My First Apartment Crowdfund Deal
My first commercial real estate equity deal was a multifamily apartment building in Southern California. No, I don’t deal with tenants, toilets, and termites. In fact, I have never seen this apartment in person. I leverage the expertise of a professional real estate company and participate through a syndication structure which I found on an online crowdfund platform, RealCrowd. RealCrowd operates as an online listing platform only, so this was a direct to sponsor deal without any platform LLC intermediary. (I discuss syndication here and different types of equity structure offerings here).
Admittedly, when I invested in this property over a year ago, I was pretty green to real estate crowdfunding and didn’t do much due diligence. I briefly looked at the IRR, equity multiple, some nice pictures and decided to pull the trigger. (Don’t do what I did.) I did listen to the online webinar, but did not speak directly with the sponsor.
Note: Due to the confidentiality agreement and nature of private placement, I cannot publicly post detailed financial information or name of the sponsor. So we’ll refer to this deal as ‘Melrose Place’ after the 90’s TV show.
Project Code Name: Melrose Place
Investment amount: 30K
Deal Type: Equity
The sponsor specializes in low-rise, garden style vintage apartment buildings in the B neighborhoods of LA. The buildings they target are older- built in the 50s to 70s; vintage SoCal, and ripe for value-add. The strategy is to buy off-market apartment buildings at discounted prices, renovate the units, bring leases up to market rates, and sell in 1-3 years. The sponsor has a strong local presence and ties to local brokers and lenders. They turn and churn many of these same type of value-add deals each year so this is not their first rodeo. The principal has over 40 years of real estate experience and over twenty years in the SoCal market. They have a tried and true formula and stick with it.
The apartment building is class A-/B+ in a class A- neighborhood. It is a former REIT owned property and has going-in under-market rents (approx $500 / unit in rental upside) and significant value add potential. There is no new apartment development in the foreseeable future in this area due to high barriers to entry.
The plan is to renovate the building and increase rents to market value. This increases the net operating income (NOI), which in turn increases the value of the property. This will be explained in more detail in future posts. For now, here is the formula you should know.
CAP rate = NOI / Price
The value-adds for this property:
Improve landscaping and common areas,
Update the units’ carpet, bathroom, kitchen, appliances, cabinets. New interior paint.
Where do I come in? Remember this is an equity deal. I am a limited partner (LP) investing in the equity portion of the capital stack. This deal is a simple equity/debt capital stack structure. The sponsor puts in 10% of the equity and the passive investors put in 90%. The purchase is leveraged with senior debt at 70% LTV, with a 2 year interest-only payments and a five year term.
Melrose Place Numbers:
IRR: low 20’s
Equity multiple: 1.5x
Hold period: 2-5 years. The deal is underwritten for a 5 year hold but most of their past deals are sold after 1-3 years.
Cap rate: 3.5
Preferred Return: 8%
Cash on Cash: 0% during the first year of repositioning and rehab. 6-7% after the first year.
Waterfall: After preferred return to investors pari parsu and after return of capital, 60/40 in favor of the LP investor to 30% IRR hurdle, then 50/50 split.
GP equity: 10%
Debt: Senior debt with interest only payment for the first two years, then principal plus interest starting in year three. 70% LTV.
Step-by-step investment process:
Since this is the first equity deal I’m presenting, I’ll walk through each step of the process.
On the RealCrowd platform, various commercial real estate deals are vetted and curated for presentation and fund raising. There is a deal synopsis which includes sponsor information, key metrics, targeted return profile, and property information. Due diligence documents are available for download and review. These include the deal sheet, financials, operating agreement, private placement memorandum, and sponsor track record.
The first step was to reserve a spot by clicking on the ‘Apply to Invest’ button. I entered my desired investment amount and verified my accredited investor status through a third party service. The third party required documentation (W-2 and/or brokerage information) to be sent online. After review, they issued me a letter of verification.
After being accepted by the sponsor, I was sent an electronic copy of the private placement memorandum (PPM) and the operating agreement (OA). I electronically signed and submitted those through DocuSign. The documents were countersigned and the next step was funding.
The sponsor sent me wiring information which I verified myself with a confirmation email to the sponsor. I learned to do this cautionary extra step after hearing about wire transfer scams. I went to the bank and wire transferred the funds for a $30 fee. The sponsor confirmed receipt.
All signed documents and quarterly reports are posted on my RealCrowd dashboard for easy access.
Things I like about this deal:
- Hold time is shorter – target 2 year hold. As my first deal, I was a bit nervous about illiquidity and the potentially overheated LA market, so I chose a deal with a shorter hold period
- Sponsor’s equity or “skin in the game” is adequate. 10% is average and the minimum I’d like to see. This aligns their interest with the LP investor. More would be better, but I understand they have finite capital and want to seed their cash in as many deals as possible.
- Fees are average but not excessive. I do want the sponsor to be able to pay their bills and keep the lights on.
- Current rents are significantly under market allowing room for rent growth.
- High IRR projected in the low to mid 20’s. Can’t beat that, however, this is over a shorter hold period.
- Sponsor track record is good. They deliver what they promise. The exited IRR on past projects have matched or exceeded projected IRR.
- A sensitivity analysis provided showed that even if the CAP rate was 50 basis points above market, the IRR would still be in the mid to high teens.
- The provided feasibility study was favorable in terms of demographics, employment, population growth, comparative set, and price analysis.
Things I don’t like:
- CAP rate is low at 3.5. But this is likely the relative going CAP rate for the high-priced and ultra-competitive SoCal Market. If the market cools off and the CAP rate rises, this could adversely affect the exit price. This is a major risk factor for this project. Looking back, I get queasy on how I pulled the trigger on this CAP rate. I’m just hoping the sponsor can unload this property onto another investor before the market turns cold.
- Projected increase in NOI is a bit aggressive. However, the sponsor has a good track record of meeting their projected IRR so I trust their calculations. I verified the supplied comparables and they seem accurate.
- Vacancy rate: The rate of 3% was used in the pro forma. That is a bit aggressive and I’d prefer at least 5%.
- Communication is average. The sponsor has their own investor portal which includes a one page monthly progress report.
- Promote of 60/40 is less investor friendly than I’d like. I would prefer at least a 70/30 split after the pref.
- No distribution during the first year. That means no cash flow to me until repositioning is complete. I would prefer cash on cash distributions during year one.
Millionaire Doc Hypothesis:
My hypothesis is the SoCal market will continue to experience population and job growth over at the least the next couple of years. The local economy is well diversified and the unemployment rate is low. The single family housing market is red hot and continues to outprice first time home buyers, forcing them to remain in multifamily housing. Millennials will continue to stick to renting until they start families. Baby boomers will continue to retire and downsize to rental units. All this will continue to drive annual multifamily rent growth and keep vacancies low. CAP rates will hopefully remain steady, even in an increasing interest rate environment. But there is a real risk of CAP rate expansion.
The short term hold will allow a strategic post-stabilized exit while the option of a 5 year hold allows the sponsor to ride out a potential negative downturn. The sponsor is experienced and specialized in geographic location and niched in asset type. The sponsor is also concurrently engaged in multiple similar projects. This will result in efficiencies of scale on the rehab side and rapid lease-up on the management side.
There are risks to this deal of course. The main ones I see are
- Market and economy risk. A cooling of the real estate market may cause values to drop.
- Execution risk. The sponsor may not be able to renovate the units according to pro forma.
- Assumption risk. Factors like vacancy rates, rental income rates, and expense rates may be incorrect.
A year into this deal, the property is underperforming. The sponsor attributes this to higher vacancy rates than expected early during the year, and also higher expenses than initially budgeted. I should have caught this in the vacancy rate the sponsor used in their proforma. They used 3% which is a bit aggressive and I would have preferred 5%. There was a gas leak on the property which was promptly fixed. Subsequently, the net operating income and cash flow are significantly less than projected . They have renovated over half of the units which are now leased out at market rate. Occupancy rate is currently around 90%. The good news is the rental market is very strong and the units are leasing at higher than estimated market level rates.
Communication is consistent with a one page summary sheet detailing each month’s activities. These include actual and budgeted general figures like rental income, operating expenses, operating cash flow, occupancy rate, average unit rent. The figures are also broken down monthly and year to date. They haven’t sent many photos of the newly renovated areas which would be nice to see. A picture is worth a thousand words.
A recent email to investors spoke of a potential buyer. The sponsor will test the market and if there is an attractive offer, they may sell the building even though they have not totally completed their turnaround plan. We’ll just have to see in the next couple months.
Looking back, was this a good deal and would I do it again? I think the vacancy assumption used in the pro forma was aggressive. I would prefer a more conservative vacancy rate of 5-6%. instead of 3%. The purchase CAP rate is low, meaning this asset is in a high priced, competitive market. If the economy and local market cools, the CAP rate expands and the price will drop. Finally the promote structure could be better in favor of the investor. The sponsor quality is average- not bad but not great. My investment criteria have become more strict and I am pickier in what I invest in these days. So all in all, I would not invest in this deal today.
The deal is up on the board in the Real Estate Portfolio page (under Main Menu tab) and I will post updates throughout the hold period.
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What do you think? Have you invested in real estate crowdfunding? Syndication? Comment below.
Until next time,
Invest in Life.