HOW PASSIVE MULTIFAMILY INVESTMENTS GENERATE PROFIT
Few people would argue with the suggestion that investing in multifamily real estate can be tremendously profitable. But, if you were to ask the typical passive investor exactly how these investments generate such excellent returns, many people wouldn’t be able to articulate the basics.
As an investor, it’s important to understand how these investments work, so you know what to expect, and you can plan for how and when these returns will be delivered.
Let’s start at the high level. A typical passive multifamily investment will generate two types of cash returns and potentially one type of tax benefit. The two types of returns are Cash Flow and Profit at Sale/Refinance. The potential tax benefit is Depreciation.
The term Cash Flow refers to the payments made to investors during the investment hold period at some regular interval. The most typical payment is quarterly, but it could be more or less often. The amount of cashflow available for distribution is directly related to the operating performance of the property. Each year, the property generates income, pays some of it out for basic operating expenses (taxes, insurance, property management, etc.), pays some of it out for large renovation projects (often called “Capital Expenses”) and pays some of it to the lender in the form of monthly mortgage payments (often called “debt service).
Assuming there is money left over after paying operating expenses, capital expenses, and debt service, the leftover income can be used to pay the investors and the operators. The better the property performed in the previous period, the more cash flow investors should expect.
Many multifamily projects will require significant renovation in the first year or two, which in addition to the direct costs of the construction work will also lead to greater tenant turnover and likely higher vacancy. For this reason, cash flow is often lower in years one and two than in later years, and in some cases, projects won’t pay any cash flow for 12-24 months.
Properties that expect to provide lower cash flow earlier in the project – or potentially throughout the entire project – will often make up for it in other ways. For example, low cash flow early in the project may be replaced by high cash flow a couple years into the project. Or, the heavy construction that often leads to low cash flow can pay off later at refinance or sale.
Which leads us to the second type of cash return investors should expect…
Profit at Sale/Refinance
While regular cash flow payments are obviously great, the big cash return is generally seen at the time the property is refinanced (a new – bigger – loan replaces the original loan) or the property is sold. If there was a large renovation on the property, this renovation likely helped to increase the rents which will directly lead to a higher sale price.
When a property is sold, the profits generated between purchase and sale get distributed to the investors and the operators. Assuming the operators were successful at carrying out the business plan, the profits at sale can provide a large portion of the returns investors will see. For this reason, projects that have more renovation involved tend to have a greater increase in value at refinance or sale. Large renovation projects are more risky, but also potentially a lot more profitable.
But it isn’t all about the returns. Multifamily investments can provide a tax benefit known as depreciation as well.
Literally speaking, depreciation means a reduction in the value of an asset over time. As you might expect, the physical structure in a real estate investment (as opposed to the land it sits on) will deteriorate over time. The IRS recognizes that there is a cost associated with maintaining the physical asset, and they compensate investors in the form of a tax deduction known as depreciation.
If you own a piece of real estate, a percentage of the value of the physical structure can be used as a deduction against the property’s income each year. In many cases, this deduction can completely (or nearly completely) offset the income the investment is generating, making that income nearly or completely tax free.
Many multifamily investments will pass this depreciation benefit on to investors, allowing them to offset the income they generate from the regular cash flow payments. That said, there are two important things to understand about depreciation…
First, depreciation is a short-term benefit. It puts extra money in your pocket every year while you own the property. But, when the property is sold, previous depreciation deductions taken from the property will have to be repaid to the IRS. Depending on your financial situation, the amount repaid may be the same, more or less than the amount you originally were able to save through the deduction.
Second, if you are investing through a tax-advantaged account – like a self-directed IRA or Solo 401k – you may find that you can’t utilize the depreciation deduction, as you’re already avoiding or deferring taxes on the income you’re generating.
For both of these reasons, it’s important to speak with a good CPA, accountant or tax adviser to understand how a particular investment will impact your financial situation.
Let’s Look at an Example
Now that we have a basic understanding of where the returns are coming from on a typical passive multifamily investment, let’s look at an example and really dig in. Included are some terms you may not be familiar with that you’ll want to understand when it’s time to make an investment.
Below is what you might get when first looking into a new investment opportunity. In fact, this is an investment overview of a real deal that our team put together last year:
The first line indicates that this is a 506(c) offering, meaning that only accredited investors will be allowed to invest in this deal. Depending on the operator and the deal, non-accredited investors may or may not be allowed to invest.
The second line indicates a hold period of 5 years. This is the anticipated hold time given the business plan that the operators have laid out for the property. Keep in mind that the hold period can change – in either direction – based on market conditions, property conditions and potential opportunities. In some cases, operators will choose to sell earlier if there is an opportunity to capture large returns quickly. In other cases, operators will hold the property longer, if they believe that there will be more advantageous opportunity to sell in the future.
The third line indicates a Pref of 8%. Pref is short-hand for Preferred Return, and that directly relates to the regular cash flow you should expect to receive from the property.
An 8% Pref means that the passive investors in the deal will receive the first 8% annual cash flow on their investment before the operating team receives any cash flow. For example, if an investor were to put $100,000 into this project, they could expect to receive $8,000 in cash flow ($100,000 * .08) each year, before the operators of the property received any cash flow.
We mentioned that sometimes in the early years of an investment, there might not be much or any cash flow. What happens if you don’t get your 8% Pref in year one? Typically the deficit will accumulate and will roll over into year two. For example, if you only receive $3,000 in year one, your deficit for year one would be $5,000. That $5,000 would roll over to year two, and in year two, you are now owed $13,000 – your $5,000 for year one and your $8,000 for year two.
Until any deficit is paid and investors are all caught up on their Preferred Return, the operators of the deal do not get any cash flow. This is why operators work so hard to generate strong cash flow – until investors get at least their Pref, operators are getting nothing.
Now, you might be asking, what about the cash flow after the Pref is paid? When there is additional cash flow, it is split between the investors and the operators in a predefined proportion. In this case,you’ll see that proportion on line five.
Line five indicates a split of 70/30, meaning that investors own 70% of the equity in the deal, while the operators own 30% of the equity. Any cash flow above the Pref is split, with 70% going to the investors and 30% going to the operators. For example, if in year one, there is enough cash flow to pay the Preferred Return, and there is still $100,000 in cash flow leftover, that $100,000 will be split with $70,000 (70%) going to investors and $30,000 (30%) going to the operators.
Profits at sale are treated the same way, first being used to pay any previous deficit in Pref payments, and then being split in the same fashion – 70% of the profit going to investors and 30% of the profit going to the operators.
Lines six, seven and eight are examples of other metrics used to define the overall expected returns from the project.
Average annual return tells us, on average, what our simple percentage return would be each year of the project after adding up all the cashflow and profits from sale/refinance. For example, if our $100,000 investment generated an 90% return in five years (we earned $90,000 in profit in addition to getting our $100,000 back), the average annual return would be 18% (90% / 5).
Internal rate of return (also known as IRR) is a complicated metric, but commonly used for passive investments like this. It indicates the compounded return (assuming all cash flow was reinvested and your profits could compound).
And finally, the multiplier indicates how much you could expect your investment to grow should the project go as planned. In this case, you could expect your $100,000 investment to grow 1.8 times – to $180,000 – between the start of the project and its completion.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.