There are a lot of ratios to look at when investing in real estate, and it can get confusing. One of the lesser used but still important ratios is the break-even ratio.
The Break Even Ratio answers the question:
At what occupancy rate am I breaking even?
Good question to know the answer to, right?
Additionally, it allows lenders and other investors to assess the rental property for its ability to meet its operating expenses, debt service, and provide a level of profit.
Break Even Ratio Formula
To calculate the break even ratio, simply take the debt service + operating expenses – any reserves and divide by the gross operating income.
Break Even Ratio Example
Let’s say a given property has an annual debt service of $15,000 and it’s annual operating expenses are $12,000. The total yearly expenses for this property amounts to $27,000.
Now, let’s say this property has a gross income of $33,000 (not to be confused with the net operating income).
Total Expenses / Gross Income = Break Even Ratio
$27,000 / $33,000 = 81.8%
So, you need roughly 82% occupancy to break even and cover your expenses.
Break Even Ratio vs Debt Service Coverage Ratio
The DSCR and BER are clearly related. As you might remember, the debt service coverage ratio is the NOI / Debt service. It is the relationship between the NOI and Debt Service.
The break-even ratio is the relationship between all costs and income.
So, these are very closely related but answer slightly different questions.
The DSCR lets a lender know the borrower’s ability to pay the debt service. So, a DSCR of 1.25 means the borrower net income is 25% more than all of the operating costs (including debt service). They could lose 25% of their NOI and still cover the debt service.
The break even ratio is slightly different. It tells you how much of your gross income you can lose in order to break even.
So, the debt coverage ratio compares net income to the mortgage. Break even ratio compares gross income to total expenses.
When To Use Break Even Ratio
The break even ratio is important for both investors and lenders. It’s used to know what occupancy level you require in order to still cover your bills.
For example, if your break even ratio is 92%, an investor or lender may feel this deal is shaky because of the high occupancy required to keep the building afloat. It’s really common for occupancy levels to drop below 90%, especially during a recession.
On the other hand, if the break-even ratio is 75%, an investor or lender would be far more confident in the deal knowing that during the worst case scenario of a 25% vacancy rate, the property could still cover all of its expenses and obligations.
Additionally, investors may analyze a deal by looking at the break-even occupancy rate both at acquisition and after the building is remodeled and stabilized.
For example, if we are buying a deal with a heavy rehab component, we might expect it is currently underwater or barely breaking even. So, a break even occupancy of 95% or even over 100% would be expected.
We could project out one or two years and look at what the stabilized property would look like, and determine the break even occupancy at that point. Let’s say that in year two, the break even ratio is a much healthier 82%, so we might choose to take this deal.
On the other hand, if we did all this remodeling and work and the break even ratio was 90%, we might reconsider investing in the deal.
Break Even Ratio Rule of Thumb
As a general rule of thumb, lenders will look for a break even ratio of 85% or less. Just like everything else in real estate, this number fluctuates and depends on the lender and property, but a ratio under 85% is good.
This means the total rent collected can drop by 15% and you still can cover all of the bills. That’s pretty good for income producing property.
Analyzing Real Estate Deals
When analyzing your rental property deals, there are a number of metrics you’ll want to use to determine if it’s a good deal.
The next thing you want to look at is the average cash on cash return as well as the overall return on investment over the timeframe of the deal. You’ll want to look at the in-place cash on cash return day 1 and compare it to the cash on cash return once the work is complete and rents are pushed.
You do this because you want to walk into a cash flowing property day one, then add value. It’s a lot harder to buy something that is cash flow negative and turn it around.
This is where you’ll look at the break even ratio to see how the deal performs both day 1 and after it’s stabilized.
Now, you’ll want to look at overall financing and how that affects your returns. This is where the debt coverage ratio comes into play. If the DSCR is too low, you’ll get less loan proceeds which means higher cash out of pocket and lower cash on cash returns.
With all of this information, you can make an informed decision to buy or not to buy.
There are many factors that you should consider. You will note that earlier on, most people used to visit banks in order to get loans that could enable them build or buy a house of their dreams. This used to work well for some people.
However, others used to have a difficult time securing loans. This is because some banks used to charge higher interest rates. This normally discouraged these people. This is the reason why you should consider using a mortgage broker.
What are the advantages of working with this broker? These include:
1. Enable you to Save Money
Would you like to save more money when you are buying a home? You should consider using the services of a mortgage broker. You will realize that this broker can help you compare several home loans from dozens of lenders.
You will not be dealing with one lender only. The good news is that you will be dealing with different lenders. This can help you get a good deal in terms of interest rates and fees.
This can play a major role in helping you save more money.
2. Saves Time
The process of getting a home loan can be very tasking. You have to visit different lenders so that you can compare their interest rates. Sometimes, you might not have all this time. You might end up choosing a lender who charges you more interest.
If you want to save more time, you should consider using the services of this professional. The good news is that this professional will do most of the work for you.
This will include the following activities; liaising with conveyances, real-estate agents, lenders and even settlement agencies.
3. More Peace of Mind
Securing a good mortgage loan can be very hectic. Most people normally struggle to secure these loans successfully. This can make you not to enjoy some peace of mind.
However, the good news is that this professional can help you secure a good loan successfully. You can trust that he will go for the best option out there. This can help you have some peace of mind as you will be doing other activities either at home or at the workplace.
You will realize that this professional will stay in contact with you to check if you have the right mortgage from the right lender.
4. Little Chances of Refusal
There are people who normally apply for a mortgage loan and are denied this loan. This could be due to their credit score, among other factors. This can be detrimental. You are likely to get frustrated.
Some lenders are very strict. However, there are some who are lenient. This is because different lenders normally have different credit policies and restrictions regarding who they will lend to. This is the reason why you should choose this broker to help you out.
This broker will considerably reduce the chances of refusal because he has vast knowledge on lender policies. He will help you settle for a good deal. Thus, an increase the chances of you building or buying your dream home.
5. Professional Advice
You can trust that this professional will help you understand all the mortgage-related information. He or she will help you understand the numerous types of mortgage available out there.
You will note that each of the mortgage types normally has its own parameter and technicalities. This can actually be very confusing to the common man. This mortgage broker will help you sort out all this information and also explain the different types of deals available in the market.
The good news is that this expert will help you narrow down the information to finally choose the mortgage that suits your needs. Sometimes, it is difficult to understand all the legalities that are related to mortgages.
However, this professional will give you professional advice in this field. This can help you avoid certain pitfalls since you will be fully aware of everything that you must know.
6. More Convenient
We all like convenience. The good news is that the professional will work hand-in-hand with home loans and lenders every day of the week. You can trust that this professional will assure you that the entire process will go smoothly and successfully.
7. He Represents you
The good news is that the mortgage broker normally represents you. You can trust that he will work on your behalf and not on behalf of a particular bank.
He will work with different lenders to ensure that you get the best deal out there.
8. You do not have to Pay this Broker Directly
You will realize that you do not have to pay this broker directly for their services. In most cases, they are normally paid by the financial institutions that arranged your mortgage. This makes it ideal to work with this broker.
The mortgage broker normally works for you. He is independent and can help you navigate the often confusing world of mortgages. He or she will work on getting the best deal for you.
This is because dealing directly with the companies can be hard. Some of them might not have the best interest in mind. This is the reason why you should consider using the services of a mortgage broker.
In addition, he or she will help you save more time in the long run. You can carry on with your usual activities either at home or at work as the broker works for you.
You will even manage to save more money. Consider hiring the services of this broker, and you will not regret. The services of this broker are truly incredible.
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At trillions of dollars, it’s no secret that the real estate market has been one of primary resources for the world’s wealthy to pad their accounts.
But contrary to popular opinion, real estate is still a desirable asset class for entrepreneurs with smaller bank accounts. Here are five ways to fund your first real estate investment—even if you’re low on cash.
1. Know Your Numbers
Remember, while property values fluctuate, your rental income is locked into a leasing agreement—and so is your valuation.
That means, as long as the numbers work, the market can do what it wants. Asset-based lenders (B2R Finance is one) lend primarily on the cash flow of the property, rather than personal income like more traditional lenders.
For instance: If you have a lead on a four-family property that’s fully leased and cash-flowing, you can finance up to 80% of the property’s value.
Or translated in layman’s speak: You don’t really need a credit score or a great job to get financing.
Have you ever driven around your city and seen all these apartment complexes, shopping plazas, or even office buildings? I always used to think they were all owned by rich billionaires.
…some of them are, but not all.
The reality is that a lot of these large properties are actually owned by regular people like you and me to generate passive income.
The answer: with real estate syndication.
It’s what I used to recently close a 192 unit deal in San Antonio with my partners.
But what exactly is real estate syndication?
Syndication is a way which multiple real estate investors pool their funds together in order to purchase a property that is more expensive than any of them could have afforded on their own.
Generally, there are two types of partners in these deals: 1) General Partners (GPs) who accept additional risk, put the deal together, and operate the asset 2) Limited Partners (LPs) who have limited risk and invest more passively.
Real estate syndications are an effective way to spread risk. Since each investor can allocate a smaller sum to each deal, they can effectively spread their risk across multiple property types and diversify by geographic region.
Real Estate Syndication Structure
Syndications in real estate are amazingly diverse in their structure so it’s impossible to cover everything. In general, there are four components:
Return of investor capital – Limited partners should always get paid back first, and this ensures they get paid first
The preferred return – Not all deals have a preferred return, but when they do this is where it pays out. Investors get the first portion of the deal before the general partners.
The catch-up – Many deals don’t have a catch-up tier but this is where the sponsor will get 100% of the profits after the preferred return until the predetermined split is met.
Carried interest – profits are split based on the agreed amount (such as 80/20 or 70/30)
Let’s break it down further…
What Is A Preferred Return In A Real Estate Syndicate?
According to Mark Kenney over at ThinkMultifamily, a preferred return is “a return that investors received BEFORE the general partners receive a return.” In essence, after the investors receive their initial capital back, they received a preferred rate of return before the general partners get any payout at all.
Mark, an investor and real estate coach who owns over 2,000 doors in Tennessee, Georgia, and Texas, says that he doesn’t like to use a preferred return but has in the past on deals that didn’t expect any distributions for 12 or 18 months.
The preferred return would accrue and give incentive for people to invest in the deal.
Andrew Campbell, the co-founder of Wildhorn Capital, a multifamily operator based in Austin, Texas has a different opinion. He said he likes to have an 8% preferred return for the majority of his 450 door portfolio.
It “gives some certainty to investors about their overall returns. Plus, 8% also happens to beat the historical stock market return of 7%.”
What Is A Waterfall In A Real Estate Syndication?
The waterfall refers to the overall distribution of funds and tiers that were mentioned above, but it is often referred to as how profits are split after the preferred return is met. Andrew Campbell explains it perfectly:
“Profits generated above any preferred returns are generally split between investors (Limited Partners) and deal sponsors (General Partners). In our case, above the 8% pref we split profits 70% to Limited Partners and 30% to General Partners.
Some deals and sponsors will have additional “waterfalls” where at 18% IRR (for example) the split would go to 50/50. The general idea is that the higher the returns are to investors, the more the sponsors make, and everyone is happy.
The downside of multiple waterfalls is that sponsors can sometimes be incentivized to return investor capital early (to boost the IRR) and trigger these waterfalls.That can sometimes put unnecessary risk on the asset if they are being to aggressive.”
Kenny Wolfe, the founder of Wolfe Investments who has been involved in over $91M in real estate transactions doesn’t like the complexity of the waterfall structure many syndicators use.
“We have steered clear of preferred returns mostly because those are usually accompanied with up-front fees charged to investors. Our investment structures are tied to the performance of the investment, and not just closing deals like the typical preferred return strategy.”
“If we make our investors money, then we’re rewarded. If we don’t then we aren’t rewarded.”
I originally didn’t plan to dive into the fee structure at all, but since Kenny brought up some great points, I think I’ll dive into the fees and how some different structures affect the incentives and performance of deals.
The Fees When Syndicating Real Estate
There are a lot of different types of fees used in syndication. Some are more common than others but all have their pros/cons. Here are the most common ones
I’ve seen this anywhere from 0 to 5 points with 2 being the most common. Acquisition fees in a syndication are really common and most have them, but not all.
Syndicators are running a business and that has costs. Acquisition fees help pay for the operating costs, staff, flights, hotels, diligence, and other costs that are needed to run the business.
On the other hand, acquisition fees can be enormous on large deals and can drive some deal sponsors to be short-sighted and focus on closing deals rather than operating deals profitably.
Think about it, a $10M deal with 2 point acquisition fee is $200,000. That adds up fast! You can see how some sponsors will lose track of buying good deals and focus on just closing deals, regardless of how good they are.
Asset Management Fee
This generally ranges from 1-3% of gross rent revenue. This may or may not go to the deal sponsor and it goes to cover the cost of managing the asset and management team that was hired.
Since the syndicator only gets paid when the asset is cash flowing, there isn’t much incentive to take on difficult projects. That’s where the construction fee comes in. If there is a major rehab project a fee can be imposed to compensate the project manager while the asset isn’t producing income.
It can vary but is often 1-2% of the construction cost.
There are a lot of competing interests in a deal and it’s difficult to align everyone 100% of the time – that’s why trust must be built with anyone that you’re investing with.
But, a few major points to consider are how all the fees and the preferred return and waterfall all fit together.
Deals with high preferred returns and high fees create incentives for the sponsor to find and close deals, but not a lot of incentive to maximize cash flow. As Andrew pointed out, deals with huge benefits to the sponsor at certain levels can cause them to sell early to bump the IRR artificially and trigger that waterfall distribution.
But, deals that compensate the sponsor more will create more incentive to produce high returns.
That’s why there are so many different ways to structure deals! Every sponsor and investor pool is different so they can create deals that work for everyone.
Structuring a Syndication Deal – Example
Similar to how Andrew structures deals, let’s say that in this deal there will be an 8% preferred return, 70/30 split thereafter, and have a 2 point acquisition fee and 2 point asset management fee.
The limited partners will get 70% of the returns after the 8% pref and the sponsor will get the other 30%. The sponsor will get 2 points up front and 2 percent of the gross revenue.
Example 2 – Syndication Structure
Kenny, on the other hand, keeps it simple. He might charge an 80/20 split with no acquisition fee, no waterfall, and no preferred return. The asset management fee is 2% as well in this example.
So, the limited partners get 80% of all the profits and the general partner gets 20%. If it does well everyone does well and if it does poorly everyone does poorly. There are very limited fees except for the asset management fee.
Example 3 – Hybrid Structure
Mark kind of does it a third way. He said he generally does the 80/20 split, but he does charge an acquisition fee and asset management fee but rarely does a preferred return.
The acquisition fee is more similar to Andrew but his split is more similar to Kenny.
It’s interesting to see how 3 different real estate syndicators have three entirely different ways to structure their deals.
How To Find Real Estate Deals to Syndicate?
These are large deals and you don’t typically see them on the MLS, so how exactly do you find deals for a syndication?
Well, three different deal sponsors had three different answers:
“Now that we’re established as a solid buyer we get off-market deals across the US. We look at the on-market deals as well. These days the off-market deals have been much more attractive.”– Kenny Wolfe
Andrew Campbell appears to have a more holistic view for finding deals.
“It’s a full-time job, and it all comes back to relationships. Meeting and networking with brokers, talking to owners, title agents, insurance providers, property managers. Leads can come from anywhere, and in this market, you want to make sure you can see as many properties as possible, and the earlier and more off-market/limited market they are the better.”
Mark Kenney has seemed to be extremely successful working directly with commercial real estate brokers.
“We generally work through brokers to finds deals.”
What About LoopNet for Commercial Real Estate Syndication?
I’ve known about LoopNet for a while, so I was curious about it. Kenney put it simply though:
“Loopnet is far from dead. We do a ton of volume on it and use it almost exclusively for smaller listings.”
How Do You Find Commercial Brokers and Get Them to Take You Seriously?
Commercial brokers are dealing with a lot of big players in the market, and it can be difficult to get them to take you seriously if you are a new player.
Mark pointed out that “a market generally only has a few major names. The top 2 or 3 people have access to virtually all the deals, so you just need to identify them.”
He continued, “it’s not hard to get yourself onto their email list, but it can be more difficult to get people to take your offers seriously. It’s important to have some experience in the field and if you don’t, then partner up with someone who does have the experience.”
In the end, money talks and the highest offer usually wins. So, you can make up for experience with higher offers.
The Cost To Syndicate A Real Estate Deal
Now that we’ve got past the “what is a syndication in real estate” and the “how to syndicate in real estate” part of the article, we can get into the costs and money aspect.
The first logical question is about the cost of a syndication.
There are several major fixed cost items that every syndication requires, including – SEC attorney, earnest money deposit, diligence, private placement memorandum, loan application fees, and more.
So, let’s break them down. As some fees are percentage based, I’m going to create a hypothetical $2,000,000 deal.
Attorney for Contract – $3,000
SEC Attorney for PPM – $12,000
EMD – 1% – $40,000
Diligence – $25-$50 per door – $2,000
Loan Application – 1% – $20,000
Other Financing Costs – 0.5% – 1% – $20,000
Total Costs – $97,000 to get the deal done, of which $40,000 goes toward the purchase.
So the total fixed costs are $57,000 or 2.85% of the total deal price. As you can see, this is not cheap!
The syndicator has to front all the money and if the deal doesn’t close most of that money can be lost. So, you can see one reason why syndicators are compensated pretty well.
How Big Do Syndication Deals Need To Be?
We are talking some pretty big numbers here overall. Realistically though, how big or small does the syndication deal need to be in order for it to make sense?
Universally, all of the deal sponsors wanted to do larger rather than smaller deals. Both Mark and Kenny said they want deals over 80 units which allows for full-time on-site property management. Andrew prefers to look at it as a dollar figure and prefers to do deals over $8 million to keep the fixed costs as a small percent of the total costs.
How Do You Find Investors?
Most people reading this are probably wondering how you can find people to invest so much money. Most people can save up $50-100k, but you are talking about raising hundreds of thousands, or even millions of dollars for a deal. How?
Andrew says it’s a “second full-time job” which comes back to relationships and marketing. He does at least 5 sit-down meetings a week to grow those relationships.
Kenny is so well established that most of his new investors come from referrals though he also does a meetup, podcasts, and general outreach.
Example Syndication Deal
You might be wondering how much a syndicator can actually earn from one of these deals. So, I put together this example based on the knowledge I gained.
Let’s assume we found a property somewhere in Texas with a 6.5% capitalization rate. It’s about 70 units and is selling for $60,000 per unit. That’s $4.2M total.
A 6.5 cap rate means the property has a net operating income of about $273,000 per year before finance costs.
With about $875,000 as a down payment, that’s about $190,000/year in finance costs (I’m rounding).
So the cash flow is about $83,000/year.
Of course some of that goes toward principal, and eventually, the deal will be sold and that will get distributed back to the investors. For now, though, let’s just focus on cash flow and not the entire return.
What The General And Limited Partners Earn In A Syndication
I’m going to keep the numbers super simple so I can do it all in my head. Let’s take the 1% asset management fee out of the gross rents. We don’t have a number for gross rent (only NOI). Let’s say it’s $8,000. If you were the asset manager, great you get to pocket that. If not, someone else does.
The rental income is now $75,000.
Of that cash flow, let’s say the syndicator is doing a 90/10 split and will earn 10%.
And let’s say he also put in about $100,000 into the deal, they would have a total equity of 21.4% and would get about $16,050 in cash flow. That’s about a 16% cash on cash return for the principal (excluding the asset management fee). Don’t forget, they earn the same returns as other LPs on the cash they invest, and then get their split just for doing the deal.
Realistically, this example doesn’t include any growth in value and is a very simple example.
Now You Know The Basics
…and it’s time to download your deal calculator to help you start analyzing your next deal.