What do you get when you mix a “value-add apartment building deal,” none of your own money, a preferred return for the investors, and a cash-out refinance?
Answer: YOU owning the majority of an apartment building without using your own money.
Moved a bit too fast for you? Let’s slow it down a bit.
Using a real-world case study, I’m going to show you how you can own the majority of a building even though your investors will finance the whole thing.
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The Set Up
Let’s assume you purchase a 15-unit apartment building for $530,000. You raise the $250,000 from 5 investors that you’ll need for the down payment, closing costs, and renovations.
This is a value-add opportunity because the rents are below market. You determine that the previous owner has not raised the rents in about 7 years because she didn’t want her tenants to leave. She’s currently collecting an average of $475 per unit but the median rents for similar units in that area is actually $600 – about $125 higher per month per unit. That’s about $22,000 more per year! At a capitalization rate of 8%, the prevailing cap rate in this area, that’s an increase in value of about $275,000!
So you know the upside potential is pretty good but you also estimate it will take 3 full years to get there.
There are two ways you can structure this deal with your investors: the first option is simpler and in the second option you end up being the majority owner of the building, even though you may not have any of your own money in the deal.
Option # 1: Straight Equity Split
The simplest way to structure this deal is to give your investors the majority of the equity. How much depends on what your target return is for your investors. For the purpose of this case study, let’s say that you will give the investors 70% equity for providing the cash investment with you retaining 30% for putting the deal together.
I have a sophisticated deal analyzer that I use to model these things, so I’m going to wave my hands a little bit for brevity’s sake.
What I want to do is to compare the compensation you receive as the syndicator vs. that in Option # 2 (below).
Assuming we sell the building after 5 years, you will receive 30% of the cash flow distributions as well as 30% of any profits from appreciation. If you add all that up, your total compensation over 5 years will be about $50,000, including a $41,000 check from appreciation when you sell the building.
Not bad for not having any of your own cash in the deal!
But there is an even BETTER option.
Option # 2: Preferred Rate of Return
Instead of giving your investors a straight equity split in their favor, you could offer them a generous preferred rate of return.
What’s a preferred rate of return? An example might explain it best.
Let’s assume you give your investors an 8% preferred rate of return. They invested $250,000 cash in the deal. The preferred return means that you agree to pay out 8% of their invested capital FIRST before any kind of equity split. In this example, 8% of $250,000 is about $20,000. This means you pay out the first $20,000 of available cash flow to your investors and then you split the rest based on your equity.
An 8% preferred rate of return is generous towards your investors. It means that they have a higher degree of certainty that they will make at least an 8% cash on cash return on their money. If cash flow is a bit tight, it could mean that you get paid nothing, but the investors do.
Investors are generally very happy with this kind of arrangement, which by itself represents a nice little return for most investors. If you offer them a small upside in addition to that, they would be thrilled! You could offer them 25% equity in this deal, which means that after they receive their preferred pay out, they get 25% of whatever else is left, either from cash flow or a profit at sale.
There is one major disadvantage of a preferred return for you as the syndicator: your cash flow compensation will be greatly diminished.
Paying out 8% of invested capital drains the majority of cash flow, leaving you with precious little compensation from cash flow while you own the asset. Furthermore, the preferred pay out raises the risk. What if cash flow is not what you projected? Your obligation is $20,000 per year (almost like a interest-only loan), but what if there’s only $15,000 to distribute? That means you now owe $5,000 to the investors. Let this go on for several years and you’ll NEVER get paid anything, EVER, even when you sell because you owe all this money to the investors.
Therefore, use the preferred return cautiously, and only for investments with LOTS of cash flow to safely cover this liability.
However, there is one major advantage of this arrangement: you have 75% of equity in this deal, remember? While the preferred pay out is in place it doesn’t do you much good, because 75% of zero is still zero. But what if the preferred pay would disappear? That would increase cash flow and with that, your compensation.
How could we eliminate this preferred pay out? The answer is a cash-out refinance.
Eliminating the Preferred Return with a Cash-Out Refinance
Instead of selling the asset after 5 years, we will instead refinance after 3 years (the time frame during which we added most of the value by increasing the rents), return most or ALL of the investors’ principal and hold the building for another 3 years (or even forever!).
Investors like this strategy because they get their principal back after 3 years which eliminates their risk. And they still enjoy 25% of all cash flow distributions and profits.
You like this model because the refinance eliminates the preferred pay out. Yes, the refinance increases the debt service, but it’s peanuts compared to the 8% you were paying out before.
If we model this scenario in a deal analyzer, we notice several things:
- The overall return for the investors is about the same between Option # 1 and # 2.
- As we discussed in Option # 2, your compensation DURING the investment is much lower compared to the previous option.
- But when you finally sell the building after 6 years, your profit is a whopping $118,000. That’s because you now get 75% of the appreciation you created by raising rents. Compare that with $41,000 in Option # 1, and you only had to wait one more year to get it. (BTW, if you were to wait to sell for another 4 years, your share of the profits would be $226,000!).
If you’re buying a value-add apartment building deal with other people’s money and you’d like to eventually own the majority of the building, then giving the investors a preferred rate of return and a minority stake in the venture is the way to go.
Once you’ve refinanced the building at a higher valuation, you’ve returned most or all of the investors’ principal and eliminated the preferred pay out.
The investors’ risk is off the table and you own the majority building. What a great way to build long-term wealth.
Thoughts? Share them below!