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Real Estate Investing

Break Even Ratio, Explained

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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.

First, you want to know what it will be worth when any upgrades or rehab is completed. This is called the After Repair Value. You calculate this by doing a comparative market analysis (if it’s a smaller deal) or by using capitalization rates (if it’s a larger 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.

This article originally appeared on IdealREI.  Follow them on Facebook, Instagram and Twitter.

 

Featured image: Image by Steve Buissinne from Pixabay

Real Estate Investing

How To Make Real Estate Syndication A Success Without Using Your Money

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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.

But how?

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…

Real Estate Syndication

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.”

He continues,

“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

Acquisition Fee

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.

Construction Fee

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.

Aligning Interests

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 where deals go to die.”

But, David Eldridge of NAI Glickman Kovago & Jacobs, a commercial brokerage firm in Worcester, Massachusetts, said,

“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.

This article originally appeared on IdealREI. Follow them on FacebookInstagram and Twitter.

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Real Estate Investing

REAL ESTATE: 20 Ways To Find Off-Market Deals

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As the market heats up, it becomes more and more fashionable to find off-market deals.

But, not all “off-market” deals are worth buying. In fact, a huge portion of off-market deals aren’t on the market because… you guessed it, they want more than the property is worth.

But, it’s also true that most on-market deals will sell at or above market value in today’s hot market. .

So it’s a catch-22. Most off-market deals want more than the property is worth, but if it goes on the market, it will definitely sell at full value. So what do you do?

Even if 90% of off-market deals are a waste of time, that other 10% of the deals might sell well below market value, whereas anything listed online will definitely sell at market value. So, there is still some opportunity for money to be made.

So, today we’ll cover different ways to find the coveted “off-market deal.”

1. Pocket Listings

This is a deal that an agent or broker has but hasn’t brought it to market yet. This is more common in commercial deals and also residential deals that aren’t very marketable.

There are a few reasons why a seller may not want to openly market the deal. The biggest of which, is they do not want to spook the in-place management or tenants. If tenants are afraid their rents will jump, they will start to move which lowers the Net Operating Income of the property and makes it less marketable. THe management

Here’s why:

It sells the deal almost immediately, the broker can probably get near the asking price (or they would put it on the market), and it sells virtually instantly which makes the broker look good.

So get to know some high-powered brokers and get on their buyer’s lists.

2. Direct Mail

Some people hate it while others swear by it. Essentially you buy a mailing list, write letters to the owners, mail it out, and hope to get a call.

The response rate is low, around 0.5%, but people who direct mail look at it another way – for every 1000 homes they mail to, they get 5 calls and probably close one deal.

That’s really not bad if you think about it.

I personally sent out a direct mail campaign this year and had a response rate of over 3%. I closed a 20%+ cash on cash deal and sent less than 1,000 letters. So, it’s totally possible to create a great campaign with great results!

3. Driving Neighborhoods (and following up)

This works for both residential and commercial. Choose a market, drive around, and write down all the properties that appear to be in distress.

Then find the number of the owner and call them.

If the property is in distress, the owner is probably motivated to sell.

4. Cold Calling

This is related to #3, except you are just calling a list of properties instead of driving them first.

5. Property Management Companies

They will probably be the first ones to know when an owner wants to sell. They may be able to make an introduction between you and the owner.

6. Eviction Court

Look for houses with recent or pending evictions. For multifamily, look for a property with a large caseload of evictions which could signal a property in distress.

Owners with eviction problems are more likely to entertain an offer to sell.

7. Create a Website

People always take you more seriously if you have a professional looking website. In fact, it’s gotten to the point that lack of a website will actually hinder you from succeeding, even if it doesn’t generate much traffic or sales.

7a. Create Great Content for Owners

Having a website is a requirement, but if you want it to generate traffic, name recognition, and leads, you need to create content for your target audience.

People tend to talk to other people like themselves, and that’s true for how they write as well. That’s why accountant and attorney websites are usually so terrible because they are focused on impressing other attorneys and accountants!

Flip it around and focus your content on your target audience. If you want to buy single-family homes, create content for people who are trying to sell a single family. Same is true with multifamily.

8. Title Company

They probably know all the major groups that are buying/selling in your area. If you have a good connection here they might be able to make an introduction

9. Landlord or Apartment Association Meetings

You want to be the first to know when a current owner is selling. So, go to their professional meetings.

Photo by Antenna on Unsplash

10. Real Estate Investing Meetings

If another investor knows about an off-market deal but doesn’t have the money to get it done, they may be willing to tell you about it.

11. Start a Podcast

Similar to creating a website, a podcast is a great way to meet other real estate professionals and start building those relationships.

12. Tax Delinquencies

If an owner can’t pay their taxes, they are probably motivated to sell.

13. LoopNet or MLS

A lot of people believe LoopNet or the MLS are terrible places to find deals. There will undoubtedly be a good deal here or there on these services, you can also use them to get to know some of the brokers in a new market.

Ask the brokers for references to good property managers then ask those managers for references to more brokers.

So, internet listing services are a good way to get a conversation going, even if you don’t ever close a deal from it.

14. Tradespeople/Vendors

They tend to get around and know all the major communities and property owners in the area. You could ask for some insights into different areas, which are full and which are vacant, and which ones have problems.

15. BiggerPockets

BiggerPockets is focused more on the single-family side, but may also be a great place to find other professionals.

16. Networking

Relationships rule everything in real estate. Do we really need to go into detail about why you need to be at every networking event in your city?

17. Create a YouTube Channel

YouTube is the #1 video search engine. People often search YouTube because it’s a lot easier to convey a message in video than in writing. So, if you are trying to reach a target audience, it’s a great idea to create video content for them.

18. Bankers and Brokers

Mortgage brokers and bankers may not know who wants to sell, but they will know all the major owners and sellers because they’ve probably worked with a lot of them.

19. Craigslist

Look for properties that are for rent. A listing means there is a vacancy. It’s usually just part of ordinary turnover, but if you see a property being listed a lot, there may be a problem.

20. Start a Meetup

People love networking. In addition to attending other networking events, you can create your own. Since it’s your event, you will have the stage which builds your name.

21. Find a Bird Dog

Take any one of the categories in this article and get another person to do it for you. In return, you’ll compensate them for every deal closed.

 

Featured image: Photo by Harmen Jelle van Mourik on Unsplash

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Real Estate Investing

5 Strategies To Close Your First Real Estate Deal

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