Wednesday, July 17, 2024

The Mega-Profit Potential of Apartment Syndication | Real Estate

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What is your top priority in life?

Forty-four percent of millennials say it’s having children. Half say getting married and 72 percent want to own a home. But the single highest priority, at 80 percent, is being able to retire financially secure.

Although retirement is top of mind among millennials, most don’t really know what it takes to be able to retire—or even better, retire early.

Today, I’d like to share with you the secret to early retirement and wealth accumulation that few people ever speak about: building passive income through investments in an apartment value-add syndication.

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How to Double Your Money in 5 to 6 Years

Investing in a syndication as a passive investor typically doubles your investment in five to six years. Additionally, it’s a method that requires relatively little work. What’s even better, the money you earn can qualify for special tax benefits, such as depreciation, capital gain tax, 1031 exchanges, capital expenditure, and tax deductible interest.

In this article, I’ll explain exactly what an apartment value-add syndication is, how to invest in it, and why it’s a better option than purchasing a home.

Related: What is Real Estate Syndication – Really?

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What Is Apartment Value-Add Syndication?

An apartment value-add is the act of buying and renovating an old apartment to increase its occupancy and rental income. The rent you increase can vary from $50 to $500. For a 100-unit complex, the revenue can increase by as much as $50,000.

The amazing thing is that this additional revenue, assuming no additional expense, will increase your net operating income (NOI), allowing you to sell the apartment at a much higher price. The increase in selling price can be 10 to 20 times the increase in NOI, so a $50,000 increase in revenue can increase the selling price by as much as $1,000,000!

However, not all markets are priced the same. A hot market, like Los Angeles, typically has a higher selling price relative to a less popular city, like Tucson, Ariz., for the same NOI.

Now that we’ve covered what an apartment value-add is and how it generates money, let’s talk about what a syndication is. A syndication is a group of investors that raises equity and collaborates to execute a value-add deal. It involves two main parties: one called the general partner (GP) and the other called the limited partner (LP).

A typical GP consists of one to four people or LLCs, and a typical LP ranges from five to 50 people. The GP will source the deal, analyze it, create and execute a business plan, manage the apartment, and sell it based on the timing of the market—hopefully for a handsome profit.

This process typically takes four to six years. The LP’s responsibility is to find a trusted GP who knows what he or she is doing and has a successful track record. The LP should also understand the market condition of the property’s location. A general rule of thumb for selecting a market is to identify areas with high population and employment growth.

Related: Compelling Tax Benefits of Real Estate Syndication

The Ins & Outs of a Real-Life Apartment Syndication Deal

Let’s dive into an example of an apartment syndication deal in Tucson, Ariz., that I recently invested in. It’s projected to earn 15 percent IRR (Figure 1), a much more profitable return than that from buying a home.

Return on Investment

For this particular deal, the preferred return was 6 percent with an 80-20 split. This means that the GP promised me (the LP) at least 6 percent annual return.

If the property doesn’t generate enough cash flow to meet the 6 percent return, then the missing cash flow carries interest into the next year. It’s possible for an LP to earn low returns throughout this project and then receive a large payout at the end when the building is sold.

The 80-20 split means that the LP will get 80 percent of the cash distribution that exceeds the 6 percent preferred return, and the GP will receive the remaining 20 percent.

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Figure 1. Projected Return for an LP in an Apartment Value-Add Syndication

The above chart shows an equity multiple of 1.9X, which means that I can expect to almost double my investment in a span of five years. An IRR of 15.2 percent means that I will be earning an average of 15.2 percent annual return.

The return gets better year-over-year as the units are renovated; however, it dips in the fourth year because the loan for the first three years is interest only. Principal payments start in year four.

Additionally, the 15.2 percent annual return here is far greater than a 15.2 percent return through stocks. This is due to the tax benefits associated with real estate—perhaps even greater than a 20 percent annual return in stocks.

ROI Varies Greatly by Market

Lastly, let’s instead look at the return for a three-bedroom house in Los Angeles. Here are the assumptions for the house:

  1. Purchase Price: $639,000
  2. Down Payment: 20% or $127,800
  3. Closing Cost at Year 0: $3,000
  4. Interest Rate: 4.25%
  5. Monthly Rent: $1,000/room (for all 3 bedrooms)
  6. Expense Ratio: 40%
chart 2
Figure 2. Projected Return for a 3-BR House

This three-bedroom house investment will earn you 10.5 percent IRR but negative cash flow in years one to four. The negative cash flow is due to operating expenses and monthly mortgage. (Note that I am accounting rental income for all three bedrooms.)

A 10.5% IRR is not a bad return, but the negative cash flow makes buying a house in L.A. a risky investment because its return is mainly based on market appreciation. During a market downturn, an apartment value-add deal with positive cash flow is much more sustainable than a house with negative cash flow.

However, a house in a less expensive area may generate positive cash flow. A cost-efficient strategy some homeowners use is buying a duplex or triplex with six to nine total bedrooms and renting them out. Generating positive cash flow with this strategy is almost impossible in hot markets, like Los Angeles and San Francisco, where houses are very expensive.

Finally, I want to point out that REITs neither generate the same return as those of apartment value-add syndications nor give you the same tax treatments. REITs typically generate about 8 to 10 percent returns but do not offer you any of the tax benefits I mentioned earlier.

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Would you ever invest in an apartment syndication deal? Why or why not? If not, what would you invest in instead? 

I’d love to hear your thoughts in a comment below. 


Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

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