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Reasons to Consider Investing in Multifamily Real Estate as Inflation Rises | Resident First Focus

As inflation rises, investing in multifamily real estate can be a smart move for several reasons:

Inflation-Resistant Income: With inflation, the dollar's value decreases over time. However, multifamily properties are known for providing steady rental income that tends to increase with inflation. As prices for goods and services rise, so does the value of rent, which means that property owners can continue to generate stable cash flow and protect their investments from inflation.

Hedge against Inflation: Multifamily real estate is considered a tangible asset that can serve as a hedge against inflation. As the cost of living increases, the value of multifamily properties can appreciate, allowing investors to benefit from both rental income and property value appreciation.

Diversification: Investing in multifamily real estate can help diversify your investment portfolio, reducing your overall investment risk. Real estate investments often behave differently from other investments like stocks and bonds, providing investors additional protection against market volatility.

High Demand: Multifamily properties are in high demand, particularly in areas with limited housing availability. As inflation rises, many renters may struggle to afford single-family homes, which could increase demand for multifamily properties, leading to higher rents and better returns on investment.

Tax Benefits: Multifamily real estate offers several tax benefits, such as depreciation deductions, which can offset rental income and reduce tax liability. Additionally, investors may take advantage of 1031 exchanges, which allow them to defer capital gains taxes when they sell a property and reinvest the proceeds into another property.

Overall, multifamily real estate is a solid investment option that can provide inflation-resistant income, hedge against inflation, offer diversification, and provide tax benefits. As inflation rises, these benefits become even more pronounced, making multifamily real estate an attractive investment opportunity. However, as with any investment, it's essential to research and consult a professional before making any investment decisions.

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Why and How to Invest in a Low Cap Rate Environment | Resident First Focus

Investing in a low-cap rate environment can be challenging, but it is still possible to make profitable investments if you understand the reasons behind the low-cap rates and adjust your investment strategy accordingly.

A cap rate is the ratio of a property's net operating income (NOI) to its market value. In other words, it measures the return on investment a property generates based on its current value. Conversely, a low cap rate means the property generates relatively low returns compared to its market value. 

We may currently be in a low-cap rate environment for several reasons. One reason is the high-interest rate environment. When interest rates are high, investors are less likely to invest in real estate, slowing demand and property values. This, in turn, leads to lower cap rates. Another reason is the shortage of available properties. As demand for real estate increases, supply may struggle to keep up, causing property values to rise and cap rates to decrease.

If you are looking to invest in a low-cap rate environment, there are a few things you can do to maximize your returns. 

First, consider investing in properties with high growth potential. For example, properties in areas experiencing rapid population or economic growth may see a substantial increase in value over time, despite their low cap rates. Additionally, look for properties with value-add potential. You can purchase these properties at a low cap rate and then add value through renovations, management improvements, or other strategies like valet trash, ultimately increasing the property's NOI and value.

Second, consider using leverage to increase your returns. With today's interest rates, you may obtain a mortgage at a favourable rate by buying points, allowing you to purchase a property with a low cap rate and still generate positive cash flow.

Finally, be prepared to hold onto your investment for the long term. In a low-cap rate environment, seeing substantial returns on your investment may take longer. However, by being patient and holding onto your investment, you may see a significant increase in the property's value and your return on investment.

In summary, investing in a low-cap rate environment requires careful consideration and understanding of the reasons behind the low-cap rates. You may generate positive returns despite the low cap rates by investing in high-growth potential properties, using leverage, and holding onto your investment for the long term.

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What Renters Aged 55+ Want from their Properties | Resident First Focus

Rental demand is growing among Americans aged 55 and above. This is a movement that is expected to continue as Baby Boomers age.

So the question evolves: how will you capture a share of this market?

Investors, sponsors, and property managers need to understand what older renters want from their apartments. One of the challenges is that the demographic of renters aged 55+ is remarkably diverse. There is no particular “renter profile” for this age group. The demands of someone 55-years- old looks a lot different than someone 80-years-old.

Research reveals a few things that older renters have in common, at least in terms of what they want out of their apartment -- including property upgrades that will make your asset more appealing to renters as they get older.

1. Accessibility.

Older Americans seek homes that are effortless to get in and out of. Dwellings with extended driveways or multi-level entrances can be challenging for older adults to navigate. To improve the lure of your property, offer parking as near to the entrance as doable. Be sure walkways, the route itself, and any bricks and pavers are as level as feasible.

This is true for decks, as well. Raised decks or grand front porches may look nice, but they are not exceptionally practical for older adults. Instead, try to keep outdoor patios level with the adjoining indoor rooms.

If space allows, install an ADA-compliant ramp. This will draw a larger share of renters who may be desiring a home where they can age in place. You get the added advantage of appealing to disabled residents of all ages.

Lastly, consider widening doorways. This is especially advantageous for residents whose mobility may be constrained by a wheelchair or walker. At least 36” is needed for wheelchair access, though 42” is preferable.

2. Inclusive Rents.

Many of today’s renters aged 55+ have owned their own homes before. They are wary of the upkeep and maintenance required, often a driver of downsizing to an apartment community. Older Americans are looking for units where the yard work, snow removal, and

other landscaping chores are all included in the rent.

This demographic is also looking for rents that include all utilities: heat, hot water, gas and electricity, cable and Internet, even parking and laundry. That is frequently the case that after one spouse passes away, the other battles to oversee their budget or stay on top of bills. Older renters prefer units that include some or all of these services in the standard monthly rent. It is one less thing for them to worry about as they age.

3. First Floor Bedrooms and Bathrooms.

An estimated 40% of all new homes have a first-floor primary bedroom with an en-suite bath, a 15% increase over the past decade. “That is the No. 1 request these days from Baby Boomers,” says Bruce Nemovitz, a Certified Seniors Real Estate Specialist based in Milwaukee. As Baby Boomers age, getting up and down the stairs becomes more of a challenge. One spouse may sleep on the couch without a first-floor bedroom while the other is upstairs, which is not ideal. First-floor bedrooms and bathrooms allow people to age in place.

Be sensible with upgrades if you are preparing to add a full bathroom on the first floor. Install grab bars in the shower and next to the toilet. Consider adding a comfort-height toilet that is easier for older adults to get on and off. A walk-in shower with bench seating is ideal. Otherwise, be sure the tub has a swing door to allow easy entry and exit.

4. Room for Guests.

Folks who have hosted their children, grandchildren, friends, and distant family at their homes over the years may be apprehensive about downsizing. They worry that if they sell their longtime family home, they will not have room for people to stay. Typically, older Americans are looking for properties with at least a second (if not a third) bedroom that can be used as an office or for visiting friends and family.

5. High-End Finishes.

Many Baby Boomers are accustomed to high-end finishes in their homes, and they are looking for the same level of quality when they downsize or begin renting. Kitchens and bathrooms must have a modern, sleek feel. Consider investing in high-end amenities such as wine refrigerators and automated window coverings.

6. Better Lighting and Larger Windows.

Lighting becomes even more critical as people age. Proper lighting is not just an option—it is a safety measure for some. Motion-sensor lights are perfect for driveways, entryways, hallways, and other common areas. These lights brighten up an area sans an older adult fumbling through the dark looking for a switch. Inside, add multiple light switches to reduce the number and length of trips needed to turn a light on or off.

Consider investing in more oversized windows if you are about to embark on a renovation project. More oversized windows will increase the amount of natural light that the home gets.

7. Space to Gather.

Older adults live longer into retirement and increasingly place a high priority on remaining social. To lure renters aged 55+ to your property, consider incorporating various spaces to gather. This could be at the unit itself: open floorplans with combined kitchen/living areas can be fantastic for entertaining, as they are well-lit and appointed outdoor areas.

Consider upgrading lobbies, clubhouses, and pool areas if you own or manage a larger community. Host regularly programmed events that encourage residents to mix and mingle.

Investors, sponsors, and property managers are increasingly vying for their share of this market demographic. That is why it is so essential to understand the priorities of older Americans. A range of property upgrades—some simple, others not as much—can be made to improve the appeal of your property among renters aged 55+.

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Real Estate Sponsors: What Do They Do and Can They Foresee the Future? | Resident First Focus

Real Estate Sponsors: What Do They Do & Can They Foresee the Future?

 The real estate market ebbs and flows in cycles. Historically, real estate evolutions have endured anywhere between seven and twenty years. Numerous elements can impact the real estate cycle, from a national recession to a real estate-specific supply and demand imbalance. Few things are as crucial as a well-aligned supply and demand. Inequality between the two can lead to all sorts of trouble. Too much demand can lead to inflated prices and rapid appreciation, while too much supply can stagnate the market and create depreciation. 

Knowing where we are in any given real estate cycle is paramount to those weighing investing in a real estate syndication and affects a deal’s overall performance. For example, let us say, if a newly-constructed building is brought to market on the brink of a market downturn, the profitability will be vastly different from that same building pushing to lease up or sell when the economy is strong.

 Nevertheless, real estate sponsors must assess each deal based on their best conjectures about how the market will behave when property stabilization is reached and at the exit. 

 There has been much talk lately about the future of real estate. Some experts say it is on the brink of a significant slowdown, while others remain optimistic. Whatever your opinion may be, one thing is for sure; the market is constantly changing and evolving. This means that real estate sponsors need to stay ahead of the curve to stay successful. To do this, they often turn to forecasting tools and techniques to predict what will happen next. So, what are some of these considerations? Moreover, how dialed-in are they? Let us take a look.

 The Role of Real Estate Sponsors 

Real estate sponsors oversee every aspect of a real estate syndication. The all-around focus is optimal overall deal performance. This is the anatomy of a Commercial Real Estate Deal. The process of real estate syndication can be broken down into four main phases: origination, due diligence, closing, and management. Each stage has its own unique set of tasks that must be met to succeed for the syndication. 

 When folks invest in a real estate syndication, they hope that the sponsor will make appropriate and profitable decisions and expect them to be analytical enough to make the best of passive investors’ hard-earned capital.

 One of a sponsor’s fundamental obligations is to generate a forecast that outlines a property’s income and expenses. Unless the sponsor is acquiring an already-stabilized property, where the income and expenses are known, the sponsor must make several informed assumptions.

 In the case of a reposition or value-add deal, for example, a sponsor has to make hypotheses about how much it will cost to enhance the property and, in turn, what rents they can achieve after that. The sponsor also has to make conjectures about the rate of lease-up (often referred to as the “absorption rate”) and what capacity they will have vacancies over time.

 Of course, these deductions must be underpinned in both experience and market context. An adept self-storage sponsor, for example, might know that a specific size unit generates more income per square foot and lease-up faster than others. Accordingly, the sponsor might design the redone facility to supply more units of those types than average.

 Considerations for Predicting the Future

While nobody can predict the future, there are many aspects a sponsor can (and should) consider when positioning their pro forma. These factors include:

 Economic growth: Both macro and micro-level economic factors and demographic trends affect how real estate performs. The national economy is strong, and unemployment rates are low; greater investor confidence usually strengthens the actual market. However, micro-economic factors typically are more likely to impact a specific real estate deal. For example, real estate in the North East might not be doing well, but a property within a particular sub-market might be blossoming based on hyper-local prerequisites.

 A sponsor will want to pay keen attention to those hyper-local economic situations. Who are the major employers? What type of employment diversity exists? Are the local job market and pay growth expanding or contracting? What is the average pay of people employed locally? How have COVID and the Work From Home phenomena impacted the region? How an area experiencing hyper-local economic growth is positioned to fare better amid a real estate cycle’s general ebbs and flows.

 Real estate inventory: Supply and demand significantly impact how an individual property performs. A sponsor should figure out the supply of the product type in question. How much competition exists? What is the quality of the current competition? What are these competing properties’ rents and occupancy rates, and are they rising? If so, at what rates? Have similar projects been permitted, and if so, what are the fees and their construction and delivery timeline, and how does that correlate to local regulations? How long will “in-migration” last? How much available inventory is on hand? All of the above and more go into pro forma assumptions.

 Capital markets: Most real estate sponsors fund their deals with debt and equity. The cost of debt can fluctuate depending on where we are in a real estate cycle. Today, interest rates are closer to the 4 -to-6% range, pushing the total cost of debt higher than in recent memory. However, if your forecast has debt at 3% and now it is 4%, that is a 30% increase in lending costs.

 The availability of debt also matters. For example, capital might be readily obtainable in a strong economy and at record-low prices. However, capital markets become restrained during a market contraction, as we recently saw during the depths of the COVID crisis. As a result, it becomes more challenging to access capital which can, in turn, drive costs up.

 A sponsor readying their forecast today might be making suppositions predicated on the availability and cost of capital today. However, the capital markets may look dissimilar five or seven years down the road, along with the inflation costs on construction material and labor between now and exit. A deal that may have been effortless to refinance under existing market conditions may be more complicated or pricey to refinance in the future, impacting the total profitability.

  Predicting the future: “Past performance is no guarantee of future success.”

 Sponsors are considered to be knowledgeable and held are held to a higher standard. Those who invest want some loose guarantee that they will inevitably earn a return on their capital. Nevertheless, as noted above, many factors can control how well a deal performs.

 It is always different on a go-forward basis. Given this arm-twisting to “guarantee” returns, many sponsors will make conservative projections about a deal’s future profitability. After all, it is sounder to “under-promise and over-deliver” than vice versa. However, when a sponsor delivers several projects that outperformed expectations, the new anticipation becomes that a sponsor will generate the same level of returns on their future deals – something a sponsor cannot always guarantee. It is a tricky sponsor catch-22!

 Modeling Forthcoming Outcomes Absent Perfect Information

 There are numerous ways for real estate sponsors to enhance their ability to predict the future. Some develop highly sophisticated, in-house models that assign values to several incomes, cost, and vacancy factors. Based on certain market assumptions, numbers can be squeezed, turned up, or down. However, these assumptions are grounded in experience, historical and current market conditions, and concentrated analysis by many individuals. 

 They are now turning to predictive analytics to help them do this. Predictive analytics is the practice of using data mining and modeling techniques to predict future events

The real estate industry is constantly changing, and as a result, sponsors are always looking for new ways to predict the future. 

 Recently, some have turned to artificial intelligence to make more informed decisions about their investments. While this technology is still in its early stages, it could significantly impact the industry in the years to come. 

 By analyzing trends and predicting future changes, these companies hope to stay ahead of the competition and ensure their success in the market. Conversely, sponsors who do not experiment with AI may find themselves at a disadvantage in the competitive market. Therefore, it is essential to look at how big data is being used in real estate and what it means for the industry. 

 It is presumably best to present some range of best, worst, and most-likely outcomes. Experienced investors will want to ensure that the worst-case scenario supplies an outcome (i.e., returns) that they are still pleased with, all while hoping that the sponsor will crush that worst-case scenario.

 Sophisticated sponsors will likely have made conservative assumptions. For example, they may bake in a higher-than-average vacancy rate than in today’s tight market or include a higher-than-average contingency budget in case of inflation around construction cost overruns and higher labor costs. This conservative strategy increases the chances that a sponsor will supersede investors’ expectations.

 Conclusion 

 Many factors can influence the profitability of syndication, some of which are out of the sponsor’s control altogether. While a sponsor does not have a crystal ball nor control the future, they can make safe assumptions and take measures to minimize the risk of a market downturn.

When vetting syndication, be sure to ask the sponsor about their assumptions. Understand how they draw conclusions about specific numbers and what strategies they might use if market conditions change.

 Finally, it is crucial to understand that a syndication’s past performance does not assure future success, neither does a sponsor’s past performance. A sponsor is equally motivated to generate results, but their predictions about a deal’s profitability will invariably be imperfect until they have a crystal ball.

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What Is A Debt Service Coverage Ratio? | Resident First Focus

One of the most essential concepts in real estate investing is leverage. Leverage is the capacity for someone (or a team of people, such as a sponsor or development group) to finance a considerable part of the property’s purchase and/or redevelopment costs. 

Differing from stocks, bonds, and other equity investments that require an individual to pay face value, investors can use leverage to lower their up-front and out-of-pocket expenditures. For example, if someone is buying a $1 million property, they might finance $750,000 using a traditional bank loan. This leverage caps their out-of-pocket expenses to $250,000 – a considerably lower barrier to overcome than needing to pay $1 million privately.

However, getting a loan of this size (or more) can be difficult. This is because lenders will typically look at the borrower’s personal earnings, the value of their assets, and the parcel’s income-generating potential. 

When assessing whether or not to make a loan, lenders will use a “debt service coverage ratio” metric to determine the latter—i.e., the property’s income-generating potential. In this piece, we look at the significance of DSCR and how investors can use this metric to mitigate their risk.

What is the Debt Service Coverage Ratio (DSCR)?

A debt service coverage ratio (DSCR) is a key metric used by lenders to determine the ability of a property to repay its debts. The ratio measures how much cash flow is available to cover mortgage payments, taxes, and other debt obligations. To calculate the DSCR, you need to know the total Debt Service (mortgage payment + other debt payments) and the net operating income (NOI). 

The higher the DSCR, the more likely it is that a property can repay its debts. Lenders will typically require a DSCR of 1.25 or higher for non-owner-occupied properties. 

If the ratio falls below 1.25, it may signify that the company is struggling to meet its obligations. As a result, Properties with a low DSCR may be less desirable to investors and property managers. Understanding the DSCR can help you make more informed decisions about your investments.

Furthermore, an asset with a DSCR of less than 1.0 is considered losing money and chances are, it won’t have enough income to cover debt payments. From a lender’s perspective, the higher the DSCR, the better.

The DSCR ratio is used concurrently with the loan-to-value (LTV) calculation. As a result, properties with a higher LTV ratio may have a lower DSCR ratio and vice versa. Therefore, to meet a lender’s favored DSCR ratio, a borrower may have to put more equity into the deal to reduce the LTV. Ultimately, this is one of the primary routes lenders mitigate the risk of borrower default.

How to Calculate the Debt Service Coverage Ratio

The debt service coverage ratio is as follows:

           DSCR = Net Operating Income (NOI) / Debt Obligations

For this computation to be accurate, the borrower needs to grasp the property’s NOI. 

The NOI tots up all rental income plus other amenity income (e.g., parking fees, car wash fee, storage fees, laundry or vending machine income, billboard/signage fees, valet trash fees, etc.) Occupancy losses and all operating costs (including property taxes, maintenance, and management fees) are then deducted from that sum to determine the NOI. 

           NOI = Total Income – Total Operating Expenses and Vacancy Losses

Debt obligations are more common. Basically, like a mortgage, it is the principal and interest payment owed to the lender each month. A lender’s DSCR tally might also include property taxes and insurance. If these are added in as debt obligations, they should not be considered into the operating expenses when figuring total NOI. They should only be accounted for onetime on either side of the DSCR equation.

I.e., let’s say a self-storage facility has an NOI of $3.0M and an annual debt service of $2.2M. In this case, the DSCR would be:

           $3.0M / $2.2M = 1.36x DSCR

Most lenders desire to see a DSCR in the range of between 1.25x and 1.50x. so the above is pretty strong. From a lender’s point of view, the higher the DSCR, the better, basically this signals that there's more income readily available to cover debt obligations.

 The Importance of DSCR

DSCR is paramount to any borrower interested in securing a loan to purchase, renovate or refinance a commercial property. This is valid regardless of product type (i.e., multifamily, office, hospitality, retail, self-storage, and the like). Some lenders may be inclined to originate a loan founded solely on a borrower’s income, credit, and the value of their assets. Most, however, will also look at the portion of the revenue generated by the property and if that is adequate enough to cover debt obligations. 

The key to a successful loan is how much you make and whether or when it will be paid back. This is typically true among asset-based lenders, who nearly exclusively rely on DSCR to ascertain if borrowers qualify for a specific loan amount. The more income an asset yields compared to its debt service obligations, the greater the likelihood of loan repayment. For this reason, banks and credit unions predominantly rely on DSCR (debt service coverage ratio) as one factor in determining if someone can get their hands on some money from these fine institutions!

Most lenders favor DSCRs of at least 1.25 to 1.50x. This implies that the property generates 1.25 to 1.50x the revenue required to cover debt payments. 

With an ample DSCR, a borrower may be able to close a loan based on the strength of a relationship at advantageous terms regardless of their personal income or credit history. It truly is all about the deal!

Beyond financing, DSCR can be a helpful tool for those looking to conduct a quick, side-by-side breakdown of different investment opportunities. While DSCR is only one method to use, it does deliver a fast, easy-to-understand snapshot of a project’s potential profitability. 

Using DSCR to Increase Profitability

DSCR can prove to shed much light for investors. For example, look at the in-place NOI and debt service and then, understand the DSCR to be low, may use this as a flag to identify cost savings. Let's say, an investor may find that in-place rents are below the market average. If they can affect a rent rate increase, which is possible in today’s market, can increase the DSCR calculation.

Likewise, a property manager may find that their operating expenses are above average. This could be what an owner needs to make property improvements that lead to greater efficiencies or bring on vendors that increase NOI. 

As you might suspect, a property’s DSCR can fluctuate over time. This is because the calculation relies on a snapshot in time; the inputs to that calculation may vary from year to year as leases renew, resident rollover, property improvements are made, etc. Assuming a property’s DSCR substantially grows with time, it may be worth refinancing the current loan into a new loan with a lower rate and /or better terms since lenders will see the deal more appealing as the DSCR grows.

Collectively, any modifications a lessor makes to enhance the DSCR will result in greater profitability for investors. 

Conclusion

The DSCR is an essential metric for any company owner interested in obtaining a loan – real estate-related or otherwise. The loftier the going-in DSCR and the taller the projected DSCR after property improvements, the less risk associated with debt repayment. Deals with smaller risks will naturally qualify for better rates and terms among commercial lenders. 

By comprehending a property’s DSCR, investors can make more educated decisions about property improvements, operations, and financing options – conclusions that will eventually impact a project’s total cash flow, and by extension, the returns investors might anticipate. 

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Preferred Return in Real Estate: What is it? | Resident First Focus

What is a Preferred Return in real estate? The explanation may surprise you. There are many types of preferred returns, and it's essential to understand the difference between them to make an educated determination about your investment strategy. For example, there is a true preferred return vs. pari passu (even) preferred return - one offers more protection than the other for investors against losses on their investment property.

One of the primary appeals to investing in a real estate syndication is the prospect of passive income without having to shoulder the responsibilities of property ownership and administration daily. But, of course, few investments are ever genuinely secure. As a result, there is some danger associated with investing in a real estate syndication, although it may be reduced by investing in syndications that offer a higher return.

A preferred return ensures that investors profit before the sponsor (i.e., the syndicator) receives cash dividends.

In this post, we examine what investors should know about guaranteed rates.

Preferred Return Profit Distribution

Every real estate fund or syndication has a "distribution waterfall" to describe how different tiers of investors will be paid back, when, and for how much. In addition, most arrangements have some leveraging or bank debt. Before equity investors receive a return on their investment, debt is generally repaid first with interest before interest on the principal is paid out.

Preferred returns are the earnings that are then returned to investors before the syndicator makes any distribution. In other words, the phrase "preferred return" implies that investors have priority when distributions are made. As a result, investors receive 100% of the profits distributed until a preferred return barrier is breached.

If no profits are generated and shared, there is nothing for investors to receive. For example, if the preferred return is set at 8%, but there isn't enough cash flow to make an 8% distribution, investors may only receive less than that (or nothing) until the property begins generating cash flow. Preferred returns aren't always guaranteed; it's a widespread misconception among real estate investors.

Preferred Return vs. Equity Return

Preferred return and preferred equity are two distinct concepts. Preferred equity is a term used to describe a particular position in the capital structure, usually subordinate to debt but before common stock. Preferred equity is similar to holding Class A shares of stock. Before common shareholders receive any cash flow payments, preferred equity investors will generally earn their initial investment back as well as an inevitable percentage return on this investment.

The return on preferred equity may be paid out of current cash flow, build-up, paid out when the business is sold, or a combination of both.

Preferred stockholders are entitled to a preferred return, but the timing and rate of that return might differ.

True vs. Pari Passu Preferred Return

Preferred returns might be structured in a variety of ways. For example, investors will receive a "pref" on their co-investment before the sponsor earns any distribution in a preferred return scenario. Some syndications, on the other hand, are structured with a "pari passu" preferred return. “Pari passu” is latin for “equal footing” and is also used relatively speaking within estate planning. Here, the pref serves as a threshold up to which investors and sponsors earn an equal distribution; returns above that point are unequally shared in favor of the sponsor who is then said to be earning a "promote," i.e., a disproportionate share of the profits in exchange for achieving or exceeding return expectations.

How Preferred Returns Are Structured

Preferred returns are often constructed with a "hurdle" rate, which must be surpassed in a specific capital distribution scenario. For example, a preferred return hurdle of 6% means investors must achieve a 6% return on their investment before any other money flow occurs. Return hurdles might vary from 5 to 12 percent, but they generally fall between 6 and 8 percent. Before the deal is offered to investors for consideration, the return hurdle rate is always determined.

Preferred returns can also be made up of a single payment or several payments over time. A return is cumulative if it's calculated as a sum from previous years' revenue. In cases where there isn't enough cash flow to reach the hurdle rate in one year, investors will be paid the remainder in future years as additional cash flow becomes available. When it comes to performance, investors should expect rates of return in the 10% range for any deal with an 8% hurdle rate. For example, if there is only enough cash flow to pay back 6% one year and you have a non-cumulative preferred return, the value of your pref does not build up over time even if the barrier rate isn't met. 

When compound interest is used, the calculation is even more complicated. If the former, the interest will increase with time and create fluctuating interest payments.

Preferred returns may also be structured with a "lookback" or "catchup" provision. 

A lookback provision, often known as a "clawback," refers to a clause that stipulates that if the limited partners do not achieve their agreed-upon return rate after disposition, the general partner (i.e., the sponsor) must give back a portion of the cash flow previously sent to them. One of the main reasons for a GP to fulfill – and perhaps exceed – syndication return expectations is owing to this lookback provision. 

On the other hand, a catchup provision ensures that limited partner investors will receive 100% of the deal's cash flow until an agreed-upon rate of return is achieved (a "real" preferred return). After they've reached that rate of return, all funds will go to the general partner. Thus, the catchup provision works similarly to a lookback provision in that it helps guarantee that the LPs get at least their intended return on investment.

How Preferred Returns Work 

The preferred return is the order in which partners are repaid their equity investment, as well as their share of the profits until a certain threshold has been achieved. This may be referred to simply as "the pref." For example, if an investor puts $500,000 into syndication with a 6% pref and one yearly dividend, they will get the first $30,000 before the syndicator receives any share of the profits.

Let's assume that the project's desired return has decreased to 8%, but the asset pays out distributions at 12.5%. The sponsor has now surpassed the intended return of 8%, and in this case, after investors are paid the 8% preferred return, there is a 4.5% remainder. Thus, for a 75/25 payout split deal, 75 percent of any extra money goes to investors and 25 percent to sponsors.

Why Is a Preferred Return Important?

There are several reasons why preferred returns are so important. First and foremost, offering a preferred return is one method to encourage people to put substantial amounts of money into a real estate syndication. The preferred return provides some optimism that investors will be repaid at least something, especially when the preferred return is cumulative and compounded over time.

A sponsor's preferred return is another method to align the interests of the sponsor and investors. The actual preferred return structure necessitates that the sponsor makes certain cash flow distributions before collecting anything. This helps to encourage sponsors to not only fulfill but also exceed investment goals. The sooner they start getting profits of their own, the more diligent they will be with company plan implementation.

The Takeaway on Preferred Returns

Although no real estate investment is ever guaranteed, one-way investors can safeguard their funds is to join syndication that offers a simple preferred return structure. This way, investors may rest assured that they will be repaid as soon as feasible and before the sponsor makes the transaction profits.

Investors will always want to read the private placement memorandum accompanying any deal opportunity to know how the equity waterfall is structured. These legal documents will shed light on what kind of pref you can expect, the hurdle rates that must be surpassed, profit splits, and whether the deal includes catchup or lookback provisions. In addition, all parties involved in the equity waterfall must align interests so that everyone benefits.

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A Guide to Equity Waterfalls | Resident First Focus

This is a blog post that talks about the basics of equity waterfalls. It goes into detail on how they work and what to watch out for when using them. We will also discuss some of the most common pitfalls with this type of structure. So if you want to learn more about Equity Waterfalls, keep reading!

Equity Waterfalls: A Basic Overview

There is much information on how equity waterfalls work in the commercial real estate world and why they are used. This blog post will be in-depth in discussing them to make sure you understand everything about this important topic. Many investors are still confused about what an Equity Waterfall structure looks like, despite it being relatively simple to understand. When someone mentions equity waterfall in commercial real estate, they’re describing how cash will flow from an asset, how it’s distributed, and when. 

Unfortunately, there are a myriad ways to structure these distributions, which makes the equity waterfall concept so complex and, in practice, even harder to model. To help with this issue, we have included charts along the way that represent different types of structures that can be implemented into your legal documents if needed. We want our readers to come away from reading this article with complete understanding and clarity.

Understanding What’s Behind the Name

In any equity waterfall, the first step is to identify how much money will be available for distribution once debt service has been paid. In other words, this amount determines where funds from the real estate project’s cash flow go first. Then, the remaining dollars are generally distributed following a priority sequence (hence ‘waterfall’) among limited and general partners - both those who invested initially and their successors, including additional investors or even grantor trusts set up by LPs.

In your mind’s eye, look at it like this. Gains accumulate in a “pool” until that pool is full, at which point profits spill over to the next pool of investors in a tiered manner. It’s just like when water in nature, that collects at the top of a waterfall and then, after reaching a certain level, spills over to a pool below, sometimes multiple times — same for real estate waterfalls. 

The order of priority depends on state law; however, it most commonly starts with profits generated through operating income before considering appreciation (capital gains). At times, there is also an opportunity cost component included that considers what could impact payout ratios. The profits of a project are divided unevenly amongst the project’s partners. Operating partners (e.g., the real estate developer) are given a disproportionately more significant share of the profits if the project beats expectations. A bonus, or a promote, is the extra slice of the pie. Promotes are used as a bonus to incentivize developers to exceed profit expectations.

Standard Equity Waterfall Terms Explained

Before looking at an example, it’s helpful to understand a few terms often used when discussing commercial real estate equity waterfalls. These are all crucial components involved in the structure of a waterfall. In addition, understanding these terms will help you understand why certain tiers of a waterfall function the way they do.

Return Hurdles: This is the first tier of a waterfall. It’s often referred to as “the hurdle rate” or simply “first-loss.” The return hurdles are percentage returns that must be met before you can move on to each lower tier in the waterfall structure (preferably with no losses).

Growth Hurdles: This is an extra layer of protection for investors beyond return hurdles— it exists only if it has been written into an agreement between investor and developer. Growth hurdles function similarly to return hurdles, but they apply once all returns have been achieved; growth hurdles ensure there will be future value even after this point, providing further cash flow opportunities down the line.

Preferred Return: At its most basic level, the preferred return is how partners are reimbursed their equity investment and share of profits until a specific threshold has been achieved. For example, partner A invests $100,000 at a preferred return of 20% in addition to their share of the profits until they have reached that threshold. Partner B then invests $50,000 and has a 12% preferred return rate + their share of the profits after partner A’s threshold is met. As a general rule of thumb, those in line to receive a preferred return are taking on less risk and, therefore, are expected to earn less of an overall return on the project. Preferred investors can include all equity investors or only select equity investors.

Lookback Provisions: When equity waterfalls distribute cash flow before the disposition of the asset, the deal will typically contain what’s known as a “lookback provision.” This gives the investor their share of gains that occurred on or after the date they invested. So, for example, if Partner B invests $50k in July and partner A sells an asset for a gain of $200k in November, Partner B would be entitled to 50% (or half) of those profits because he had invested before it happened.

Catch-up Provisions: On the other hand, some equity waterfalls are set up with a “catch-up provision,” which allows them to distribute money flow to various parties throughout the bargain. This provision is meant to correct the early-investor bias that occurs when partner B invests after Partner A. So, for example, if Partner B invests $50k into a deal in July and then exits with his partners at the end of December (inside 12 months), he would be entitled to none of those profits because it happened within 12 months.

After Exit: The logic behind these provisions makes sense – your first money should get you more than your second or third money…right? But sometimes, other factors are involved, like credit market conditions where investors aren’t willing to put new cash into deals despite reasonable exit multiples. At times like this, though, not all equity waterfall structures will produce distributions equally across various classes of equity.

A Common Equity Waterfall Structure

The most basic equity waterfall has four stages. The first stage, as previously said, is where the cash flow builds up into a pool.—once that pool overflows, the profits flow to the next level.

Tier I. Return of Capital: 100% of cash flow distributions go straight to the LP in this tier.

Tier II. Preferred Return: All cash flow is distributed to the LP again until a preferred return on their investment is achieved. The preferred return is sometimes called the “hurdle rate” and can range from 7-10% or more.

Tier III. Catch-Up: The catch-up provision comes into play here. All payments in this level are credited to the GP until they reach a certain proportion of profits.

Tier IV. Carried Interest: Exacerbating the issue, the GP will get a considerably more significant proportion of cash flow distributions in the form of promotes until all cash flow is consumed.

A Sample Equity Waterfall

Many different types of equity waterfalls are possible. However, to keep things simple, we’ll provide a basic five-tier illustration below based on IRR. The investor has invested $400,000 (10% of the total equity), but the Sponsor has invested $4 million (90% of the total equity). The LP has put down $4 million (90% of the total equity), while the GP has put down $400,000 (10%).

Here’s how a typical waterfall might be organized in this scenario:

And here is how that might take effect, in practice:

This is a typical equity waterfall, which depicts the financial and structural status of a deal in its early phases. As you can see, the LP has put additional money into the partnership (financially), thus earning a higher return before the GP receives a larger share of profits. Remember that the above investment waterfall is only one example of investment waterfalls. Equity waterfalls might get quite complex depending on the number of investors, lenders, and other partners involved in a transaction.

Conclusion

Even for those with many years of expertise, the concepts behind real estate equity waterfalls are sometimes difficult to grasp. They can contain intricate tiers, returns, and interrelated provisions to support a structure of uneven profit distributions from a specific venture. 

Key Takeaways:

- Understand what each tier means.

- Know the difference between a waterfall and an LPI model.

- Use your knowledge to negotiate more equity into your investment or fund.

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CRE Hard Costs vs. Soft Costs – What’s the Difference? | Resident First Focus

Hard Costs vs. Soft Costs – What’s the Difference?

Real estate development is not for the faint of heart. Taking a project out of the dirt or redeveloping an existing site has many variables, and concurrently, many costs. These costs encompass both hard fees and soft costs that collectively make up a project budget. 

This article details the contrast between hard and soft costs and the related line items of each.

What are hard costs?

Anything consumed in the tangible development of a property is typically considered a hard cost. This encompasses the physical materials needed to build a project (e.g., steel, concrete, interior furnishings, etcetera.) and the contractors’ labor required to develop the project. 

Material costs: Material hard costs can comprise of steel, wood, cement, drywall, electrical, carpet, plumbing appliances, life safety systems, green & HVAC systems, landscaping, and more. To determine the supplies needed for a project, a developer requires an advanced design team, including architects and engineers. 

In addition, there are third-party construction estimators who can help allot quantities and costs to each of these material line items. However, most developers will adopt a market average (e.g., a specific dollar amount per square foot) as an estimate during their early cursory underwriting exercises. 

Advanced earthworks, like bridges, require abutments, grinders, and decking. Roads, i.e., a new 2-lane undivided road – average around $2 million to $3 million per mile in rural areas and about $3 million to $5 million in urban areas. Constructing a new 4-lane highway? $4 million to $6 million per mile in rural and suburban areas, $8 million to $10 million per mile in urban areas.

Labor costs: Labor costs are among the highest and most variable hard costs that belong to a project. The big differentiator is whether a developer employs union or non-union labor. The former can be significantly more expensive, but developers are required or sometimes incentivized to engage union labor for a defined percentage of construction in some markets. 

Labor required during the project usually includes disciplines and skillsets from: construction (e.g., carpenters, plumbers, electricians), site work professionals (e.g., excavators, environmental remediators, and others concerned in site grading); and landscapers.

In a stifled labor market, developers pay a premium for labor costs. In an unrestrained market, labor may be more affordable. It varies on the availability of craftsmen and women, so in turn, labor costs can fluctuate year over year and differ from market to market. 

Contingency: Nearly every construction forecast figures in a contingency line item. A contingency is an amount of money, a reserve set aside to cover unexpected costs or site conditions. Developers will customarily build in a 5-10% variance into their hard cost pro forma. 

Other Site Work Expenses to Consider

There are other site-related hard costs to account for in the budget, including:

Land acquisition. Most developers will consume significant time examining opportunities before actually pushing forward with a purchase and sale agreement. 

For example, a developer may approve an NOI (notice of intent) with the seller. Next, they’ll place some funds into escrow to prove their good faith intent to move forward with the deal. 

Then the developer will then spend additional time reviewing the site conditions and starting preliminary design work (soft costs) before finalizing the purchase and sale agreement. Between P&S and closing, other requirements may be met, such as securing permits needed to proceed with the development. 

Thus, the developer is picking up multiple soft costs even before receiving the parcel. Finally, upon closing, the developer will transfer the funds required to purchase the property, otherwise understood as land acquisition. 

Environmental remediation: Depending on the property’s location and prior use and history, the site may need some ecological remediation. Almost all urban projects necessitate some level of remediation. “Greenfield” sites, the least contaminated, are likely in outer suburban and rural areas. Consequently, remediation costs can fluctuate depending on the scope and characteristics of the contamination. 

Utility and road extensions: Some construction projects require new utility connections and/or roadway extensions. Both forms of site work are considered hard costs and will be reflected in the budget accordingly.

Advanced earthworks like bridges require site work like abutments, grinders, and decking. Roads, asphalt or concrete, i.e., a new 2-lane undivided road – about $2 million to $3 million per mile in rural areas and about $3 million to $5 million in urban areas. Constructing a new 4-lane highway? $4 million to $6 million per mile in rural and suburban areas, $8 million to $10 million per mile in urban areas. 

What are soft costs?

Soft costs are all of the expenses beyond the hard project costs. They are the foreseen intangibles that are critically important to a project. 

Labor costs during development

Labor costs during development are linked to various professional services. The most significant professional services line items are commonly by way of architecture and design. As a result, project management-labor fees usually trail in cost. 

Architecture:  several architects could be required to plan a successful project. These could involve master planning architects, concept design-level architects, individual building architects, and landscape architects. 

Engineering: In commercial real estate development, multiple engineers are usually involved in designing and executing a project. Engineers can originate from various disciplines: traffic, environmental, civil, and more.

Project Management: Real estate development projects usually have a dedicated project sponsor. The core role of that sponsor is likely to identify, acquire and aggregate capital for the development undertaking. Sometimes the sponsor will initiate the development process themselves; other times, they’ll outsource these responsibilities to a third-party project management company. The project manager will customarily collect a percentage or set a monthly fee to provide the day-to-day supervision of the development project on behalf of investors. In addition, the project manager will ordinarily work as the quarterback to the other consultants, authorities, and contractors involved with the project.

Accounting / Legal fees:  Bookkeeping and legal fees are two integral soft costs part of the forecast. Accounting is frequently managed in-house by the sponsor or developer; otherwise, it’s outsourced similarly to project management responsibilities. Even large real estate developers with their in-house legal teams will regularly seek assistance from outside counsel, depending on the project’s demands. Legal fees accrue from facilitating permitting and entitlements, managing city and state regulatory processes, and the like. 

Carrying Costs

Every pro forma should reflect carrying costs. Carrying costs are the non-controllable fees that a real estate developer must pay each month, regardless of the project’s status. These fees typically include taxes, utility bills, and insurance. 

 Financing Costs

There are numerous types of multifamily loans for developers to examine, reaching from traditional financing to CMBS/life co debt products. Furthermore, some multifamily loans can be structured with an interest-only period to relieve the developer until the property is fully leased-up and stabilized. In any event, the type of financing used for a project can significantly reshape the pro forma. 

Permits and Other Regulatory Fees

Real estate developers will need to pull a full scope of permits for their projects. For example, there may be fees blended in with rezoning a site for a new use. If a variance is needed, there’s typically a cost associated with that, as well. In addition, state permits may come into play, such as building permits granted by various authorities, environmental regulatory agencies, or highway departments. Determining which permits and regulatory fees will apply or if a project is exempt is typically one of the duties of the local outside counsel and/or project manager. Often there are penal and insurance-related consequences if the correct permits are not obtained.

Post-Development Costs

The soft costs continue as they relate to a project, even as it nears or reaches completion. 

These costs include:

Advertising: Most developers will retain a marketing agency or brokerage shop to assist with advertising their property. This helps with lease-up efforts and expedites stabilization.

Property Management: Let’s say a developer chooses to hold (instead of sell) the property upon receipt of Certificate of Occupancy (COO); a property manager will be necessary. A property manager – an individual or a team of people – will oversee all day-to-day onsite activities. This includes lease-up and renewals, subsequent rent collection, minor repairs and maintenance, and down the road, investment in capital improvements as needed, and more. In addition, property managers will often hire third-party contractors for ancillary tasks, such as valet trash and landscaping.  

Security: Must be baked into every property management budget. This could be investing in and then monitoring security cameras to a fully-staffed team of people who work a desk in the lobby at a downtown office building.

Conclusion 

Whether you’re a developer or a passive investor, it is crucial to understand what goes into a project’s pro forma. This necessitates a fundamental knowledge of the soft costs and hard costs associated with the development project. 

These costs can be challenging to determine, especially for first-time developers. Still, it always makes sense to have high confidence in the budget before moving forward. 

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Utility Reflections for Multifamily Investors | Resident First Focus

Utilities – they may not be the sexiest part of your multifamily investing strategy, but if you’re not evaluating your approach to them, you could be missing out on serious cash. That’s particularly the case if you own an older property that lacks submetering and/or utilities are baked into the price of your resident’s rent.

This review will examine the advantages of two of the leading utility billing systems: submetering and ratio utility billing systems (RUBS). We’ll also address other ways for multifamily investors to reclaim money on utilities, including utility benchmarking, convergent billing, and vacant cost recovery. 

Submetering: Pricey But Highly Effective 

If utilities in your multifamily property are still on a combined system or if you have a project coming out of the dirt, it might make sense to investigate investing in a submetering system for major utilities such as gas, water, and electricity. Submetering tracks each unit’s usage, and therefore, it is the most reliable way to charge residents for their precise utility usage accurately. Furthermore, since submetering holds each resident accountable for their individual utility use, it can motivate residents to reduce their water and energy consumption.

While breakthroughs have driven down the cost of submetering, it can still be a costly process, and therefore, it isn’t suitable for everyone. To establish the price point for submeter installation in your area, obtain quotes from various submeter installation firms in your area. 

Ratio Utility Billing System (RUBS): A Economical Option 

If submetering exceeds your budget, using a Ratio Utility Billing System (RUBS) could be the answer. contrary to submetering, RUBS usually does not require any capital expenditure or connecting of any equipment

Instead, RUBS employs a standardized process to designate a fair fraction of the building’s overall utility charges to each unit. This approach considers factors like the number of bathrooms and the number of residents plus the unit’s overall size. Public-service fees are then invoiced to residents via RUBS, including electricity, gas, water, sewer, and trash.

RUBS can be launched turnkey at zero cost to the property owner and billed to residents in their overall monthly utility bill in many scenarios. 

Some industry authorities say RUBS results in a 5%-40% decline in overall utility use. In addition, RUBS has been endorsed by both the National Apartment Association (NAA), National Multihousing Council (NMHC), and the U.S. Environmental Protection Agency as an attractive approach for apartment managers to reward their residents for preserving water and reducing electricity use.

Utility Benchmarking: Knowledge is Power 

Utility benchmarking requires analyzing and tracking an apartment’s utility use over some time. The conclusions can parallel a community to similar properties and identify ways to lessen the property’s utility use. 

Benchmarking a community’s public works needs has a range of commensurate advantages, namely assisting property owners to descry billing variances, locate malfunctioning equipment, and gain approval for green federals funding programs, like Freddie Mac’s Green Advantage or Fannie Mae’s Green Financing programs. 

Benchmarking everyday living costs at apartment communities is voluntary in most parts of the U.S. However, it is now compulsory for structures over a specific size in many states. HUD has also considered demanding that multifamily borrowers participate in utility benchmarking, although those guidelines have not yet been brought to the forefront. 

Convergent Billing: An Effective Payment Compliance Method 

At some apartment communities, notably older ones, residents may often face multiple, separate bills per month for public works services and other expenses. There are numerous moving parts here that can lead to residents overlooking paying some of their accounts. However, in the manner of convergent billing, all of a resident’s bills (including rent and all utilities) are bundled into one statement. A streamlined approach increases the likelihood that residents will pay their bills on time. 

Vacant Cost Recovery: Reflective Billing and History Audit

Quietly, on average, 3-5% of all pre-COVID apartment residents aren’t paying their utility bills – generally due to oversight that leaves the community answerable for covering the unit’s utility costs (i.e., the fees for public works services that are not yet in the resident’s name). Vacant Cost Recovery (VCR), interchangeably referred to as Vacant Unit Cost Recovery (VUCR), is how a third-party firm examines a building’s utility use and billing records to charge residents for their earlier outstanding utility usage. At larger apartment communities, 300+ units or more, this can often result in the retrieval of thousands of dollars in utility fees. 

The Bottom Line: Utility Decisions Matter

The big takeaway is that multifamily apartment managers should put more consideration into their utility systems. A few strategic decisions can result in significant cost savings that, in turn, improve an investor’s ROI. If you haven’t reviewed these options yet, make 2021 the year you do!

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CRE Investing | Learn the Difference Between “Promotes” and “Splits” | Resident First Focus

One of the main things someone wants to know when investing in commercial real estate is how much of a profit they can earn. You’ll quickly find that developers partnering with third-party equity sources typically secure profits greater than the percentage of equity they invest into their projects. So what gives? It all comes down to how the ‘equity waterfall’ is structured and the extent to which the developer is earning a ‘promote’ vs. taking a more straightforward profit ‘split.’

These considerable profits, often called a promoted interest, grant sponsors (the developer or operator) to secure more considerable earnings than they would ordinarily if based singularly on their tangible ownership or stake in the project. Investors figure in these situations around the performance of the project to incentivize the sponsor. For example, a sponsor may only invest 15% of the required equity, a disproportionate buy-in, but get 45% of the profits if the project does well.  

These promoted interests are structured on a term sheet through a so-called “waterfall,” which is mathematical architecture/formula for divvying up distributions to the partnership in private equity or real estate finance. Waterfall tiers boost the incentive or share of the profits to the sponsor as the project meets specific profitability milestones.

Respectively, each tier usually triggers an IRR calculation, an equity multiple, or the greater of each. This space can get complicated swiftly when considering senior positions, catch-up provisions, look-back provisions, etcetera. We will do a cursory overview. We aim to clear up common mistakes around misused industry lingo that refers to these promoted interests as either a “promote” or a “profit split.”

The Profit Split

Let’s begin with a sample of “split” or “profit split.” We have a partnership agreement linking an equity investor and sponsor to develop a 100-unit multifamily community. The investment and waterfall structure is as follows:

Split Example:

90/10 co-invest

10% preferred return

70/30 split to a 12% IRR

60/40 split to an 18% IRR

50/50 split after that

 The context on the 3rd bullet above sounds like “seventy, thirty to a twelve,” with 70% of this tier’s profit goes to the investor & 30% belongs to the sponsor. Partners divvy up each level according to the breakdown in the waterfall without regard to how much each party invested into the project. While the joint venture should payout preferred returns based on pro-rata ownership, profit splits are not dolled out that way.

 The Promote

This second model of a promote tier structure looks almost identical with a cursory look, but it’s a bonus, a premium that is structured quite differently:

 Promote Example:

90/10 co-invest

10% preferred return

30% promote to a 12% IRR

40% promote to an 18% IRR

50% promote after that

The situation on the 3rd bullet here reads like “thirty percent promote to a twelve.” One way to look at this is to see three parties in your mind’s eye when discussing promotes, the investor, the sponsor (both have each invested capital and are shareholders). The last party is the developer, who has advanced nothing but is a highly incentivized party. The caveat is that the developer and the sponsor can be on in the same. It’s easier to see why envisioning three separate parties makes this concept easier to understand. The developer funds the promotion based on co-investment, and the remaining percentage is split between the investor and the sponsor.

Let’s look at the first tier closely. Say that there was $1M for distribution of this tier before crossing the 12% threshold. Thus, 30% would go to the developer ($300k). The balance of $700k is divvied up 90/10, so the investor would get $630k, and the sponsor would get $70k. Since the sponsor and the developer are one-in-the-same, their gross share comes to $370,000. If this were viewed as splits instead, the split or division at this level would be $700k to the investor and $300k to the sponsor.

Translation

It is beneficial to convert promotes into splits. Often there were multiple term sheets on a project, some using promotes and some are using splits; if everything is viewed as splits, then the concept is easier to understand. Our promote example above translates to:

 Promote Example as Splits:

90/10 co-invest

10% preferred return

63/37 split to a 12% IRR

54/46 split to an 18% IRR

45/55 split after that

As you can see, the formula is very different using promotes instead of splits; now, the sponsor’s concluding tier frees up to 55% of the profit. This would grow significantly if the sponsor raised their co-invest too. For example, raising the co-invest to 20% here would boost the split to 60% since we are expecting a 50% promote.

Why does this Matter?

At this point, you may be believing that this concept sounds simple enough. The intention is that this material is mixed up time and time again by seasoned experts. Pay keen attention to each of these two expressions.

“70% to the Investor and 30% to the Sponsor” “70% to the Joint Venture and 30% to the Sponsor”

What has been substituted is that the word “Investor” is swapped out with the term “Joint Venture.” Sometimes, term sheets are clear on intention, but a quick and cursory review might often point to the wrong conclusion. It’s a complex area, and inadvertently, sometimes folks say “promotes” and mean “splits,” or vice versa. While this is less commonly confused in context, it is misrendered sometimes during deal talk. In essence, “promotes” and profit “splits” are not the same thing!

The exercise here is to be accurate, explicit, and precise with syntax. If you reply “promote,” make sure you mean “promote” and not profit “split” because they are, in fact, very distinct. Also, when examining equity proposals, be conscious that even advanced equity groups are sometimes guilty of maltreating terms. Managing proper real estate terminology, especially in drafting term sheets or negotiating joint venture structures, is crucial to professionalism and successful deal-making.

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Why Developers Prefer Non-Recourse over Recourse Loans | Resident First Focus

Why Developers Prefer Non-Recourse over Recourse Loans

Nearly all commercial real estate deals are at least partially financed with a bank loan. Bank loans can come in different forms, including those with and without recourse. In an ideal world, and all else considered equal, a borrower will typically want to obtain a non-recourse loan as a means of limiting their personal liability. This article looks at the difference between recourse and non-recourse loans and why commercial real estate investors overwhelmingly prefer the latter.

Recourse vs. Non-Recourse Loans

When obtaining a commercial real estate loan (for either a purchase, new construction, or a refinance), borrowers usually have two options: recourse and non-recourse loans.

A recourse loan is personally guaranteed by the borrower(s). You sign something called a personal guarantee (often referred to as a “PG”). If you have partners in the deal, you’ll all sign the PG “jointly and severally.” The PG essentially says that whatever happens, you are on the hook personally. If something goes wrong and you default on the loan, the bank can come after you, your house, your car, your retirement accounts, any other investment properties, and similar types of collateral until the loan is repaid.

With non-recourse debt, the only recourse a lender has if something goes awry is the property, its furniture, fixtures, and equipment (FFE), the leases, etc. Non-recourse loans are generally made to what is known as a “special purpose entity” (SPE) – usually an LLC or Limited Partnership – that is structured for the sole purpose of that real estate deal. Only the assets held by the SPE are available as recourse to the lender. This shields the borrower’s other assets in the event the business venture fails.

The Benefits of Non-Recourse Loans

 With a few exceptions (which we’ll get into below), most borrowers will want to obtain a non-recourse loan if possible. Non-recourse loans have several benefits compared to recourse loans, including:

Protection of personal assets. The first, and most obvious benefit of a non-recourse loan, is that the borrower’s personal assets are not tied to the loan. This allows the borrower to take on some degree of risk without worrying that the bank will seize their primary residence, retirement accounts, and other assets should the deal go sideways. 

Underwriting is simpler. The process for obtaining a non-recourse loan is much more straightforward than getting a recourse loan. This is because a recourse loan requires the bank to underwrite the deal and borrower in question and the borrower’s other assets being put up as collateral. For example, if the borrower uses another investment property as collateral, the bank must underwrite that asset. 

Less complicated for equity investors. Recourse loans can be incredibly complex for equity partners in a joint-venture or GP/LP situation. In a deal that needs recourse, whoever is putting up the recourse will expect to be compensated for taking on that recourse. This can complicate an otherwise clean waterfall structure. Recourse loans are also a turnoff for equity investors because it complicates their bookkeeping. They must now carry the recourse loan on their books as a liability, which most equity investors do not want to do. 

Easier to obtain future loans. Recourse loans are considered “contingent liabilities.” In other words, it is only a liability if something goes wrong. Whenever a borrower is looking to obtain a loan, the bank will inquire about the borrower’s other contingent liabilities. A bank is more inclined to give a loan to someone who has few contingent liabilities on their books. Another way of looking at it is if someone needs to get a recourse loan for one reason or another, they’ll have better luck getting one if they don’t already have several outstanding contingent liabilities. The bank will then need to quantify all of those liabilities. For the investor who only does one or two projects simultaneously, this might be no big deal. This becomes a bigger consideration for a developer doing many projects at once (and therefore, has several loans on their books). 

More leverage with the bank if things go awry. Here’s a little secret that not many people talk about: with a non-recourse loan, the borrower has the upper hand when trying to renegotiate with the bank if something with the deal goes wrong. The borrower can tell the bank, “work with me here, or I’ll walk away…”. This makes the bank much more likely to negotiate with the borrower on new terms that help the borrower see the deal through to the other side.

Other Considerations for Non-Recourse Loans

As you can see, there are clear advantages to obtaining a non-recourse loan. So why doesn’t every borrower go this route when trying to finance their commercial real estate deal? There are a few other factors to take into consideration when looking at recourse vs. non-recourse loans.

First, not everyone can get a non-recourse loan. A borrower’s ability to obtain a non-recourse loan depends on a few factors, including:

The risk profile of the deal. The riskier the deal, the more likely the bank will want to have enhanced collateral.

The reputation of the borrower. The reputation of the sponsor is critically important. Typically, only experienced sponsors can obtain non-recourse loans. They must have a proven track record and be considered highly reputable in their local marketplace or with that asset class. Many borrowers will have to “earn” their way to getting a non-recourse loan by doing several recourse deals first before banks will trust them enough to do a non-recourse deal.

The amount of equity in the deal. There are some cases in which a bank will offer a non-recourse loan on a higher-risk deal sponsored by a relatively unknown borrower. These cases typically require the borrower to put substantial equity into the deal, resulting in a lower loan-to-value (LTV) ratio. This shows the bank that the borrower has substantial skin in the game and is less likely to walk away from the deal if they encounter challenges. Similarly, the lower LTV offers more protection for the bank if the borrower defaults and the lender needs to repossess the property. Non-recourse loans with a low LTV are sometimes considered a “prepaid guarantee.”

A second consideration is that both recourse loans and non-recourse loans have become known as “bad boy carveouts.” This means that a loan can be non-recourse except in the case of a list of specifically prohibited actions, such as voluntary bankruptcy or committing fraud.

Is a Non-Recourse Loan Right for You? 

All else considered equal – such as the interest rate, LTV, and other loan terms – most borrowers will want to opt for a non-recourse loan. The only time a borrower will want to take on a recourse loan is if the deal and/or marketplace requires it.

That said, those who need to utilize a recourse loan should know that recourse is entirely negotiable. Recourse loans are incredibly nuanced. For example, some deals can be done with just partial recourse that burns off after achieving certain milestones. Other deals can be done so that recourse is capped at a certain amount.

When in doubt about which loan product is best for you, consult with a third-party advisor who can walk you through your options.

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How to Choose a GC for Your Multifamily Construction Project | Resident First Focus

If you’re interested in developing or renovating multifamily housing, choosing a general contractor (GC)is one of the most critical decisions you’ll make. Whether you’re a developer yourself or simply interested in investing in a development project, it’s essential to understand a contractor’s role and, just as importantly, decide on a qualified, professional contractor that will get the job done correctly.

The Role of a General Contractor in Multifamily Construction

As general contractors for single-family homes, multifamily contractors are accountable for nearly all stages of the building process. This generally includes:

Design: A general contractor will be tasked with working with a project’s architect and helping suggest modifications and improvements that can conserve time and money while reducing risks and potential safety hazards.

Permitting: A GC will typically be responsible for obtaining all relevant city and county permits for a construction or rehabilitation project.

Hiring subcontractors: From plumbers and electricians to flooring specialists and security installation firms, a GC will generally solicit bids from several subcontractors to settle on the company with the best mixture of price and quality.

Purchasing supplies: While certain subcontractors may buy their supplies and bill the GC, in general, most building materials will be purchased directly by the general contractor.

Zoning/building codes: While a building’s architectural plans must follow zoning ordinances and building codes, it’s also a contractor’s responsibility to ensure these codes are followed and fulfilled during the building and construction process.

GCs and Multifamily Construction Loans

The vast majority of apartment construction projects are funded with commercial construction loans, which involve the lender either making payments to the borrower, paying the general contractor, or making payments directly to the general contractor. 

When choosing a GC for your development project, it’s essential to consider the construction financing process. In most cases, a construction lender will want to approve a general contractor before they fund a loan-- one with significant experience and a sizable surety bond to lessen the lender’s risk if the contractor cannot complete the project.

Before agreeing to a loan, a lender will typically also want a borrower to have a takeout commitment from a permanent lender. This means that the borrower will have the capacity to refinance their initial construction loan, fully paying back the construction lender. Takeout commitments regularly have a set timeline, after which the commitment will no longer be valid, so it is in both lender’s interests (as well as the borrowers) that the general contractor finishes the project on time. In addition to timing considerations, the lender offering the takeout commitment may also want a say in a borrower’s choice of General Contractor. Therefore, investors and developers will always want to consult with lenders before selecting a GC.

How to Select a Quality Multifamily General Contractor

In general, research is the first step in selecting a general contractor for a multifamily development project. A developer or investor may wish to search online, ask other developers for recommendations, or even wish to find local properties they like, and then look at city or county records to determine which contractors worked on them. If they are utilizing construction financing, they may also wish to ask their lender which general contractors they recommend. In today’s overheated construction market, quality builders typically have their hands full, so developers may want to be wary of GCs that directly advertise to potential clients.

Start early: For large multifamily development projects, it can often take nine months or more to receive the proper approvals from a municipality. Choosing a quality general contractor early in the process can often speed this up, as they usually know how to navigate the permit approval process.

Create a detailed project description: Providing a comprehensive project description is the best way to get an accurate cost estimate and work timeline from a GC.

Get bids from several contractors: For smaller projects, investors developers should typically get at least three competing bids from contractors. For larger projects, it may be advisable to get 5-6 offers, but this depends on the number of available firms in the area. Typically, more bids encourage more competition, bringing down prices.

Investigate references: Checking references is an essential part of your due diligence as an investor or developer. Beyond ensuring that past clients haven’t had any serious issues with the contractor, you can also determine the style in which they work. Asking specific questions here is key – including how long it took a contractor to return their calls and whether the contractor could complete the project on time and on (or under) budget. You may even want to call past clients that they did not provide as references (or even past employees) to get a complete idea of their reputation and abilities. If a contractor has not provided references--make sure to ask-- and, if they aren’t eager to offer them, you may want to look elsewhere.

Cost and Budget Analysis When Choosing a General Contractor

As a multifamily investor or developer, knowing how much you’ll pay for your general contractor is essential to the selection process. Below, we’ve listed some of the most important factors to consider. Typically, costs are categorized as either hard costs, including materials and physical labor, or soft costs, which involve design consultations and the permitting process. In addition, pre-construction costs must also be accounted for, which can include the soft costs mentioned above and other contractor costs, like budgeting, due diligence, meetings, and conducting a feasibility analysis.

Flat fees vs. Percentage fees: There are two common GC fee structures: flat fee pricing, pricing based on a percentage of total costs, and a smaller flat fee. By choosing a flat price, a client can expect greater certainty concerning overall expenses, but contractors may be somewhat less transparent about how and when they spend their money. 

In contrast, cost-based pricing can lead to more significant uncertainty, but a client can generally expect a greater degree of transparency from their GC. 

Still, unforeseen change orders do exist. A change order is a document used to modify the original agreement on a construction project. It details the changes in the scope of work, cost, and schedule that are required. In many instances, the construction contract dictates the change order process. Beyond that, change orders can be a significant profit center for a contractor.

Choosing subcontractors: It’s always crucial for contractors to get multiple bids from subcontractors, but this is especially true in the case of cost-based agreements, as the client will be paying directly for any increase in costs related to overpaid subcontractors. This is where choosing the right contractor is essential; an untrustworthy firm may choose higher-priced subcontractors to increase their percentage-based fee. While cost-based agreements generally permit owners to have a hand in selecting subcontractors, many clients will often defer to a contractor, especially if they don’t have significant construction experience.

Financial strength: Make sure that any contractor has the financial capacity to fully finish the project with a reasonable margin for safety. Clients may wish to see a contractor’s financial statements to ensure they have a net worth of at least the cost of construction (this may not apply to more extensive projects), as well as a sufficient degree of liquidity. A contractor should also be fully licensed, bonded, and insured – something we touch on below. With all this in mind, it’s essential to appreciate that clients will generally pay a general contractor in a series of predetermined disbursements, be issued monthly or on an incremental basis, as the various stages of the project are completed.

Always Hire a Bonded, Licensed, and Insured GC

If you want to make sure that your multifamily construction project goes smoothly, it’s imperative to ensure that you choose a contractor who is licensed, bonded, and insured. When it comes to licensing, contractors are licensed by a state board or agency, and while specific names vary by state, their functions are generally the same. Working with an unlicensed contractor is extremely risky because you will typically not have the insurance or ability to pursue certain kinds of legal claims against them.

In addition to being insured, a contractor should also be bonded. A bonded contractor has purchased a surety bond similar to but not the same as a traditional insurance policy. Surety bonds help protect owners in the case that a contractor is not able to complete the project on their own. 

For instance, if the contractor has financial issues, the surety company may lend them cash, while if they abandon the project entirely (or do not do correct quality work), the surety company will typically replace them with a new contractor. Most construction lenders require that a general contractor is bonded and may even be a “dual obligee” under the surety bond contract.

In addition to being licensed and bonded, a contractor should also be insured, which, in most cases, indicates that they have general liability (GL) insurance. General liability insurance can help protect both property owners and general contractors in a variety of scenarios, including personal injury lawsuits by subcontractors, as well as provide a way for an owner to sue a general contractor or their subcontractors for shoddy work without putting the GC (and the project) in financial jeopardy.

The Takeaway: Do Your Homework on GCs Before Selection

In some ways, choosing a general contractor is like choosing a spouse – choose wisely, and things will go well, but chose poorly, and you could be in for serious trouble. Like a spouse, you’ll typically have to communicate and negotiate with your contractor regularly. A good GC needs to be reliable, trustworthy, communicative, and financially responsible since you’ll be trusting them with hundreds of thousands (if not millions!) of dollars. In addition, a GC should be able to negotiate the complex relationships between city officials, architects, lenders, and subcontractors in a way that makes your project go as smoothly as possible.

Credit: https://www.multifamily.loans/apartment-finance-blog/choosing-a-general-contractor-for-a-multifamily-construction-project

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What to Know About Investing in Private Equity Real Estate | Resident First Focus

Private equity real estate is a new favorite of the investment world. Investors regularly see the numerous advantages of private equity real estate. Those who might otherwise be contemplating alternatives to investing in large commercial real estate ventures can now do so via a private equity real estate fund, enabling folks to diversify their portfolios. Furthermore, a single fund can present the options to invest in multiple assets rather than in one commercial deal.

Private equity real estate is also tax-efficient. Most funds are structured to last several years, so unless one of the fund’s assets is sold inside a one-year period (which is rare), the profits are taxed at the long-term capital gains rate rather than short-term capital gains. This is before the privileges of pass-through depreciation. Bundled, these tax benefits can save an investor 20% or more on the profits earned each year.

Are you taking notice? Great! Here is a cursory guide around buying into private equity real estate.

What is private equity real estate?

Private equity real estate points to the pooling of funds deployed to acquire public and private commercial real estate assets.

· What it means

Capital is typically raised through private real estate equity funds, and those funds are usually restricted in terms of which sorts of assets they can invest in. Some funds are highly targeted; for example, they may only invest in value-add multifamily apartment buildings. Other funds may be more versatile, permitting the fund manager to invest in multiple product types, such as multifamily, office, retail, hospitality, or industrial.

Notwithstanding the fund’s target investment type, the fund is ordinarily accountable for all real estate activities, including acquisition, financing, redevelopment, repositioning, stabilization, ongoing asset management, and, ultimately, disposition of the property.

· When it became popular

Commercial real estate has long been viewed as an “alternative investment,” and as a result, institutional investors would typically only invest a small portion (if any) of their portfolio in this asset class.

The feeling toward commercial real estate began to change in the mid-1990s as CRE property values began to fall. Private equity real estate funds were founded during this time to extend capital into undervalued and underperforming sites.

 Who can invest in private equity real estate?

Investing in private equity real estate is ordinarily limited to private investors, institutions, and select other third parties, as outlined below:

· Private investors

Private equity real estate is generally only open to a select group of private investors; usually, high-net-worth individuals or others are deemed accredited investors. To be considered a qualified investor, a person must have at least $1 million in assets (excluding their primary residence) or have yearly earnings of at least $200,000. Duos with joint incomes of $300,000 or more over the past two years are also qualified to invest in most private equity real estate funds. The expectation among private investors is that they will contribute significant capital (e.g., $100,000 to $250,000 or more) in a single deal or fund.

· Institutions

Institutions tend to be the leading investors in private equity real estate. Institutional investors encompass hedge funds, pension funds, mutual funds, endowments, banks, and insurance companies.

· Third parties

Handpicked third parties, such as asset managers, can frequently invest in private equity real estate on behalf of institutions like those listed above.

Private Equity Real Estate vs. REITs

There’s a crucial contrast to be made between private equity real estate and public real estate investment trusts (REITs). Public REITs are primarily publicly traded stocks of existing real estate companies. Shares of REITs can be bought and sold with the click of a button. Private equity real estate is much more illiquid. It can often take years to recover initial capital contributions and profit to private equity real estate investors. This is one of the reasons why private equity real estate limits who can invest. Contrast this to REITs, who allow any investor with a brokerage account to buy or sell shares. REITs continuously raise capital, whereas funds tend to be more limited when open, usually with a precise fundraising goal outlined in advance. It’s a wholly different business model.

Another key differentiator is that private equity real estate funds tend to be less regulated than public REITs. For example, REITs must comply with strict stipulations regarding the percentage of real estate-related assets they own, how they combine capital, and from whom, how, and when dividends are distributed to investors, etcetera.

One exception to the above: private equity real estate investments can be pooled and structured in many different ways, including private REITs, though this tends to be less common than structuring as an LLC, S-corp, or other legal structure. 

Should you invest in private equity real estate?

Let’s say you’re an accredited investor and are considering investing in private equity real estate. What determinants should you be contemplating before making that decision? Typically, you’ll want to analyze three fundamental factors: the amount of upfront capital required, level of risk, and potential returns.

· Upfront capital

Before investing in private equity real estate, gauge how much upfront capital will be required by the fund. Some private equity real estate funds mandate a minimum investment, such as $50,000 or $100,000. Others require an initial offering of at least $250,000. That is not an insignificant amount, regardless of how wealthy the investor. This is also why private equity real estate tends to be narrowed to accredited investors, institutions, and related third parties. The presumption is that these parties have the capital required to make that initial investment and understand the risks connected with doing so.

 It is important to keep top of mind that, unlike a REIT or other investments, the upfront capital investment in private equity real estate is illiquid. It could take years for that money to be returned to investors. Are you comfortable knowing that you cannot touch that money for some time?

· Risk

One reason commercial real estate has long been viewed as an “alternative investment” is the risk associated with these projects. The industry has matured dramatically over the past few decades. Still, the downside is that investors can lose their entire investment if the fund fails to meet expectations.

 That said, there are ways to alleviate risk. You’ll want to vet the fund’s sponsor thoroughly – what level of expertise do they have? How long have they been investing in private equity real estate? What is this fund’s business model? What is their intended exit strategy?

Knowing the ins- and outs of how a fund is structured and how the fund will use your capital is critical for any investor looking to lessen potential risk.

· Returns

Although profits are rarely guaranteed, private equity real estate can produce significant returns for investors. The annual rate of return principally depends on the arrangement and nature of the fund. For example, a fund that invests in Class A properties in core markets should

be expected to generate 6-8% returns annually. Core-plus strategies, including Class A/B properties located in secondary markets, are considered somewhat riskier but will usually make annual returns of upwards of 10%. Value-add and opportunistic real estate deals can have

double-digit or more returns, but again, these initiatives tend to carry the most risk. Any investor will want to consider their risk tolerance, economic climate carefully, and extraneous events like a pandemic, i.e., COVID, before investing in a private equity real estate fund.

Conclusion

Private equity real estate is an attractive way for high-net-worth individuals and accredited investors to produce passive income. They also present a unique opportunity to expand one’s portfolio without taking on the day-to-day management of direct ownership.

Yet, as is the case with any significant investment, you’ll want to learn the nuances of any fund. Be sure to pick through the documents carefully, and of course, confer with your financial advisor as appropriate.

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How to Become a Designated “Real Estate Professional” – PART 2 | Resident First Focus

In Part 1 of this two-part series, we plunged into how real estate income is taxed. We introduced browsers to the idea of becoming a “real estate professional” and the various tax advantages of doing so. Now, what you’re presumably wondering is how to achieve real estate professional status.

Let’s begin this follow-up piece by affirming that earning the designation is no easy task, especially for those already employed full-time. Nevertheless, those who can (either alone or in partnership with their spouse) will achieve an even greater return on real estate investments given the tax benefits.

How to Achieve Real Estate Professional Status 

The IRS has specified guidelines describing what is needed to obtain real estate professional status. It’s more tricky to achieve than one might assume. The IRS uses a two-step method in which investors are obligated to meet both criteria to qualify:

1. The Quantitative Test

An individual must spend at least 750 hours per year actively managing their rental portfolio. This must be their primary occupation. In other words, you must expend more working hours running your rental portfolio than you do in any other profession. 

If you’re someone who spends 1,500 hours per year at your day job and fills 750 hours of your time managing your rental property, you will not meet a Real Estate Professional qualification. You would need to work 750+ hours in real estate and spend fewer hours at your other job.

Pursuits that count toward that 750-hour threshold include: supervising repairs or renovations to a property, privately performing construction activities, selling a property, and showing and/or renting your rentals. 

Time that does not count includes ancillary investment activities, such as investigating new opportunities and time spent “on-call” for residents. Travel time is seldom acceptable toward the 750-hour minimum, but IRS rulings have varied – so those wanting to be conservative may not want to include this time in their overarching calculation.

Technically, the IRS prefers that a 750-hour minimum is invested into each rental property. However, the IRS does permit grouping assets by selecting all of those interests as a single activity. By doing so, you are required only to spend 750 hours across your entire rental portfolio. 

As a standard caveat, the IRS wants you to have at least a 5% ownership stake in all of the rental properties for which you are professing to be a Real Estate Professional. 

In aggregate, memorize this method: 750-hours + 50% or more of your time + 5% ownership stake.

2. The Material Participation Test

 To achieve Real Estate Professional status, you must “materially participate” in each rental asset.

 According to the IRS, the following activities qualify toward material participation: “Real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” You are required to perform these tasks, all or in part, on a regular, continuous, and “substantial” basis to be deemed a Real Estate Professional. 

The IRS utilizes a 500-hour threshold to circumscribe material participation that spans industry classifications, an easy bar to attain for those in the real estate industry. Real Estate Professional designation has a 750-hour threshold requirement already.

A significant clarification to make: material participation does not mandate managing properties day-to-day. It is possible to employ a property manager and still supervised the threshold. Besides, it is not necessary to have a real estate license to qualify.

We discussed above that hours spent on investment exercises do not count toward the Quantitative Test. Still, activities as an investor (e.g., studying and reviewing financial statements, generating reports of finances or operations, or managing the finances) can be included in the Material Participation Test – if you are supervising your asset(s) day-to-day. 

Beyond the above, these activities do not qualify.

· As noted above, investing in assets as a limited partner does not qualify for either the Quantitative Test or the Material Participation Test.

· You and your spouse CANNOT combine your hours spent on your rental portfolio to reach the 750-hour minimum threshold. One of you needs to meet both requirements independently.

· An enterprise (such as an LLC) may pass as a Real Estate Professional if greater than 50% of the gross receipts for the business are from real estate.

Required Real Estate Professional Documentation 

There are undeniable advantages to obtaining Real Estate Professional status, but it is a designation that most people grapple with achieving. The IRS takes this designation sternly and will audit those who seem unlikely to reach the threshold. Accordingly, if you’re a high-earning professional operating in another field, the IRS may find it unusual that you also lend more than 50% of your time supervising your real estate portfolio.

Anyone who’s contemplating filing as a Real Estate Professional will want to preserve accurate records in the event of an audit. The IRS states that an individual can prove their Real Estate Professional status by any “reasonable means,” which the IRS does not specify.  

Tracking systems are critical:

· Use an email account reserved for all real estate endeavors and communication. This makes it more straightforward to find and track emails if needed for an audit. 

· Log all calls as they occur. In your log, record notes to define the reason for the call.

· Use an earmarked calendar to keep up with all meetings, events, site visits, etcetera., linked to your rental portfolio. Again, make comprehensive notes about each of these appointments to use as reinforcement if needed.

· Open a bank account that is only used for your rental assets. Similarly, have a credit card that is designated exclusively for rental property expenses. You want to be careful not to mix or co-mingle funds (personal and those related to your portfolio).

· Use accounting software (and hire an accountant) to keep up with all of your income and expenses in real-time. Remember: If the IRS questions your position on an audit, then the onerous responsibility of showing you qualify falls squarely on your shoulders.

Strategies for Becoming a Real Estate Professional

We’ve alluded to this already, but it’s essential to reiterate: becoming a Real Estate Professional is no easy task for those with already-demanding day jobs. Still, it is not impossible to qualify, particularly for married couples where one spouse is otherwise unemployed.

Here are a few approaches for becoming a Real Estate Professional:

1. If you are now employed full-time, you can have your spouse pursue the designation. Of course, your spouse has to produce the work – not just say they’ll do the job. Confirm your spouse is on board with this approach. You’ll want to review the criteria closely and to ensure your spouse is up for the task.

2. If you work part-time (or could work part-time), assess the number of hours you spend working at your other job and determine whether you’d be able to spend 50% of your spare time running your real estate portfolio.

3. If you’re retired, take on more of your real estate portfolio’s day-to-day administration. You may find that you’re now spending 500+ hours on your rental properties each year, in which case raising your time spent could speedily put you over the threshold required to qualify.

Conclusion

It might make sense to evaluate whether or not to become a Real Estate Professional. It’s undoubtedly not the right move for everyone, particularly for already high-income-earning people who are better off concentrating on their day jobs than their real estate portfolios. That said, it’s a relevant designation to at least be aware of. Conceivably, this may not be the right season of your life to seek the status. Perhaps this isn’t something you’d want to reconsider until way down the road.

Figuring out how your rental income is taxed – and how to lessen that tax burden potentially – is necessary for anyone interested in maximizing their rental income.

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How to Become a Designated “Real Estate Professional” Part 1 | Resident First Focus

Holding rental property is an attractive way to earn passive income. This monthly income is also very tax advantaged, implying there are various approaches to offset the taxes you would otherwise pay on this income.

Depreciation is one such example and a concept that most people already understand. In short, depreciation is a deduction or discount that owners can take over many years. For residential assets, depreciation is taken over a 27.5-year period, which the IRS acknowledges as a residential building’s “useful life.” I.e., a rental facility with a cost basis of $300,000 would produce a deduction of $10,909 per year ($300,000 / 27.5 years), which can, in turn, be used to counterpoise your taxable income. You can write-off or take depreciation even if your property is technically profitable and increasing in value. 

But there are other nuances to how rental real estate income is taxes—nuances that are not as well understood by most everyday investors.

In this two-post series, we take a glimpse into how real estate income is taxed. As you will certainly see, there is a spectacular benefit to becoming a designated “real estate professional.” We’ll study the benefits of this designation carries and how you might be able to qualify.

An Overview of How Real Estate Income is Taxed

For now, let’s assume that you are not a “Real Estate Professional” according to IRS standards. You are an individual who works their 9-to-5 in an office environment, managing your rental assets on an as-needed basis. This designates you as a “Passive Real Estate Investor,” which is the same with most who buy rental properties.

Passive real estate investors should presume to be taxed as follows:

Taxed as Ordinary Income: Any income earned thru rental profit is deemed “ordinary income,” implying that you will be taxed according to your tax bracket. High-income-earning professionals tend to be in higher tax brackets and can consequently foresee paying upwards of 38% taxes on net income created by their rental portfolio.

Net Investment Income Tax: This is an added 3.8% tax that applies to anyone whose adjusted gross income for the year tops $200,000 (or $250,000 for those who are married and filing jointly). The 3.8% tax is on all passive investment income, which includes rental income.

As aforementioned, there are various write-offs, like depreciation, which can lessen your tax burden. Deductible expenses comprise of but are not limited to: advertising, local property taxes, repairs and maintenance, commissions, cleaning and maintenance, homeowners’ association dues or condo fees, depreciation, snow removal, pest control, insurance premiums, interest expenses, landscaping, management fees, supplies, trash removal fees, travel, and utilities. 

Anything you subtract must be “ordinary and necessary,” according to the IRS. For example, travel needs to be directly associated with the property. If you’re commingling business with pleasure, you must designate the travel costs between deducible business expenses and nondeductible personal expenses. Still is always better to have a separate entity and the corresponding account to operate out of. Excellent record-keeping, especially with software, is the most reliable way to defend yourself in the event of an audit. 

An individual who is a passive real estate investor is limited to taking $25,000 in write-offs each year. In theory, even a profitable rental property can generate “paper losses,” which can later be used against other passive income – such as dividends received on a stock portfolio. If you have more passive losses than passive income in a given year, you can “carry” those passive losses and roll them forward to the next tax year.

There’s another designation, called an “Active Investor,” which expands the deduction threshold from $25,000 to $50,000 for those who qualify. It is relatively straightforward to become qualified as an Active Investor. It would be best if you were involved in the decision-making process. For example, if you’re a limited (silent) partner that’s bought into a real estate fund, you’re most surely a passive investor. If you’re privately and wholly invested in two or three rental properties, you are an active investor. There is no burden of proof required to show the IRS that you are an active investor; obtaining this designation supremely easy for those who otherwise qualify.

Of course, this benefit doesn’t last forever. Regardless of whether you’re a passive or active investor, your eligibility to take these deductions begins to diminish once you make more than $100,000 in adjusted gross income. A single person who makes more than $150,000 in adjusted gross income cannot declare any write-offs against their passive income. 

Rental Income is Taxed Differently if You’re a “Real Estate Professional” 

In extension to Passive and Active Investors, the IRS has a third designation for “Real Estate Professionals.” Rental income is taxed very conversely when you’re a Real Estate Professional.

Let us elaborate.

Anyone who is a Real Estate Professional can write off 100% of their real estate losses (real or paper) on their ordinary income (not just passive income, as is the case with the other classifications). There is no ceiling on the value of the deductions you take. Therefore, Real Estate Professionals, especially those with large rental portfolios, can counterbalance their whole income (active and passive) via deductions, thereby showing zero tax liability at the end of each year.

Even if you can’t offset all of your income, you can unquestionably offset a big piece of it by employing this designation.

For example, let’s say you make $300,000 a year as a surgeon. Your rental portfolio produces $50,000 in losses each year via depreciation, expenses, and other deductions. Your spouse takes over the responsibility of handling your rental portfolio and is therefore eligible for Real Estate Professional status. The $50,000 can then be used to offset your earnings as a surgeon, thereby reducing your modified adjusted gross income to $250,000. This scenario saves you approximately $14,000 in taxes that year!

CONCLUSION

Are you intrigued? Thinking about becoming a real estate professional? We don’t blame you! Now we’ll need to address how to go about acquiring this coveted designation. Stay tuned for Part 2 of this series; then, we’ll investigate precisely how to go about becoming a qualified real estate professional. None of the above constitutes tax advice. Please confer with your Certified Public Accountant and/or Real Estate attorney for more definitive solutions.

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How to Conduct Due Diligence on a Large Apartment Complex | Resident First Focus

Some multifamily IRO investors have acquired smaller properties, ranging from 2-to 30-units. The idea of buying a property more significant than that can unquestionably be intimidating. But it doesn't have to be. It is critical to complete a meticulous due diligence process. This piece explores how to conduct due diligence on a large(r) apartment community.

What is due diligence?

Due diligence (DD) is the careful, meticulous evaluation of a potential investment. It serves the new buyer by reaching a comprehensive understanding of the apartment community's repair needs and economic performance potential. It comprises an evaluation of the asset along with its financials. However, let's dial in on physical property walk-throughs.

In concert with your home inspection, the due diligence walk-through typically happens after a Purchase and Sale Agreement (PSA) has been approved between the buyer and seller.

What to Look for During a Walk-Through

With actual due diligence, you want to examine every nook and cranny of the property and develop a complete list of the repairs/rehab required. Next, use that file to build a full capital budget to counterbalance against your original underwriting, looking for any unexpected concerns you didn't initially account for, and make sure the lender's rehab plan is approved.

The due diligence (DD) process includes:

Unit Walks: We suggest a shutterbug style approach. You'll be taking 40+ full-view pictures per unit, including flooring, countertops, fixtures, etcetera. You'll want to make the unit number the first picture so you can bookend and differentiate between units after the fact. Take snapshots of the service tags on appliances to accumulate serial numbers and make/model information, which can benefit property management down the road. You want to see each unit during DD as you never know what you may find behind closed doors.

Major Systems: Inspection of all major systems involves scoping plumbing lines, examining building foundations, notating HVAC systems, etcetera. Contemplate using drones to get footage of the area and gain a birds' eye view of systems like the roof.

Deferred Maintenance:

Check the structural integrity of railings, staircases, and balconies.

Keep an eye out for wood rot, cracked sidewalks, fence conditions, and more.

Note every item across the property to immediately conclude if the condition is good, functional, or needs replacement.

Use of Technology: In addition to using drones to fly the property, several new technologies can help streamline your due diligence process.

Many firms carry a standard point-and-shoot and now $3k Matterport professional 3D cameras to capture the walk-through of units to share with team members back at the office. The Matterport also enables the production of 3D dimensional floor plans. These cameras are pricy with a 135-megapixel resolution and pairs with any iOS device running the Matterport Capture app. Depending on the portfolio's breadth, some Class B and C apartment buildings may not have this option, with its unlimited 4K print quality photography to view floor plans, helping to lease units.

Additionally, Sketchfab can create 3D models for the building exterior, which can be used to do mockups for exterior capital improvements, like new exterior paint or roofing.

Many DD teams will also use phones and tablets to upload pictures in real-time to the cloud as they check-in and out of units. This allows any buyer and his/her partners to observe inspections in real-time and virtually access the report. This feature is invaluable when all the partners cannot be present during the unit walks, especially if they are travel restrictions during the current pandemic.

What precautions are being made given current COVID-19 concerns?

The due diligence team members, residents, and staff's safety should be the priority. Take extra precautions during site visits, including wearing masks and avoiding touching anything inside of units as much as possible. Gloves can be used in instances where needed, such as opening electrical panels, peeking into HVAC closets, etcetera.

Another advice is that the current climate is to minimize the number of people and time spent in each unit. The typical time in a unit can often be less than 5 mins. Get in and out!

Closing the Deal

If everything at the property is in as-expected condition, now is your time to seal the deal! Finalize any negotiations with the seller and bake the final numbers into your underwriting. If the numbers still work, including the cost of any capital improvements, you could soon be the proud new owner of a larger apartment community – a great way to grow and scale your real estate portfolio.

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Understanding "Gross Rent Multiplier" in CRE | Resident First Focus

Beginning with the right tools and applying a deliberate strategy within your investment search towards a future acquisition of an investment property can help avoid many of the most well-known mistakes that befall new investors.

One way you can conserve time while searching for properties and recognize potentially beneficial properties for your portfolio is by promptly totting up the Gross Rent Multiplier of particular properties and, as an aggregated total, across various neighborhoods, cities, or even entire states.

What is a "Gross Rent Multiplier"?

Gross Rent Multiplier (GRM) is an uncomplicated property income-producing analysis formula used by investors to scrutinize, access quickly, and analyze investment properties inside an asset portfolio.

The distinction between the GRM and other systems is that it singularly uses the gross scheduled income (GSI) comparative to a building's price/value to screen the property/portfolio. The metric is rudimentary in real estate analytics and is practiced chiefly as a suggestive screening tool rather than a definitive value indicator.

GRM's ratio of the subject property's price to its gross rental income. Gross rent multiplier (GRM) is used to predict multi-unit and commercial income-producing real estate investments. It uses the building's price, divided by the gross rents, to reach a ratio that may be scrutinized and matched up with comparable investments in a similar market.

The GRM formula is as follows:

GRM = Price / Gross Annual Rent or Gross Scheduled Income (GSI)

Based on the formula above, the GRM is calculated by dividing the fair market value of a property or the property's asking price on the market for sale by the estimated annual gross rental income. This implies that asset revenue numbers are available. If the seller does not produce an actual rent roll, you'll need to do some market research to feel better about the average asking rents at properties relative to the asset in question.

Keep top of mind that the GRM won't predict the amount of time it will take to pay off the property because other factors drive that period, not least of which is responsibility for meeting obligations that lessen available resources to amortize the expense of purchasing a building. The gross rent multiplier also does not account for any debt used to buy the property.

Let's say an investor plans to acquire a multi-family rental property for $35 million with a monthly gross rental income of $360,000. The property generates another $3,000 monthly in ancillary income, such as through valet trash NOI generated from an on-site, third-party vendor. Therefore, we need to multiply $363,000 ($360,000 + $3,000) by 12, which comes out to $4,356,000 in rent annually.

Gross Rent Multiplier = Property Price / Gross Scheduled Income (GSI) = $35 million/$4,356,000 = 8.03

So, we have found that the GRM for this property is 8.03.

The GRM is deployed only as a benchmark for comparing one property against another. Professional developers typically look at so many communities that they need to apply rapid screening tools to determine worthy additional investigation. Other metrics like price per square foot, the cost per unit, rent per square foot, and the like need to be kept top of mind.

What is a "Good" Gross Rent Multiplier?

This number varies depending on several factors. The most crucial to be conscious of is that it will progressively decline as the market cycle expands and property prices rise. Inevitably, as the market rises from a recession, the GRM will typically be comparatively low as investors return to acquiring properties as liquidity starts to come back into the flow. High single-digit GRMs may be the norm in such circumstances.

As the period lengthens and cash for investment becomes more immediately available, both from lenders and equity investors, values grow quicker than rents, and the GRM goes up – conceivably into the teens.

An unwritten rule is the lower the GRM, the more conceivably lucrative the deal. Class B and Class C assets in secondary or tertiary markets will ordinarily have a flatter GRM than Class A properties or properties established in primary, core markets.

Recollect that whenever you run the Gross Rent Multiplier formula, it is crucial to remember to check all operating costs before pulling the trigger on an asset. The fact that a property has a low GRM does not indicate it is a sure thing. Operating costs, like utilities, management, maintenance, repair costs, vacancies, and other expenditures, are critical in evaluating whether a property is profitable and has investment potential. Factors including late & non-payment to vendors can have positive impacts on this number.

Investors are compelled to weigh apples to apples when studying at GRM. For example, examining a Class C industrial building's GRM to a Class A apartment building's GRM is not especially beneficial, principally if these assets are located in different markets. Instead, use GRM to counterbalance comparatively similar holdings in the comparable condition in similar markets.

Why is the Gross Rent Multiplier Important?

One of the most definitive steps in the commercial real estate investment process is distinguishing between properties to determine how much time and means to designate more in-depth research around investment opportunities. Commercial property appraisals are very different from residential, and there is an abundance of factors that go into favoring a property. Property comparisons are much more challenging when you have to worry about building expenses and maintenance and dealing with the vagaries surrounding rental income, raises, resident concerns, and all else that arises with operating a thriving commercial asset.

GRM enables you to swiftly analyze two comparable properties, which may vary in various locations, or have different characteristics, justifying additional quantification using other, more well-defined, comparison methods. As such, it is an invaluable way to preserve time while searching for investment properties; instead of delving into the financials of each parcel a sponsor comes upon, they'll discover the Gross Rent Multiplier swiftly and efficiently, helps make swift decisions on whether to look closer or to pass.

Conclusion

There are reasonable grounds to adopt a Gross Rent Multiplier to assess potential commercial properties. The utilization efficiency makes even the most amateur investors employ this approach to their advantage, with limited risk of creating errors with more complicated formulas. The time gains reached by GRM are also exceptional, it only requires a few seconds to learn if a property meets your GRM terms, and you can use the technique with communities, counties, cities, or whole states.

However, this metric should be applied in combination with additional similarly broad and connotative ratios such as rent per foot, the price per foot, gross per unit price, etcetera, to ascertain if anything seems out of variance with a property type and location. Once an asset has been vetted by these 'blunt' estimations and opportunities identified, the more advanced evaluation techniques commonly used in advanced feasibility studies will help investors develop a sharper picture of their potential investments. 

Still, some fancy Cap Rate, considered more stable and reliable due to its consideration for the operating expenses and the income property's vacancy rate, making it a more well-defined assessment of its actual performance.

The Gross Rent Multiplier is a useful scanning tool for the investor in recognizing where opportunity may lie. When utilized with an assortment of other similarly broad, indicative metrics, it helps distinguish properties worthy of more in-depth investigation.