Upon successfully investing in your first real estate syndication, acquiring a 100-unit apartment building in a promising submarket in a bustling metropolitan area alongside a group of other investors, the question arises: what comes next?
As an investor in a real estate syndication, you should anticipate receiving periodic updates from the sponsor team regarding the property’s condition, including any renovations, maintenance concerns, and occupancy trends, typically on a monthly basis. These updates may also include photographic evidence of any property updates. Furthermore, you can expect to receive a comprehensive financial statement every quarter.
How do Cash Flow Distributions Work?
In addition to the periodic updates, you can also anticipate receiving regular cash flow distributions, typically on a quarterly basis, which may commence as early as the month following the acquisition or may take several months.
These distributions represent a fresh source of passive income, which means that you can receive these payments without any effort on your part. This is certainly an attractive feature, but it begs the question: where do these payments originate? After all, an apartment building is not an ATM. To satisfy your curiosity (and ours), let’s delve into this topic further.
Every investment property, from a small rental house to a large apartment building, is a business. As a business, the asset generates income, as well as expenses.
Gross Potential Income, Net Rental Income
Rental income is the primary source of revenue for multifamily real estate, but it’s not as straightforward as simply adding up the monthly rent checks.
Let’s say you invested in a 100-unit apartment building and each unit rents for $800. The gross potential income would be $80,000 per month or $960,000 per year. However, this is the gross potential income, meaning the total income if all units were rented at market rates without any concessions.
The net rental income takes into account vacancy costs, loss to lease, and concessions. If 10% of the units (i.e., 10 units) are vacant, each renting for $800, your monthly vacancy cost would be $8,000. Over the year, assuming the vacancy rate stays the same, the annual vacancy cost would be $96,000.
To calculate the net rental income, subtract the annual vacancy cost from the gross potential income:
$960,000 gross potential income – ($8,000 vacancy cost x 12 months) = $864,000 net rental income
This means that your net rental income is $864,000, which is the amount available to cover operating expenses, mortgage payments, and provide cash flow distributions to investors.
It’s important to note that there are other factors that can affect rental income, such as concessions, loss to lease, and bad debt. Concessions are incentives offered to new tenants, such as a free month’s rent, to encourage them to sign a lease. Loss to lease is the difference between the actual rent collected and the market rent, while bad debt is uncollectible rent owed by tenants.
An apartment building, like any other business venture, entails several expenses. These expenses include property management fees, legal fees, payroll, insurance, pest control, landscaping, cleaning, utilities, maintenance and repairs, and more. It is important to note that each apartment building is unique, and therefore, its expenses will differ.
Assuming a projected monthly operating expense of $38,000, it is the responsibility of the sponsor team and asset manager to optimize these expenses over time. For the time being, it is prudent to factor in a monthly operating expense of $38,000, translating to an annual operating expense of $456,000.
Annual Operating Expenses:
$38,000 monthly operating expenses x 12 months = $456,000 annual operating expenses
The net operating income, or NOI, is the result of subtracting the operating expenses from the rental income.
Net Operating Income (NOI):
$864,000 net rental income – $456,000 operating expenses = $408,000 NOI
It is important to recognize that mortgage cost is an essential aspect of repayment to the lender each month, and neglecting it could result in a foreclosure.
Purchasing an apartment building entails a down payment, usually around 20%, with the lender financing the remaining 80%. The principal and interest payments are part of the monthly expenses, and they are paid to the lender.
Assuming a monthly principal and interest payment of $20,000, this translates to an annual mortgage payment of $240,000.
Annual Mortgage Payments:
$20,000 monthly mortgage x 12 months = $240,000 annual mortgage payments.
Cash Flow/ Cash on Cash Returns
Cash on cash returns, also known as the first year total cash flow, are an important metric to consider when evaluating real estate investments. Once you subtract all the expenses from the property’s income, you can determine the cash flow for the first year. It’s worth noting that this calculation only accounts for the first year and that many factors will change in the coming years as the sponsor team continues to optimize and improve the property.
Assuming an 80/20 deal structure, where 80% of the profits go to the investors (i.e., the limited partners), and 20% go to the sponsor team (i.e., the general partners), let’s look at an example.
Suppose the first year’s total cash flow is $168,000 after subtracting the mortgage ($240,000) from the net operating income ($408,000). In that case, the first year’s cash flow to investors would be $134,400 (80% of $168,000).
If you invested $100,000 into this deal, you would receive a quarterly cash flow distribution of $2,157, resulting in approximately $8,628 in passive income for the first year. It’s important to remember that these projections are not guaranteed as there are numerous factors involved in the calculations.
An apartment building is a living, breathing entity that is subject to market fluctuations, tenant turnover, and unforeseen expenses. Nevertheless, projections like these are a great way to evaluate your potential returns on investments and to understand where each dollar of your investment is going and where each dollar of projected cash flow is coming from.
Real estate investing can be an excellent way to generate passive income, but it’s important to do your research and consider all the factors before investing. By understanding the cash-on-cash returns and the structure of the deal, you can evaluate potential investments and make informed decisions.