Where do returns Come From on a Real Estate Syndication?
by Christopher Levarek
“Profit isn’t a purpose, it’s a result. To have purpose means the things we do are of real value to others.”
- Simon Sinek
One of the main things I like about real estate is the simplicity behind the business plan. Unlike stock, bonds or ETF’s, I can clearly see where the income or cash flow comes from with real estate. Increase the income generated for the property and the return on investment increases.
Today, I want to share such information and show just how a real estate syndication generates returns for investors. The key is understanding where exactly cash flow comes from and how it is created or increased to go from the property to the investor’s pocket.
Investor Distributions
A good reason for investing into real estate is the desire for passive income. This passive income comes to the investor in the form of cash flow distributions. These distributions themselves come from cash flow on the property, but where does that cash flow come from?
At a high level, a real estate property has income and expenses. Let’s review some key concepts to understanding the income and expenses to see how cash flow then is distributed.
Scheduled Gross Income
This is the overall capability of revenue that can be generated from a real estate property. This income mainly comes from rental income or a tenant’s rent due each month. Let’s break it down in an example property :
Apartment complex with 50 units and a $750 rental rate
50 x $750 = $37500 (monthly income)
$37500 per month * 12 months = $450,000 (annual income)
So this property would generate $450,000 in potential gross income per year. We highlight potential because this would be if all the stars aligned, everyone paid rent and no expenses, discounts or units were vacant.
Effective Gross Income
Ok, now if we factor in the cost of vacancies and delinquencies in lost rent, we arrive at effective gross income. Let’s look at how that might look on this example property.
5 units vacant x $750 lost per unit in rent = $3750 vacancy cost per month
$3750 per month x 12 months = $45,000 lost annually if the vacancy remains constant for 12 months.
So if we subtract the Vacancy cost, we will get the Effective Gross Income.
$450,000 in gross scheduled income - $45,000 in annual vacancy cost = $405,000 in effective gross income or sometimes called Net Rental Income.
*Note : For simplicity we have left out a few other costs to consider such as loss to lease, concessions, delinquencies which also factor into the effective gross income.
Expenses (Operating)
Like any business, real estate property has expenses. These expenses include property management fees, repairs/maintenance, landscaping, legal fees, pest control, marketing, etc. Every business will have varying expenses and so too will every apartment complex. No two will be the same.
If we continue our example from above, let’s consider that the total monthly operating expenses equal around $15,000 or $180,000 per year. To increase income, the management team works to decrease these expenses however, let’s use this figure for our example.
Annual Operating Expenses
$15,000 monthly x 12 months = $180,000 in annual operating expenses
Net Operating Income
The NOI or net operating income is the Effective Gross Income - Total Expenses.
$405,000 effective gross income - $180,000 operating expenses = $225,000 NOI
So all we’ve done at this point is subtract the Expenses from the Income and this gives us this NOI, or Net Operating Income. If this number is positive, this is a good sign! This means the property is cash flow positive and generating income.
We still have one more expense to cover, this is the mortgage or Property Loan.
Mortgage
So this should be fairly familiar concept if you own a home. Like the majority of many properties, apartment complexes will have a mortgage or property loan typically accounting for 60-75% of the purchase.
If we continue with our example, let’s assume that the property has a monthly mortgage payment of $10,000 or $120,000 per year.
Annual Mortgage Payments
$10,000 monthly mortgage x 12 months = $120,000 annual mortgage payments
If we take these mortgage payments and subtract them from the NOI, we arrive at Cash Flow. We’ve made it!
Cash Flow
As the management team of the syndication executes the business plan to decrease expenses and increase rents, cash flow should increase annually however let’s look at year one and what this might look like with the example.
$225,000 Net Operating Income - $120,000 mortgage = $105,000 cash flow in year one
This cash flow is then distributed to partners in the agreed partnership split or arrangement. Let’s assume this project uses a 6% preferred return from cash flow to investors and then a 6% preferred return from sale to investors.
In this case, let’s say investors contributed 1.4 million in total capital to the project. Investors would be given 6% return on the $1.4 million contributed first before the management team, as a this is a preferred return.
$1,400,000 investor capital * 6% preferred return = $84,000 first-year cash flow to investors
This leaves $21,000 in cash flow for the sponsor management team after investor payout.
If you the investor, had invested $100,000 in this deal, you could expect to receive a quarterly check of $1500 or $6,000 annually. Remember, this is only the return from cashflow, so the return from the sale would then be added to equal overall “annual average return” for your investment.
In Final
As you can see, from Income to Expenses to Mortgage to Cashflow, investing in real estate utilizes a highly visible business plan or process that can be mapped out. The income turning to cash flow that is distributed each month or quarter can be clearly tracked from a tenant paying the rent to the check hitting your bank account.
This is a high level overview of this business model and of course variations are found throughout, however the fundamentals are the same each property.
Will all the projections always be 100% accurate? Most definitely not!
Issues will occur, rents will not be paid and expenses will vary per month. It is important to note like any business plan, things might not always go according to plan. Yet, now you have an understanding of how returns are generated on a real estate syndication and what to look for as you review the investment summary or property projections/actuals.
In addition, a good sponsor team should build in reserves and buffers to have a conservative approach allowing for these what if scenarios
For you the passive investor however, knowing what to look for is important to understanding the investment and a great place to start. Invest Smart!