Passive investment is an excellent way of diversifying your investment portfolio for better returns. In particular, passive investments in real estate, if invested wisely, can provide a steady cash flow that can either supplement or replace your main income. Some passive investors gave up highly paid jobs and make their living from the proceeds of their passive investments. Whether you are a seasoned passive investor or just beginning to consider becoming one, this article can provide you with valuable information and guide you through the passive investment process.
Here are 5 steps you should follow when considering an opportunity to join a syndication as a passive investor.
Step 1: Determine the Exact Nature of the Opportunity
Ostensibly, this is the very first step that one should take before considering a real estate opportunity. It is imperative to determine the nature of deal;
Location: is the property located in an area you feel comfortable with? Is it in a market that you are familiar with or at least comfortable with. Some investors like to invest in their ‘backyard’ and some are comfortable investing out of state. Additionally, make sure you understand the location’s demographics profile – is the property located in a decent area or in a crime zone? If you are unfamiliar with a certain city or neighborhood, look up the crime rate on Trulia and Google the city/neighborhood name to gather more information that will help you assess whether the property is located in a decent area or in a crime zone. Some investors have a higher appetite for risk, where returns are high, but the risk is high as well. Knowing your preference when it comes to property’s location can help you save time and focus on the right deals for you.
Hold period: take a close look at the business plan – does the syndicator plan to hold the property for 3-5 years? 10 years? Longer? Every investor is comfortable with a different time frame, and knowing your ideal hold period will help you screen the numerous investment opportunities out there and focus on the ones that fit your needs.
Risk Profile: is the deal low risk (core or core plus, no renovation or raising rents needed) or a high risk (repositioning of a Class B apartment building in a Class D neighborhood). Make sure you understand your appetite for risk before making a decision to join a syndication. Don't be tempted by high returns! The higher the returns, the higher the risk, so make sure you are comfortable with the risk associated with the deal.
Return Driver: is the opportunity based on appreciation (low cash flow throughout the hold period and high appreciation factor), cash flow (high cash flow during the hold period with a modest appreciation projections), or both. Finding opportunities that have strong cash flow and appreciation is ideal, but very hard to find these days. It’s a balancing act and you should know in advance if you favor cash flow or appreciation as a main driver for returns.
Step 2: Evaluate the Sponsor’s Experience
Once you decide that an investment opportunity is the right opportunity for you, the next step involves evaluating the experience of the sponsors. Consider the experience level and competence of not only the sponsor, but of the sponsorship team as a whole. A sponsorship team with a well-balanced backgrounds and experiences in real estate and outside of it can be a great asset and will add unique value to the deal.
Step 3: Look for Your Ideal Return
The most experienced and seasoned players in the realm of passive investment provide effective clues and guidance, when it comes to looking for an appropriate and most preferred return. In fact, in their book it’s not feasible to consider any passive opportunity unless and until it does not include a preferred return for them. It’s best to take a leaf out of their book as a preferred return essentially guarantees receipt of the first installment of the profit amount, before it’s split for the manager’s share. When this happens, it helps in recouping the original investment amount on a priority basis. The amount of return definitely depends upon the level of experience at the end of the day.
Step 4: Review the Profit Distribution
Profit distribution is one of the most critical factors in any investment as this determines the ROI at the end of the day. Thus, it’s extremely important to review this factor before considering any opportunity of passive investment. Profit distribution ironically depends upon the managers’ experience and their share of contribution in terms of work and labor throughout the lifespan of the investment opportunity. Some sponsors offer an equity spilt that ranges between 5%-95% and 30%-70% (where 95% and 70% goes to the investors, respectively). Generally speaking, the more experienced the sponsor, the higher their share. In this scenario, the sponsor will receive an agreed portion of the profit regardless of their performance (with the exception of a preferred return payout).
Another format of profit distribution is waterfall. Waterfall distribution is directly related to the sponsor’s performance and allocates a higher portion of the profit the higher returns the sponsor provides. Today, however the vast majority of sponsors don’t offer this option.
As a passive investor, you should decide which profit share mechanism you are most comfortable with.
Step 5: Evaluate the Pro Forma Assumptions
One of the most effective mechanisms to ascertain whether one is dealing with an aggressive management or a conservative one is by reviewing the assumptions used in Pro Forma. These assumptions provide a first-hand feel of whether the opportunity is going to perform as ascertained. However, the goal should be to look for a conservative manager, who will be using the conservative assumptions to make sure that they are able to under-promise as well as over-perform for setting up long-terms relationship with the investor. The main assumptions you should review are the rent growth trajectory, the occupancy and the exit cap rate. It is advised to have a conversation with the sponsor and ask how they arrived at the assumptions.
About the author
Ellie is the founder of Blue Lake Capital LLC, a real estate company specializes is multifamily investing throughout the United States. She is also the host of a weekly podcast called "That REllie Happened?! Unbelievable Real Estate Stories with Ellie". She started her career as a commercial real estate lawyer, leading real estate transactions for Israel’s largest development company. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100,000,000. Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations. She graduated from the MBA program at MIT Sloan School of Management and holds Masters in Laws from Bar-Ilan University in Israel.
You can read more about Blue Lake Capital at www.bluelake-capital.com and learn more about Ellie at www.ellieperlman.com