As an investor, there are various ways you could put your money to work. When you’re in the world of private placements, you may have heard of preferred returns. These refer to the order in which profits from a project are distributed to investors. Preferred return indicates a contractual entitlement to distributions of profit. Those who were promised preferred returns are given priority when the distribution of profits happens. This is maintained until a predetermined threshold rate of return has been met.
Preferred returns are usually expressed as a percentage of return on an annual basis. For example, if in an agreement you were promised a preferred return of 8% for a $100,000 investment, then you would receive $8,000 ($100,000 x 0.08) in annual return if available from the net revenue.
As an investor, the rate of preferred return is a vital component in checking the health of a particular investment, as it reveals the intent of your partners in returning your money. When you have preferred returns, you’re given priority over the company’s income before the general shareholders. That means the people running the company should work hard enough to not only meet the promised preferred returns but also generate enough excess income to be profitable.
In short, the operators will be focused on reducing the time spent before you get your return on investment, to increase your overall return. This will ensure that your goals as an investor and the goals of those running the company are in sync, and no one is out to cut the other short.
By the nature of preferred returns, it is indeed more advantageous to the one with the capital. Thus, when you’re offered an investment, it pays to look for this clause. An operator may choose not to offer preferred returns because doing so will delay their split of the profits. While this is acceptable, as an investor, you may see this as a misalignment of interest. Another reason why operators may not offer preferred returns is if they are not as well-capitalized and need the proceeds from the cash flow to fund their syndication operations.
Types of Preferred Returns
Now that we’ve talked about preferred returns, let’s discuss their types.
The first is cumulative versus non-cumulative. When you’re tasked to review a private placement memorandum (PPM), you will want to make sure that you take note of whether it’s a cumulative preferred return. Cumulative preferred return is ideal because it will help protect your overall return and here’s why.
Remember our example earlier? Let’s say, you’re given a preferred return of 8% per annum. In a non-cumulative preferred return, if you do not receive your total preferred return for one year, then you lose the difference. Say, in year 1 you receive back 6% (rather than the 8% that was anticipated). With a non-cumulative return, youforfeit the right of getting the difference after that year has elapsed. Every year the preferred return resets and does not carry forward.
A cumulative preferred return gives you the right to add the difference and roll it over to the next year. For example, if your preferred return was 8% and you only received 6% one year, then your preferred return the following year would increase to 10% (8% + 2%).
In the normal business cycle, cash flows are expected to increase year to year as operations begin to stabilize and become more profitable. Thus, while the promised return in percentage is fixed, the actual value of such will be bigger since the number where it’s computed from also gets bigger as the years pass. This can lead you to get a return on investment sooner.
As a reminder, always read your documents carefully to be aware of whether you are investing in projects with a cumulative preferred return.
Another type of preferred return is the preferred return with catch-up. This setup is considered the second position in the waterfall distribution schedule. Here, once your share of the profit is achieved and is set aside, the operator receives all or most of the profits until the operator “catches up” and reaches the same portion of equity you received. This type of catchup provision allows the operator to receive its entire equity split as originally agreed by both parties.
What Else To Know
Another aspect that you should know about concerning PPMs is the difference between Preferred Returns and Preferred Equity. To differentiate both, let’s go back to the life cycle of the investment. Assuming that funding is already secured, your investment can either be with a preferred return, preferred equity, or both. We discussed how preferred returns work. When it comes to preferred returns, the actual return of your overall capital is not in the picture.
When you have preferred equity, you’re prioritized to get your returns during the hold period and also have a priority treatment to get back your initial capital when the asset is sold.
So it is a good business practice to consider adding an equal amount of preferred equity and preferred returns in your portfolio for risk management purposes. Preferred returns help you with a steadier, consistent cash flow; while as a preferred equity investor, you would receive your specified return and your initial capital back before any of the other investors.
When Do Preferred Returns Go Away?
Preferred returns are often calculated based on how much capital you contributed times the interest promised. However, there are distribution structures where your payouts are deducted from your capital. Thus, every payment you receive means a return from the capital you invested. This will also mean that since your returns are based on your unpaid capital, then it’s safe to assume that you will get smaller payments over time.
Some operators will say that this is a good idea because you are not paying taxes on the cash flow. However, since your preferred returns are based on unreturned capital contributions, your preferred returns will gradually diminish. Some operators prefer this structure because it allows them to achieve profitability quicker.
As an investor, It’s generally better to choose preferred returns that are distributed from profits alone and not deducted from your initial capital so that your payouts will not be diminished. Typically you do not have to worry about the taxes right now anyway, since the depreciation each year should offset all the distributions you receive.
You also do not have to worry about the return in the capital, as preferred returns are not the most efficient way to get it back. Usually, to reduce your unreturned capital contributions or get it back completely, you need to go through a capital event such as a refinance or supplemental loan. Through these events, you would receive a portion of your initial capital back and this amount would reduce your unreturned capital contributions.
To make the above example less confusing, let’s pick up from our last scenario. You invested $100,000 and because of this, you will be getting an 8% preferred return rate (or $8,000 a year). Instead of deducting this amount from the initial capital, treat it as a dividend gain. In year three, when the operations have stabilized and the company is ripe and due for refinancing, that’s the time you can lobby to get a portion of your capital back. Your preferred return would then be based on the remaining unpaid capital. Thus, if during the said refinancing you were able to get around $40,000 back, then you will still be able to enjoy the fruits of the 8% preferred return rate on the $60,000.
With this example, it is important to note that even though your unreturned capital was reduced, this does not reduce your equity position in the overall deal. This amount is only used to calculate your preferred returns. However, some operators will reduce your equity position during a refinance or supplement loan, so be very diligent in reading the PPMs to make sure you know exactly what you are getting yourself into from the start.
Conclusion
Remember that just as with any venture you may get into, always protect your capital first. That’s the basic rule of risk management. Do not look so far ahead, especially to the potential gains, and overlook the red flags and risks that might be lurking in the PPM. Look at preferred returns as a powerful tool for you to protect your capital. It allows you to have preferential treatment in getting back your capital (and more) and eventually helps you grow your portfolio as a passive investor. By carefully choosing preferred returns, you reduce your risk when putting your money in private placements, since you are prioritized to receive the proceeds of all cash flows first.
Maybe you’ve heard of a 1031 Exchange or simply a 1031. A term that got its name from the IRS Code section 1031, it is an exchange or a swap of one property for another that is a powerful tax strategy allowing for the deferral of capital gains taxes.
Anyone who owns real estate can harness the power of the 1031 exchange. Just by following this process, you can replace your property and buy a replacement investment, while deferring tax payment on what you gain from the sale.
Want to know how you can have more cash flow through this investment? Or want to earn passive income without being pummeled by taxes?
In this article, you will find key points regarding the 1031 Exchange – rules and concepts you should know if you are thinking about any kind of real estate investment, and when using the 1031 Exchange to invest in a real estate syndication.
A Better Return on Investment
This exchange into syndication helps you by offering a better return on investment while giving you an increase in cash flow. Therefore, when you exchange it with a larger and more valuable property via syndication, the benefits increase twofold.
Deferring Taxes
With this exchange, you get the ability to buy like-kind property while deferring capital gains taxes. If you continue re-investing into other properties, doing this exchange until your death, the investment will be handed down to the heirs, and the cost of the property will reset to the current investment value allowing you and your heirs to avoid the capital gains tax.
However, if you sell the property and take the proceeds (without reinvesting), you will have to pay the capital gains.
Timeline to Execute the 1031 Exchange
The IRS has a specific time frame in which the 1031 exchange needs to be executed, and it needs to be followed for the exchange to run smoothly.
You have 45 days to identify the asset that you will be acquiring, starting from the day of the sale of your existing asset. The IRS does not allow you to access the funds or to touch the property once you sell it. It is also a requirement that you engage a qualified accommodator to facilitate the transaction.
Once you have identified your next asset, the IRS gives you a further window of time so that you can close on the asset. This means that you have a total of 180 days from the day you complete the sale of the original asset to the closing of your next asset. The IRS has strict rules and a timeline to follow and if you are unable to follow those rules you will have to pay the capital gains.
The Role of Accommodator
The role of the accommodator (a qualified intermediary) is to facilitate the process of the transaction from the sale of your asset to the closing of your next asset.
The intermediary helps you walk through the entire process and steps required for the syndication and makes sure that you never miss the timeline, which is outlined by the IRS. In doing so they will help you avoid a taxable event.
The accommodator you hire must be an independent entity and should not be related to you.
Once you hire the accommodator, you will have to enter agreements, including an Escrow Account Agreement, Like-Kind Exchange Agreement, and others that will allow the intermediary to act on your behalf through the transaction process.
Identification Rules for Next Property
There are some rules set by the IRS that you can use to identify the replacement properties. You must choose to follow at least one of these options.
These rules are:
The 3-property rule
Investors, most of the time, use the 3-property rule to identify up to three properties that might generate more cash flow. This means you can exchange into one or all the replacement properties.
If you want to identify more than three replacement properties, you will have to use the 200% fair market value rule.
200% fair market value rule
What is that? How does it work?
Let us give you an example.
Suppose you sell your property for $2,000,000, and identify up to 3 replacement properties for exchange.
You can identify a fourth or fifth replacement property as long as the sum total value of all the properties combined does not exceed $4,000,000 or twice your property’s selling price.
95% Exception Rule
The 95% Rule allows for you to identify any number of replacement property options, regardless of valuation, provided that you follow through and actually acquire a property or properties that equate to at least 95% of the identified value within the exchange period.
For example if you sell your property for $2,000,000 and then identify more than three properties worth $10,000,000 to exchange into, that is allowed if you actually end up spending at least $9,500,000 or 95% of the identified value within the exchange period.
Can I 1031 Exchange my Residential or Vacation Home?
Your primary residence or vacation home is not qualified for this type of exchange. However, there is an exemption, which is known as Section 121. This is a complicated structure, and you will need to take qualified advice to make sure that the exchange is properly executed.
1031 Exchange is a technique for investors who want to earn passive income from real estate. You need a clear understanding of the process so as to leverage it correctly. The procedure
can be complicated and that’s why most investors prefer to work with experienced partners.
Our aim is to help you grow your wealth. We are here to help you with the 1031 exchange so that you can enjoy the benefits that apartment syndication provides.
Investing in real estate is an endeavor as rewarding as other investment vehicles such as stocks or bonds but can involve a lesser degree of management in monitoring your holdings (especially if you’re engaged in apartment syndications). So, what is the best way to generate income from real estate?
In this article, we will focus on rentals. Specifically, we’ll identify which type of real estate investment you might find better: Apartment Syndications or Single-Family Rentals.
First, let’s define these two. Apartment Syndications are, simply put, the pooling of money from numerous investors to buy an apartment complex which will then be fixed up, if needed, and rented out. This is a partnership where a manager handles the transactions of the rental property while you, along with other investors fund the endeavor.
Single-Family Rentals (SFRs) are self-explanatory—you buy single-family homes, fix them up for a cost if necessary and then rent them out.
Now, let’s differentiate between the two in terms of cost. Naturally, single-family homes are typically cheaper as a whole than multi-family apartments; although apartment complexes often come out cheaper on a per-unit or “door” basis. So, if you’re simply looking at a $100,000 single-family home compared to a $1,000,000 apartment complex, the difference in the cost would be staggering. However, we’re talking about apartment syndication here, which means that the cost to acquire an apartment complex is divided among the investors, so, you won’t have to worry about shelling out as big of an amount.
Apart from acquisition costs, you also have to deal with repair costs. When buying any property, repair costs are usually incurred. You want the place to be in pristine condition so that you can rent it out sooner and at a good price.
For both single-family rentals and apartment syndications, repair costs would naturally depend on the condition of the property when you bought it. The only difference between the two is how much of the cost you shoulder. With SFRs, you don’t have anyone to share the burden with, compared to joining apartment syndications, where the General Partner (GP) takes care of the arrangement, and you typically just pay a fraction of the cost.
Another thing you have to consider is maintenance expenses. In a typical lease agreement, renters do not shell out money for maintenance and upkeep, so these costs would all have to be shouldered by the lessor.
If you’re managing one or multiple single-family rentals by yourself, you have to pay for the costs out of pocket. Logistics would also have to be considered if you have to visit multiple properties all at the same time, just for maintenance. In apartment syndications, the partnership may bring in or hire a third-party property manager, who’ll take care of the maintenance, the cost of which will be spread among all investors.
Vacancies are where you have real leverage when it comes to apartment syndications. Suppose you only manage one single-family rental. What happens when that becomes vacant? Your cash flow will come to a halt until another tenant occupies it. In contrast, when a single unit in a multi-unit apartment rental is vacated, the partnership’s cash flow, including yours, will not be as affected since the other units are still generating income.
Economies of scale are something that we hear often when it comes to production. You exploit the inverse relation of increasing output versus the cost to produce said goods. But what does this mean in the real estate context?
Expenses and maintenance costs in apartment syndications are typically far less, compared to managing a portfolio of separate, single-family homes because in syndications all units are, quite literally, under one roof. As the number of rental units increases, net income is also increased as you reduce your cost, making it more cost-effective than managing a portfolio of single-family rentals.
Is Rental Still in Demand?
Now that we’ve discussed a few key points regarding real estate investing—rentals, in particular, let’s take a look at the demand for rentals. While some events or instances might influence families to move outside of the city and to the suburbs, potentially choosing to buy a property instead of renting, the demand for units located in key metropolitan areas will still be there.
Each city, district, and state have factors affecting the rental market, such as median household income, that may or may not hurt rental demand. A higher per capita household income may mean that more people in a certain area are able to buy homes instead of renting. However, it’s still more probable that a larger percentage may not be able to afford one and will continue to rent.
There are also commercial establishments that, due to the nature of their businesses, cannot afford to have their employees work from home. This is one thing that can contribute to steady demand in rental properties, especially in apartment complexes in key locations.
We’ve also seen instances where baby boomers who are approaching retirement, opt to let go of their large family home, and just choose to rent. Young families on the other hand, continue to rent as they save up enough cash to buy their first homes in the future. In both instances, the logical choice would be to choose a place that’s either near where they work or is in the vicinity of establishments they frequent.
Investing in apartment syndications certainly has its merits. People who have opted to invest in multifamily will tell you that it’s a worthwhile and relatively safe investment. We are Trinnium Equity Group, and we have been successfully providing our clients with professional guidance in the world of apartment syndications. If you would like to know more, schedule a call with us. We’d be more than happy to discuss details with you. We have a team of experts who can walk you through each step of the process in order to make this investment opportunity as easy as possible.
Are you searching for the bestpassive investment opportunities? Passive multifamily real estate investing is a tried-and-true method that lets you take advantage of real estate’s stability without the direct responsibilities of being a landlord.Steady cash flow and tax advantages are just a few of the great things about investing passively!
However, not all investments are equal, and many investors don’t know how to evaluate the quality of a passive investment opportunity.
When looking at properties, many people tend to only look at returns – but there are other parts to the puzzle! Here is our top advice for finding passive investment opportunities that will serve you well for years to come.
Know how to mitigate risk
Real estate is generally considered to be a low-risk investment in most cases. Property values can generally be trusted to increase year after year, and multifamily has historically performed better than many other asset classes during recessions.
That being said, no investment is devoid of risk, even if you’re working with a company that does everything it can to protect investors. So, what are the specific risks of the deal that you’re considering? And what is the operator of the deal doing to mitigate the risks?
There are different styles of underwriting, from aggressive to conservative. It’s often a good idea to work with a company that underwrites its deals conservatively. This gives you a margin of safety so that you can make more realistic plans. It’s smart to be conservative when it comes to debt structure, income projections, and budgeting for capital expenditures. This is far better than working with a company that will overpromise and underdeliver.
Understand cap rates
When looking for conservative underwriting, the capitalization rate – or cap rate – is one of the most important numbers to look at. This number helps to determine the value of the multifamily real estate property. Cap rate is calculated by dividing the property’s net operating income by its current market value.
The cap rate will depend heavily on how the market is doing, so it is subject to change over time. In many markets, the cap rate will be around 6%. Most likely, the cap rate will hold steady, but good financial projections will usually build in a margin of safety by projecting slightly lower cap rates in the future. Be wary of financial projections that show a steady cap rate 5 years in the future. While this is likely, it should not be promised. And, be especially wary if the cap rate is even lower in the financial projections.
Ask about reserves, cash flow management, and rent growth
Always make sure that there will be reserves at closing. In other words, make sure that there’s plenty of cash left at closing for renovation costs and a “safety net” for any unforeseen circumstances.
Ask about cash flow management and be sure that the company operating the deal operates above the line. In other words, ensure that they calculate the net operating income with plenty of room to take money out without hurting the bottom line. Keep in mind that this will reduce returns on paper, but it’s actually a good thing! You want to be wary of returns that seem too high to be true.
Also inquire about rent growth. When you’re investing in multifamily, the goal is to increase profit over time by improving the property and raising rental rates accordingly. Rent growth is definitely something that you’ll want to count on. Just be aware that it will take time. There’s no way to promise rent growth within the first year, because that would involve kicking out all the tenants and renovating the building instantaneously… which is clearly not realistic! Expect rent bumps to start no earlier than year two or three.
Work with a trusted syndicator
If you have already found a company that you want to work with, does the operator or syndicator of the deal have the chops for property management and passive investing? It takes a team of knowledgeable people to manage properties and make solid investment decisions. Make sure to find a team you can rely on with confidence!
Ask the syndicator questions. What’s their strategy for picking a good market, finding great deals, and operating multifamily properties to their highest potential? Will they conduct thorough due diligence? Do they take a scientific approach to real estate investing? Do they have good references from mentors or from real investors in their syndication? How will they work to protect their investors?
A trustworthy operator or syndicator will often put their money where their mouth is by passively investing in their own deals. You may want to consider working with someone who trusts their process well enough to invest in it themselves.
If the company is a large group of partners or a joint venture, then you may want to find out who has the bulk of the decision-making power in the group and determine whether they have a good track record. Property managers, attorneys, and board members are all important parts of the team.
And lastly, it is very important that the sponsor is willing to guide you through the passive investing process and answer all your questions with transparency. This will help you decide whether this is the right deal for your specific needs. If you’re putting your hard-earned money into the venture, you deserve to understand the process fully.
Go forward with confidence!
As you can see, the best passive investment opportunities will always come down to the syndicator of the deal. There’s no substitute for finding a good syndicator who will answer all your questions, make smart and educated decisions, and work to protect their investors.
A little bit of knowledge goes a long way when it comes to selecting a long-term partnership with a multifamily syndicator. When you’re prepared to ask questions and delve into the financials, you can confidently select the investment that is right for you!
We are at the age in which people have increasingly become financially savvy in such a way that we get to talk about passive income now more than ever. The generations before us were fairly contented with the income they get from the usual 9–5 job, and rightly so because money had more value then than it has at present. Nowadays, you just can’t live with one source of income alone and expect to be financially free right away.
Hence, passive income comes into play. Passive is defined as something that happens without your direct participation. Income is, well, money derived from investments, work, or labor.
When we talk about passive income, what’s the first thing that comes to your mind? Is it effortless income? Income that goes directly into your bank account without you lifting a single finger? If those are your definitions of a passive income, then you belong to most of the population.
However, our definition of passive income is different. The notion that passive income requires no effort is dreamy at best. Let’s take income through dividends as an example. You can argue that to earn it, you won’t have to do anything; but in the first place, you must have the capital to earn interest as dividends.
Hence, passive income does not equate to effortless income. Nothing is free. Every form of passive income requires an initial investment in terms of time, capital, or effort. However, passive income differs from traditional income because, with passive income, you only have to spend time to set it up during the initial phase and leave it running once it’s set up, and it may be minimal time. So passive income is not directly tied to your time.
In traditional 9–5 jobs, you have to spend a uniform 8 hours per day 5 days a week to earn your salary. However, in passive income, time is typically necessary during the establishment only, and minimally after that.
With traditional income, your earnings are affected or interrupted if you take some time off. With passive income, a system is in place; thus, the benefits continue to pour regardless of whether you participate or not. Investing in passive real estate is the perfect example.
Passive real estate is a type of investing wherein you invest in other people’s deals through syndication. Syndications are managed by professionals. They are in the business of buying and selling properties and almost everything in between. They sometimes need outside capital to be able to expand, and that’s where you come in.
In this scenario, the large amount of work required in traditional methods of investing in real estate is reduced.
Although syndications are attractive, you have to take note that your first goal in investing is to protect your capital; thus, performing proper due diligence upfront is extremely important. Once this assessment is done and all goes well, you can just expect the investment to bear fruits soon.
This act of strategically using your available resources to generate a high amount of income is technically called leverage.
What Is Leverage?
In your science class in second or third grade, you may have learned that if you’re having trouble lifting something heavy, using a lever may be able to do the trick.
When you’re having a challenge in buying something with your own available resources, you use leverage. This concept is not new, and you probably have done this before. When you bought a house, you borrow from a bank so you only put up a 20% down payment instead of paying the full price of the house. In this scenario, the bank acted as your leverage (putting up the 80% remaining balance in exchange for the house in case of default).
How Leverage Is Applied in Real Estate
In real estate, leverage can be in different forms. The first, of course, is the example earlier regarding money or capital.
Let’s say you have $100,000. You can choose to use that as a down payment for a $500,000 property and earn income from that one property. That’s a great idea, right? Sure! But going through this route means your possible income is tied to that one property. What happens if it doesn’t pan out as planned?
This is where you can use your capital as leverage one step further. You can use the same investment capital of $100,000 as part of a syndicate. Syndications pool money from different investors.
Your initial $100,000 will have more purchasing power once pooled together with other investments pledges. That means your money can go toward a larger, more profitable deal than you could afford alone.
Financial strength is the second form of leverage that we’d like to discuss. Financial strength can be briefly described as how sound your inflow and outflow of cash are, namely your balance sheets, when getting into investments.
Think of it as your credit score but from a business perspective. When you undertake a real estate project on your own, you bear the necessary expenses and possible risks out of your own pocket. Again, if the deal doesn’t work out, you will bear the brunt of the damage.
However, if you invest in pooled investments such as syndications, you don’t have to worry about things such as balance sheets and financial health because banks look at the balance sheet of the company managing the syndications and not your own.
Why is participating in pooled investments crucial? First, doing so allows for a large room for expansion. Usually, the larger the syndication is, the sounder its position is. Large syndications have advantageous access to capital. Therefore, banks are inclined to further grant them loans, thereby allowing these companies to invest in other properties, and the cycle goes on.
At this juncture, you probably get the idea how joining a syndication might be in your best interest compared to getting in on your own. Another thing you can leverage by joining a syndication is their knowledge and experience.
How long does it take for one to master something? Let’s use physicians as an example. Before they acquire their license and become consultants, they have to go through 10 years of education. Similarly, no one becomes a real estate expert overnight. It takes years and years of experience to become one.
By investing in a syndication, you can have access to the company’s vast amount of knowledge and experience without having to go through all the process yourself. This situation is perfect for (1) those who are just getting started because you don’t have to devote much of your precious time learning the ropes because doing so may result in missing out on lots of opportunities and (2) those who don’t want to be bothered about the intricacies of real estate investing. They can just simply put their trust in the company (after due diligence, of course), and let the money run the investment for them.
Usually, a syndication already has a team of experts who are knowledgeable when it comes to spotting the best real estate deals in the market. This built-out team is another aspect you can leverage on. Imagine having access to a team of specialists who can give you sound business advice. This team also has the technical knowledge on how to make each property deal profitable consistently. The best part is you don’t have to build this team from scratch!
Last, but certainly not least because it is possibly the most important, is time. Building a profitable real estate portfolio entails mind-wracking effort and a huge amount of time. That is time that you may not have or may be better spent elsewhere (such as with the ones you love or with self-improvement activities).
When investing in passive real estate projects, you’re leveraging the limited time that you have. You may invest time upfront (during due diligence), but compared to the years of passive income a good investment can bring, that time is well worth it.
Instead of doing everything firsthand, that is, trading time for money, you will only spend a small amount of time for great, long-term benefits, like hanging out with family, friends, traveling, or just enjoying life in general.
You can argue that building a passive income should be worth your time, and you’re correct. Between working hard and working smart, why not choose the latter? If you can take advantage of a vehicle that can bring you to your destination (that is, financial freedom) quickly, why not choose that?
Conclusion
Leverage is a powerful tool. If you learn to use leverage together with passive income and real estate investments, you will become a sophisticated and efficient investor. Most importantly, you can achieve your financial goals quickly, thereby having time to spend on other important things in life.
At the end of the day, our ultimate goal isn’t simply to make a great investment but to make an investment that will allow us to live the life we want and to have the time to spend with the people who are special to us.
