8 Keys For Passive Investors to Know to Invest with Confidence

May 28, 2019

As a passive investor, you work hard for your money and you want to be able to invest your money into a secure asset that has potential to grow and multiply your capital.

 

In order to invest in the right deal for you I’ve outlined eight areas to research to help select the best apartment syndication for you. Through research, learning, and asking the questions, you will give yourself the best opportunity to succeed as a passive real estate investor.

 

Personal Risk Profile

 

As Socrates said “To know thyself is the beginning of wisdom.” This is true not only in life, but also with investing. Before someone invests in any asset class, they should understand their personal risk profile and how much risk/reward someone is comfortable with when they invest. Just like stocks, bonds, and CDs, real estate can deviate significantly with risk/return characteristics.  

  

Most risk profile questionnaires are geared towards the stock and bond markets because the mass population invests in these markets. You are able to take ascertain on the risk profile from these online questionnaires how risk adverse or risk tolerant you are. Below is an easy 10 question test that can help educate you on where you land on the risk spectrum.

 

Risk Tolerance Questionnaire

 

Many people associate real estate investing as a risky endeavor. This narrative is completely untrue. If you invest without doing your due diligence it can be true, but there is a lot of evidence that real estate is less risky than investing in traditional markets. Below are only a few reasons why this the case.

 

  • Real estate is backed by a hard asset

  • Investment in an asset is local, more insulated from macroeconomic trends

  • Real estate is a hedge against inflation

 

Asset Class

 

Now that you have determined your risk tolerance, the next step is to determine which asset class to invest in. Multifamily has multiple asset classes and each class provides a different type of risk/return characteristics. It is important to know what your required return will be for each investment. This will help you determine which asset class to invest in. Traditionally, the lower the asset class the higher the return and the higher the risk.

 

Below is a high-level breakdown of each asset class.

 

Class A

  • Highest quality asset you can purchase.

  • New upscale assets with many amenities that are in prime areas of a city

  • Returns are typically less because Class A deals are the most stable and desirable assets in a market so the returns tend to be less

  • Some people may buy in hopes of great appreciation

  • Potential vacancy spike during a recession due to white-collar workers living here

  • If supply surpasses demand, large concessions are possible to fill vacancies


Class B

  • Located in good areas of a city, with a mixture of white collar and blue collar workers

  • Generally, 15-30 years old

  • Cap rates are higher than Class A properties but lower than Class C

  • Bought for consistent cash flow and the opportunity for appreciation.


Class C

  • Generally, workforce housing and tenant base are blue collar workers

  • 30-40 years old

  • Ability to find under performing assets and force appreciation through strategic business plan.

  • More recession proof than A or B Class properties because people move to lower cost housing when economy is suffering.

  • Can be the first to appreciate in a rising market

  • Typically, Class B and C deals provide a greater return than Class A deals.

 

 Class D

  • Likely in the worst areas of a city and are known as war zones

  • Built over 40+ years ago

  • Most tenants are on Section 8 or another government-subsidized program

  • Can be an operational nightmare with tenants because of high crime area, vacancy (economic and physical)

  • Many communities will need security guards or local law enforcement to patrol area

  • If operated properly, can achieve significant returns because of a low purchase price

  • Buyer pool will be limited when you go to sale.

 

Selecting the Market

 

Market selection is an important factor in deciding where to invest and if the investment will be successful or not.
 

Characteristics to look at when selecting a market

 

  • Population of city or area (MSA)

  • Job growth

  • Population growth

  • Industry diversity

  • Economic drivers

  • Supply/Demand for tenants

  • Completeness of buyer pool

  • Cost of living

  • Median and average income

  • Cash flow or appreciation market

 

These questions do not have a right or wrong answer they are strictly personal preference, but by asking these questions you have a better understanding of a particular market you want to invest in. Your market preferences may shift overtime as well given changes in the economy or your life stage.

 

Remember that a rising tide lifts all boats. Meaning that even if you are in a subpar investment if it’s in a good market, the market can lift the investment to have extraordinary results.

 

Selecting the General Partner (Sponsor)

 

Selecting the right general partner for a passive investor is crucial to their success. Before a passive investor jumps into any deal with a general partner, they should understand who the general partner is, what their values are, and how they handle adversity. Investing in multifamily deal is a long-term relationship and like any relationships there will be highs and lows. You want to select a partner that can mitigate the lows and quickly navigate the ship in the right direction.

 

A few questions to ask any general partner to help decide if they are right for you.

 

  • What is their track record with multifamily investing?

  • What is their track record with other business ventures?

  • Do they hire a third-party property management company or have an in-house property management company?

  • If the GP hires a third-party property management company who is it and what is their track record?

  • What mistakes did they make in past or on current deals and how did they overcome it?

  • How have they handled adversity in their personal and professional life?

  • Can the GP provide references of their current investors?

 

As a passive investor, you are normally investing a minimum of $50,000 per deal. It is important to spend a little time in getting to know the general partner and make sure they are a good fit.

 

Holding Period of Investment

 

Every deal has a different holding period because it is unique and each business plan will never be identical. As a passive investor, it is important for you to align your goals with the correct investment. For instance, if you need your capital back in 5 years, it doesn’t make sense to invest in a deal that is forecasted to be held for 7 year.

 

Most deals typically project a 3-5 year holding period, but this isn’t always the case for a multitude of reasons so it is important to know the sponsors end goal.  

 

Debt Structure

 

Debt on a property plays a significant role in how long the general partner plans to hold the asset. The debt structure can potentially determine how successful a deal is.

 

The higher leveraged a deal is the higher the returns will be. Conversely, if an asset has less leverage it will produce lower returns, but can help weather a recession/downtown better than a higher levered asset.

 

Interest only debt helps increase returns of a project, but if a property is struggling to perform in the interest only period it will likely do worse when the loan rolls into the amortizing period because now you have to pay the principal of the loan as well. Since apartments are priced higher now than ever, lenders have increased the interest only periods in some situations to 5 and even 7 years. Lenders are providing this structure to help the deal meet specific requirements while allowing investors to potentially overpay for a property. If you are contemplating investing in a project with 7 years I/O I would be hesitant and make sure you know the deal fundamentals.


Deal Underwriting

 

Underwriting a deal is arguably the largest factor in determining how successful a deal will be. The underwriting helps the general partner decide what price they are going to offer on a deal.  

All passive investors should understand the basic mechanics of how deals are underwritten. I am a numbers guy, so I would argue that anyone who invests passively in a deal should know how to underwrite a deal properly. All general partners state they underwrite deals conservatively, but this is just not true. By knowing what to look for in their financial models will illustrate if the deal is truly underwritten conservatively or if it leans towards the aggressive side.

 

For example, if the purchase price for a deal provides a 6% cap rate and the exit cap is at 6% or lower this is an aggressive stance the underwriter has taken and can change the exit value dramatically. Cap rates have compressed significantly in this market so the exit cap should be higher than the going in cap rate.  

 

Another example is if the subject market over the past 5 years has a growth rate of 5.5% and the syndicator is projecting a growth rate at or above 5.5%, they are not underwriting the deal conservatively.  

 

These are only two of many examples I could provide on underwriting. Small nuances in the underwriting a deal can have a major impact on the overall return. This is why you should not take their word for it, but investigate the numbers for yourself. As a passive investor hopefully you will trust the general partner; however, you should still verify they are providing accurate data.

 

Fees

 

All deal sponsors have fees in each deal they sponsor. Fees are a good thing because they typically align the sponsors interest with the passive investor’s interest to create a mutually beneficial relationship. Additionally, fees help compensate the sponsor for the time, risk, and energy, they put towards creating the opportunity for a passive investor to invest in.

 

There are many different fees a sponsor has, but these are some of the most common fees:

 

  • Development/Acquisition

  • Brokerage

  • Asset management

  • Property management

  • Construction

  • Financing/refinancing

  • Disposition/Termination

 

The fees typically range between 1% to 5% depending on fee selection. A sponsor will usually only incorporate a few of the above fees into each deal. It is up to the passive investor to decide if the fees the sponsor is charging are fair, they align with your investment goals, and you are still able to achieve the predetermined return you require from an investment.

 

Conclusion

 

When you first start investing passively in real estate it can be a daunting task. However, if you put some effort into learning about real estate and break down these 8 steps into manageable action items it is not hard to learn how to passively invest in real estate.

 

By going through these 8 steps you are further ahead than most people, you know more about yourself and the market you want to invest in so you will be able to invest with confidence.

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