by Joe Firmin 3 ½ Minute Read
Are you considering investing in a real estate syndication but are leery that it sounds a little too good to be true? You’re not alone.
Many investors are shocked when they first learn about the potential cash flow returns they could receive through investing passively in real estate syndications.
The key, though, to putting your doubts and skepticism to rest, is to understand where that cash flow comes from and how it makes its way from the asset itself to your pocket, and that’s exactly what we’ll cover right here.
Cash Flow Distributions
Typically, within the first few months after closing, you can expect to start seeing monthly cash flow distributions - your new stream of passive income!
But how is it that these investments are so lucrative? Where does the money really come from? The rest of this post will discuss just that!
Where Cash Flow Comes From
Every investment property, no matter the size or number of tenants, is an asset that generates income as well as expenses. Let’s focus on how apartment complexes generate income, the expenses they typically incur, and how the cash flow (net income) is calculated.
Gross Potential Income
In the case of an apartment building, the main source of income is the residents’ rent that’s due each month.
To illlustrate, let’s say the average monthly rent per unit in a 50-unit building is $800. That means the gross potential income is $40,000 per month, which comes out to $480,000 per year.
Monthly Gross Potential Income
50 units x $800 each = $40,000 per month
Annual Gross Potential Income
$40,000 per month x 12 months = $480,000 per year
Now, don’t get too excited. I hate to break it to you, but that $480,000 is the gross POTENTIAL income for the whole complex and assumes 100% occupancy, full rent payments and no expenses, deals, or discounts (e.g., “first month’s rent free!”). Next let's talk about the NET.
Net Rental Income
Vacancy costs (units not rented), loss to lease, and concessions (free rent, etc) decrease the potential income, and once they are removed, you’re left with something called net rental income.
Assuming only 10% of the units are vacant (i.e., in a 50 apartment complex, only 5 are empty), at $800 a month, the monthly vacancy cost would be $4,000.
5 units vacant x $800 in lost rent per unit = $4,000 vacancy cost per month
If the vacancy rate remains constant throughout the year, the annual vacancy cost would be $48,000.
$4,000 per month x 12 months = $48,000 per year – ouch.
Net Rental Income
Remember, to get the net rental income, we must take the gross potential income (the total income if all units were filled) and subtract out the vacancy cost.
$480,000 annual gross potential income – $48,000 annual vacancy cost = $432,000 annual net rental income
Don’t forget, in a real estate syndication, you are purchasing shares in a business – the apartment community. In every business, there are business expenses.
Operating expenses like utilities, maintenance, repairs, property management, cleaning, landscaping, utilities, legal and bank fees, pest control, etc. have to be paid. No two apartment communities have the same needs or the same expense structure.
Let’s presume that total projected monthly operating expenses equal $19,000, which works out to $228,000 per year. The sponsor team would work toward reducing these expenses over time, but we’ll use this figure as a starting point.
Annual Operating Expenses
$19,000 monthly operating expenses x 12 months = $228,000 annual operating expenses
Net Operating Income (NOI)
NOI or Net Operating Income is what’s left from the net rental income after operating expenses are removed.
$432,000 net rental income – $228,000 operating expenses = $204,000 NOI
If you’re a little confused at this point, don’t sweat – stay with me! There are a lot of numbers here. The important thing to remember is that you want the NOI to be a positive number and as high as possible! This positive number shows that the asset has the potential to generate a profit and thus create those cash flow distributions that got you interested in the first place.
Next, let’s talk about the mortgage. Because all large apartment communities are purchased with lender financing, you’ve got to pay the lender back. Much like in a single-family home purchase, a loan on a commercial multifamily property consists of a down payment and a loan amount – usually around 25% down and 75% leveraged – and the loan would need to be paid back through monthly principal and interest payments.
In this case, let’s say the business owes $10,000 each month (which is $120,000 per year) in mortgage payments.
Annual Mortgage Payments
$10,000 monthly mortgage x 12 months = $120,000 annual mortgage payments
Cash Flow / Cash on Cash Returns
Now that we’ve subtracted the expenses from the income, we arrive at our cash flow for the first year.
Keep in mind that a number of factors can change in subsequent years as the sponsor team optimizes the property and its expenses, so the cash flow figures tend to increase over time, though this is not guaranteed.
First-Year Total Cash Flow
$204,000 NOI – $120,000 mortgage = $84,000 first-year total cash flow
This amount is then split up, according to the agreed-upon structure for the deal. Assuming this deal uses an 80/20 deal structure, 80% of the profits go to the passive investors (i.e., the limited partners), and 20% goes to the sponsor team (i.e., the general partners).
First Year Cash Flow to Investors
$84,000 first-year cash flow x 80% = $67,200 first-year cash flow to the passive investors
Depending on your level of investment (e.g., the $ amount invested / total $ invested by all investors), you would get a share of that cash flow each month, in the form of a distribution check or direct deposit.
Your Monthly Cash Flow Distribution Checks
If you’d invested $50,000 into this deal, you might expect a $375 check each month, which works out to $4,500 for the year.
So, there it is. The cash flow that arrives in your bank account each month originates from the rent that the residents pay. Then, from that rent, we deduct the expenses, pay the mortgage, taxes, and insurance, and what’s left over is then divided and shared with investors.
Is this passive income guaranteed? Absolutely not guaranteed.
Considering all the variables - location, team members, residents, economy, and MUCH more - it’s important to keep in mind that these are, although useful numbers, just estimates. Projections are fun to track but should never be taken as absolute truth.
However, now that you have a better understanding of where the cash flow in a real estate syndication comes from, you should be able to more thoroughly understand and vet the figures you see in a pro forma and investment summary, which will lead you to make wiser investing decisions.
If you’re interested in learning more about becoming a passive real estate investor in real estate syndications, consider joining the Freedom Network. It’s absolutely free to join with no commitment necessary. If you don’t join, we won’t be able to send you opportunities (sorry, SEC rules). So join today!