JF2458: A Contrarian Perspective on Passive Investing In Apartment Syndication | Syndication School with Theo Hicks
In today’s Syndication School episode, Theo Hicks shares a list of some of the reasons why some people may not want to invest in apartment syndication real estate and how you can potentially counteract the reasons when you’re pitching your idea to other investors.
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Theo Hicks: Hello, Best Ever listeners, and welcome back to another episode of the Syndication School series, a free resource focused on the how-to’s of apartment syndications. As always, I’m your host, Theo Hicks. Today we’re going to talk about a contrarian perspective on passively investing in commercial real estate; more specifically, passively investing in multifamily.
Obviously, the purpose of Syndication School is to teach you how to become an apartment syndicator. An important aspect of this is putting yourself in the shoes of your customer, a.k.a. your passive investors, and understanding what makes apartment syndications a good investment for them, but also what might necessarily make it not a good investment for them. Not objectively, obviously, but based off of their own personal preferences and goals. So we’re going to go over a list of some of the reasons why someone would not passively invest in real estate. Of course, another purpose of this episode could also be if you were to come across these objections, I’ll go over a few different ways to counteract those if they were to come up during a conversation. But obviously, passive investing is a great way to achieve financial freedom and achieve financial independence for your passive investors, but it’s not going to be for everyone. Every single person you talk to, passive investing is not going to be the ideal investment for them. So by being honest with them is going to be better for you in the long run, and of course better for them as well.
Let’s go over this contrarian perspective of when someone would not passively invest in apartment syndication. I’ve got four scenarios or four situations where, again, someone might decide not to passively invest or this might be an objection they have to you when they learn more about apartment syndications. Really, this is going to come down to the differences between being an active investor and being a passive investor. What I’m going to talk about today can apply to all asset classes. I’m not going to go specifically into why you should not passively invest in apartment syndications. That’ll be something I’ll go over in a future episode. For this episode, it’ll be more of syndications in general, as opposed to being an active investor.
The first reason why someone will decide not to passively invest is because they want to have control. This is probably the biggest difference between being an active investor and a passive investor. As a passive investor, someone who’s investing with you – they’re not going to have any control over the investment. They can decide to invest with you or not, and then depending on how you have your investments set up, they might be able to decide which deals to invest in assuming you’re not doing a fund. But if it is a fund, the only thing to really do is choose to invest with you, and then you decide what is purchased. Once you’ve purchased the asset, you have control over the entire business plan, and they don’t.
So for people that want complete control over their investments, then passively investing in real estate is probably not going to be ideal… Because if they want to control, they should be an active investor. They should be doing the apartment syndications, because then they’ll be able to decide what renovations to perform, what the investment strategy is going to be, who to rent to, what kind of rent to charge, when to refinance, sell, or get supplemental loans, and really everything else in the business plan.
Now, again, if this objection were to come up, something you could say back to them is “Okay, I understand what you’re saying.” But in return for not having that control over the investment, they don’t need to know as much about the actual process, nor do they require investing the ongoing time into that process. They can get some education on the process, they can find who to invest with, and then it’s relatively hands-off from there, and the active investor is doing all the work.
So in a sense, it’s going to be a full-time job for them if they want to do what you’re doing, because it’s your full-time job. They’re going to know how to find a team, they’re going to have to understand all the different things that are required to implement a business plan. If they want to do that, great. You can mention that you have resources on that as well. But ultimately, if that’s not going to stop them from deciding not to passively invest, they truly want to have control, then they’re going to have to put in some effort. But passive investing might not be the only option for them. You could convince them to passively invest while they’re working up to their active business. I did an episode before on how investing passively in syndications can help you become a syndicator yourself. So lots of ways to counteract that objection. So that’s number one. If you want to control, passive investing is probably not for you.
Theo Hicks: The second is if you want the potential for very high returns. As a passive investor in your deals, they’re going to be exposed to a lot less risk. So they’re going to invest into, hopefully, your proven investment system, run by you, the experienced commercial real estate operator. You’ve successfully done deals with them in the past, so they kind of have an idea of “Okay, this has worked in the past, it’s going to work in the future.” So they’re going to give you their money, you use that money to buy a property, and then in return, they get a portion of those profits. Now, because it’s going to be plugged into a proven system, because it’s hands-off, there’s going to be a lot lower risk when it comes to passive investing, which means that your passive investors are going to make a lower return. These returns, obviously, as everyone knows, are going to vary greatly depending on what is being invested in. But overall, you as the syndicator are going to make a higher return on your investment than your passive investor. 99 times out of a 100.
A quick example would be that you acquire an asset and you structure the compensation with a 70/30 split. The passive investors get 70% of the profits, you get 30% of profits. Even though they’re getting that 70%, there are way more passive investors and there are GP’s. So that 70% is spread across more individuals. Plus, you as the operator are charging other fees like acquisition fees, asset management fees, things like that. Plus, you probably have your own money in the deal, which means you’re also getting a portion of that 30% as well. Plus, you have way less than 30% of the equity in the deal, too.
Because of these very factors, you’re going to make a lot more money. You can make even a thousand plus percent ROI. I’ve put together an example of where you as a GP can make a thousand percent ROI. Let’s say you’ve got a 10 million dollar investment, you get to raise four million dollars for your investors, invest 3.8 million, and then you invest the remaining 200,000. After five years, the apartment community is sold and the overall equity multiple to your passive investors is a two, which means that the total profit over that five year period is going to be four million dollars.
Assuming a 70/30 split, if you kind of do the math, four million dollars is technically 70%, because that’s what went to the passive investors. When you do the math, you determine that if 70% is four million dollars, then 30% is 1.7 million dollars. That’s what the GP’s will get. And then since the GP’s invested $200,000 as passive investors as well, then they’ll receive an extra $200,000 of that four million dollars in profits from the LP side. Let’s say there’s a 2% acquisition fee of $200,000, and that’s not even accounting the asset management fees or any other fees that are charged. You add all that together, you’ve got $200,000 from investing as an LP, you’ve got another $200,000 from the acquisition fee, and then you’ve got the 1.7 million dollars from your 30% equity split – that’s 2.1 million dollars in five years based off of a $200,000 investment, which is over a thousand percent ROI, compared to the 200% ROI of a 2x equity multiple that your passive investors made.
Again, this is accounting for really all the other fees like asset management fees, property management fees, if the proper management company is in-house, disposition fees etc. As you can see, if you’re active, your ROI, based on how much money you invest, which could be nothing depending on how you structure it – you might not invest any of your own money; it’s always good to, but you might decide not to – then it could be an infinite ROI. Sure, you’re investing a lot more time for this ROI, but overall, the point is that as an active investor, you can make a higher ROI than a passive investor. If a passive investor wants to make a thousand percent ROI in five years, they’re probably not going to accomplish that by passively investing in your deals. Again, just like the control objection in return for this lower return, they’re getting a relatively low-risk investment that’s pretty much hands-off. Doubling your money in five years is still a pretty solid return compared to other investment vehicles, but it’s not the same as 10x-ing your money in five years. So if you want the potential for higher returns, then passive investing may not be the option for you.
Theo Hicks: The third reason why someone might not want to passively invest in your deals is if they aren’t an accredited investor or if they don’t have a pre-existing relationship with you. I’m not going to go over the details of what an accredited investor is, because we’ve been doing Syndication School for a while and we’ve talked about it a lot on other episodes… But in order to invest in apartment syndications, or syndications in general, then you most likely need to be an accredited investor. There is an exception where you can raise money from non-accredited investors as long as you have a pre-existing substantive relationship with them. But if this passive investor is not accredited and they don’t know any sponsors, then they can’t passively invest.
I did do a Syndication School series — I’ve just completed a two-part series on how to automate that relationship-building process, and some tactics on how to leverage your thought leadership platform to create that relationship with an individual so that they can invest in your deals. If that is a problem for them, if they can’t passively invest because they don’t meet the requirements, then assuming you’re doing 506B and they don’t need to be accredited, then you can go listen to that two-part series to figure out what you need to do to start with that process. Again, I’m not an SCC specialist or attorney; that’s just an educational episode from the Best Ever Conference that a syndicator was using to meet those pre-existing substantive relationship requirements of the SEC. If you’re doing 506C and they aren’t accredited, then they need to become accredited. There’s really nothing you can do about that… Except, I guess, maybe direct them to someone who does 506Bs.
Ultimately, this fourth scenario, I’ve kind of hinted at this before, which is that if someone enjoys being a business owner, they want to operate a full-time successful commercial real estate company, then passively investing is not going to be the ideal investing option for them. If you’re talking to someone and they have a strong desire to create a commercial real estate company, and maybe they’ve retired or they sold another business and they have the capital and the time to do so, and that’s something that they really want to do – well, then passive investing in commercial real estate is probably not going to be the best thing for them, because of the reasons we’ve mentioned before. They’re not going to have any control; they’re just going to find you, and then it is hands-off. They can’t help you with the business plan. That’s just not how it works, and you don’t want them doing that either. So if they really want to be a business owner, if they want to start their own commercial real estate company, then passively investing in your deals is probably not the best thing for them.
Now, just like the control aspect of this, as well as the return aspect of this, when it comes to being a business owner, there are business owners, there are active sponsors who are also passively investing. So a good way to overcome really any of these objections is to explain that to them. Say, “Hey, I get that you want the potential for higher returns by running your own business.” Or “I understand that you want to have control over the business plan.” Or “I understand that you want to create your own commercial real estate company. You can do that, but you can passively invest in the meantime while you’re buildnig that up, and hey, by the way, by passively investing in commercial real estate, here are some of the things that will benefit your full-time business. You’ll get a behind-the-scenes look at how the process works, analyzing markets, how sponsors communicate with investors, evaluating markets, evaluating deals, things like that.”
So overall, in conclusion, when would passively investing not be good for someone? Well, if they want complete control over and have the expertise to operate their own investments, then passively investing might not be the best thing for them. If they are comfortable with higher risks in return for potentially higher returns, while also, again, investing a lot of time into managing those investments, then passively investing might not be the best option for them. If they aren’t accredited or do not have a pre-existing substantive relationship with a commercial real estate operator, they aren’t going to be able to passively invest. And bottom line, if they love the idea of operating a commercial real estate business on a full-time basis, then they should not passively invest. I guess it should be when you should not *exclusively* passively invest, because again, you can run your own business while passively investing at the same time. Most sponsors that I know passively invest in their own deals, and they passively invest in other deals as well.
As I mentioned, we have a Syndication School episode as well as a blog post on the benefits of investing in other people’s deals. I think it’s titled “Why I Invest in Others Syndications.” So check that out. Check out our other Syndication School episodes on the how-to’s of apartment syndications. Check out all the free documents that we have. Those are available at syndicationschool.com. Thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.
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