Do you remember the 5-paragraph essay structure from elementary school? Its guidelines for introducing a central idea, providing 3 supporting paragraphs, and closing with a strong conclusion provides freedom and structure at the same time.
Similarly, real estate syndications go through a progression of stages with a clear beginning, middle, and end, which helps individual investors to operate as a cohesive team according to a clear business plan.
Phase #1 – Acquire
The first stage begins with sponsors getting a property under contract. Not only can finding a great property be difficult, but this phase also requires impeccable underwriting skills, solid projection calculations, and negotiation skills to compete with other prospective buyers.
Before making an offer, sponsors work diligently to discover the property’s needs, examine estimated expenses, and develop a business plan. Then when the property is under contract, we refine these elements through the due diligence process. After we’re confident with the research, the deal, and the pro forma, we share the deal with investors like you to gauge interest. Once all investors send in their funds, we then close on the property.
Phase #2 – Renovate
The term “value-add” means exactly what it sounds like; we’re doing work that adds value to the property, which is why renovations typically kick off upon closing. This work is commonly called renovations, rehab, capital improvements, or just CapEx.
In accordance with the business plan, transitions begin in cooperation with the property management team. The rehab work might include renovating vacant units, building new amenities (or improving existing ones), improving the exterior curb appeal, water/power conservation projects, or others.
This phase can last 12 to 24 months or longer, depending largely on the time it takes for tenants’ leases to expire so unit interiors can be renovated.
Exterior and common area renovations may include updating or adding light fixtures, a dog park, covered parking, or landscaping.
Phase #3 – Refinance, Borrow Against Equity, or Sell Early
Since commercial properties are valued according to the income they generate, the whole point of the renovation phase is to fetch rent premiums to increase revenue.
Let’s say the renovations cost on average $5,000 per unit. If the apartment complex has 100 units, that’s a rehab budget of $500,000.
Most tenants will happily pay an additional $100 per month for the opportunity to move into an updated unit, and with 100 units, that’s an additional $120,000 per year in rental income.
At first glance, if you focus on payback period, that might not seem like a good deal. After all, it would take more than 4 years of collecting the additional $120,000 per year rental income to pay back the rehab cost (i.e., $500,000 divided by $120,000).
But wait…that’s where the magic of the cap rate comes in with commercial real estate valuation! At a conservative 6% cap rate, that extra income raises the property value by $2 million in additional equity! That’s undeniably a good deal!
With that additional equity, a sponsor may attempt to refinance, take out a supplemental (second) loan, or – if the market is right – sell the property early. Through a refinance or supplemental loan, you (as an investor) would receive a portion of your initial investment back, while still cash flowing as if the entire amount were still invested.
Let’s pretend you invested $100,000 into a value-add multifamily syndication, and after 18 months, the sponsors refinanced the property and returned 50 percent of your original capital. Here’s where you celebrate, because, this means you got back $50,000, plus you’re still receiving cashflow distributions of 7-10% based on your original $100,000 investment.
Related article: What You Should Know About Cap Rates as a Passive Investor
Phase #4 – Hold
Throughout the hold period, rents increase each year according to the market, thus increasing revenue and contributing toward further steady appreciation of the property. The length of this phase, preferably 5 years or less, is based on the individual property, sponsor, and business plan.
Phase #5 – Sell
At this point, since the property displays completed updates, increased revenues, and appreciation, the best use of investor capital is to sell the property so that they can seek their next investment project. During this phase, sponsors prepare the asset for sale (i.e., disposition).
Sometimes the asset can be sold off-market, creating minimal disruption for tenants. Otherwise, sponsors muster through the whole listing and sale process. Occasionally, if investors agree, a 1031 (like-kind) exchange may be initiated. This allows investors to roll their capital and proceeds into another deal with the same sponsor without being taxed on the capital gains.
Either way, once the sale is complete, you get your original capital back, plus a percentage of the profits. Time to pop open the bubbly!
There you have it! Just like a five-paragraph essay, you have structure and focus within each step. Remember, every deal is different and not all syndications go through all five phases.
As a passive investor, you get to avoid the legwork, but you still want to understand the typical phases of the value-add multifamily syndication process so you’re informed every step of the way.
Further reading: Value-Add Investments: An In-Depth Look