In a previous post, we introduced multifamily syndication as a real estate investment strategy. We learned that this strategy requires a sponsor or general partner to put together a deal and bring in passive investors to invest in an apartment community and share in the returns. The passive investors are integral in this setup because without passive investors, the syndicator most likely does not have enough capital to close on a deal.
When evaluating whether to invest in a real estate syndication, it is important to understand the different investment strategies and how they affect your return and risk levels. There is no one size fits all strategy, it highly depends on your investing goals and risk tolerance.
So what are these different types of investment strategies in multifamily?
Turnkey
Turnkey is a common term used in single-family homes but is a general term that means the home is move-in ready (e.g. you can just “turn the key”).
A turnkey property is an apartment building that requires no work after purchasing it. This means that the asset is stable (>85% occupied with paying tenants) and there are no renovations or improvements that need to be done. In this case, the new team takes over with minimal changes to the operations of the business. This also means that rents at the property are at market value and the returns are already maximized.
This type of investment tends to be considered low risk since there is already money coming in from the tenants as evidenced by previous rent records. The business plan is straightforward, continue to run the apartment complex similar to the last owner, and collect rents. There is less risk since there is no need to do renovations that may get held up.
With that said, the returns on a turnkey property are usually lower compared to the other investment types. A benefit is that these investments generally cash flow from day one.
The property doesn’t require any improvements that would increase the revenue and therefore force an increase in the value. The cashflow is lower than strategies that require more work. There could be a potential upside at the sale of the property if the market appreciates, but that is not usually something to assume or bank on.
Distressed
This type of property is the opposite of a turnkey apartment. Distressed properties have lower occupancy than stabilized ones. There may be tenants that don’t pay rent. When evaluating a property, it is important to understand the difference between economic occupancy and physical occupancy. Economic occupancy is the percent of tenants living in and paying rent. It can be different from physical occupancy which is the percent of occupied apartments.
The units are often outdated or in bad shape, the common areas are not welcoming, mismanagement, sub-optimal operations, and possibly a lot of delinquency. Often there are significant repairs that are required. When the property is in rough condition and/or there is less than 85% economic occupancy traditional financing options are often out of the picture. The sponsor team may need to get a private loan to do the work at higher interest rates or raise more capital to buy the property with all cash.
With this type of investment, the goal of the syndication team is to stabilize the asset and start generating a profit. The business plan will often include all or some of the following:
- renovating the interior and exteriors of the property
- finding a better property manager
- improving the quality of living of the residents
- Fill vacant apartments after renovations by finding new tenants.
These efforts increase the occupancy rate of the property and bring the rents closer if not to market rates.
As you can see this is a big effort that requires a solid business plan and team in place. When things go as planned, the returns are great at the sale of the property since now the occupancy and rents are stabilized. The revenue of the property has significantly increased so the value of the property is much higher than what it cost to acquire it. This type of property has the highest risk and highest potential for return.
Distressed properties require a lot of heavy lifting with many moving parts at the cost of not being able to execute the plan well enough to realize a return. These properties generally do not cash flow until later, once parts of the business plan have been executed to bring up the economic occupancy. The draw is to increase the value through a large amount of forced appreciation and deliver returns later to the investors, often at the sale or refinance of the property.
Value-add
The value-add strategy sits between distressed and turnkey. For me, it is the goldilocks option of just right. A value-add apartment is a property that is stabilized but has the opportunity to be improved to increase its value. Typically the team acquiring the property will have a plan to improve the asset over a 12 to 24 month period with the goal of selling after 3 to 7 years.
There are several ways to add value to this type of property. Some include the following:
- hiring a property management team that has more experience and is more efficient, bringing down expenses and improving the tenants’ experiences
- better operational procedures, again bringing down costs
- renovating the interior of the units and renting at a higher rent
- Renovating the exterior of the property to bring in new tenants at higher rents
- better amenities that can either bring in higher rents or can be charged separately
The high-level goal here is to decrease expenses and increase revenue. Unlike distressed properties, the renovations required for this type of property are lighter and don’t require a full makeover.
I consider this type of investment as the best of both worlds. The property is stabilized and is already bringing in consistent income but this income can be increased by adding value. This has a relatively low-risk profile, much lower than distressed properties, but has the potential upside to forced appreciation by doing work to the property to increase its value.
Typically these properties cashflow early on with distributions to investors on a monthly or quarterly basis. The team is continuously working on their plan to bring the value of the property up. After the sale, the investors get their equity share and often a large distribution from the forced appreciation.
Comparing the Strategies – Which Strategy should you invest in?
While these are high-level strategies, each property is different. It is important to understand these differences so you can make an informed decision and ask the right questions to the sponsor team.
Depending on your tolerance for risk, you may want to pick the turn-key property with consistent returns (often lower) from the beginning. If you want to go for the largest returns and take on more risk, then investing in a distressed property may be the best option.
If you are more interested in getting regular cashflow with the potential of a larger profit when the property is sold, then I would consider passively investing in syndication with a plan to execute a value-add strategy.
If you have questions or would like to learn more about passively investing in multifamily schedule a call with our team!