There are so many factors to consider when evaluating a potential investment and at times it can be overwhelming, especially for those who may be investing in their first real estate opportunity. Investing in real estate is not rocket science and sometimes it’s just about gaining a little clarity on what you are looking for. These are many of the things you should be taking into consideration when breaking down a multifamily investment.
-There are many different fees a Sponsor can charge. Here are some of the most common fees you may come across;
-Acquisition Fee – A fee the Sponsor receives at the formation stage of the offering. The fee compensates the Sponsor for time, effort, and expertise used in obtaining the investment opportunity. Typically, the acquisition fee is stated as a percentage of the price of the property acquired. Generally, this method uses 2% to 5% of the price of the property.
-Asset Management Fee – The Sponsor receives payment for managing the company, apart from managing the real estate which they may not actually do. Asset management fees may be based on the amount of money raised from investors. If the company raised $2 million dollars, the asset management fee might be 1% to 2% of that amount, paid annually. Many Sponsors also set the amount of the asset management fee as a fixed annual dollar amount, paid monthly or quarterly.
-Refinance Fee – When a property is a value add or a new construction project there can be a time when the property can be refinanced to return the investors a portion of their original cash investment without selling the property. If the Sponsor has ownership interests in the company, they may get a share of the refinancing proceeds. In addition, the Sponsor may get a percentage of the refinancing proceeds. It is common for the refinancing proceeds to go directly to the investors as a return of capital. If the proceeds exceed the investors’ original investment, the Sponsor and the investors will split any excess. Sometimes the refinancing proceeds are simply split between the investors and the Sponsor without regard to whether the Sponsor has any ownership interests.
-Disposition Fee – Typically charged for services rendered in an investment disposition, including sales marketing, negotiating and closing of the deal.
-There are several other fees that can be charged, you want to look out for investments that are fee heavy, especially those that lean towards the Sponsor being paid first. That being said, you actually do want your Sponsor to get paid so there is an incentive for he/she to perform, just be sure that his/her interests align with yours and the Sponsor is not making money if the investment is not performing.
-The next thing to look for in the offering is the investor returns and the splits between the Sponsor and the investors. There are too many ways that the splits can be structured to label them all here, but here are a few ways they may be structured to give you an idea.
-Straight Equity Split – These splits can range anywhere from 60/40 to 70/30 to even 80/20 with the investor getting the greater of the two and the Sponsor with the lessor. In the example of a 70/30 split the investor gets 70% of the equity and the Sponsor the remaining 30%.
-Preferred Return w/Equity Split – This is a scenario where the investor receives the “preferred return” before the Sponsor gets paid anything. If the investment does not hit this preferred return (let’s say 7%) then the remaining balanced is accrued until that payout is caught up. At that point there would be a split of equity as decided in the PPM.
-Waterfall – These splits can be structured in many different ways. One of these ways is as the investment hits identified markers the returns adjust. For example, you could have an 8%, 12%, 15% waterfall where once the 8% is achieved the split turns more in favor of the Sponsor, and again at the 12% and 15% marks. Although this seemingly does have a performance piece tied to it and your interests are aligned with the Sponsor, be careful with these. This falls under the same category of having too many fees. Typically, the more experienced and senior Sponsors are able to pull these off.
-Every Sponsor will have a different structure and none of them are better than another. Ultimately, it comes down to the returns of the deal and whether there is a sound operator and business plan in place to achieve those returns. Do not overthink the splits, again it’s about the return on investment. Here is another thing to think about when taking a look at the returns.
-Cash on Cash vs Overall Return on Investment – Be careful that the investment is not backloaded. Meaning you receive very little returns during the meat of the investment and only make the majority of your return upon sale. The sale is speculative as the Sponsor is not able to tell you where the state of the market and the investment will be in 5-7 years, so there is an assumption made here. These assumptions are well thought out and backed by data and several key factors. However, you want to be sure that your returns are made throughout the life of the investment and not just at the sale to ensure a stable, prudent investment.
-When you look at the returns of an investment it comes back to your goals and why you are investing in the first place. If you are not sure what type of returns you want to make then you are probably not quite ready to invest yet and need to educate yourself a bit more. Once you have a goal and a target return in mind you can go out and shop these investments and find the best one that fits what you are looking for.
-The timeframe of each investment will vary based on the business plan. These can range anywhere from several months to even as long as 10+ years. Most if not all of these investments are not liquid so your money will be tied up for a period of time. It will be important to ask what the expected timeframe of the investment will be and whether or not you will be able to sell your shares or pull your money out. Each deal will be different. Again, this goes with making sure the investment fits your goals.
Business Plan – Operating Agreement
-What is the business plan? Meaning how do they plan on getting the investment to perform the way they have projected? There are many types of investments from buy & hold turnkey, light, medium and heavy value add to ground up development. Each of them comes with their risks and rewards but typically buy and hold along with light value add would be on the more conservative side where as heavy value add and ground up development is more high risk. So back to the business plan. Multifamily is great because it literally is a business. If you operate it more efficiently than the one next door then your property will sell for more. The greater your Net Operating Income (NOI) the more the property will sell for, which is why having an experienced and focused operator is so important. So how do you increase the NOI? There are countless ways but typically it is by managing the property more efficiently (saving in expenses) or improving the property and increasing the incomes via rent increases or other income streams like charging for utilities, laundry, vending machines, etc.)
-When looking at the Sponsor’s business plan you need to ask yourself if it makes sense. Can they really get the rent increases and the expense savings to where they say? There are several resources at the end of this document that can help you research some of these items but they will vary deal by deal. You can also call brokers, property management companies and other investors that are local to that area. Bigger Pockets and Facebook Groups are also a great resource for asking these types of questions.
-Next thing to look at is who the property management company (PM) is that the Sponsor has selected, is it 3rd party property management or do they provide their own in-house? Neither is bad, you just want to be sure that the PM being used has a good track record and has experience in managing the type of asset that is being purchased. For example, if the subject property is a class C value add project then you want a PM that has prior experience with this type of asset and work. A PM who only focus’ on buy and hold class A properties would not be a good fit here.
-Next is the exit strategy. Are there multiple? What happens if there is a recession and the plan was to sell/refinance in year 3 and now that’s not possible? What are the back up plans? At the very least there should be 2 exit strategies. Whether that is refinancing after stabilization and returning capital back to the investors, stabilizing and selling in year 5, or holding long term and taking advantage of the cash flow. It boils down to not putting all of your eggs in one basket, there needs to be multiple exit strategies just in case things do not go as planned.
-Along the same lines as exit strategies, one thing you will want to know is the CAP rate a re-sale or reversion CAP rate. This is the speculative piece we talked about earlier. The reversion CAP rate is the rate that is used to derive reversion value which is what the Sponsor expects to receive as a lump sum at the end of an investment. I know, fancy right! Basically, that is a fancy way of saying where does the Sponsor think the market is going to be when they plan on selling the asset or what does he/she expect to sell the property for. Again, this is all speculative which is why you want to be sure that the Sponsor is being conservative or has a very good reason for his/her assumption. There are so many variables at play here so a rule of thumb is not possible, just be sure to check with credible resources and ask the question of whether the CAP rate at re-sale is justified.
Lastly, you need to make sure the business plan follows the 3 rules of Multifamily real estate investing.
1.) Be sure the property cash flows
2.) Be sure the Sponsor has raised sufficient funds to cover the cost of ALL capital expenditures, emergency reserves and working capital
3.) Be sure the Sponsor is securing long term debt, preferably 10+ years
Private Placement Memorandum (PPM)
-A private placement memorandum (PPM) is a legal document provided to prospective investors when selling stock or another security in a business. It is sometimes referred to as an offering memorandum or offering document. A PPM is used in “private” transactions when the securities are not registered under applicable federal or state law, but rather sold using one of the exemptions from registration. The PPM describes the company selling the securities, the terms of the offering, and the risks of the investment, amongst other things. The disclosures included in the PPM vary depending on which exemption from registration is being used, the target investors, and the complexity of the terms of the offering.
-The following are some questions you should be asking yourself as you read through the PPM.
-Do I have to stay in the deal the entire time or can I sell my interest?
-What happens if the project needs more capital?
-What happens to your money if the lead Sponsor passes away?
-What happens to your money if you pass away?
-What are the voting rights?
-Can the lead Sponsor be removed if they are severely underperforming?
-What is the compensation structure?
-What are the terms of the loan?
-What is the funding and payout schedule?
-How will I be updated on the project after closing?
-Make sure you read the entire document! You are giving your hard earned money towards this investment so you better understand all of the risks that come with it. These are just some of the many questions that should be asked before going into an investment. As mentioned earlier, if these questions cannot or will not be answered by the Sponsor then that is a clue and you should run for the hills!
Does the investment fit your goals?
-After you’ve done your due diligence the last question you should be asking yourself is does this investment fit my goals? Just because everything looks like a “good deal” does not mean it’s the right investment for you. You have to take a look at where you are in your life and what your 1, 3, 5 and even 10 year goals are. If the investment fits your goals then great! If not, then pass and try to find one that does. Here are a few more things to think about when asking yourself if this investment fits your goals.
-What is the minimum investment?
-How long will my money be tied up for?
-Do I trust the Sponsor?
-Do I believe in the business plan?
-Do my interests align with the Sponsors and their vision for the investment?
-Will this investment bring me closer to achieving my goals?
-Do I feel comfortable with the risks outlined in the PPM?
-Investing in real estate is not difficult. And you can build great wealth with it as a vehicle. However, you need to be educated and prepared just like you would with any other investment. Otherwise, it is just speculation and gambling. And when you play that game the house always wins!
-Be sure you know who are you investing with
-Be sure the Sponsor has a solid and trustworthy team with a positive track record
-Be sure your goals align with both the Sponsors and the investment itself
-Do your own due diligence, trust but verify!
-Follow the 3 rules of Multifamily real estate investing