Savvy investors know something when applying to refinance an apartment building that you don’t. But we’re going to change that right now. Have you ever wondered how landlords can afford to own entire apartment buildings? What if we told you that the smartest among them do it without spending any of their own money?
It’s true, smart investors can find ways to fund high-level investments without spending their own cash? The guide below may give you the clues to a future where you own most of an apartment building without having to fund the purchase yourself.
Let’s look at this through an example and show you two routes to this success. Using a real-world case study, I’m going to show you how you can own the majority of an apartment building even though your investors will finance the whole thing.
Our Case Study
Let’s say that you have found a 15-unit apartment building available for the modest sum of $550,000. To make this purchase, you raise $250,000 from several investors needed for the initial payment, legal costs, and the inevitable renovations.
Before the purchase, you observed that this was a value-add opportunity, with the option to raise rents to be aligned with the local areas. Raising the rents from $475 per month to the median rental values for the area of $600 means an opportunity to earn an additional $22,500 per year over the previous landlord. This implies a capitalization rate of 8%, the prevailing cap rate in this area.
Clearly, this is an excellent opportunity with a decent return. You estimate it will take 3 years to reach this level of return, as tenants may leave with the rental increase, and new tenants will need to be found.
So, let’s look at the options for how you could structure the deal with your investors. The first is the simplest option, but the second will leave you as the majority owner of the building without necessarily putting any of your funds into the project.
Option 1: Straight Equity Split
The easiest way to structure the deal would be to give your investors the majority of the equity, given that they are funding it. Something like 70% for the investors and 30% to you for putting the deal together and managing the project.
If you all agree to sell the building 5 years later, you receive 30% of the cash flow distributions and 30% of the increase in the property’s value. Based on the values we calculated above, you should be looking at around $50,000 from the rental income, plus 30% of the appreciation, which might run into $20-40,000 more.
Not only is this a great return without putting any of your own money in, but you also don’t risk depreciation of property value, should there be a crash at the time you are selling, as your funds are not involved.
But there is a better option.
Option 2: Preferred Rate of Return
You could consider offering your investors a preferred rate of return rather than a straight equity split.
In this scenario, you would agree to pay the investors a % of their investment amount before any agreed split. So, for example, if you offered the investors for this project an 8% preferred return on investment, you would pay them 8% of the $250,000 they invested, equating to around $20,000 yearly. If your projection of a $22,500 return on the project holds good, you’ll pay the investors their cut, and then the remaining $2,500 would be split based on your agreed equity.
Of course, this generous 8% preferred return rate means that if cash flow goes down, you could be caught short financially.
Investors are generally happy with this arrangement, as it presents a good ROI per year. You may also wish to offer a stake in the equity, for example, 25%, which means that whatever is left over after the preferred rate of return, they get 25%, you keep 75%, either from cash flow or a profit at sale.
The critical risk to be aware of is that if cash flow is lower than the agreed rate, you will still owe those funds to the investors. This means that you may have years where you receive little or no income from the project. Because of this, use the preferred return with caution. It is best used for investments with a lot of cash flow to reduce the risk outlined above.
However, there is one significant advantage of this arrangement: You have 75% of the equity in this deal, remember? While the preferred payout 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.
Of course, the significant advantage of this deal is that you own 75% of the property but have yet to put any money into the project. If you could eliminate the preferred payout, your cash flow would increase. Is there a way to do this?
Eliminating the Preferred Return with a Cash-Out Refinance
Indeed, there is! Instead of selling the property after 5 years, you can a refinance or cash-out refinance the apartment building after 3 years, the period that is in this scenario you would reach the expected level of return. By refinancing, you can return the investors’ principal funding and simply continue holding onto the property.
Because you have returned the capital, you no longer need to pay out the preferred return rate, but you would continue to supply the investors with 25% of the cash flow and profits from the eventual sale, as they would own this part of the property.
This strategy eliminates the risk to investors after 3 years, and they still enjoy 25% of all cash flow distributions and profits, making this a popular option. For you, this option eliminated the preferred rate payout. You do have the refinance to service, but the rate on that compared to the 8% is minimal.
Interestingly, the return for the investor for Option 1 and 2 are very similar. But for you, the difference is startling. Option 1 would provide you with around $40,000 after 5 years without any investment. Meanwhile, option 2 results in a huge $120,000 after 6 years. That’s well worth waiting the extra year. Or hold on for another 4 years to see a profit of around $230,000
Ultimately, the idea of buying a value-add building using the money from investors or through a refinance apartment building program will appeal to many people. Offering a preferred rate return along with a minority stake in the building is an ideal way to get investors on board with the idea.
Your agreement will make it clear that once the investors’ capital is returned, the preferred rate payout ceases. When you refinance, you can eliminate this cost and enjoy the profits for the remainder of your ownership of the property.