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Positioning Your Passive Investment to Prosper Now – and 10 Years from Now

Since the JOBS Act of 2012, we have seen a flood of real estate Sponsors and investors enter the market. It’s great to see options for accredited investors to invest in institutional quality commercial real estate. In fact, there has been a seven-year market for multi family real estate that has only seen an upward trend in investment returns. Most opportunities have reasonable proformas attached to them. However, the past couple of years have also seen speed deals trading from seller to buyer and again from to seller to buyer, and so on. In a bull market, this can be attractive to a passive real estate investor. But the gravy train will come to an end, as all bull markets do. It may be time to consider a defensive investment strategy that can be successful in both a bull or bear market.

Recalibrating your investment criteria could help you avoid major market corrections and unintended landmines that could easily erase your past success.  Below are a few multi family real estate ideas to consider.

Investment Terms

Look for investment opportunities with a debt structure greater than a 3-7 year term. If the loan on your investment matures during this time-frame and the market is soft or down, your exit options may be very limited. There are attractive loan products that are fixed at 30, 35, and even 40-year terms. These products virtually eliminate interest rate risk and do not force a discounted sale in a down market because of a short loan term.

Exit Options Are Important

When investing in multi family real estate, confirm that the Sponsor has more than one exit strategy. Many new Sponsors in the past decade have been able to buy, rehab, and flip in a very favorable market. Today, I would recommend at least three exits options to give yourself a seller’s market position that may favor you in a sale.

If your investment opportunity has a short-term loan of seven years or less or a bridge loan of three years or less, verify that the Sponsor has a legitimate refinance exit strategy. Ideally, that strategy could carry your investment for another 10-35 years to be able to absorb an extended market correction. Interest rates are rising, construction costs are increasing, and inflation may creep. You do not want to put yourself in a position where market conditions negatively impact your ability to sell at a discount as your only exit option.

Consider an investment that has a truly assumable loan. This helps the buyer acquire the asset by avoiding excess closing costs, and the buyer assumes the existing interest rate on the loan. This could save hundreds of thousands of dollars on the transaction. It also benefits both parties.

The HOLD strategy exit is top on my list for several reasons. In my mind, this is our exit strategy in 10 years, or when we are ready to sell. It is difficult enough to find, fund, and manage an institutional quality investment – so why hurry to sell? Say you have long-term fixed rate debt, a stabilized tenant base, and a Class A property that produces cash flow. It might also provide depreciation paper losses on the annual K1’s. Why would a Sponsor or passive income investor want to sell in three or five years? You are creating tremendous value. And you can always refinance into a 30 or 35-year loan with a cash-out to the investors and continue to hold the asset for continued cash flow. That is pure financial ecstasy. There is a caveat to the HOLD strategy: there is a price for our asset in any year, but I want our investors to dictate the terms from a position of strength.

Know Who You’re Working With

Finally, set your expectations wisely for the return on your passive investment. When an investment seems to have overly attractive returns, it’s prudent to set your expectations at 30% less than what the Sponsor is projecting unless you have an extended relationship with that Sponsor. Or, unless the Sponsor has a proven track record. If you can live with that number and the Sponsor can prove up more than one exit option for your investment, you are probably fishing in the right pond. While there are exceptions to the rule, we implement investment strategies that we believe through experience will thrive and persevere in cyclical markets whether they are up, down or sideways.

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