Cash Flow in a Real Estate Syndication — Where Does it Come From?

Are you considering investing in real estate syndications but think it sounds a little too good to be true? If so, you’re not alone.

Many investors are shocked when they first learn about the potential cash returns they could receive through investing passively in real estate syndications.

The key to clearing up your doubts is to understand where the cash flow comes from and how it makes its way into your pocket. That’s exactly what we’ll cover in this article.

Cash Flow Distributions

Within the first few months after closing on an apartment building, you can typically expect to start seeing monthly cash flow distributions – your new stream of passive income!

But how are these investments so lucrative? Where does the money really come from?  

Where Cash Flow Comes From

Every investment property, regardless of size, is an asset that generates income as well as expenses. Let’s take a look at how apartment complexes generate income, the expenses they typically incur, and how the cash flow is calculated.

Referring to the graphic below may help. If you’re familiar with a profit and loss (P&L) statement, also called an income statement, it will look familiar to you!

Gross Potential Rent

Annual Gross Potential Rent

$80,000 per month x 12 months = $960,000 per year

Now, before you get too excited, understand that $960,000 is the gross POTENTIAL rent for the whole complex, assuming 0% vacancy and full rent payments, all at
the maximum rates, with no concessions (i.e., discounts, such as “first month’s
rent free!”).

Net Rental Income

Vacancy costs, loss to lease, concessions, and bad debt decrease the potential income (i.e., the Gross Potential Rent). Once these items are removed, you’re left with the Net Rental Income​ – the income you actually collect.​  The total sum of these items that are subtracted from the Gross Potential Rent are sometimes referred to as “economic vacancy.” Let’s look at the most common losses from the Gross Potential Rent – vacancy and loss to lease.

Vacancy Cost

Assuming only 7% of the units are vacant (i.e., in a 100-unit apartment complex, only 7 are empty), at $800 a month, the monthly vacancy cost would be $5,600.

7 vacant units x $800 in lost rent per unit = $5,600 vacancy cost per month

If the vacancy rate remains constant throughout the year, the annual vacancy cost would be $67,200.

$5,600 per month x 12 months = $67,200 per year

Loss to Lease

Earlier we said the market rent in this theoretical apartment complex – the amount you’re targeting for new leases – is $800 a month. However, just because that’s the market rent doesn’t mean that’s what everyone is paying.

There may be long-time tenants whose rent was raised over the years, but not as much as the rent for new leases raised. And maybe about 9 months ago, the market rent was $780 a month, so you still have tenants paying that lower amount. These differences are the loss to lease.

Regardless, you’ll almost always have some amount of loss to lease. In this example, just to keep things simple, we’ll say the loss to lease is constant through the year at $2,400 a month, or $28,800 for the year.

Net Rental Income

Remember, to get the net rental income, we must take the gross potential rent (the total income if all units were filled) and subtract out the economic vacancy – the vacancy cost, loss to lease, and any other losses.

$960,000 annual Gross Potential Rent – $67,200 annual vacancy cost – $28,800 loss to lease = $864,000 annual Net Rental Income

Total Income

Besides the rental income, apartment complexes usually also collect income for various things like preferred parking, utilities reimbursements, laundry facility income, and vending machines – these are collectively referred to as “Other Income.” The complex’s Total Income equals the Net Rental Income plus the Other Income. To make our example simple, we’re going to pretend there is no Other Income so the Total Income is the same as the Net Rental Income.

$864,000 annual Net Rental Income + $0 annual Other Income = $864,000 annual Total Income

Operating Expenses

Of course, the business has expenses, too.

Operating expenses like repairs and maintenance, marketing, property management, landscape maintenance, utilities, property taxes, insurance, legal and bank fees, etc. have to be paid. No two apartment complexes have the exact same needs or expense structure.

Let’s presume that the total projected monthly operating expenses equal $32,000, which works out to $384,000 per year. The sponsor team and property manager would work toward reducing these expenses over time, but this works as a starting point.

$32,000 monthly operating expenses x 12 months = $384,000 annual operating expenses

Net Operating Income (NOI)

Net Operating Income (NOI) is what’s left from the total income after the operating expenses are removed.

$864,000 Total Income – $384,000 operating expenses = $480,000 NOI

If you’re a little confused at this point, that’s alright! There are a lot of numbers here. The important thing to remember is that you want the NOI to be as high as possible, meaning that the asset has the potential to generate a profit and create those cash flow distributions that got you into this in the first place.

Mortgage

Next, let’s talk about the mortgage. Much like in a single-family home purchase, the purchase price on a commercial property consists of a down payment and a loan – usually around 25% down and 75% loan – and the loan would need to be paid back through monthly principal and interest payments.

In this case, let’s say the group owes $22,000 each month (which is $264,000 per year) in mortgage payments.

$22,000 monthly mortgage x 12 months = $264,000 annual mortgage payments

Cash Flow

Now that we’ve subtracted the expenses from the income, we arrive at our cash flow for the first year. 

Keep in mind that a number of factors can change in subsequent years as the sponsor team optimizes the property and its expenses, so the cash flow figures tend to increase over time, though this is not guaranteed.

First-Year Total Cash Flow

$480,000 NOI – $264,000 mortgage = $216,000 first-year total cash flow

This amount is then distributed according to the agreed-upon structure for the deal. If the deal uses an 80/20 “straight split” deal structure, 80% of the profits go to the passive investors (i.e., the limited partners), and 20% goes to the sponsor team (i.e., the general partners).

First Year Cash Flow to Investors

$216,000 first-year cash flow x 80% = $172,800 first-year cash flow to investors

Depending on your level of investment, you would get a share of that cash flow, each quarter or month, in the form of a distribution check or direct deposit. Mailbox money!

Your Monthly Cash Distribution Checks

If you’d invested $100,000 into this deal, you might expect a $666.67 check each month or a $2,000 check each quarter, which works out to $8,000 for the year. 

Related article: Exploring Projected Returns in a Real Estate Syndication

Recap

So there you have it. The passive income that arrives in your bank account each month originates from the rent the tenants pay. Then we pay the operating expenses and mortgage, and what’s left over is then divided and distributed to the investors.

Is this passive income guaranteed? Absolutely not!

Considering all the variables – the location, team members, tenants, the economy, and a whole lot more – it’s important to keep in mind that the projections are only estimates, although useful ones. They’re fun to track, but should never be taken as absolute truth.

Now that you have a better understanding of where the cash flow in a real estate syndication comes from, you should be able to more thoroughly understand and vet the figures you see in the pro forma and investment summary, which will lead you to make wiser investing decisions.

Further reading: Your First Real Estate Syndication: A Simple 5-Step Process