Multifamily commercial real estate is one of the most attractive asset classes out there. Why? The advantages are numerous: fundamentals are good, the returns are attractive, there are material tax benefits and consistent cash flow, the effort required as a passive investor is minimal. So then, is passive investing in a multifamily deal something that you should be thinking about? Being a multifamily investor myself, it’s probably no surprise that I believe the answer is a resounding yes — however, interested potential investors need to ask themselves these five questions before they get started:
1. Do you currently generate excess cash flow or have free available cash doing nothing or generating subpar returns? Most (but not all) so-called multifamily syndications (groups of investors pooling money together to buy an asset) require a minimum investment of $50,000 to participate. Sometimes a minimum is less, say $25,000, however usually this is usually the case with less-experienced syndicators who are struggling to raise money. More experienced deal-makers tend to prefer to deal with a smaller number of investors.
2. Are you an accredited or sophisticated investor? Many syndications are conducted through SEC 506(b) or 506(c) offerings, which are accessible to investors who are accredited or at least sophisticated (506(b) allows both, but limits sophisticated investors to 35 purchasers). Do you qualify? The regulations define an accredited investor as a person whose individual net worth (or joint net worth with their spouse) exceeds $1 million or who had an individual annual income in excess of $200,000 (or $300,000 income with their spouse) in each of the two most recent years, among other stipulations. A sophisticated investor is generally defined by the Securities and Exchange Commission as someone who has “such knowledge and experience in financing and business matters that he is capable of evaluating the merits and the risks of the prospective investments.”
3. How well do you know the sponsor? The term “sponsor” is typically used to describe a company that sources a deal, raises capital for the acquisition and manages the asset during the holding period. How well do you know the people you are entrusting your money with? Do you have a solid relationship of trust with them? Can they provide business references? How responsive are they to your questions and concerns? If they are not responsive to you before you give them your money, how responsive do you think they are going to be once you have already parted with it? How many sponsors do you know? There are plenty of sponsors looking for investors. Get to know them, build a relationship with them, ask others about them, watch them. There is no rush to invest; there will never be a shortage of sponsors looking for money. Take the time to do your research. It’s better to develop a pipeline of deals to look at and spend a few months just analyzing various structures and investment opportunities before you pull the trigger on your first one — that’s how you develop intuition and start to better understand what a “good deal” looks like.
4. Do you have enough liquid assets? Investments in any private offerings are, by nature, illiquid. There is no well-established trading market for such investments. Many multifamily syndicated offerings have a target hold period of five to seven years. If you suddenly need liquidity and want to sell, you probably won’t be able to do so easily. The sponsor most likely will need to approve such a sale, and even if you find someone to take over your investment and buy it from you, it will likely be at a discount to a fair value. As such, when you invest in a syndication you should be prepared to have your money locked up for years. If you feel you might need this cash for certain life events one or two years down the road, you’d be better off finding more liquid investment alternatives.
5. Have you spent the time necessary to educate yourself about multifamily investing? Do you have sufficient knowledge to be able to analyze a deal and ask a syndicator the right questions? It would be advisable to read up on multifamily fundamentals and familiarize yourself with main drivers of a multifamily investment. All sponsors say that they use “conservative underwriting.” But is it so and are you able to tell? Do you know what metrics to look at and what the conservative benchmarks are? How well do you understand such concepts as cap rate, cash-on-cash return or IRR? Do you know how to analyze an area? Are projected rents realistic? What is the market rent growth assumption and do you find it conservative? What kind of a loan is used to finance the acquisition and what are the implications for you as a passive investor? Do you understand all the fees being charged by a sponsor? If you cannot answer those questions, do yourself a favor and spend some time educating yourself before you invest. Read some books, talk to more experienced investors, listen to some podcasts — you’ll thank yourself later!
To summarize, I do believe that investing in private multifamily offerings could be very lucrative. However, I still urge all current and prospective passive investors to be cautious, weigh all pros and cons and tread carefully.