5 Reasons Apartments may be the IDEAL Investment

For more than 25 years I’ve dedicated my career to investing in stocks. Bonds were interesting too, but they were largely tools for diversification. They protected your portfolio during those nasty periods when stocks sold-off.

It wasn’t until more recently that I discovered what may be the IDEAL investment: passive apartment syndications. In this post, I’ll share some of what I’ve learned about this fascinating space, and why I’ve launched a firm to help busy individuals access these opportunities.

IDEAL? Hopefully, you hear the alarm bells sounding. Anything that sounds too good to be true, probably is, right?

That’s what I thought at first. But as I learned more, I’ve changed by mind. My greatest regret is that I didn’t begin this journey earlier in my life! Fortunately, it’s not too late.

Before I dig into the good stuff (the why), let’s clarify what I’m talking about. The real estate asset class includes a lot of stuff, from publicly traded REITs to office buildings to single-family fix and flips. The type of investments I’ll discuss are limited to Apartment Syndications. These are passive private equity investments in stabilized apartment buildings.

In English… a group of investors pool their money and partner with an experienced operator to buy a large existing apartment building (typically 80-300 units). In the value-add opportunities I like, the operator will renovate units in older buildings (often 80’s vintage construction) and then increase rents, which boosts income/cash flow. Keep in mind that these are B or C class properties in attractive markets with population/job growth. I’m not looking at fancy class A towers.

Example of a recent investment in Atlanta, GA.

Investors will usually receive a preferred return annually during the investment period (can be 5-7 years), and then share in any gains when the apartment is later sold. Depending on the opportunity, target returns are currently running ~100% over 5-7 years, comprised of income (~8% annually in preferred returns, paid in cash either monthly or quarterly!) + capital appreciation when the property is sold.

Again, in a typical transaction, investors own 70-80% of the total equity, with the general partners retaining 20-30% of the equity for finding, structuring, and then managing the deal.

Returning to the “ideal investment”, we can begin to dig into the “why”. Real Estate investor Brian Adams provides a neat way to think about some of the basic attractions of apartment syndications using the acronym IDEAL (a bit cheesy, but useful):

I = Income

D = Depreciation

E = Equity

A = Appreciation (especially forced appreciation)

L = Leverage

I’ll add a few more TiPS (benefits):

T = Tax-advantaged

P = Performing Asset

S = Scale

A bit more in brief on each of these value levers…

Income: Apartments generate income from the rents generated less expenses. This can be paid out monthly or quarterly. We often see distribution in the 8-10% range and many syndicators offer a preferred 8% return, meaning the limited partners get paid first up to 8% before the general partner gets paid anything.

Depreciation: The building, not the land, depreciates, which reduces your taxable income. Many syndicates also utilize accelerated depreciation techniques as well. More on this below in the tax section.

Equity: Your equity increases as the loan is paid down, and as improvements to the property and operational efficiencies generate higher rents (income).

Appreciation (unrelated to market factors): This is my favorite and what makes apartments (commercial property valuation model) stand out over non-commercial (less than 5 units) and single-family rental properties. If you can find apartments that need some work (value-add) which then allow you to increase the Net Operating Income (NOI), you can greatly increase the market value of the property, even if the general market in that area is stagnant. This is not like in residential, where homes are valued based on what other comparable properties sold for.

In commercial valuation, the model is NOI / cap rate = market value. A cap or capitalization rate is simply what an investor should expect to earn if they paid 100% cash for an apartment.

Example: If an apartment costs $1M and the cap rate is 6, then the investor should expect to get 6% or a return annually of $60K from the investment.

Assume the cap rate stays the same and that we’re able to increase the NOI even modestly, per the equation above, the market value will increase significantly. This concept, called forced appreciation, is what makes apartment investing and commercial real estate so powerful. It’s also not well understood by the average investor.

Let me walk you through it to show how powerful this can be.

A partner of mine shared this example: At one of our 300+ unit apartment acquisitions this past year, we identified a desire for covered parking. A survey of residents suggested about 2/3 would pay for covered parking for a modest $25/monthly fee. If 200 units then paid $25/monthly fee, that generates about $5K/monthly revenue or $60K/yr. The cost was $90K to build it so we would break even in about 18 months. But from a valuation model, we added $1M of equity.

How’s that? We increased NOI $60K / 6 cap (.06) = $1,000,000.

That is the true power of value-add apartment investing and the concept of forced appreciation. Keep in mind, we were not relying on comparable properties to drive appreciation so much as looking at what value-add opportunities our own residents would be willing to pay for and letting the valuation model take care of the rest. That ability to directly increase value is extremely compelling.

Leverage: Obviously you need to be prudent with leverage, but when used appropriately it can boost equity returns substantially. Typical leverage in these deals will be 60-80%, with the debt provided by banks and/or federal agencies.

Tax-Advantaged: Investing in real estate is a highly tax-efficient investment. It’s not uncommon for annual distributions to investors of 10% or so to be offset on paper as a loss on your annual K-1 partner distribution tax statement. This is not only due to depreciation (mentioned earlier), but also property taxes and loan interest which are significant deductions. You generally enjoy this benefit over the life of an average five-year investment.

Additionally, value-add syndicators frequently do a “cash out” refinance after the renovations are complete in a few years after the property is purchased and property NOI is optimized. This refinance is considered by the IRS as a return of the investors capital and is not a taxable event. At time of sale, say in year 5, there is some depreciation recapture (your purchase cost is reduced by the depreciation each year, so the gain will be higher), but the expected gain at sale is considered a long-term capital gain. That’s important because long-term capital gains are treated at a lower tax rate, currently 15%.

Performing Asset: Most of the value-add older apartments in strong markets are making money even before renovation programs. In bank talk, this is considered a performing asset which reduces investor risk. There are investors who like turnaround plays and will invest in apartments where the occupancy is less than 70%, and not making money, but that is a lot riskier for my tastes.

For me, I’m interested in apartments that have an occupancy of greater than 90% with an opportunity to boost rents from renovations and improve costs / operations of the buildings by hiring professional management companies. This lowers investor risk considerably.

Scale: The more units in an apartment, the more opportunity to gain economies of scale by lowering your cost per unit in maintenance expense. Keep in mind there’s a threshold in the number of units where onsite property management and maintenance make sense. The cost of an onsite manager to manage 100 units versus 200 units are about the same cost, but the cost per unit goes down as you move up the scale as an example.

OK. Deep breath here.

If you’re still with me, that was a lot. IDEAL+TiPS = 8 powerful value drivers that get me super excited about investing in large, multifamily apartments. This is especially true when focusing on value-add Class B/C is where we find the most opportunities for attractive returns for investors.

Keep in mind that even if we have found the IDEAL investment, I’m not suggesting you should put all of your eggs in this basket. Stocks and bonds still have an important place in one’s asset allocation.

The point is that as a former professional investor and CFA charter holder, I’m surprised I hadn’t heard more about the many benefits of direct, passive apartment investments? Why did it take so long?

I had plenty of friends who invested in real estate through rental properties or flipping houses. But there’s nothing passive about either of those activities. And they are very difficult to scale. Large apartment syndications are passive and scalable.

Maybe now you understand why I’ve fallen for this space and eagerly want to help others learn more, whether to diversify their broader portfolios or to generate passive, tax-efficient income.

In future notes, I’ll share thoughts on the apartment market cycle, risks to consider, and how you can use funds in your IRA or a 401k from an old employer to invest in these opportunities. We’ll also walk through the evaluation and investment process using a real investment I made last summer.

Thank you for your interest! For more information, sign up for our newsletter or email us at david@18.232.5.186.