Written By David Thompson
As part of a syndication team that spends ample time educating and answering investor questions I wanted to compile some of the most Frequently Asked Questions (FAQs) as part of a quick study guide for new folks who are looking to invest in this area. It’s also good for folks who are new to raising private equity what to expect most from investors in the way of questions. These are in no order and note that there are various types of deals and syndication structures so one size does not fit all. I’m going to focus on value add apartment syndications which is a very mainstream investment niche many investors get involved in as their first foray into syndication.
1) What is syndication? In its simplest form, syndication is the pooling of investor money where the investor is typically a passive, limited partner. The other partner to the deal is the general partner, or active partner that puts the deal together, manages the business plan to provide a return for the benefit of all investors. You will hear General Partner (GP), Syndicate and Sponsor often used interchangeably.
2) What are your return projections and how are your returns calculated? As of this writing, typical cash on cash returns are in the 8-10% range and an internal rate of return (IRR) of 16 – 20% range. You may also see an average rate of return which is simply the total return over 5 years divided by 5. In value add syndication, the average annual return may be deceiving (higher) than the IRR (Internal Rate of Return) as a large part of the investor returns come in the year of sale (modeled as year 5). IRR typically would be a better measure for varying cash flows over a set time horizon.
3) When will I get my original investment back and what is the holding period? Typically, at time of sale. For our deals, year 5 is the target. It could happen in year 3 or year 7 or longer if we have a long downturn but 5 is typically what value add syndicators have as a target.
4) What are the risks? They are outlined in the PPM. That said, I like to provide a few data points. In 2009, at the bottom of the financial crisis, delinquency rates on single family homes was 5% vs 1% on MF apartments. Additionally, in Houston when oil went from $100 barrel to $50 barrel Class A (new apt buildings) had to offer concessions and vacancies rose to 15% while Class B (older MF where value add syndicators play) remained steady at 8%. Lastly, we buy proven. Our typical apartment acquisition will have occupancy greater than 90% and usually higher than that and the previous owner was making good money (T12 – trailing 12-month audit will prove this out). We want to improve proven properties not buy on hope.
5) What is a limited partner? A passive investor in the deal. They have limited liability. Their risk is limited to the amount they invest in the deal, no more. Their other assets are protected. They cannot be sued, they are not on the loan and are not responsible for the active performance of the property.
6) What is the minimum investment? We set it at $50K and increments of $5K.
7) When will I get paid? We do monthly (after 30 days of full monthly operations upon closing of the property). That can be direct deposited into the investors account. Most syndicates do monthly or quarterly distributions.
8) How will you communicate with me? Monthly quick updates (email) on how the investment’s progress. Typical bullet points / some pics on how many units were renovated, rents we are getting, etc. Quarterly property management financials can be reviewed. Following March of each year you will receive a K-1 statement from us for your tax filings.
9) What kind of tax impact is there? Apartment syndications are very tax efficient. As a partner in our limited partnership, you will benefit from your portion of the investment’s deductions for property taxes, loan interest and depreciation which are the big ones. We like to use a cost segregation strategy as well to accelerate depreciation since we don’t plan on holding onto the asset for a long time. You will get a K-1 statement from the partnership in March of the following year for the current tax year. It’s not unusual on a $100K investment to experience a min 8% preferred return or cash in your pocket of $8K while experiencing a paper loss on your annual K-1. Additionally, any refinances or supplemental loans are reviewed as a return of equity so no tax impacts. At time of sale, there may be an opportunity to 1031 exchange into another property that the sponsor wants to buy to continue to defer your long-term gains tax. Keep in mind some depreciation recapture may occur at time of sale if a 1031 exchange does not occur in addition to the long-term capital gains tax you would be responsible for paying on the gains.
10) What is the process / timeline? Once we have a property under contract, due diligence is about 60 days. We start the equity raise process with investors which runs about 5-6 weeks end to end. Marketing deck goes out, investor conference call takes place, investors reserve a spot, review the PPM / sign and fund. About 2-3 weeks later we close on the property. About 60 days later first investor distribution.
11) Why would we purchase a property where the Yelp reviews were so poor? We believe that’s a good thing. As value add syndicators, if all news was good, there would be nothing to improve. The property is often re-branded (new name), new website, new property management team is brought in. Focus is on operational improvement and renovating the property. There’s a focus on intangibles such hosting monthly community gatherings to foster a sense of community that may have been lost which can improve retention, reduce turnover. This can be turned around faster than you think. Re-branding, re-positioning the asset is the focus.
12) How do you renovate with people living there? When we take over a property, even a 300-unit apartment will have 15 vacant units if occupancy is at 95%. We start there. Next month when 10-12 leases are up, we introduce the residents to their new renovated unit (move them in) and start renovating their vacated unit and keep repeating this process month after month. We expect that the improved unit will be so dramatic that retention / new lease signups will be high.
13) What is a supplemental loan? It’s very common to create a lot of value once the renovations are complete and the forecasted rent is being achieved. That is when the value is optimized in a value add strategy. You go back to the bank with a higher assessed property value and either refinance the property (if you had a variable rate loan) or you obtain a second loan on the property (called a supplemental loan) if you have an attractive fixed rate in place that you want to keep. This second loan allows you to pull equity out for the investors benefit which increases the cash on cash returns and IRR on the project.
14) What is a sensitivity analysis? We like to show investors under different scenarios if our forecasts are off, what is the breakeven point for profitability given a decline in occupancy or if rents don’t project where we expected. Surprisingly most of our scenarios allow occupancy to go to 75% to break even. During the 2009 financial crisis, third party data proved that in one the submarkets in Dallas where we have five apartment communities (Richardson) that the worst level was 85%. That is comforting to our investors to know this information.
15) Can I use a 1031? You cannot 1031 into our deals or out of our deals since you are technically purchasing units of our Limited Partnership and not actually the land itself. That said, there are mechanisms where we expect to be able to 1031 from one of our deals into another one of our deals, thus deferring the tax you would have normally paid on the sale of the first apartment.
17) What happens if we have a hardship and want to get out before we sell the property?There is nothing in our prospectus for a workout or formula for such a scenario. The investment should be considered an illiquid investment. That said, as a partner with you, the general partner will review your issue and see if there is something that can be done based on your circumstances.
18) What are your fees? Most important is returns forecasted should be post fees. Most common two fees are acquisition fee (2% I see most often) based on purchase price and paid once to the sponsor at closing. This covers all the sponsors costs to find and put under contract this one deal. The second most common fee is the asset management fee (typically 2%) based on the monthly revenues. The asset management fee is for the sponsor to hold the property manager accountable and to ensure execution of the business plan. Industry averages are 1-3 % for both fees.
19) What is a PPM? The Private Placement Memorandum is required by the SEC and describes the offering, risks, includes the partnership agreement, investment summary and subscription agreement. It is a lengthy legal document well over 100 pages. The subscription agreement is what investors will review, sign and includes basic information as to number of units and amounts being purchased, accredited investor’s declaration form, etc. I like to pre-wire new investors if they have never seen a PPM before because the risk section is a bit heavy (like the Surgeon General’s warning) highlighting about every possible risk that could happen. I tell investors that there are risks to every investment, yes, you can lose your entire investment, but certainly I highlight the good track record MF investments have had in severe market down markets. Additionally, no lender is going to give us $10m to $30m unless we are experienced, have a good business plan, conservative underwriting (bank’s will underwrite the deal as well), have adequate insurance and have the property condition report completed by outside experts (often 100-pages) highlighting what fixes need to be made before we take over the property.
20) Are your forecasts conservative? It should be yes. Good sponsors will want to underpromise and overdeliver. You want to review all financial assumptions from the sponsor and ensure they make sense. Key ones to focus on would be rents (check the area comps for before and after renovation pricing – you want to be under where the market is before and after), rent growth and occupancy. Review the T12 (prior 12 months from previous owner). Does the value add improvements, increased income and timing of those improvements make sense to the forecast?
21) What if we have a downturn in the economy? We won’t want to sell in a down market. The goal would be to continue to pay the preferred return minimum and hold on until the market is healthier to achieve a better price at sale. Class B/C value add properties tend to hold up much better in downturns because folks need a place to stay and rents are more in line with the market / service economy demographic that is typically still employed in downturns versus the class A renter making $100K/yr. whose jobs are more at risk (i.e. Houston oil crisis example).
22) What is a preferred return? Typically, 8% is what I see most. This favors the limited partner. It essentially means that the first 8% return on an investment (distributions from cash flow or capital events such as refi proceeds or sale) will go entirely to the limited partner, nothing to the general partners. This is not a guarantee but the next best thing.
23) What is a split and what is a waterfall? The split is investment returns that go to the investors in the portion of the split. So, if the split is 70% to the limited partner and 30% to the general partner, after the preferred return is paid (if there is one), then the partners splits all other proceeds from distributions or capital events 70/30. That split can change if a certain hurdle (or waterfall) is achieved. Example: A split could by 70/30 then go to 50/50 once the IRR hits say 18%. Any returns higher than 18%, will then be split 50/50 LP/GP. That is a waterfall.
24) What is an accredited investor? We currently market our deals under SEC regulations 506 (b) meaning we can only share our deals with investor who are accredited and we have a relationship with. The definition in the U.S. is a person earning $200K per year or a couple earning $300K per year over the past two years and expected to do so in the current year; or a net worth of $1m (excluding your primary residence). Since we don’t advertise our deals the accreditation determination is by self-disclosure of the investor by a checkbox. If the deal is advertised to the public, then verification by an outside third party is required.
25) Do syndicates invest in their own deal? You will typically see this being the case to align with investors. However, when the GP invests, that money goes with all other investors money into the LP investment bucket (70% split). In other words, the GP split of say 30% is what the GP wants to earn for doing all the work. If he puts money in the deal, he’s increasing his stake in the deal so it is going in on the LP side. That’s how it works.