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20 Questions You Should Ask Before Investing in a Multifamily Syndication
It’s no secret that passive investing in a multifamily real estate syndication is a proven way to generate and preserve wealth. Many other passive investors and I can attest to the power of long-term investments in real estate, but it’s important to not get carried away in the hype. Before you decide to take action and start investing in this space, it’s important to make sure you’re asking the right questions. I’ve compiled a list of what I believe are the top 20 most important questions to answer before investing, sorted by (1) about the sponsor / structure, (2) financial metrics / associated risks, (3) process / timeline and (4) general.
About the Sponsor / Structure
1) What is the Sponsors track record?
Answer: The answer to this question will vary by Sponsor; each has their own history and business structure, and thus a different track record. To speak to our Sponsors specifically, we only partner with what we firmly believe to be the most top notch Sponsors in their niche who hold high values, proven track record of delivering results to Limited Partners (LPs) and have a strong history of performance.
2) Does the Sponsor invest in their own deals alongside passive investors?
Answer: The most common answer to that question is yes. Sponsors will invest alongside LPs in their own deals to show alignment, not to mention they are also interested in the strong returns they are projecting. Typically, the Sponsor team will bring +20% of the capital needed to close the deal while the remaining capital is raised from Limited Partners.
3) How is the deal structured and are they allowing non-accredited investors in?
Answer: The answer to this question varies. Typically, our syndicated deals are structured as 506(b) under SEC Regulation D which provides for unlimited spots for accredited investors (see Question 18 for definition of Accredited Investor) and up to 35 spots for non-accredited investors. The other most commonly used syndication structure is 506(c) under Reg D which only allows accredited investors to participate.
4) What is the hold strategy and how long can I expect to be in this investment?
Answer: Typical hold strategy is 3-7 year hold with an average of 5 years. Most Sponsors have a clause in the legal docs that allow for a longer hold period (say 100 years). The reason that this is so exaggerated is so that we are at no point forced to sell by outside factors. Our goal is to optimize value, and this allows us to hold through a down market and wait until the market has recovered.
I advise that an investment in our deals should be considered an illiquid investment. That being said, we operate in good faith and will work with LPs to try to find a solution if they need to get out of the investment due to a particular life event. However, there are no guarantees.
5) How is the deal structured in terms of profit sharing with the LP & GP?
Answer: All of our Sponsors structure their deals as a waterfall. The first “hurdle” in the waterfall is the 8% preferred return (pref), where LPs receive 100% of profits until they reach an 8% return. After this hurdle, most of our deals are structured at a 70/30 split (you may see different splits with other Sponsors), where all profits after the 8% pref are split at 70% to the LPs and 30% to the General Partner (GP). You will sometimes see a second IRR hurdle, where after XX% IRR (typically 15-18%) the split goes to 60/40 or 50/50. If this information adds a degree of confusion, I recommend concentrating on the projected returns (see A7), as they are more easily understood and by nature have the waterfall structure built in.
This information will be laid out in detail and readily available in the investment summary.
6) What are the common fees and how does the Sponsor make their money?
Answer: First and foremost, all fees are separate from return projections. What that means is that fees will have no impact on the return projects you will see in any of our deal decks; the LPs are not paying any fees “out of pocket.” That being said, Sponsors most often make their money in three ways. (1) The acquisition fee (1-3% of purchase price) which is paid at close and covers all costs associated with finding and putting the property under contract. (2) The asset management fee (1-3% of monthly revenues) which covers costs associated with executing the business plan; overseeing the property management company and construction management company, identifying and implementing value-add strategies, improving operational efficiencies, etc. (3) The equity split of profits after the pref; most common here is 70/30 (70% to the LPs and 30% to the GP), but you may also see 60/40, 80/20, etc.
Financial Metrics / Associated Risks
7) What are the projected returns?
Answer: Typical projected returns metrics are as follows:
Preferred return (pref): 8% (LPs take 100% of profit until they reach an 8% CoC)
Internal rate of return (IRR): 16-22% (a time sensitive rate at which your money grows, annually, over the life of the project)
Cash-on-cash (CoC): 8-12% (a rate of return that determines the cash income on, or in proportion to, the cash invested, measured annually)
Equity multiple: 1.7-2.3x (on a $100K investment, LPs earn $170-$230K, including return of initial investment)
That said, all of our Sponsors consistently exceed projected returns, made possible by our conservative underwriting.
8) What is the minimum investment?
Answer: Typical minimum investment is $50,000 or $75,000 with increments of $5,000.
9) Should I invest all of the capital I’m looking to put to work in to one deal or spread it across multiple?
Answer: Spread your capital across a number of deals. The key to a strong investment portfolio is diversification. The beauty of our strategic partnerships is that we are able to offer opportunities for diversification across several strong rental markets.
The amount of capital you should put to work in each deal will depend heavily on the amount of capital you are looking to deploy in total. If you are looking to deploy $1MM, for example, you can benefit from diversification by investing $100K in 10 deals. On the other hand, if you only have $100K to invest, consider placing $50K in 2 deals. Each investor’s financial situation is unique to that person, so there is no steadfast rule to follow here.
10) Are there any tax benefits from a passive investment in commercial real estate?
Answer: There are many. Depreciation and accelerated depreciation can result in a paper loss on an LPs K-1 statement (pass through tax doc), which can also be used to offset other gains in your investment portfolio. It is not uncommon to see a paper loss anywhere from 30% to 80% in the first year of investing in one of our deals. For more info on bonus depreciation, read this. It is possible to utilize a tax deferment strategy known as a “1031 Exchange” to transfer profits from one real estate investment into another similar investment with no taxes due on transfer. A supplemental loan or a refinance can return a significant amount of initial invested equity, which the IRS considers a non-taxable event. As stated in the answer to Question 19, you can invest using pre-tax retirement savings, which would allow you to return your profits to your IRA account, tax free.
11) What are the risks associated with this investment?
Answer: I’m not going to sugarcoat the answer to this one. Due to outside factors not in our control (namely, market conditions), there is a risk that you can lose your entire investment, just like you could in the stock market, single family homes (SFHs), or small business/start-up, etc. On a more positive note, we view this as a very highly unlikely possibility for several reasons. First, our conservative approach to underwriting leaves room to bear a market downturn. Second, we buy cash-flowing assets. That is, assets that provide a return day one and are not gambling on a large amount of appreciation to increase returns to investors. Cash-flowing multifamily assets can weather downturns better than just about any other investment, and we rely on our extensive experience and proven systems to mitigate as many risks as possible to ensure our passive investors money is protected and growing.
All risks associated with an investment will be laid out in detail in the private placement memorandum (PPM).
12) What would happen/what is the Sponsors strategy in the event of a down market? What’s to stop the Sponsor from selling in a down market and wiping their hands clean of the asset?
Answer: All of our partners’ number one value is capital preservation and downside protection. That being said, the goal during a downturn would be to hold until the market recovers, while still providing the 8% pref to investors. If things get really bad and we do not meet the 8% pref in a given year, we have a catch up that entitles investors to the 8% pref the next year PLUS the difference from the previous year. I.e. if we only return 4% in year one, LPs are owed 12% in year two. Additionally, we underwrite conservatively to ensure that, even in tough times, we are still able to provide a return to investors.
The Sponsor also makes more money in a strong market and thus benefits from holding through a downturn, just as our LPs do. The final, and most important part is remembering that relationships, reputation and brand are the most critical assets to the sponsorship team. Our Sponsors are all, by no mistake, top notch Operators and are in this game for the long haul; putting our investors interest firsts and foremost, even if that means bearing some of the negative implications, helps to maintain that already strong relationship, reputation and trust/faith among our current and prospective partners.
Process / Timeline
13) How frequently are distributions made?
Answer: Returns are most commonly sent out in quarterly distributions.
14) How often will communications/updates be sent out?
Answer: Again, this varies by Sponsor, but most often we update our passive investors monthly. Updates will outline a number of items including, but not limited to; value-add implementation progress updates, property pictures and financial statements. One advantage to multifamily syndications over buying a blue-chip stock online is access to the Sponsor team in charge. Even though updates may only come out monthly, most often the Sponser team is only a phone call away if you need a question answered.
15) Will I be able to 1031 from one deal in to the next?
A15: You cannot 1031 in to our deals since you are purchasing units of our Limited Partnership and not actually the property itself. However, although not guaranteed, there is potential to 1031 from one of our deals in to the next, given the right timing, thus providing the extremely powerful benefit of tax deferred growth.
16) How involved can I be as a limited partner?
Answer: Most Limited Partners invest very little time or effort into a deal once their initial investment is made. Some Sponsor teams will allow Limited Partners to see behind the scenes if they have a desire to learn the business, but this is not a common occurrence.
General
17) What is syndication?
Answer: Syndication, in its broadest sense, is a pooling of resources (time, money, knowledge, manpower, etc.) in order to achieve a larger goal than one would not be able to achieve alone. More specifically, in terms of commercial real estate value-add syndication, it is a structure in which a GP pools money from investors/LPs. The GP implements the business plan and provides a return to LPs who have a limited/passive role in the project. I offer a more in depth explanation in my blog on the topic which can be found here.
18) What is an accredited investor?
Answer: An accredited investor is an individual who meets one or more of the following requirements: $200K+ annual income for the past two years with the expectation to make the same the following year; a combined spousal annual income of $300K for the past two years with the expectation to make the same the following year; $1MM net worth, excluding primary residence.
19) Can I invest with my LLC or SD IRA?
Answer: Yes, many of our clients invest using pre-tax retirement funds. There are some things to consider, however, such as the UBIT (unrelated business income tax), which is why I recommend seeking the counsel of your CPA, financial planner, etc before investing using pre-tax retirement money.
20) Can I see a presentation from a previous deal?
Answer: I always encourage potential passive investors to watch a recorded webinar of a previous deal we have done in order to familiarize themselves with the types of acquisitions we make. While no two deals are the same, you can learn a lot from seeing a deal a Sponsor has taken down in the past. After watching the video, follow up with the Sponsor and ask how the deal is performing today. Are they meeting or beating expectations?
