Most investment professionals will tell investors it’s important to diversify. Many investors have almost all of their portfolio in stocks, so they take that to mean diversify stock holdings. Yet, the most prudent investors diversify across asset classes. This strategy can provide even more risk-adjustment. For example, an investor may hold certain portions in stocks, cash, bonds, and hard assets like real estate. To that end, apartment syndications offer a very attractive opportunity to diversify a portion of one’s portfolio. Here’s 6 benefits of doing so:

Asset Appreciation:

Over time, well-managed apartment properties appreciate in value. Strategic improvements to the property, such as renovations or upgrades, can lead to increased rental rates and higher property values. Additionally, appreciation can be driven by market factors like job growth, population growth, and economic development in the surrounding area. As an investor in an apartment syndication, you can benefit from this potential appreciation when the property is eventually sold.

Inflation Hedge:

Real estate, in general, has long been considered a hedge against inflation. As the cost of living rises, so do rental rates, allowing apartment syndication investors to maintain their purchasing power. This means that investing in apartment syndications can offer protection against the eroding effects of inflation on your investment portfolio.

Tax Benefits:

Investing in apartment syndications comes with several tax advantages. Depreciation is one such benefit, allowing investors to offset their passive income with a non-cash expense, potentially reducing their overall tax liability. These tax benefits can significantly enhance the after-tax returns for investors.

Economies of Scale:

Larger apartment communities benefit from economies of scale, which can result in more efficient property management and cost savings. For instance, maintenance costs, property management fees, and marketing expenses are often lower on a per-unit basis for larger properties compared to smaller ones. These cost efficiencies can directly contribute to higher net operating income and, subsequently, better returns for investors.

Lower Volatility:

Compared to stocks and other traditional investments, apartment properties tend to exhibit lower volatility. The demand for rental housing remains relatively stable, even during economic downturns, as people will always need a place to live. This stability can provide a cushion to your portfolio during turbulent market conditions, reducing the overall risk profile of your investments.

Professional Management:

When you invest in an apartment syndication, you’re essentially partnering with experienced real estate professionals who are responsible for managing the property. These asset and property managers have the skills and expertise to identify, acquire, and operate apartment communities, allowing you to benefit from their knowledge without having to take on the day-to-day responsibilities of property management.

In conclusion, apartment syndications present a compelling opportunity for investors looking to diversify their investment portfolios. With benefits like portfolio diversification, asset appreciation, inflation hedging, tax advantages, economies of scale, lower volatility, and professional management, it’s easy to see why apartment syndications are an attractive option for savvy investors. As with any investment, it’s essential to conduct thorough due diligence and ensure that apartment syndications align with your overall investment goals and risk tolerance.

If you’re thinking about investing in an apartment syndication, one question you may have is whether or not you can withdraw all or a portion of your money after you’ve invested. 

At New Sight Capital, we’ve made it our mission to educate prospective investors about all the mechanics of syndications before those investors join syndications.  And this is a really important question. Redemption is the term given to the process of an investor giving their shares back to the syndicator in return for their investment funds.   The investor is “redeeming” their shares for the cash they used to purchase those shares.

Most apartment syndications do not allow for redemptions.  

Apartment syndications, by their nature, are illiquid investments.  Investors put their capital into the deal in exchange for shares in the asset ownership and those shares cannot be liquidated by the investors prior to the syndicator selling the property.   

Is redemption spelled out to investors ahead of time? 

Yes!  Whether or not an investment offering allows for redemption of shares must legally be presented to investors prior to investing funds.  In apartment syndications, the disclosure of the redemption policy is detailed in the PPM (Personal Placement Memorandum) and SA (Subscription Agreement) documents.   Investors must review and sign these documents in order to invest in apartment syndications, and we encourage every investor to fully read and understand these important documents.

Why don’t apartment syndications allow for redemption?  

There’s really two answers for this question. First, syndications are long-term investments.  Often, it takes the syndication anywhere from 3-6 years to achieve its business model and return objectives.  As such, investor funds are needed for that duration.  The second reason has to do with liquidity and dilution of investor returns.   Apartments are businesses that have liquidity demands.  They need capital to remain in business and execute their objectives.  If the syndications allowed for investors to redeem their shares it would require the syndications to keep considerable amounts of capital in reserves to compensate investors’ redemptions.   And, those reserves would have to be raised ahead of time from investors.   Basically, it would almost double the amount of investor capital needed to be raised which would dilute shareholder equity which would greatly reduce or eliminate investor returns.

Are there exceptions? 

Yes.   Although PPM and SA documents do not allow for share redemptions they may allow for transfer of shares to another entity.  In essence, this could allow an investor to sell their shares to another investor.  In our experience, we have found this to be a difficult undertaking but it may be possible.   The degree of permissibility would depend on the exact rules and restrictions outlined in the syndication documents.

All of this is why we only allow investors to invest in our apartment syndications if they know and realize these are long-term, illiquid investments.   We believe in the returns, value of the asset class, tax advantages, and capital growth of these investments, but investors should understand ahead of time they are in it for the long haul.

As always, we are here to answer questions around this and other apartment investing topics.  Feel free to reach out to russ@newsightcapital.com. And if you’ve not already registered with us, please do so by clicking here and we’ll send you our “Apartment Syndications for Doctors” investment guide and video.

Property and liability insurance is a necessary expense.  Recently, the costs of coverage premiums has become a topic of conversation among asset managers within the world of apartment investing.   The question begs to be asked:  are insurance premiums a real threat to NOI or just a terrifying figment of the imagination?

Before we dive in, let’s clarify that there are many reasons to have property and liability coverage on large multifamily investments.   Apartment complexes are large, valuable assets that are funded by both a lender and investors.   There’s a lot to lose for all parties involved.   Having protection against loss of property and income in case of natural or other disasters is a key component of risk protection.  In addition to risk protection, lenders will require there be a certain amount of property and liability protection to ensure full coverage of replacement value, as well as loss of income that could occur from damage to the property.  Usually, the lender has the final say in what minimum coverage looks like.

Insurance premiums are a line item in every pro forma modeling of an apartment syndication.  We often obtain several quotes based on the desired or required levels of coverage and that cost is incorporated into our underwriting model before we even make an offer on a property.  Historically, those cost projections for premiums have been fairly reliable and stable.   That is, until recently.

In the last 6 months or so, there has been unexpected, dramatic shifts in the cost of required insurance coverage.   The cost increases are much more dramatic in select markets, but costs are rising essentially throughout all multifamily markets in a way that is affecting apartment syndications.   This is occurring to the extent that these costs are now a new, unpredicted headwind for many apartment investment operators.

Background on Increasing Insurance Costs

Insurance carriers underwrite their coverage based on their risk exposure while also ensuring profit margins for themselves.   And the cost associated with covering both of these aspects has risen due to several compounding factors.

First, the position of the insurance carriers is that there has been an increase in the frequency and severity of natural disasters.  Some markets obviously are experiencing the higher end of the disaster cycles than other markets.   We can look at the contrasts in severity of disasters on the Florida west coast vs the lack of severity in an inland market, like Atlanta.    But, the fact that even Atlanta is seeing significant increases in coverage costs is a clear indication this argument doesn’t tell all of the story.

Another factor in the rising costs of coverage could also be attributed to the volume of litigations associated with those involved in the claims process.  Whether it be the costs associated with litigating these cases or the payout of damages associated with the litigations, there’s no doubt that insurance carriers carry more cost risks on their end.  To what degree these claims are genuine vs fraudulent may not matter,  as the costs always get passed along to the customer (apartment syndicator operators).

A third factor in rising insurance coverage costs is inflation.  There’s no doubt the cost of most items related to replacement and repairs is higher than it was 1-2 years ago.  Even when inflation starts to cool, there are continued risks of price increases on items that insurances would need to cover in the event of losses.  Again, these are passed along to the customer in the end.

Finally, some insurance carriers are leaving certain markets altogether.   In their mind, the risk exposure to their profit margins are too great to continue to operate in certain areas of the country.   Carriers may also feel uncomfortable with certain state or local regulations pertaining to their operation of coverage.  Either way, this means there is less competition among carriers in the select markets.   With less competition, we have seen prices increase because the carriers understand operators have very few choices for carriers. 

Public Policy vs Insurance Industry

The impact of costly premium increases is not confined to just large multifamily assets.  In fact, these increases are being felt by many business and property owners–especially in select markets.  If there is an upside to that it is that politicians and local and state government officials are aware of this impact.   There are proposals and legislative agendas in key markets, such as Florida, that could help alleviate the cost burden.  This would be through clarifying regulations, increasing competition, and making it more favorable for carriers to operate in those markets.  However, the implementation and impact of such agendas could still be at least a year away.

Real-world Impact for Apartment Investors

While this is not a fatal threat to most apartment syndication investors, it is absolutely a significant headwind.   In less affected markets, these insurance premium increases can be 10 to 30%.  However, in more exposed coastal markets, the increases can be multifactorial  (2-3x).   That is a very significant line item impact.

There is opportunity to pass along some of these costs to renters.  However, most apartment syndications have already built into their underwriting a pro forma model of rent increases.  These increases are the foundation for NOI growth and returning value to investors.   Is there room for even more growth to absorb the increased costs of insurance premiums?   Perhaps, in some assets in key markets that were bought with ample enough room for rent growth.   However, many markets will simply not be able to absorb these costs into rents—especially the markets that are seeing more dramatic increases in premium costs.

What then?  The simplest answer is that NOI will take a hit.  It would be disingenuous for any apartment syndication operator to say there is no risk for decreased NOI from these shifts in costs.   The question of how much impact is felt on investor value will vary from asset to asset.

Efforts to Mitigate Impact Insurance Costs

While this is a significant headwind, operators are already engaging every option they can to mitigate the impact of coverage increases on investors in these assets.

In some assets in select markets, again, passing along some of these insurance costs to renters may provide partial relief.  However, this alone will not mitigate all the exposure—and certainly less so in the more affected parts of the country.

The second mitigation avenue is cost containment or reduction elsewhere on the P&L.  Operators will need to get more creative about where they can conserve costs elsewhere.  This could mean bringing certain tasks in-house or outsourcing depending on the benefits of each.  Many costs are fixed, so the relief will be limited and dependent on each situation.

Lastly, there has already been a movement to property managers that offer a master coverage policy.   Some property managers are large enough to leverage their scale to obtain a master policy.   Operators can migrate a property to one of these property managers and be covered under their master policy.   Significant savings could then be realized compared to the cost of coverage outside of these arrangements.  However, even then, year over year premium increases can still be in excess of 20-30%.

One final word for investors in apartment syndications. 

Yes, this is an unexpected headwind that has not been previously experienced to this degree in this asset class.   Yes, it is a head wind for NOI growth.  Could this affect an operator’s ability to deliver distributions to investors?  Yes—especially if the operator is prudent enough to enter into cash preservation mode to protect against future risk.   However, we would encourage investors to appreciate the long term nature of these investments.

Most investors understand apartment syndications are 5 to 6 year investments.   These are not short term opportunities.  This allows these investments to weather short term headwinds and still deliver returns for investors on the other side.  I also think it’s important for investors to invest in opportunities that have preferred returns that accrue for investors.   This ensures that, if your operator does not pay you to the annual preferred return, any shortfall is accrued and must be paid to you before the operator can share in free cash flow.   This puts investors interests first and provides additional protection among the current headwinds.

If you are investing in apartment syndications, it’s critical that you fully understand the term preferred return.  In this article, we’ll be defining this term and giving you 7 things to know about this very important structural preference for investors in apartment syndications.

First, let’s define an apartment syndication as the collective pooling of capital from “smaller” investors to acquire and operate a large multifamily property for the purpose of paying returns to general and limited partners.   Investors are referred to as limited partners, which are passive, liability-shielded participants.  General partners are the individuals with the active role in the syndication.

The preferred return is the annual payout target to each investor, expressed as a percentage of the investment.   For example, if an offering is structured with a 6% preferred return, then the target yearly cash distribution would be 6% of the amount the investor originally invested in the offering.   For a $100k investment, this would target a $6k cash distribution to that investor.

Here’s 7 things investors should know about preferred returns:

1. Prioritizes the investor ahead of the general partners

This is the most crucial thing to know, and it’s why we advise investors to only invest in deals that have a preferred return.  That’s because it gives “preference” to the investor (limited partner) over the individual(s) operating the offering (general partners).  In essence, it creates a waterfall on how operational cash flow is treated.   When there is ample, positive cash flow from the property, the syndication must pay investors the preferred return first.  Only once the syndication pays to this target can it then start to split operational profit to the general partners along the equity split.

For example, let’s take a syndication that has a 6% preferred return and a 70/30 equity split.   The general partners cannot be paid from operational cash flow until the first pay investors to the 6% annual threshold.  Then, if there is remaining cash flow it follows the waterfall and is split 70% to investors and 30% to the general partners.  This truly ensures investors are put first, but it also incentivizes the general partners to perform well for their investors in order for them to be compensated.

2. Not a guaranteed annual yield

Notice how our definition is with respect to coming from “ample” cash flow?  A preferred return is not part of operational expenses.  Rather it is paid when there is significant enough cash flow after all expenses.   That’s important because investors can get confused and think preferred returns are the same as the annual yield on a CD or government bonds.  Those fixed return investments must pay their annual yields—no questions asked.  

But, that’s not the same as a preferred return in apartment syndications.  It’s best to think of it as a contractually-obligated “we owe you X before we pay ourselves.”   When the cash flow is ample enough, the preferred return is paid.  But, in the event cash flow is not adequate (or some other hurdles exist), the preferred is not paid in full.

A side note to this conversation is that while bonds and CDs provide guaranteed, fixed income, they do not have the tax benefits associated with distributions from apartment syndications.

3. Accrues when not paid in full

Having worked with hundreds of investors, we have seen this aspect overlooked by more than a few investors.  Considering we often are personally invested alongside our investors, we can understand the frustration when a syndication does not pay its full preferred return.  Yet, the key thing is that any shortfall on a yearly basis is accrued and added to the subsequent year’s preferred return.

For example, let’s say a syndication paid a 5% return but had a 7% preferred return.  That syndication still owes the investor 2% and its accrued.  The following year, the accrued preferred return is now 9%.   And so on and so forth.

This continues to put the investors first because the general partners are still not being paid from profits until the preferred return is met—that includes any accrued return.  

4. There can be hurdles beyond cash flow 

We defined the preferred return above with respect to payouts from ample operational cash flow.  There’s some added nuance to this definition that we have encountered and believe investors should know.  And, it has to do with the largest investor in every property:  the lender.

The reality is the largest and most-prioritized investor in any property is the lender.  They won’t contribute acquisition funds (debt) unless they are guaranteed a certain % return (interest) and given first preference in payout (mortgage payment).   In order for lenders to be successful in not losing money, they can make rules the borrower must follow that further stabilize their ability to get paid.

Translation:  the lender can contractually prevent investor distributions in some situations even if there is positive cash flow from the property.   For example, the lender may require a threshold of positive cash flow be met before paying distributions.  Or, they may require a certain debt-service-coverage-ratio.  Lenders can also require a certain amount of the capital expenditure budget be executed for property improvements before distributions can be paid.  Or, they can require certain interest or operational cash reserves be funded before distributions.

Some lenders are less restrictive than others.  In reality, each situation is unique but the point is sometimes the payout of a preferred return is affected by more than just having ample cash flow.  Yet, the protection for investors, again, is that the preferred return accrues if one of these hurdles affect payout of distributions.

5. Not the same as “Cash-on-Cash Return”

As with most things, terms that are meant to clarify can often lead to more confusion.  One of the biggest confusions is equating a preferred return with cash-on-cash return.   The preferred return is the contractual obligation to pay investors before general partners are paid.  Whereas the cash-on-cash return is the actual payout of distributions.   The cash-on-cash return can be lower or higher than the preferred return.

Most investors first encounter cash-on-cash return as a projection within an investment offering.  When general partners create an offering to investors, they will present projected returns such as total return, IRR, average annual return, and cash-on-cash return.   Really, what the term is referring to is what the general partners are projecting to be the actual distributions paid to investors as a percentage of their initial investment.  Often, the cash-on-cash is projected on a year-by-year basis in the investment offering’s pro forma return model.

It’s not uncommon for the cash-on-cash return to be lower than the preferred return during the initial years of a syndication.  For example, a syndication may have a 7% preferred return but its pro forma return model may project a 4% cash-on-cash (actual distributions) in year 1 and a 10% cash-on-cash in year 2.  If that came to fruition in year 1, it would mean that 3% of the preferred return carried over into year 2 but that the syndication was able to meet and exceed the accrued preferred return.

That can sound a little confusing but think of cash-on-cash as actual distributions—and if cash-on-cash is lower than the preferred return in any one year, the deficit is accrued onto the following year’s preferred return target for investors.

6. Will vary from deal to deal

There is a range of preferred return percentages that investors will encounter as they review apartment syndication offerings.  A very common range is 5 to 8%, but it will vary.   7% and 8% were very common preferred returns in recent years.  However, as rising interest rates and reduced leverage from lenders impacts underwriting of cash flow, it will be increasingly common for investors to see preferred returns in the 5 – 6% range.

7. Doesn’t Reflect Total Return

While we think investors should only invest in apartment syndications that have a preferred return, it’s not reflective of total return for investors.  Yes, the preferred return is focussed around prioritizing the passive income aspects of these investments.  However, apartment syndications’ greater return is truly found in equity growth.  

When we look at the life-cycle of most apartment syndications we find 3 stages:  asset improvement (physical/operational), growth on NOI, and sale of the asset at higher value due to the NOI growth.   Apartment properties are essentially valued like businesses.   Valuations go higher as profit goes higher.   As the general partners work to increase NOI, the investors will experience equity growth which will be realized as profit from the eventual sale of the asset.   It’s this total return over the lifecycle of a syndication that we believe investors should consider—in addition to the very important aspects of a preferred return.

In closing, we highly encourage you to consider apartment syndication offerings that clearly put investors first by way of the preferred return structure.  There’s many aspects of this structure to consider when investing but we also encourage investors to consider them among the greater context of these offerings.

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