The 5-Step Quick Start Guide to Passive Apartment Investing

Do you want to get started passively investing in apartments? In this quick start guide, I'm going to break down the five basic steps to help get you started in multi-family real estate.

1. Learn the Structures

In true passive investing, there are two structures that are used to invest in an apartment deal:

1. Syndication
2. Fund

Let's talk about the general setup of both of these structures. We have two sides:

1. The limited partnership (LP)
2. The general partnership (GP)

The LP is made up of the passive investors. These are your programmers, doctors, lawyers, accountants, business owners, and professional athletes. It could be you, it could be somebody else. These are all the passive investors who have the capital but they don't have the expertise, the deal flow, the management skills, or the track record.

There are four components to every single real estate deal. I call this the Real Estate Matrix:

1. Deal
2. Financing
3. Capital
4. Management

Every single real estate deal in the history of mankind has had these four components to it.

Suppose each passive investor has $100,000 they want to invest in an apartment deal. But they don't have the experience. Now, what’s missing for these passive investors? Obviously, they have the capital because they each have $100,000 they want to pool together. But they don't have financing, they don't have the deal, and they don't have management.

This is where the general partner (GP) comes in. The general partner brings the three other components of the deal and together they can actually invest in and improve an apartment deal. This is called syndication. Through the syndication model, both sides earn a certain percentage or split. They share the profits so they're now able to acquire the apartment deal. The general partnership brings the deal, the financing, and the management. I don't just mean collecting rent, but where to buy, when to buy, what price to offer, the improvements you make, when to raise rents, when not to raise rents, when to sell, when to refinance — making all the decisions needed in the syndication. Then the partners are able to pool their resources together and participate in a much stronger deal than they would be able to do on their own. This is the true power of syndication.

Syndications and funds share a similar structure. On both sides, you have the limited partnership and the general partnership. The difference with a fund is that the investors (limited partners) don't invest in a single deal. The fund has multiple properties in it and the fund itself will sell and acquire new properties over the life of the fund. Some funds can last for 10, 20, or 30 years. So the limited partnership doesn't invest in a specific opportunity but in the fund criteria. And then the general partnership will go out and manage the fund itself.

2. Understand the Opportunity

First, you need to understand the pros and cons of investing in apartments. When I first started investing, I didn’t know this and so I invested in the wrong type of real estate (until I discovered multifamily). There are a lot of pros of investing in apartments:

●    Strong cash flow (that’s a huge bonus)

●    Tax benefits through depreciation and cost segregation

●    Forced appreciation

●    Stability, because we have the scale working in our favor

If you own a duplex and one tenant moves out, there goes 50 percent of your revenue gone overnight. If it’s a fourplex or a quad, that’s 25 percent of your revenue, gone overnight. But the larger you scale, the more efficient the deal becomes because you have full-time staff, your maintenance costs per unit go down, and your financing gets better. Those are the benefits that come with scaling and the stability aspect of the portfolio. That’s why lenders love lending on multi-family real estate. The banks will compete to lend on apartment buildings.

So now that we know the benefits of apartment buildings, what are some of the cons?

●    It’s illiquid. It’s not truly a con, but some think it’s a bad thing. When you invest in these deals your money is tied up for potentially 4-7 years. It’s a long-term investment. If you want to get in and out of a market quickly, this type of investment probably isn't for you.

●    (Limited) access. There are deal minimums — a minimum investment required — for some of these deals. Sometimes they require a specific net worth or a specific income. So there are some barriers to entry. These deals are not accessible to everyone.

Now let's talk about how we actually make money. My preferred strategy is called the value-add approach. Everybody has seen on TV these “fix-and-flip” type of shows where they'll buy a house and then they'll flip it and then they put up fake numbers on the screen to make it look really good. We've all seen that. (I call that “realstatement” — real estate entertainment.)

So what's the value-add when it comes to apartments? Apartment buildings are valued using the income approach. That means they are valued based on the money they generate. So, the more money a property generates with its NOI (net operating income), the more the property is worth. This is the basis of the value-ad approach.

So let's say we're able to acquire property that has below-market rents, needs renovations, and is not at the same standard as properties near the market median line. So what we can do is acquire this property below market value, raise the rents, do the renovations, add additional income streams to boost up the NOI, which in turn raises the value of the property. This is how we make money with apartments.

Now if you're passively investing, you don't have to become a spreadsheet analysis wizard or become a true underwriting expert. But you do have to understand the whole idea of the value-add approach. And in the end, it comes down to forcing appreciation, controlling every aspect we can in the deal because we just don't want to wait for the market to go up. We want to control the value of our asset, based on things that we can control. So we control this through raising rents, optimizing expenses, changing marketing branding, bringing on different staff members, renovations, adding different amenities, adding covered parking, valet trash pickup, etc. All these things come down to boosting up the NOI.

Once you understand the opportunity and what you are investing in with all the pros and the cons with apartments, you have to figure out whether or not you can actually invest in these deals. And on this second point, I had alluded to minimums and thresholds investors have to hit to invest in these deals. And so this directly leads us to our next step.

3. Figure Out What Type of Investor You Are

There are two types of investors: accredited and non-accredited. Accredited investors are in a different rung or level when it comes to investing in these apartment deals.

When it comes to individuals investing in apartment deals, they can meet the accredited investor criteria in two different ways:

1. Income
2. Assets (net worth)

So with income as an individual, if you earn $200,000 or more and you have earned that in the past and have a reasonable expectation of earning the same, you are an accredited investor.

As a couple, if together you earn $300,000 or more and you have earned that in the past and have a reasonable expectation of earning the same this year, you are also accredited.

Now when it comes to assets or net worth, if you have a net worth of $1 million or more consisting of rental properties, retirement accounts, stocks, cash, or foreign property (but not including your own home or principal residence), then you’re considered an accredited investor.

Non-accredited investors are those people that do not meet the criteria mentioned above.

Now, what does this do? Well, some offerings are only available to accredited investors. So if that’s you, this really opens up the amount of opportunity you have to invest in apartments.

But there are people who are very sophisticated with their understanding of apartments and real estate investing, but they don't meet the criteria. Some offerings allow non-accredited investors to participate. They might have some different minimums or different criteria, but depending on the offering, you can invest whether you are accredited or non-accredited.

Once you've figured out if you are accredited or non-accredited, you have to...

4. Build Your Team

Your real estate success team is made up of many different individuals:

1. You need an accountant who understands sophisticated real estate investments. You know you're going to be getting all these tax benefits through depreciation and cost segregation. They have to understand how this works.
2. You also need a lawyer who understands sophisticated real estate investments and the syndication or fund structure — not just somebody who's familiar with flipping houses. You need someone who has worked within the syndication and apartment structure before and who understands everything that goes into a PPM or OM, which are the documents that you will receive and sign when investing in a syndication or fund.

These two make up your support team right now. You can add a financial advisor as long as they understand real estate syndication and you can add people to your success team.

On the other side, we have sponsors or GPs. As you know, GPs are the active parties in a real estate syndication. The sponsors and the GPs will be your gateway into investment opportunities. The GPs will find a real estate investment deal, put it under contract, and go out and raise the money from the limited partners. They have to build the limited partnership.

So you want to be able to get on the GPs list or exclusive network for their future deals. In that way, whenever the GP acquires a deal, they'll be able to call you and get you the marketing package. You've already had the lead-up conversations. You're comfortable with each other. So when they have the next multi-family or apartment opportunity, they can approach you.

Once you have your support team and are on the GPs contact list, you're now ready to invest.

5. Analyze the Deals

Is it a syndication or a fund? If it's a fund, you're going to be analyzing the fund criteria. What sort of properties are they going after? What class of property? If it's a syndication, you're going to be looking at the market. Now let's use a syndication for this example.

●    Market — You have to know what drives a market. Again, you don't have to be a spreadsheet wizard, but you have to understand market cycles and what starts off the market cycle. What are the key drivers that go into growing the market?

●    Hold Period — How long is this investment going to take? Is it going to take four, five, six, or seven years? How long is your money going to be invested in the deal?

●    Returns — You have to understand how that impacts your returns. If the deal is estimated to be a five-year hold but you can hit most of your targets in year four, how does that impact your returns?

●    Underwriting — Is the underwriting — all the numbers and analysis — realistic?

What are some red flags to watch out for? Is there a refinance put in and that's worked into the underwriting and they're promising a refinancing in year two? That may or may not happen. So that could be a red flag. Are they pushing rents too high? Are they trying to bring the property up? Are they trying to bring the rents up to a level way above the market average? That may work, that may not work. You have to understand that opportunity. Again, you don't have to be the real estate expert. But when you're reviewing the deal, you have to know what to look for, what things to watch out for — you know, any red flags. Are they being too aggressive?

You're going to generate all these questions. Then you'll be able to go back and ask the general partner, “Hey I was looking at this deal. It looks pretty good but I had a question about the refinance you have worked in here. Why did you work it in there?” Or “Hmmm. I looked at all the comparable rents in the marketing package and it seems like you're trying to push $50 more per unit than all the other comparables. Why is that?” There might be a good reason. But at least, having this basic knowledge allows you to have that conversation and dig a little bit deeper, rather than just blindly investing without understanding the basics of apartment syndication.

Those are the five steps. This will help get you started investing passively in apartment deals.