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  • Writer's pictureJay Chang

Secret To Building Passive Income For Early Retirement

What is your top priority in life?

44% of Millennial say it’s having children. Next, 50% for marriage and 72% for owning a home. But the single highest priority at 80% is being able to retire financially secure. Although retirement is top of mind among Millennial, most don’t really know what it takes to be able to retire early.

Today, I’d like to share with you one secret to early retirement and wealth accumulation that few people ever speak about, and that’s building passive income through investments in an apartment value-add syndication.

Investing in a syndication as a passive investor typically doubles your investment in 5 to 6 years. Additionally, it’s a method that requires relatively little work. Lastly, the money you earn can earn special tax benefits, such as depreciation, capital gain tax, 1031-exchange, capital expenditure, and interest expense.

In this article, I’ll explain exactly what an apartment value-add syndication is, how to invest in it, and why it's a better option than purchasing a home.

Apartment Value-Add Syndication

An apartment value-add is the act of buying and renovating an old apartment to increase its occupancy and rental income. The rent you increase can vary from $50 to $500. For a 100-unit complex, the revenue can increase by as much as $50,000.

The amazing thing is that this additional revenue, assuming no additional expense, will increase your net operating income (NOI), allowing you to sell the apartment at a much higher price. The increase in selling price can be 10 to 20 times the increase in NOI, so a $50,000 increase in revenue can increase the selling price by as much as $1,000,000!

However, not all markets are priced the same. A hot market, like Los Angeles, typically has a higher selling price relative to a less popular city, like Tucson, for the same NOI.

Now that we’ve covered what an apartment value-add is and how it generates money, let’s talk about what a syndication is. A syndication is a group of investors that raises equity and collaborates to execute a value-add deal. It involves two main parties, one called the general partner (GP) and the other called the limited partner (LP).

A typical GP consists of 1 to 4 people or LLCs, and a typical LP ranges from 5 to 50 people. The GP will source the deal, analyze it, create and execute a business plan, manage the apartment, and sell it based on the timing of the market… hopefully for a handsome profit.

This process typically takes 4 to 6 years. The LP’s responsibility is to find a trusted GP that knows what he or she is doing and has a successful track record. The LP should also understand the market condition of the property's location. A general rule of thumb for selecting a market is to identify areas with high population and employment growth.

Let’s dive into an example of an apartment syndication deal in Tucson, AZ that I recently invested in and that’s projected to earn 15% IRR (Figure 1), a much more profitable return than that from buying a home.

Return on Investment

For this particular deal, the preferred return was 6% with 80-20 split – this means that the GP promised me (the LP) at least 6% annual return. If the property doesn’t generate enough cash flow to meet the 6% return, then the missing cash flow carries interest into the next year. It’s possible for an LP to earn low returns throughout this project and then receive a large payout at the end when the building is sold. The 80-20 split means that the LP will get 80% of the cash distribution that exceeds the 6% preferred return, and the GP will receive the remaining 20%.

Figure 1. Projected Return for a LP in an Apartment Value-Add Syndication

Figure 1, the projected return for this syndication, shows an Equity Multiple of 1.9x, which means that I can expect to almost double my investment in a span of 5 years. An IRR of 15.2% means that I will be earning an average of 15.2% annual return. The return gets better year-over-year as the units get renovated; however, it dips in Year 4 because the loan for the first 3 years is interest only and the principal payments start in Year 4.

Additionally, the 15.2% annual return here is far greater than a 15.2% return through stocks due to the tax benefits in real estate – perhaps even greater than a 20% annual return in stocks.

Lastly, let’s look at the return for a 3-bd house in Los Angeles, California. Here are the assumptions for the house:

1. Purchase Price: $639,000

2. 20% Down Payment or $127,800

3. $3,000 Closing Cost at Year 0

4. Interest Rate of 4.25%

5. Monthly Rent: $1,000/bd (For All 3 Bedrooms)

6. 40% Expense Ratio

Figure 2. Projected Return for a 3-BD House

This 3-bd house investment will earn you 10.5% IRR but negative cash flow in Year 1-4. The negative cash flow is due to operating expenses and monthly mortgage. Note that I am accounting rental income for all 3 bedrooms.

10.5% IRR is not a bad return, but the negative cash flow makes buying a house in LA a risky investment because its return is mainly based on market appreciation. During a market downturn, an apartment value-add deal with positive cash flow is much more sustainable than a house with negative cash flow.

However, a house in a less expensive area may generate positive cash flow. A cost-efficient strategy some homeowners use is buying a duplex or triplex with 6 to 9 total bedrooms and renting them out. Generating positive cash flow with this strategy is almost impossible in hot markets like Los Angeles and SF, where houses are very expensive.

Finally, I want to point out that REITs neither generate the same return as those of apartment value-add syndications nor give you the same tax treatments. REITs typically generate about 8%-10% return but do not offer you any tax benefits, such as depreciation, capital gain, capital expenditure, interest expense, and 1031-exchange. 

If you are interested in learning more about building wealth through passive investments in real estate, feel free to subscribe to my website or listen to this great real estate podcast "Passive Income through Multifamily Real Estate" on Apple Podcast.

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