Passive investing in real estate syndications is an excellent way to build wealth without the headaches of being a landlord. For busy professionals, this could be a better option than flipping a house as a side hustle or managing your own rental portfolio on nights and weekends. To be successful at passive investing, savvy investors need to determine what they want (and don’t want) to see in a deal.
Recently, I interviewed Lee Johnson who has invested in 21 real estate syndications. He has worked with multiple groups and has some hits and misses in his portfolio. We talked about what he’s learned and what he looks for in a multifamily syndication deal. What stood out are the three must-haves for his investments: market growth, a preferred return, and a solid debt service coverage ratio.
Every real estate professional has heard that location is the #1 rule of real estate. And while location is critical, many people simply focus on population growth and miss the real key factors that indicate success for a multifamily investor.
When I launched Target Market Insights, the show’s focus was to uncover insights to help investors find the best places to invest. Population growth is one key metric to review, but there are other factors to determine when selecting a market. Along with the population, pay attention to increases in jobs and rent. Job growth and rent growth indicate a healthy market with strong demand, factors that bode well for real estate investors.
It’s worth noting that these metrics can only provide a look back, not necessarily the picture moving forward. Therefore, it’s important to understand the underlying factors driving a market to determine if the trends are likely to continue.
A preferred return is a return hurdle that must be met before general partners participate in profits. This provides an incentive for the general partners to deliver on returns, otherwise, they will not make a profit. Typically, these range from 6% to 12%, with a 7% or 8% preferred return being most common.
A preferred return is not a guarantee. It is also not the return amount you should expect annually. It is simply the hurdle that must be met before the GPs get their share of the equity. Every deal does not have a preferred return and in these cases, returns are split based on the equity percent. With a preferred return, investors get paid first, and the GP team profits only after crossing the hurdle.
Debt service coverage ratio is a common metric that lenders use to measure the income remaining to cover the loan after accounting for expenses. Typically, banks want to see a 1.2 or 1.25 DSCR, meaning that the net operating income (NOI) is 1.2 times the debt service. The higher the DSCR, the more cash there is available to cover the loan payments. A lower DSCR indicates the property may struggle to cover the mortgage.
For distressed properties or heavy value-add deals, a lower DSCR is expected. These properties will not usually qualify for traditional loans as lenders see these as higher risk. With greater risk typically comes greater upside, so it’s not a reason to disqualify a deal just yet. You simply want to understand these risks, how they are being mitigated, and that the reward justifies the additional risk.
.Understanding where there is risk in an investment is the first step to determining if a deal is right for you. Paying attention to market dynamics, along with the deal structure and in-place cash flow are great places to start. Be sure to talk to potential partners to understand their investment philosophy and make sure it aligns with your investing goals. Whether you have done 20+ deals or you are looking for your first, developing criteria for investing will enable you to make sound investments and stay in control, even as a passive investor.
About the Author: John Casmon has helped families invest passively in over $90 million worth of apartments. He is also the host of the #1 rated multifamily podcast, Target Market Insights: Multifamily + Marketing. Prior to multifamily, John was a marketing executive overseeing campaigns for Buick, Nike, Coors Light, and Mtn Dew: casmoncapital.com