What is Your Ideal Passive Apartment Investment?
Last Updated: February 2019
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? Read on to learn how to make passive income from real estate.
Similar to determining your ideal general investment strategy (i.e. active vs. passive), you need to establish your ideal situation for investing in rental properties. 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.
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 rental properties that are turnkey 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 relatively stable. As a result, there is little to no upside potential at sale. Most likely, you will receive your initial equity investment back with minimal to no profit.
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 85% 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, 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 investing in rental properties that are distressed 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 variables to take into account with a distressed apartment, which means there are a lot more that could go wrong. Additionally, since the asset is not stabilized at acquisition, there will be little to no cash flow – and maybe 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.
Lastly, we have value-add apartments to consider when investing in rental properties. Value-add apartments are class C or B assets that are stabilized with occupancy rates above 85% 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 in rental properties with an apartment syndicator that purchases 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.
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