Some questions to ask, when passively investing into an apartment syndication
The "passive" in passive investor is a little misleading when speaking of your role as a limited partner. As with any investment, it pays to educate yourself, and while people will list 40 to 50 questions, you should ask a sponsor, here are a few key questions to consider. If some of these terms seem unfamiliar, remember that Google is your friend, and it is wise to get command of the terminology.
You need to know more about your operator(also known as the sponsor) other than, "he seems like a nice guy." You want to know their track record and the level of not only his or her experience but the experience of his entire team. Always ask for a few references as well. They are a gold mine for finding out how the operator communicates and what sort of returns they have achieved. They will also be a sort of character witness for how trustworthy that person is. This mere paragraph could evolve into an entire article, but the point is, do your due diligence on your operator.
Decide what your minimum requirement is for projected Cash on Cash return.I aim for a minimum of 8-10%. If they end up beating that projection, it is all gravy.
Decide what your minimum requirement is for the projected Internal Rate of Return (which identifies the annual growth rate). I target a minimum of anywhere from 15-18%.
With the factoring in of time, IRR can get a little confusing, so operators may opt to show a projected Average Annual Return, which takes the total appreciation of the asset averaged out over the life of the investment (a 5-year hold in this example), plus the total cash flow distributions averaged out. Thus, on a $100,000 investment, if your portion of the equity has appreciated by $60,000, and you spread that out over 5 years, that would be $12,000/year or 12%. Now add that together with your cash on cash returns - let's say 8% or $8000/year - we have a total of $20,000/year or 20% Average Annual Return. I aim for 16 - 20% for AAR,
What is your target equity multiple? I strive to double my money within 5 to 6 years, so if I put in $100,000, I want to have at least $200,000 back within 5 to 6 years, thus an equity multiple of 2x. Some operators knock it out of the park doing 3x, but it never hurts to double your money.
Location, location, location! Where is the building located? Is it in a market with strong growth in both population and jobs? People migrate to where the jobs are flowing and leave where the jobs are exiting. If the population is going down, then your vacancy will go up, so pay close attention to these fundamental, but ultra-important statistics. The Investment summary will highlight market statistics. Still, it would help if you double-checked these metrics yourself, either through google, census.gov, or a site like city-data.com, or bestplaces.net.
Make sure they have been performed and will present to you with a sensitivity analysisi.e., the "stress test." Where is the breakeven point, meaning how low can the vacancy dip to, and still have the deal be profitable? If they ran their breakeven analysis with a vacancy floor of 15%, you just might be screwed. Operators have to be conservative in their projections. If they are, you may only end up making a little money, but better this than losing a bundle.
Conservative underwriting. If the operator is projecting 5% annual rent growth, and the organic rent growth in the market is 3%, turn and run!
• In this current market, you should probably be looking for a projection of 2%. If rents are raised the first few years substantially due to a value-add strategy, make sure to offset with a higher vacancy. Turnover will occur.
• Look for an LTV(loan to value) of 75% maximum. You do not want to be over-leveraged in a hot market.
• Check the reversion cap rate, also known as the exit cap, and make sure they have added 100 basis points (1%) to the current market cap rate on a 10-year hold, or at least 50 basis points (.5%) on a 5-year hold. Conservative underwriting will always assume that cap rates will go up from where they are to protect the investor. Remember, as market cap rates compress (go down), the value of your property goes up. When you assume the market will appreciate, this is when you may get burnt. The market might appreciate, but better to presume it won't, and base your profits on either improvement to operations, or the building itself.
Look for a DSCR(debt service coverage ratio) of 1.25 minimum – the higher, the better. For those that don't know, the DSCR is simply the net operating income/debt service (mortgage). The bank wants to know the deal has enough net income to cover the mortgage.
Finally, always, always, invest for cash flow, meaning the property cash flows from day one. Make sure the operator has plenty of cash reserves, and that they have secured long-term debt to ride out the storm (a recession). If they have done the proper breakeven analysis from the previous point (three paragraphs back), the property will always have positive cash flow. If they have a 10-year fixed rate, you can ride out a recession. If they do go the long-term route, make sure the loan is assumable, so you can get out of the loan without a prepayment penalty (but that is another article in the making).
Yes, you can ask your operator 50 questions, but if you cover the essential criteria above, you should be sitting pretty. I hope this helps!