WHAT IS THE ASSET?
An extremely diverse investment scenario that can range from a small landlord who owns a few rental units to a Fortune 500 company that operates thousands of units or “doors,” as investors in the space would say.
Apartment buildings are an alternative investment that I like to call “the gateway investment.” That’s because once an investor discovers the multi-family space, there’s no turning back. Regardless of the background of the investor, it is the fact that the business model repeats so efficiently that resonates with most new investors in this space. It is also the repeatable business plan that creates a very sticky “addict” feeling when you invest in an apartment building. If you’ve had positive results with a few operators, most likely those operators have other deals in their pipelines in the same areas that are ready for the same business plan that you just witnessed work. Imagine if you found a great CEO with an IPO that was just crushing it—wouldn’t you love to invest in another one of their deals? That scenario is unlikely as it would probably take years for that CEO to take another company public (if ever again). But in commercial real estate, you get a chance to keep reinvesting with a successful “CEO” on brand new “IPOs” multiple times per year. How cool is that?
In this article, I refer to apartment building investing as the opportunity to purchase into an apartment building syndication passively. This article is not meant to explain every nuance of owning an apartment building. My goal is to show you that there’s a way of investing in apartment buildings that is within reach for every accredited investor—and even some that are only sophisticated investors.
As an investor, you get to experience the journey from (almost) start to finish. Usually, a deal is presented to an investor after it’s in contract, but before acquisition. That means you see the business plan beforehand and get to play your very own round of Shark Tank and decide if you like the business plan or not. The more experienced you become, the more you will notice if something doesn’t look right.
PRO TIP: What’s critical to understand is that you’re not investing in an apartment building; instead, you’re investing in a business that has many moving parts, and you need to be able to judge the viability of those moving parts coming together.
It was when I first invested in a 160-unit apartment building in Lexington, KY, that my investing career reached a major turning point. I found myself routinely attending conferences, followed by regular calls with other investors that I had met at these events. It wasn’t many at first, but it only took a few connections with the right people to change my trajectory forever. A well-known multi-family operator, Michael Blank, coined a powerful phrase that explains this experience: “the law of the first deal.” What Blank meant is that an investor taking on their first successful real estate deal begins to attract the attention of brokers, investors, and other important contacts. For this reason, the second deal is easier than the first, and the third becomes easier still than the second. I always thought the same concept applied to investors in other spaces within the investing community too. For me, investing in my first deal gave me motivation to attend two events: The MidAtlantic Real Estate Investor Summit hosted by veteran investor Dave Van Horn, and the relaunch of The Renault Winery Resort hosted by entrepreneur, investor, and business owner Josh McCallen. Both events allowed me to connect with two of my future partners. From there, I joined masterminds, invested in various asset classes, started an investment club, and put in multi-million-dollar offers to purchase my own apartment buildings—all of which eventually culminated in the founding of SIH Capital Group (and the writing of my new book! ). But if I rewind everything to one moment, it was that first investment in the Lexington apartment building that jolted me into action.
At its core, apartment building investing involves providing a tenant with a place to live in exchange for a monthly rent payment. In order to purchase an apartment building, an operator puts a deal together and is usually referred to as a general partner; you can think of them as the CEO. The operator pools together funds from various investors, commonly referred to as limited partners; you can think of them as the common stock shareholders. The operator then may need to secure a loan for any remaining balance. After the building is acquired, the investor may receive dividend-like payments called distributions, and those are usually paid monthly or quarterly.
This process is called a syndication, and it allows you as an investor to buy into a larger deal for a nominal amount compared to the total purchase. In most of the deals I have seen, the minimum investment was set to $50,000. This might seem like a lot of money, but it allows you to buy into a property that is worth millions and receive all of the benefits that a larger business provides.
Unlike the residential world, where a house’s price is largely determined by the selling price of a similar house next door, the value of an apartment building is based on the net operating income (NOI) of the building and the capitalization rate. The business plan should describe how the operator plans to increase both of these metrics over the life of the investment.
Net Operating Income — A formula used to show how profitable a property is by subtracting all of the reasonably necessary operating expenses from all of the revenue it produces.
Capitalization rate — A gauge of what the market is willing to pay for that profitability.
These terms are important to understand because part of your job as an investor is to evaluate any business plan in the context of where the cap rate will be when you need to sell the property (typically three to seven years). The business plan provides pro forma financial statements that project what returns you can expect to see and when. It also lays out the action items needed to raise the NOI, as well as the operator’s opinion on where the cap rate is going. Since neither you nor the operator is likely a PhD economist, what you are looking for is consistency.
At the end of the investment, the NOI hopefully is considerably higher and, depending how the cap rates moved during the holding period, the value of the building should be higher. When sold, profits are returned back to the investors, first starting with any unpaid preferred returns and then split per the operating agreement. The total returns are then weighted by the value of time, and you are left with the IRR% of the deal. While I used the word “hopefully” multiple times here, keep in mind that hold times are like moving goal posts. This is the operator’s profession and livelihood, and they are constantly getting brokers’ opinions on the value of their properties. Given the significance of the time value of money, there’s nothing stopping the operators from selling earlier if the cap rates compress on them, or if they execute on their plan faster than expected—just like there’s nothing stopping them from increasing the hold time (if proper financing is in place) if the cap rates increase more than expected, or there’s significant setbacks to the business plan. In the end, you’re investing in the operator and their ability to manage this multimillion-dollar business. It’s not much different than stocks if you think about it that way, except stocks get repriced daily, whereas in real estate, the cap rates reprice gradually over time in a much less volatile fashion.
The Pros and Cons of Apartment Building Investing
- Offers instant scale
- You can retain professional management services
- A completely passive investment if you are a limited partner
- Tax deferral opportunities
- If you eventually want to become an operator, investing as a limited partner in a few different deals is a great way to learn best practices
- There is a proliferation of amateur operators
- There is an added layer of tax planning
- Extensions may be needed for tax returns
- Potential for capital calls
- Very limited recourse for a bad operator
- Very illiquid market for a limited partner
If you liked this article and wish to continue on your path in learning about alternative investments, please make sure to check out my other educational articles as well as my book, The Alternative Investment Almanac: Expert Insights on Building Personal Wealth in Non-Traditional Ways.
Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though, the author has made reasonable efforts to ensure that the contents of this article were correct at press time. The author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article results in any investment or other losses. Your use of the information in this article is at your own risk.