What is MF Real Estate Syndication?
Multifamily syndication is a real estate investment where multiple investors pool their money to purchase an apartment building. 1802 Capital is the sponsor (also known as the syndicator) that locates the deal, raises the money to purchase the asset, and manages the investment after the deal is closed. The sponsor is also the general partner. Passive investors are the limited partners who provide most of the capital required to buy the asset in exchange for equity in the apartment building.
The primary reason to invest in a syndication deal is the opportunity to participate in larger commercial real estate deals that investors may not have access to on their own. Additionally, as a passive investor, you can own an apartment without the hassles of being a landlord/property manager. Unlike a fund or REIT, you are investing in a specific property or properties and thus have more control over your investment decision. In addition to getting all the benefits of real estate ownership, these investments are protected by the purchase of the real estate asset itself and can be an effective hedge against inflation.
1802 Capital will find the investment opportunity, underwrite the deal, put it under contract, raise capital, secure financing, perform due diligence, file the appropriate SEC registration/notices, and ultimately close on the property. From there, the real work begins as we execute on our value–add plan to raise net operating income so that we can pay out quarterly distributions and ultimately position the property for an exit strategy to return investor equity and profits.
Multifamily syndication may NOT be for you if you want to be more active in your investment or if you need your money to remain liquid. Your investment will be tied up throughout the full investment period which typically ranges from 2-7 years.
What is IRR in MF Real Estate?
The internal rate of return (IRR) is an accurate measurement of a property’s yield over time. Said differently, the IRR is the percentage of interest earned on each dollar invested in a property over the entire holding period. That being said, pro forma IRR rates can be used to compare one investment to another prior to investing in a project. Investors simply need to understand that a pro forma IRR is only an estimate. It’s critically important to choose investment partners who are conservative in their estimations and have a track record of honesty and accuracy.
There are also actual IRR calculations, which can only be calculated over time as an investment matures. As you might imagine, often times pro forma and actual IRR calculations can vary greatly depending on market conditions and how well an investment is managed. At the end of the day, actual IRR is what truly matters.
Unlike the cap rate, the IRR is a well-rounded way to estimate a real estate investment’s profitability. Because the IRR looks beyond the property’s net operating income and its purchase price, (which are used to calculate the cap rate) you get a clearer picture of the kind of returns the investment will generate from start to finish. This can be extremely helpful if you’re planning to invest in real estate for a long period of time.
When using IRR to compare real estate investments, it is important to try and compare opportunities with similar amounts of risk and structure (type of property, market, frequency of cash distributions, etc.). Better yet, for operators with multiple properties under management, you can use historical numbers to determine how successful they’ve been in the past at making money for their investors. Past performance never dictates future returns, but it is a good place to start!
What is Cost Segregation and Why Do Them?
A cost segregation study is defined as the process of identifying and separating out personal property that is, or has been, grouped with real property. A cost segregation study determines the appropriate asset class life for the entire tax basis of the property. This is important because without the study, the asset class-life for a commercial building is typically between 27.5 – 39.5 years, when in reality many of the building components/systems can qualify for shorter class lives.
With an effective cost segregation study, the assets identified to be shorter class lives will be depreciated over 5, 7, 10 or 15 years. For many commercial buildings, these assets might be special electrical, lighting, water, plumbing, mechanical, landscaping, parking, finish components, etc. It is not uncommon to identify 25-50 percent of the building’s total costs to be eligible for reclassification into shorter life assets.
According to the U.S. Treasury department, “Cost Segregation Studies are a lucrative tax strategy that should be considered in almost every real estate purchase.”
As an investor in MF real estate syndications, you are an owner of the property, thus enabling you to take your fair share of the bonus depreciation benefit. In most cases, all of the passive income returned to you from your investment will be offset by the depreciation “paper loss”, yielding tax-free cash flow. In fact, should you have other forms of passive income, they may also qualify to be offset by this fantastic tax benefit.
You need not do anything as a limited partner with 1802Capital other than wait for the annual K-1 we will issue, provide that to your tax preparer, and reap the benefits!
*We are not tax professionals. You should always consult with your accountant or tax specialist regarding your particular situation(s).
What is Bonus Depreciation?
As you learned from “What is Cost Segregation and Why do Them”, when we purchase an apartment complex, we are in fact purchasing four different things: land, building(s), contents, and land improvements. Bonus depreciation applies to anything that has a useful life less than 20 years, so for our purposes this means land improvements and contents.
Under the Tax Cuts and Jobs Act, bonus depreciation deductions increased from 50% to 100% for qualified property that is acquired after Sep 2017 and before Jan 1st, 2023. In addition, the deduction can be immediately expensed the year of purchase or when the work is performed. This includes contents such as appliances, flooring, mechanical equipment as well as improvements such as roofs, landscaping, parking lots.
Why is this bonus depreciation so important? Instead of depreciating straight line over the course 27.5 years (multifamily depreciation schedule), we can cost segregate the four items to maximize our depreciation in year one to create a substantial passive loss that we can use to offset passive gains/income immediately. 1802 Capital believes in forced appreciation through our value-add model. This means the vast majority of our renovations expense will be 100% deductible in year 1!
The 100% bonus depreciation is currently only in effect through the 2022 tax year. Thereafter, it will begin to phase out by reducing 20% each year. 80% depreciation in year 2023, 60% in year 2024 until 2027 when there will be no bonus depreciation. Tax law is fluid, so changes are possible.
What is a Cap Rate?
The capitalization rate is used in commercial real estate to indicate the rate of return based on the income that the property is expected to generate. The calculation is Net Operating Income (NOI) divided by the property’s current market value and is expressed as a percentage.
For example, a building which generates $100,000 in annual NOI and has a valuation of $2,000,000 would have a cap rate of 5%.
The cap rate is useful to compare the relative value of similar apartment complexes within a market. The cap rate for a specific market can help us determine the market value of an investment.
In a “hot” market, cap rates will begin to compress and drive lower as demand for properties boosts the value of the properties. In the above example of a $2M property generating $100k in NOI, the same property can generate $100,000 in NOI but the cap rate in this hot market might go down to 4% which would make the value of the property go to $2,500,000 ($100k divided by 4%).
1802 Capital does not rely solely on normal market appreciation, instead choosing to add value and force appreciation as well. We add value to our communities by improving the quality of life for our tenants through exterior and interior upgrades. Exterior improvements such as fresh paint, new signage, new pool furniture, and improved landscaping helps bring a sense of pride in their community while new interior improvements such as stainless-steel appliances, flooring, washer/dryers, cabinets, and fixtures greatly enhance their personal living spaces. These renovations, combined with experienced management, allow for higher rent premiums and tighter expense management. This enables us to raise the NOI in the above example from $100,000 to $150,000 which yields a new valuation of $3,000,000 at the same 5% cap rate. It’s simple to see how a small change in NOI can generate tremendously greater valuations . . . and profits!
What is Forced vs Market Appreciation?
Appreciation is an increase in the value of an asset over time. There are two main types: forced vs natural (also known as market appreciation).
When the property value increases because of market forces, that is natural appreciation. As an investor, we do not have any control over natural appreciation. Choosing the right investment in the right market increases the chances of natural appreciation.
Through 1802 Capital’s value add method, we directly control our ability to force appreciation on our investments. By transforming our properties, we are able to attain rent premiums and drive up our revenues. In addition, utilizing the best and most experienced property management teams, we can maintain higher occupancy rates and drive down expenses.
Going back to Cap Rate 101, natural appreciation occurs when the cap rate goes down (hot market) which drives up the property value. Forced appreciation occurs when we increase the net operating income (NOI) by increasing revenue and/or decreasing expenses.
At 1802 Capital, we combine the effects of both natural and forced appreciation by picking the right market and driving up our NOI.
How to select a target market?
Good opportunities exist everywhere; however, we believe we can greatly increase our likelihood of success if we pick and focus on a market where we see a favorable imbalance between supply and demand. Our model is to force appreciation through value add but we also realize the effect of a rising tide in a market and how it can naturally appreciate our investment to supplement our hard work.
We analyze demand by looking at occupancy rates within the market (or even submarket for large metropolitan areas). Occupancy rates provide us with a great real time snapshot of supply and demand, but we want to look into the crystal ball to forecast what lies ahead. Questions we have to answer include:
- Is the unemployment rate low and continuing to decrease?
- Is there sustained job growth?
- How stable is the employment base? T his includes both the quality of the companies as well as the diversity of the job base. Is there too much reliance on a single sector or even a single company who employs the vast majority of the workforce? Companies and industries can have downturns and you don’t want all your tenants impacted by one employer or industry (e.g. the auto industry in Detroit)
- Is the overall population growing?
- How much apartment construction is in the pipeline to add to supply? Favorable markets will have lower completions as a percentage of the total inventory. I n addition, it is important to compare the total number of completions to the net absorption within the market. This will show whether the completions are beginning to oversaturate the market with demand.
- Is there an abundance of move-in specials?
- What type of apartments are being built. Apartments range from workforce/renter-by-necessity to luxury/lifestyle classes.
- Is the rent growth healthy and increasing year–over–year?
- Are the state and local governments favorable towards landlords or tenants?
- What is the affordability index for home ownership? The cost of homeownership should far exceed the cost of renting.
We don’t begin to look for properties until we find a market or submarket which have favorable answers to these questions.
What is the difference between On Market and Off Market Deals?
On-market transactions are listed by a real estate broker and listed on the listing broker’s website as well as online marketplaces like LoopNet or CoStar. On-market deals can generate a lot of interest in a quick timeframe.
Off-market transactions have either property owners who have a broker but don’t want to list the property to the entire market or are property owners who don’t have a broker at all.
There are various pros and cons to each style of deal. As a buyer, off-market deals are beneficial as they avoid the need to compete in a bidding war with multiple potential buyers. You can work directly with the owner to negotiate a fair price. As a seller without a broker, off-market deals can save money on a broker’s commission which can range between 3 to 4% of the purchase price. Even if a seller has a broker, off-market deals can be less obtrusive as they won’t have to deal with so many different prospective buyers wanting to do property tours, go over financials, etc. A broker in an off-market deal will often only offer the listing to a limited number of buyers who have demonstrated their ability to quickly and efficiently close on a property, removing the pain point of dealing with numerous unqualified or inexperienced buyers.
On-market deals offer the seller the biggest audience and potential for someone to overpay for a property, especially in a hot market.
Either method can be enhanced by building and maintaining a solid relationship with real estate brokers, professional property management teams, and other key team members who want to work with us and continually provide leads and referrals.
Why is underwriting so important and what is 1802 Capital’s methodology?
Underwriting is key to any successful property investment. In short, it is the process an investor uses to financially evaluate a property and ultimately determine whether the deal makes financial sense. Thorough underwriting will not only project potential cash flows and returns but also expose the risks of the investment.
1802 Capital underwrites using a highly detailed financial model which incorporates multiple factors, including the market rent, rent growth forecast, non-rent revenue, operating expenses, vacancy rates, property tax increases, renovation capital expenses, exit cap rates, and debt terms. We input historical data such as the trailing 12 month rent, other revenues, and expenses AFTER verifying the accuracy of those figures provided by the seller (we never accept the facts and modeling presented to us by the broker in their offering memorandum). We then overlay the past and current figures with our own future projections based on how we plan to operate the property. This incredibly detailed financial analysis helps us project a future pro forma and potential overall returns based on several different exit strategies.
As mentioned, we verify all the figures provided by the seller and seller’s broker. One of the most time consuming and important figures to verify is the Gross Potential Rent. This number represents the amount of rental income one could earn from the property if the units were 100% leased at market rent. This figure is the upside of our investment. Understanding the market rent is critical in the financial modeling process. 1802 Capital performs our own rent comp analysis by researching all the comparable apartments within our investment target’s submarket. We find nearby apartment complexes that were built around the same time, with similar unit counts, unit type (# of bedrooms, # of bathrooms, sq ft), and amenities. Once we identify our comparable apartments, we then compare their rents to our target property’s rents. This verification will show us the Gross Potential Rent as the units exist currently as well as what we can expect once we implement our value–add renovations.
All of the figures we plug into our financial model can have a monumental impact on our projected returns. As such, stress tests are performed to ensure we understand the downside risks. Even if the underwriting shows that the property meets our investment objectives, if the downside risks cannot be mitigated to be within an acceptable range of risk-adjusted return, we will not pursue the investment.
Also worth noting, while 1802 Capital underwrites the property, our lenders also perform similar underwriting to determine whether or not to provide the financing necessary to complete the sale. The lender uses their own financial modeling to ensure the property is a solid investment. This acts as a separate and parallel analysis of the deal. In addition to analyzing the deal, the lender also evaluates the creditworthiness of the general partners putting the deal together.
In general, our goal is to underwrite in a conservative manner with the goal of under-promising and over-delivering.
What are the MF real estate asset classes?
Apartments are graded in order to group them into similar classes so that investors can properly understand their underlying risk and return objectives. It’s a slightly subjective process but to determine the letter grade, the property is evaluated primarily by looking at the age of the building, desirability of the property’s location, on-site amenities, interior finishes, tenant income levels, and vacancy rates.
Class A properties are the top tier apartments and can be best described as luxury/upscale apartments. They are generally less than 10 years old, or recently renovated in line with new construction, and located near areas where people want to live due to its proximity to major employers, schools, arts, and cultural activities. The interiors feature high end finishes such as hardwood floors, granite countertops, and new stainless-steel appliances. These communities often include abundant amenities like full-service gyms, resort style pools, clubhouses, rooftop patios, concierge service, etc. Tenants are usually white-collar workers who rent as part of their lifestyle and not by necessity.
Class B properties are a step below class A but tend to have nice finishes and are still located in desirable locations. They are generally between 10-25 years old and are well-maintained but potentially have some deferred maintenance issues. Amenities can vary greatly but most class B properties will offer some of the amenities of their class A counterparts. Tenants are usually a mix of white and blue-collar workers.
Class C properties are 25+ years old and will show visible signs of deterioration and are in need of renovation. They will probably have less on-site amenities and the amenities they have will be in similar shape to the overall property. These properties tend to be in less desirable locations and the tenant base is usually blue-collar and low to moderate income. Rents are below market and the units often have outdated kitchens, bathrooms, appliances, and carpets.
Class D properties are old, not very well-maintained, poorly managed, have high vacancy rates, and are very likely in areas of high crime. 1802 Capital does not invest in class D properties.
Class A properties are low risk, and most new construction in the pipeline tends to be in this class. In a strong market, land price increases and developers have to underwrite for more expensive rents in order to meet their investment objectives. This has led to a potential oversupply in class A apartments and a shortage of workforce housing. 1802 Capital focuses on finding good class B and C opportunities to execute a value-add plan. We look for homes in favorable locations with “good bones” that are in need of aesthetic upgrades. Our renovated premium units will have new flooring, new washers and dryers, new stainless-steel kitchen appliances, resurfaced counters, new or refurbished cabinets, and new finishes which allows us to fetch rents at or above market rates. We may also rebrand, add new signage, paint the exterior, update security features, add new pool furniture, etc. in order to provide a home our tenants can be proud of while at the same time increasing the value of the asset.
What is a K-1?
The Schedule K-1 is an Internal Revenue Service (IRS) tax form issued annually for an investment in partnership interests. The purpose of the Schedule K-1 is to report each partner’s share of the partnership’s earnings, losses, deductions, and credits. It serves a similar purpose for tax reporting as one of the various Forms 1099, which report dividend or interest from securities or income from the sale of securities.
While a partnership itself is generally not subject to income tax, individual partners (including limited partners) are liable to be taxed on their share of the partnership income, whether or not it is distributed.
A K-1 is commonly issued to taxpayers who have invested in limited partnerships (LPs) such as our structure. As an investor with 1802 Capital, you will receive a K-1 statement annually.
What is a preferred return?
Simply put, a preferred return is a method of profit distribution where one stakeholder is contractually entitled to receive distribution of profits until a certain rate of return has been met, BEFORE profits can be distributed to a subordinate stakeholder. The preferred return is stated as a percentage (e.g. 5% preferred return on initial investment). Should a deal be structured with a preferred return, the limited investors of any 1802 Capital investment will be paid their preferred return prior to general partners receiving payment.