By Jose Miller | Geocentric Investments
You’ve decided that real estate is the right investment for you. You’ve likely settled on one or maybe two different ways to earn money with real estate. It’s how you’re going to secure your retirement, fund your children’s college education, and even create generational wealth. Unfortunately, there are only so many hours in the day, so you’re not able to capitalize on new ways of investing in real estate.
But there is another way to invest in real estate that requires no extra time from you and is truly passive. It’s time to seriously consider investing in multifamily properties or apartment buildings.
Why invest in multifamily properties?
Multifamily rental properties offer a variety of advantages over single-family rental properties. A multifamily asset has the advantage of scale. For example, an asset with seventy units will likely have on-site management, on-site maintenance, a single pool, and less square footage per person for roofs and common areas. All of these lead to lower costs per unit. On-site management and maintenance mean better customer service, greater control over the property, lower risks, and quicker response times. All of these equate to less turnover and, thus, lower vacancies.
Unlike a single-family home (SFH) that is valued based on “comps,” large multifamily properties are considered commercial real estate and are valued based on their net operating income (NOI) – the total income minus expenses before the cost of debt. Just like an SFH, it makes sense to reduce vacancy and expenses and increase rents. Aside from market trends that you don’t control, the only thing that will increase the value of your property is how much your neighbors care about their property.
Multifamily properties can appreciate through Forced Appreciation. Forced Appreciation happens when you force the value of the property to increase, possibly because your expenses decrease through better management, renegotiated contracts, etc., or your rents increase through natural market trends or by upgrading units. In Phoenix, it’s common to find current Capitalization Rates (Cap Rates) around 6%. By increasing the NOI of a single unit by $200 and scaling that to our 70-unit property size example above, the value of this property would increase by $2.8M.
Who is involved in a multifamily asset?
There are primarily two roles when it comes to investing in multifamily properties: General Partner (GP) and Limited Partner (LP). A general partner, also referred to as a syndicator, a sponsor, or an operator, is part of the management team. They do all of the work and make all decisions regarding the asset. For example, they find the deal, analyze the property, determine the business plan, secure financing, raise investor capital, consider various exit strategies, and manage the asset. While the GPs manage every aspect of the business, from planning renovations to developing advertising strategies, the LPs are, by definition, limited in both liability and control. These limitations, however, have clear benefits. Aside from the obvious that you are only liable to the limit of your investment, your limited control means that you have no decisions to make. You don’t worry about tenants, turnover, contractors, or even property management companies. The income is truly passive. But this is also why it is imperative to partner up with GPs that are knowledgeable, trustworthy, and have a proven track record. It’s even beneficial to consider partnering with GPs that have similar values.
So, how do the partners make money?
A General Partner can make money in a few different ways: by collecting an upfront acquisition fee, collecting an asset management fee, sharing in profits, and sharing in any equity realized when the property is sold. The bulk of the GPs income comes from the sale of the property since the other fees are quite modest. On a typical asset that we operate, our business plan of improving the property, rehabbing units, and stabilizing rents is projected out over five years. This means that because we make very little profit for those five years, we are incentivized to perform because most of our profit is at the sale.
This is great for our Limited Partners. An LP makes money through preferred returns, typically paid monthly or quarterly, through tax savings due to depreciation of the asset, and from sharing in the bulk of the equity after a sale. Although most of the LP profits are also realized at the sale, a well-run asset can mean significant returns even before the sale occurs. The other benefit to our Limited Partners is that they have a preferred return, so they are paid before the GPs see any profits. This means that our goal, as GPs, of optimum performance and eventual profit, is perfectly aligned with your goal, as LPs, of maximizing the return on your investment.
And what kinds of returns are we talking about? We look for assets that will conservatively underwrite to an 8% Cash-on-Cash preferred return over a 5-year hold, and when coupled with the increase in equity, this translates to a 1.7-2.2x return on your investment over that period.
If you’re interested in better understanding how you can invest in Multifamily real estate to diversify your investment portfolio, please reach out to me at email@example.com or 480-205-5735.