Let’s say you’ve just invested in your first real estate syndication. Together with a group of other investors, you acquired a 100-unit apartment building in a promising submarket in a busy metro area. Congratulations!
Well, for one, you can expect to see regular (usually monthly) communications from the sponsor team on the progress of any renovations, status of any maintenance issues, and occupancy stats and trends, along with photos of updates to the property. Each quarter, you can also expect a more detailed financial statement.
It’s like when you sponsor a child in a developing country, and every so often they send you a photo, how tall the child is, and what your child’s favorite subject in school is at the moment.
On top of the regular reports, you can also expect to see regular cash flow distributions (usually quarterly), starting anywhere from the month after closing to several months after closing.
You can count these cash flow distributions as a new stream of passive income. That is, these checks will come in without you having to do anything. Pretty sweet, right?
But, where exactly do those checks come from? An apartment building doesn’t exactly look like an ATM, though there must be some reason these investments are so lucrative. For those of you who are curious, as I am, about where exactly that money comes from, let’s take a closer look.
Every investment property, from a small rental house to a large apartment building, is a business. As a business, the asset generates income, as well as expenses.
For an apartment building, the main source of income are those rental checks that start rolling in on the first of each month. Cha-ching!
There are, of course, other sources of income, but we’ll stick with rental income for the purposes of this illustration.
Let’s say that the 100 units of the apartment building you just acquired rent for $800 each. That means that the gross potential income is $80,000 per month, or $960,000 per year.
Monthly Gross Potential Income
100 units x $800 each = $80,000 per month
Annual Gross Potential Income
$80,000 per month x 12 months = $960,000 per year
But, obviously, you’re not going to get an $960,000 check, as sweet as that would be.
This is, in part, because this is the gross POTENTIAL income. That means that’s the total income assuming all the units were filled, at market rents, with no concessions (e.g., “first month rent is free!”).
When you factor in vacancy costs, loss to lease, and concessions, you get the net rental income. For simplicity’s sake, let’s just factor in vacancy cost and see what happens.
Let’s say that 10% of the units (i.e., 10 units) are vacant. Each of these units rents for $800, so your monthly vacancy cost is $8,000.
Monthly Vacancy Cost
10 units x $800 each = $8,000 vacancy cost per month
Over the course of the year, assuming the vacancy rate stays the same, the annual vacancy cost would be $96,000.
Net Rental Income
$960,000 gross potential income – ($8,000 vacancy cost x 12 months) = $864,000 net rental income
Just like any business, an apartment building has expenses as well.
Operating expenses include things like maintenance and repairs, property management fees, cleaning fees, landscaping, utilities, legal fees, insurance, pest control, payroll, and more.
Just like each business is different, each apartment is different and will require different expenses.
Let’s say that the total projected monthly operating expenses come out to $38,000. Part of the sponsor team and asset manager’s role is to optimize those expenses over time, but for now, let’s factor in $38,000 per month, or $456,000 per year, in operating expenses.
Annual Operating Expenses
$38,000 monthly operating expenses x 12 months = $456,000 annual operating expenses
Once you take out those expenses, you arrive at the net operating income, also known as the NOI.
Net Operating Income (NOI)
$864,000 net rental income – $456,000 operating expenses = $408,000 NOI
Still with me? If yes, high five! If no, this is exactly why you get someone else to do this. 🙂
Of course, we can’t forget that cost that it takes to pay back the lender each month, otherwise they might get snippy and threaten foreclosure. Never good.
Just like when you buy a single family home, when you buy an apartment building, you put down a down payment (usually around 20%), and the lender brings the rest (usually around 80%). As part of your monthly expenses, you would pay the lender back in the form of principal and interest payments.
Let’s say that our principal and interest per month is $20,000. This means our annual mortgage payments would come out to $240,000.
Annual Mortgage Payments
$20,000 monthly mortgage x 12 months = $240,000 annual mortgage payments
Ah, the moment we’ve all been waiting for. Now that we’ve taken the income and subtracted out all the expenses, we get to our cash flow for the first year (aka, cash on cash returns).
Note: I say for the first year, because a number of factors will change in the coming years as the sponsor team continues to optimize and improve the property.
First Year Total Cash Flow
$408,000 NOI – $240,000 mortgage = $168,000 first year total cash flow
This amount is then split up, according to the agreed-upon structure for the deal. Let’s say that this deal uses an 80/20 deal structure. That is to say, 80% of the profits go to the investors (i.e., the limited partners), and 20% go to the sponsor team (i.e., the general partners).
First Year Cash Flow to Investors
$168,000 first year cash flow x 80% = $134,400 first year cash flow to investors
Depending on how much you invested into the project, you would get a share of that cash flow every quarter, in the form of a distribution check.
Let’s say you had invested $100,000 into this deal. Your quarterly cash flow distribution for the first year would be $2,157.
Over the course of that first year, you would have collected roughly $8,628 in passive income from this investment.
Are these guarantees? Of course not.
Apartment buildings are living, breathing entities. Well, sort of. At least, the tenants are living and breathing. As such, there are MANY factors that go into the actual calculations, and these any projections are just that. Projections.
That being said, such projections are a great way to evaluate your potential returns on your investments, and to see exactly where each dollar of your investment is going, and where each dollar of projected cash flow is coming from.