher alignment of interests with the percentage-based fee as opposed to the unit-based fee. Since the percentage-based fee is tied to the actual collected income, the lower the collected income, the lower the asset management fee. So, the GP is incentivized to maximize the income, which in turn will maximize your returns. Whereas the unit-based fee is a flat fee that remains the same regardless of the amount of collected income.

 

For another level of alignment of interest, the GP will put the asset management fee in second position behind the preferred return. That means that if the preferred return isn’t distributed, they won’t receive the asset management fee. Not every GP will have a compensation structure with the asset management fee in second position. So, for the ones that don’t, the alignment of interests is lower than that of the GP that does.

 

4 – Refinance Fee

 

A refinancing fee is a fee that is paid to the GP for the work required to refinance the property. Of course, if the business plan doesn’t include a refinance, the GP will not charge such a fee.

 

At the closing of the new loan, a fee of 1% to 3% of the total loan amount is paid to the GP. However, to promote alignment of interests, this fee should only be charged if a specified equity hurdle is reached. For example, the return hurdle may be returning 50% of the LP’s initial equity. If only 40% is returned, while that is still beneficial to the LP, the GP will not collect the fee. Therefore, this type of refinance fee structure incentivizes the GP to maximize the property value such that they will hit the equity return hurdle at refinance. And the LP benefits by receiving a large portion of their equity back and – again, since the property value is directly tied to the net operating income –  higher ongoing returns.

 

5 – Guaranty Fee

 

The guaranty fee is a one-time fee paid to a loan guarantor at closing. The loan guarantor guarantees the loan. The GP may bring on an individual with a high net-worth/balance sheet to sign on the loan to get the best terms possible. Or, the GP may sign the loan themselves, collecting the fee or deciding to forgo it.

 

At close, a fee of 0.25% to 1% of the principal balance of the mortgage is paid to the loan guarantor. The riskier or more complicated the deal, the higher the guaranty fee. If the GP doesn’t have a good relationship with the loan guarantor, that individual will charge a higher fee as well.

 

Also, the size of the fee depends on the type of loan. Generally, there are two types of debts: recourse and nonrecourse. Recourse debt allows the lender to collect what is owed for the debt even after they’ve taken collateral. Nonrecourse debt does not allow the lender to pursue anything other than the collateral (with a few exceptions or “carve outs,” like in instances of gross negligence or fraud). So, the guaranty fee will be higher for recourse loans compared to nonrecourse loans.

 

Since the loan guarantor is personally guaranteeing the loan, this promotes alignment of interests. Because if they project fails, the GP is personally liable.

 

 

6 – Construction Management Fee

 

The construction management fee is an on-going annual fee paid to the company overseeing the capital improvement process. If the GP has a hands-on role in the renovation process or if the GP has their own property management company, they may charge a construction management fee.

 

This fee ranges from 5% to 10% of the renovation budget, depending on the size and complexity of the improvement plan.

 

For some syndicators, this fee will be built into the asset management fee, while others will charge a construction fee on top of the asset management fee. When a GP charges both an asset management and construction management fee, it may reduce your ongoing returns, especially while renovations are being performed.

 

7 – Organization Fee

 

The organization fee is an upfront fee paid to the GP for putting together the group investment. This fee ranges from 3% to 10% of the total money raised, depending on the amount of money raised.

 

For some syndicators, this fee will be built into the acquisition fee, while others will charge an organization fee on top of the acquisition fee. When a GP charges both an acquisition and organization fee, your overall return may be reduced.

 

 

These are the seven type of fees you will most commonly come across as a passive apartment investor.

 

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active vs. passive

Active Vs. Passive: Which Is the Superior Real Estate Investment Strategy?

 

Originally featured in Forbes here.

 

When the average person thinks of real estate investing, they might imagine a billionaire who develops massive commercial properties, or an HGTV fix-and-flipper who turns a profit by converting a run-down property into someone’s dream home. With this mental representation, it’s no wonder more people aren’t real estate investors.

 

Obviously, this isn’t the case in reality. There are thousands of different real estate investing strategies from which to choose. The difficult part — aside from shedding the false belief that real estate investing is only for the rich —  is identifying the ideal investment strategy that fits one’s current economic condition, abilities and risk tolerance level.

 

Generally, entry-level investment strategies fall into two categories: passive and active investing. The question is, which one is best for you?

 

For our purpose here, I will define active investing as the acquisition of a single-family residence (SFR) with the goal of utilizing it as a rental property and turning over the ongoing management to a third-party property management company. Alternatively, passive investing is placing one’s capital into a real estate syndication — more specifically, an apartment syndication — that is managed in its entirety by a sponsor.

 

In order to determine which investment strategy is best for you, it is important to understand the main differences between the two. Based on my personal experience following both of these investment strategies and interviewing thousands of real estate professionals who have done the same, I’ve discovered that the differences between passive and active investing fall into three major categories: control, time commitment and risk.

 

Control

 

As a passive investor, you are a limited partner in the deal. You give your capital to an experienced sponsor who will use that money to acquire and manage the entire apartment project. You have no direct control over any aspect of the business plan, so you are putting a lot of trust into the sponsor and their team. However, this trust is established by not giving your money to a random, unqualified sponsor but through an alignment of interests. For example, the sponsor will offer you a preferred return, which means that you will receive an agreed-upon return before the syndicator receives a dime. Therefore, the syndicator is financially incentivized to achieve a return above and beyond the preferred return.

 

As an active investor, you can directly control the business plan. You decide which investment strategy to pursue. You decide the type and level of renovations to perform. You decide the quality of tenant to accept and the rental rate to charge. You determine when to refinance or sell. With for passive investing, all of the above is determined by the apartment syndicator.

 

Time Commitment

 

As an active investor, the advantage of more control comes with the disadvantage of a greater time commitment. It is your responsibility to educate yourself on the ins and outs of single-family rental investing. Then, you have to find and vet various team members. Once you have a team in place, you have to perform all the duties required to find, qualify and close on a deal. After closing, as long as you have a good property management company, it should be pretty hands-off. Although, if (really, when) something unexpected occurs, you’re responsible for making those decisions, which can come with a lot of stress and a lot of headaches.

 

Of course, it is indeed possible to automate the majority, if not all, of the above tasks. But that requires a certain level of expertise and a large time investment to implement effectively.

 

Passive investing is more or less hassle-free. You don’t have to worry about any of the actions described above. You just need to initially vet the apartment syndicator and vet the deal. From there, you simply invest your capital and read the monthly or quarterly project updates.

 

Risk

 

You are exposed to much less risk as a passive investor. You are plugging into an already created and proven investment system run by an experienced apartment sponsor who (preferably) has successfully completed countless deals in the past. Additionally, there is more certainty on the returns. You will know the projected limited partner returns — both ongoing and at sale — prior to investing. And assuming the syndicator conservatively underwrote the deal, these projected returns should be exceeded.

 

Active investing is a much riskier strategy. However, with the higher risk comes a higher upside potential. You own 100% of the deal, which means you get 100% of the profits. But, you also have to bear the burden of 100% of the losses. For example, a turnkey rental will likely cash flow a few hundred dollars a month depending on the market. The costs associated with one large maintenance issue or a turnover could wipe out months, or even years, of profits. A value-add or distressed rental has a huge upside potential. However, a common tale among distressed or value-add investors, especially the newer or less experienced ones, is projecting a certain renovation budget but finding an unexpected issue during the rehab process that drastically increases their budget, resulting in a lower or negative overall return.

 

Additionally, failing to accurately calculate a post-renovation unit’s rental premium will also result in the reduction or elimination of profits. While these profit reduction or elimination scenarios could technically occur with a passive investment, the risk is spread out across many investors, and a sponsor with a proven track record and a qualified team will mitigate these risks.

 

Real estate investing is for everyone, not just the moguls of the world. However, not all investment strategies are the same. It’s important to understand the pros and cons associated with each to determine which strategy will set you up for success.

What is Your Ideal Passive Apartment Investment?

After reviewing the differences between active and passive real estate investing, assessing your current economic condition, ability and risk tolerance level, you’ve decided to passively invest in apartment syndications.

 

Great! You are one step closer to investing in your first deal. So, what’s next?

 

Similar to determining your ideal general investment strategy (i.e. active vs. passive), you need to establish your ideal passive investment. And in order to establish your ideal passive investment, you need to know what your options are first. In particular, you need to learn about the different types of apartment syndications in which you can passively invest your money and the benefits and drawbacks of each.

 

Generally, apartment syndications fall into one of three categories: turnkey, distressed or value add.

 

1 – Turnkey Apartment

 

Turnkey apartments are class A properties that require minimal to no work after acquisition. These properties are fully updated to the current market standards and are highly stabilized with occupancy rates exceeding 95%. Therefore, the turnkey business model is to take over the operations and continue managing the asset in a similar fashion to the previous owners. No renovations. No tenant turnover. Nothing fancy.

 

Of the three apartment syndication strategies, investing in turnkey apartments has the lowest level of risk. The property is fully updated and fully stabilized at acquisition. The risks associated with performing renovations, which include overspending, unexpected capital expenditures, bad contractors, incorrect rental premium assumptions, etc., and turning over a large percentage of tenants are minimized. Additionally, the asset will achieve the projected cash flow from day one, because the revenue pre- and post-acquisition remains the same.

 

The drawbacks of the turnkey apartment syndication strategy are the lower ongoing returns and the lowest upside potential compared to the other two apartment types. Because the property is fully updated and stabilized, there isn’t room to increase the revenue of the property. Therefore, the ongoing returns are and remain in the low to mid-single digits. Additionally, since the value of the asset is calculated using the net operating income and the market cap rate, unless the overall market naturally appreciates, the property value will remain the relatively stable. As a result, there is little to no upside potential at sale. Most likely, you will receive your initial equity back with no profit.

 

2 – Distressed Apartment

 

On the opposite of the end of the spectrum is the distressed apartment. Distressed apartments are class C or D assets that are non-stabilized with occupancy rates below 90% and usually much lower due to a whole slew of reasons including poor operations, tenant issues, outdated interiors, exteriors, common areas and amenities, mismanagement and deferred maintenance. Generally, distressed apartment syndicators will take over and, within a year or two, stabilize the asset by addressing the interior and exterior deterred maintenance, installing a new property management company, finding new tenants, etc. Then, they will either continue their business plan to further increase the apartment’s occupancy levels and/or rental rates or they will sell the property.

 

The major advantage of passively investing in a distressed apartment is the upside potential at sale. Once the asset is stabilized the revenue – and therefore the value – will increase dramatically, resulting in a large distribution at sale.

 

The drawbacks of distressed apartments compared to the other two types are being exposed to the highest level of risk and receiving the lowest ongoing returns. The high upside potential at sale also comes with the risk of losing ALL of your investment. There are a lot of variable to take into account with a distressed apartment, which means there are a lot more things that could go wrong. Additionally, since the asset is not stabilized at acquisition, there will be little to no cash flow – and may even negative cash flow. That means you won’t receive ongoing distributions unless the syndication structure is such that you receive interest on your investment before the sale.

 

3 – Value Add Apartment

 

Lastly, we have value add apartments. Value add apartments are class C or B assets that are stabilized with occupancy rates above 90% and have an opportunity to “add value.” Generally, the value add apartment syndicator will acquire the property, “add value” over the course of 12 to 24 months and sell after five years.

 

“Adding value” means making improvements to the operations and physical property through exterior and interior renovations in order to increase the revenue or decrease expense. These renovations are different than the ones performed on a distressed apartment. Typical ways to add value are updating the unit interiors to achieve higher rental rates, adding or improving upon common amenities to increase revenue and competitiveness like renovating the clubhouse or pool area, adding a dog park, playground, BBQ pit, soccer field, carports or storage lockers and implementing procedures to decrease operational costs like loss-to-lease, bad debt, concessions, payroll, admin, maintenance, marketing, etc.

 

Compared to the other two apartment types, value add apartments have a lower level of risk, the highest ongoing returns and a high upside potential at sale. At acquisition, the property is already stabilized and generating a cash flow. So, at the very least, the property will continue to profit at its current level and your passive investment is preserved. That also means that you will receive an ongoing distribution (typically around 8%, depending on the syndication partnership agreement) during the renovation period. Once the value add projects are completed, the ongoing distribution will increase to the high single digits, low double digits and remain at a similar level until the sale. Additionally, the increase in revenue and decrease in expenses from the value add business plan will increase the overall value of the asset, which means there is the potential for a lump sum distribution at sale.

 

What’s Your Ideal Passive Investment?

 

Your ideal passive investment will be in an apartment type with the benefits and drawbacks that align most with your financial goals.

 

Are you content with tying up your capital for a year or two with minimal to no cash flow and willing to risk losing it all in order to double your investment? Then I would consider passively investing with an apartment syndicator that implements the distressed business plan.

 

Are you more interested in capital preservation and receiving a return that beats the inflation rate? Then I would consider passively investing with an apartment syndicator that purchased turnkey properties.

 

Are you attracted to the prospect of receiving an 8% to 12% cash-on-cash return each year with the prospect of a sizable lump sum profit after five or so years?  Then I would consider passively investing with an apartment syndicator that implements the value add business model.

 

COMMENT BELOW: What is your ideal passive investment – turnkey, distressed or value add? 

 

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stop sign

When to NOT Work with a Passive Investor on an Apartment Deal

When I first started raising money from investors to purchase apartment communities, as long as the individual was interested in a passive investment and met the accredited qualifications, I accepted their capital without hesitation. And if you are just launching your syndication career, perhaps you’re doing the same. However, as you begin to gain experience and your list of private investors grows, it is beneficial to be aware of the red flags that may indicate the potential for future disputes and, if necessary, to not add or remove the investor from future new investment offering correspondences.

 

To understand these red flags, it is first important to define the ideal syndicator/passive investor relationship. The typical life cycle of an apartment syndication is 5 years. Therefore, when forming a relationship of this length, I want a passive investor who both trusts me as a person and treats me as a partner, as opposed to considering me as their vendor. Based on my experience from hundreds of accredited investor conversations and completing more than ten apartment syndications, I’ve found that there are two main factors that indicate to me that our relationship will not meet these requirements.

 

Red Flag 1 – Contempt

 

A famous study published in 1998 by marriage researcher John Gottman videotaped newlywed couples discussing a controversial topic for 15 minutes with the purpose of measuring how the fought over it. Then, three to six years later, Gottman and his team checked in on these couples’ marital status – were they together or were they divorced? As a result, they determined that they could predict with an 83% accuracy if newlywed couples would divorce. The study found that there are four major emotional reactions that are destructive to marriages and of the four, contempt is the strongest.

 

If there is contempt in a marriage, it will not last. And I believe that the same applies to business relationships.  According to Dictionary.com, contempt is the feeling that a person or a thing is beneath consideration, worthless, or deserving of scorn.

 

How I identify contempt is based on my initial gut reaction. Do I get the feeling that this person sees me as an equal and as a partner? Or do they look down on me and see me as a vendor? For example, I recently had an email correspondence with a potential investor. He led off the conversation by saying, “My standards are high. My patience for slick marketing is low.” Then, after I provided him some information about my company, including past case studies of the returns I provided to my investors, his reply was, “So what I need to hear is why do some deals with you as opposed to (the company with which he currently invests)?” I felt that this individual’s replies had traces of contempt and politely explained that we wouldn’t be a good fit. If I was earlier on in my career, I would have likely brought this individual on as a partner, but since I already have strong relationships with my current investors, I didn’t find the potential issues worth pursuing the relationship any further.

 

If you are having a conversation with an investor and your gut is telling you that this person holds you in contempt, I would consider passing on the relationship. To set the relationship up for success, only work with investors who treat you as an equal and who want a mutually beneficial partnership.

 

Red Flag 2 – Lots of accusatory questions that don’t convey that they trust me

 

The second red flag I’ve come across is when a potential investor asks a laundry list of questions in an accusatory tone. For example, I have an investor who literally sends me a list of 50 or more questions that are written in an accusatory fashion for every new investment offering. After taking the time to answer each question on multiple deals, they have yet to invest. Because they are asking questions in that manner, regardless of my answer, they will still be suspicious.

 

An important distinction to make here is that I have no issue with my investors sending me a list of questions, no matter how long. In fact, that is encouraged, because the more information I can provide about the deal, the more confidence they will have in the investment. The red flag is when the questions are asked in an accusatory manner. That conveys that they don’t have trust in me and that they’ll likely never invest in a deal. At the end of the day, the key to a successful, long-term relationship is trust, and when my instincts are telling me that there is a lack of trust, I decide to no longer pursue the relationship.

 

Conclusion

 

The two red flags to look for when having conversations with investors is contempt and the asking of a long list of questions in an accusatory tone that conveys that they don’t trust me.

 

Keep in mind that both these factors are highly subjective. Each syndicator and each investor has a different personality and will get along with different types of people. Just because you get the feeling that someone holds you in contempt or asks questions in an accusatory tone does not mean that they are a bad person. However, what it does indicate is that you will have an issue connecting in such a way that builds a relationship that is capable of surviving the course of a syndication deal. So, if either of these red flags arise, be polite, but strongly consider not working with that investor on your apartment deal.

 

If you have had a rocky business relationship in the past that came to an unfortunate end, what did you identify as the cause?

 

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aparment real estate from the ground

The 3 Secrets to Attract and Keep Your Passive Apartment Investors

Before raising money for my first deal, I thought the primary reason accredited investors would passively invest in my deal would be because of the return. However, after raising $1 million for that deal, I discovered that the return on investment was not the major concern. Because there are other syndication and investment avenues to which an investor can go, offering solid returns cannot be the driving factor.

 

So, if returns aren’t their primary motivation, what is?

 

Since my first deal, I’ve partnered with hundreds of accredited investors on more than ten apartments communities worth nearly $200,000,000. From this experience, I have narrowed down the passive investors’ three primary reasons for investing in an apartment syndication:

 

  • My money is in good hands
  • I will be updated on relevant information on the deal
  • The process is hassle-free

 

Need #1 – Is my money in good hands?

 

My first need is to know that my money is in good hands. First and foremost, that means I want to know that – at the very least – you won’t lose my money. Billionaire investor Warren Buffett has two rules for investing: 1) Never lose money. 2) Never forget rule number 1. Therefore, your main focus when managing other people’s money should be capital preservation.

 

Like any investment, there are never guarantees – not for returns or the preservation of capital. So, I need to know that you are proactively mitigating any major risks. The syndicator accomplishes this by adhering to the three principles of apartment investing:

 

  • Don’t buy for appreciation
  • Don’t overleverage
  • Don’t get forced to sell

 

Follow these three principles and I will be confident that you will not only preserve my capital, but maximize my return as well.

 

Along with this, I want to know that my money is in the hands of an experienced syndicator. So, before you’re ready to raise money for your first deal, you must establish a solid educational foundation and have a track record in business and/or real estate. If you are lacking in either or both of these areas, you can make up for your deficiencies by surrounding yourself with a trustworthy, credible team, like a mentor, property management company and broker who have experience in the apartment industry and have successfully completed syndications. For me to invest in your deals, I must be confident in you and your team’s ability to return my capital and provide me with the projected return.

 

I also need to trust you as a person. I need to have a good feeling about you and truly believe that you have my best interests in mind. This trust is established by the length and quality of our relationship and by you demonstrating your expertise through your experience, your team or your thought leadership.

 

With this trust, I will be confident that you will have common sense, make good decisions, conservatively underwrite the deal, perform all the required due diligence before purchasing an apartment and at a minimum, meet the projected returns you outlined.

 

Finally, I want to know that you are a responsive communicator. If there is a problem with the deal, I want you to not only notify me of the issue, but have a proposed solution as well. And if I reach out to you with a question or concern, I expect that same lightning quick response with an answer.

 

Overall, I want to know that my money is in good hands. The syndicator will convey this to me by proactively mitigating the risks, having the relevant experience, building a trusting relationship and being a responsive communicator.

 

Need #2 – Will I be provided with status updates on the deal?

 

Additionally, I want to be provided with ongoing status updates of the project. On a consistent basis, I want a director level – not a CEO or entry-level employee level – update on the deal with supporting data.

 

To accomplish this, the syndicator needs to provide their investors with a monthly email update (I use MailChimp) that includes the following information:

 

  • Distribution details
  • Occupancy and pre-leased occupancy rates
  • Actual rents vs. projected rents
  • (If you are a value add investor) actual rental premium vs. projected rental premiums
  • Capital expenditure updates with pictures of the progress
  • Relevant market and/or submarket updates
  • Any issues, plus your proposed solution
  • Any community engagement events

 

Then, on a quarterly basis, provide me with the profit and loss statement and rent roll so if I want, I can review the operations of the property and dig deeper into the details. My company actually provides monthly distributions – as opposed to quarterly or annual distributions – so our investors are not only provided with updates on a monthly basis, but are paid as well.

 

Need #3 –  Is the process hassle-free?

 

Finally, I want a hassle-free process. The reason I am a passive investor is because I want to park my money in an investment and not have to worry about doing any of the day-to-day operations. I am busy making money with other business endeavors, so I want to minimize my time investment in the deal.

 

After performing my initial due diligence on the deal prior to investing, I want a boring investment with little to no surprises. All I want to do is read the monthly email updates and receive my distributions. So, to effectively provide investor distributions, set up a direct deposit, as opposed to sending checks in the mail, so all I need to do is look at my bank account rather than going to the bank each month to deposit a check.

 

If I do reach out with a concern, I want a quick resolution with minimal back and forth. Therefore, you should proactively address potential concerns in your monthly updates and if an investor has a concern, have a solution in place prior to replying.

 

Conclusion

 

In summary, I’ve completed nearly $200,000,000 worth of apartment syndications with hundreds of passive investors, and if you set your business/deals up so your investors answer YES to these 3 questions, you’ll be well on your way to closing more deals:

  • Is my money in good hands?
  • Will I be provided with status updates on the deal?
  • Is the process hassle-free?

 

If you use private money investors for you deals, what have you found to be their top motivations for investing with you and not with another qualified investor?

 

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3 Essential Factors of Diversification in Passive Real Estate Investing

Jeremy Roll, who is currently an investor in more than 70 deals across over $500 million worth of real estate and business assets, is one of many speakers who will be presenting at the 1st annual Best Real Estate Investing Advice Ever Conference in Denver, CO February 24th to 25th.

In a conversation with Jeremy last year, he provided his Best Ever Advice, which is a sneak preview of the information he will be presenting at the conference.

 

What was Jeremy’s advice? He explains the three essential factors to take into account when approaching diversification in passive real estate investing – geography, asset-class, and operators.

 

Geographic Diversification

 

Some investors like to invest locally, which can be defined as a location that is within an hour or two-hour drive. Others will invest out-of-state, but all in one sub-market. There are thousands of different ways to invest and most of them are effective. However, there is a problem with having all of your properties concentrated in one geographic location: you are much more susceptible to economic, weather, and other geographically related risks.

 

If there is a major earthquake, for example, and you own 10 properties within 3 miles of each other that are all destroyed, you are in trouble. I know this is an extreme example, but it is still a risk. Since earthquakes and similar risks are such a rarity, Jeremy calls them 1% risks.

 

In last months of 2016, Florida was hit by hurricanes, which most likely had a major affect on some real estate. While it might be okay to own real estate in Florida, if you were heavily invested in one Floridian location and one hurricane wiped out half of your properties, again, you are in trouble.

 

Another weather related example – Jeremy invests in six different funds with some very large mobile home park operators, with one being the 5th largest in the world. This operator shared a story about why they have no issue with investing in areas that have tornados, but they avoid hurricane areas. The reasoning was that when a hurricane hits, it typically wipes out a massive territory. As a result, the different governmental agencies and insurance companies are too overwhelmed and can’t handle it, so it takes forever to repair the damage. But for tornadoes, a more isolated area is affected, so FEMA will come in immediately and help. Isolated areas are much more manageable. In this specific situation, these mobile home operators had all of their homes that were damaged or destroyed by a tornado replaced for free. The lesson here is that tornados are manageable and hurricanes are unmanageable.

 

Besides weather related risks, another reason to diversify across different geographical areas is that each has it’s own unique economies and as a result, it’s own unique challenges. If you are invested in a city that relies heavily on a specific employer and they decide to relocate their plant across the country, you are in trouble.

 

There are countless other examples, so all in all, it is important to spread your investments out across different geographical areas.

 

Asset-Class Diversification

 

It is also important to diversify across different asset classes, both from an asset-type and tenant perspective. For example, Jeremy won’t invest in apartments unless they are 100 units of more. For a 100 unit building, when one person leaves his vacancy rates increases by 1%. On the other hand, if you invest in a 4plex and one tenant leaves, your vacancy rate increases by 25%!

 

Diversifying across asset-types is key because certain types perform better in a growing economy while others perform better, or are at least more manageable, during a downturn. For example, office and retail don’t perform as well during a good economy, but can go through a recession relatively well. Specifically, retail with anchor tenants – big grocery stores, CVS, Walgreens. Mobile home and self-storage – can perform even better during a down turn. In 2009, self-storage vacancy only increased by 1%. This is probably due to the increase in demand that came from homeowners who were foreclosed on and needed a place to store all their personal belongings.

 

In the long-term, you want to be as diversified as possible. In doing so, whether we are in a good economy or a bad economy, the cash flow is still going to come in. This is especially important if, like Jeremy, you are dependent on cash flow to live off of.

 

Jeremy does not recommend that you invest in every asset class. For example, he personally doesn’t invest in hotel or industrial space. On average, these asset classes tend to do really well in an upturn or positive economy. However, they tend to have really quick revenue reductions during a downturn. He doesn’t want to be exposed to that volatility.

 

Therefore, it is important that you diversify as much as possible, but make sure that you are comfortable and knowledgeable in all the asset classes you select.

 

Operator Diversification

 

Whenever you invest passively, you are trading control for diversification. You are giving someone else control of the day-to-day operations and you are probably investing with multiple different investors, so your control is minimized. Therefore, if you are going to give up control, you better trade it for diversification. Jeremy finds that there is always a 1% risk with operators, due to the possibility of mismanagement, fraud, a Ponzi Scheme, etc. You are increasing your risk inherently by being a passive investor. To mitigate that risk, diversify across operators. Don’t have too many eggs in one basket.

 

Everyone has their own take on the maximum exposure an investor should have in terms of number of operators. The common number that Jeremy sees is that people don’t like to be exposed to an operator with more than 5% to 10% of their total capital. The same applies to geography and asset-classes as well.

 

It is also important to keep in mind that proper diversification takes a long time, but it is the best way to reduce risk. The more diversified, the better. Jeremy recommends that you shouldn’t invest more than 5% of your capital into an opportunity. This means that your goal should be to diversify across at least 20 different opportunities. At that point, you can determine how many operators you are comfortable with – 1, 3, 5 or more, depending on the person. It is very subjective and depends on what you are comfortable with.

 

Conclusion

Diversification in real estate investing is a must to ensure long-term success and reduce risk. Jeremy Roll diversifies his investments by keeping three essential factors in mind:

  1. Geography
  2. Asset-class
  3. Operators

 

Jeremy believes your ultimate investment goal should work towards investing no more than 5% of your overall capital into a single opportunity and to expose no more than 10% of your capital to a single geography, asset-class, or with a single operator.

 

 

What are some stories of problems you have come across that were a direct result of not being diversified enough?

 

 

Want to learn more about lease-option investing, as well as a wide range of other real estate niches? Attend the 1st Annual Best Ever Conference February 24-25 in Denver, CO. It’s the only real estate investing conference whose content and speakers are curated based on the expressed needs of the audience. Visit www.besteverconference.com to learn more!

 

 

 

Related: Best Ever Speak Brie Schmidt Sneak Peek How to Avoid the Shiny Object Syndrome in Real Estate Investor

 

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The Importance of Diversification in Passive Real Estate Investing

Putting all of your eggs into one basket can be very dangerous in real estate investing. Jeremy Roll, who currently invests in more than 70 opportunities across over $500 million worth of real estate and business assets, is a firm believer in creating a diversified investment portfolio. In our conversation on the podcast, he explains how he personally approaches diversification by breaking it down into the 3 most essential pieces – geography, asset-class, and operators.

 

Geography Diversification

 

Some investors like to invest locally, somewhere that they can drive to within an hour or two. Others will invest out-of-state, but all in one sub-market. Everyone has their different investment strategies and most of them are effective. However, the problem with having all of your properties concentrated in one geographic location is that you are much more susceptible to weather and economic related risks.

 

For example, if there is a major earthquake (or volcanic eruption) and you own 10 properties within 3 miles of each other that are all destroyed, you are in trouble. While this is extreme, it is still a risk (Jeremy calls these 1% risks).

 

Certain parts of the United States, like Florida, are frequently bombarded with hurricanes, which have a major impact on real estate. While it might be okay to own real estate in Florida, if you were heavily invested in one Floridian location and one hurricane wipes of half of your properties, again, you are in trouble. On a related note, if you are impacted by a hurricane, make sure you follow the SOS approach, especially when you have private investors.

 

Another weather related example – Jeremy invests in 6 different funds with some very large mobile home park operators, with one being the 5th largest in the world. This operator shared a story about why they have no qualms with investing in areas that have tornados, but they avoid hurricane areas. The reasoning was that when a hurricane hits, it typically wipes out a massive territory. As a result, the different governmental agencies and insurance companies are too overwhelmed, so it takes forever to repair the damage. Whereas for tornadoes, a more isolated area is affected, so FEMA will come in immediately and help. Isolated areas are much more manageable. In this specific situation, these mobile home operators had all of their homes replaced for free. The lesson here is that tornados are more manageable than hurricane.

 

Asides from weather related risks, another reason to diversify across different geographical areas is that each has it’s own economies and applicable challenges. If you are invested in a city that relies heavily on a specific employer, if they decide to relocate their plant across the country, you are in trouble. Job and economic diversity is just one of the many factors to look at when selecting a target market.

 

There are countless other examples, so all in all, it is important to spread your investments out across different geographical areas.

 

Asset-Class Diversification

 

It is also important to diversify across different asset classes, both from an asset-type and tenant perspective. For example, Jeremy won’t invest in apartments unless they are 100 units of more. If one person leaves, his vacancy rate increases by 1%. On the opposite end, if you invest in a 4plex and one tenant leaves, your vacancy rate increases by 25%.

 

Diversifying across asset-types is key because some perform better in a growing economy, while others perform better, or are at least more manageable, during a downturn (and, of course, you should always follow the Three Immutable Laws of Real Estate Investing to thrive in any market condition). For example, office and retail don’t perform as well during a good economy, but can remain consistent during a downturn – specifically, retail with anchor tenants like big grocery stores, CVS, Walgreens, etc. Mobile home and self-storage can perform even better during a down turn. In 2009, self-storage vacancy only increased by 1%. This is due in part to the increase in demand that came from homeowners who were foreclosed on and needed a place to store all their items.

 

In the long-term, you want to be as diversified as possible. In doing so, if we are in a good economy or a bad economy, the cash flow is still going to come in. This is especially important if, like Jeremy, you are dependent on passive cash flow to live off of.

 

Jeremy does not recommend that you invest in every asset class. He doesn’t invest in hotel or industrial space, for example. On average, these asset classes tend to do really well in an upturn or positive economy. However, they tend to have really quick revenue reductions during a downturn. He doesn’t want to be exposed to that volatility. Therefore, it is important that you diversify as much as possible, but make sure that you are comfortable in all the asset classes you select.

 

Operator Diversification

 

Whenever you invest passively, you are trading control for diversification. You are giving someone else control of the day-to-day operations and you are probably investing with multiple different investors, so your control is minimized. Therefore, if you are going to give up control, you better trade it for diversification. Jeremy finds that there is always a 1% risk with operators, due to the possibility of mismanagement, fraud, a Ponzi Scheme, etc. You are increasing your risk inherently by being a passive investor. To mitigate that risk, diversify across operators. Don’t have too many eggs in one basket.

 

Everyone has their own take on maximum exposure an investor should have in terms of number of operators. The common number that Jeremy sees is that people don’t like to be exposed to an operator with more than 5% to 10% of their total capital. The same applies to geography and asset-classes as well.

 

It is also important to keep in mind that proper diversification takes a long time, but it is the best way to reduce risk. The more diversified, the better. Jeremy recommends that you shouldn’t invest more than 5% of your capital into an opportunity. This means that your goal should be to diversify across at least 20 different opportunities. At that point, you can determine how many operators you are comfortable with – 1, 3, 5 or more, depending on the person. It is very subjective and depends on what you are comfortable with.

 

 

What about you? Comment below: What are some stories of problems you have come across that were a direct result of not being diversified enough?

 

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