How To Project Your Passive Investment Income
“How much money will I make?”
I hear it incessantly, like a broken record. Is that all you people think about? So help me, I will pull this blog over …
Just kidding. It’s a perfectly reasonable question. Passive investors put a lot of money on the line when they help fund a real estate syndication. Naturally, they want to have some idea of what the return on their investment will be.
Good deal sponsors exhaustively crunch the numbers and run simulations on the best-case and worst-case scenarios. The investment prospectus presented to you by the deal sponsor should include a breakdown of the projected returns on investment.
Of course, these are projections, not guarantees. Hopefully, the sponsor you chose is conservative and the deal does a whole lot better than the projections. But unforeseen complications or even bad business practices could cause the deal to underperform or even lose money. As a passive investor, you have little control over whether or not that happens.
That’s why it’s so critical to vet the deal sponsors. Do they have a track record of meeting or exceeding their projections? Were their past deals similar to this deal and they presumably know what they’re doing, or are they charting new territory with this deal? Remember, past performance may not be an ironclad indicator of future success.
The projected returns, combined with your assessment of the trustworthiness of the deal sponsor, will set this deal apart from other investment vehicles to which you might consign your capital. Here’s how to approach calculating your passive investment income …
Cash-On-Cash Return (CoC)
One of the things we love most about real estate is that it produces cash flow. You have to wait until the sale or refinance to reap appreciation, but cash flow from rent surpluses could start arriving quickly.
So how do you count your cash flow? Real estate investors use a figure called the cash-on-cash return (CoC).
“Cash flow” is just the cash left over from the rent revenue once all expenses and reserves have been accounted for. But what does this number mean? Is it good? Bad? How does it compare to another cash-flowing asset, like a dividend stock or a certificate of deposit.
CoC takes that raw cash flow number and divides it by the total cash invested in the deal. This includes the down payment, closing costs, and any cash invested in rehab and repairs or set aside as an emergency reserve. It does not include the mortgage balance. The lender doesn’t have equity, just debt. Whatever the cash flow or appreciation, the lender is entitled to the debt service payment, nothing more.
Here’s how the math works:
CoC = Net Cash Flow ÷ Total Cash Invested
Let’s say an investor group invested $500,000 into buying an apartment complex. That sum covered the down payment, closing costs, deferred-maintenance budget, and initial reserves.
After the first year, the group has collected enough rent from the property to pay all expenses — repairs, taxes, debt service, etc. — with $40,000 to spare. That’s $40,000 in annual cash flow.
Easy math …
$40,000 ÷ $500,000 = 8%
This property realized an 8% cash-on-cash return for the year — not bad!
So how does a passive investor figure out her cash flow income for the year?
Passive Investment x CoC = Passive Investor’s Cash Flow
What about the “preferred return?”
You will often see deal sponsors offer a “preferred return” for passive investors. This is a cash-on-cash return for the year that, up until this threshold of income is attained, the deal sponsor will take no cash flow himself. It’s the investor’s right to get paid first.
The preferred return will often be smaller than the projected CoC. If a deal sponsor projects a CoC of 8%, he might offer a preferred return of 7%.
So should you use this number when calculating your return, instead of the projected CoC? After all, you’re getting this much money no matter what, right.
Not necessarily. A preferred return isn’t a guaranteed return. If the investment underperforms, you still might make less than the preferred return. The deal sponsor doesn’t get paid, but he’s not required to cover your preferred return out of his own pocket — it has to come from the cash flow itself.
Levered Return On Investment (LROI)
As most people know, cash flow is only one component of the return investors expect from a real estate investment. The other major component is appreciation — an increase in the property value that can be realized as windfall profit at sale or refinance.
The number we’re looking for here is levered return on investment (LROI).
Let’s say we bought a property for $2 million and sold it for $2.25 million. That’s a 12.5% return on the investment … but if it took five years to appreciate that much, it’s an average of 2.5% appreciation per year (12.5% divided by 5). We’re doing little better than a bond, which is less risky in many ways.
But … we usually buy these properties with a commercial mortgage. Mortgaging investment real estate is a way to leverage your equity — give it more exposure to gains. You’re about to see how.
Let’s say we bought that same $2 million property, but we took out a $1.5 million loan. We only put down $500,000. (I’m not going to account for closing costs, rehab, or principal pay-down, just to keep the math simple.)
We sell that property for the same $2.25 million … but because we only put $500,000 down, our ROI is 50%, not 15%. We put in $500k and got $750k back (after paying off the loan), for a profit of $250k on that $500k. Much bigger than $250k compared to $2 million. That’s the power of leverage.
Of course, we also want to track our ROI over time. 100% LROI sounds good … but over what period of time?
Let’s say, in the above example where we put $500k down, it took us five years to realize that full 40% appreciation. Simply divide 50% by 5 years, and we get 10% annual appreciation.
Of course, in this discussion of ROI, we have only been talking about appreciation, not cash flow. Cash flow has to be included in the ROI equation as well. Let’s do it now.
For the example investment, let’s say the CoC has ranged from 6% to 8% across the five years. The cash flow might look something like this in the first 5 years:
- $30,000 – Year 1
- $35,000 – year 2
- $30,000 – Year 3
- $40,000 – Year 4
- $40,000 – Year 5
Total Cash Flow: $175,000
So that’s $175,000 in cash flow, $250,000 in appreciation, for a total return of $425,000 against the $500,000 down payment. That’s a total levered ROI of 85% … or 17% per year when divided by the five years it took to realize that return. Try to get that by investing in the S&P.
Internal Rate of Return (IRR)
Raw ROI numbers are fun, but they’re actually a little misleading because they don’t take into account the “time value of money.” Due to factors like inflation and opportunity cost, a dollar tomorrow is actually worth less than a dollar today.
Because so much of the income from a real estate investment comes at the end of the investment (sale or refinance), raw ROI actually makes real estate look more appealing than it actually is.
That’s why many investors prefer to look at the internal rate of return (IRR). IRR takes into account the “time value of money” and actually makes a better apples-to-apples comparison between a real estate investment and any other kind of investment (stocks, crypto, etc.)
IRR is a fairly complicated calculation that uses a variable called the “discount rate” to set the “net present value” of an asset to 0, based on its cash flow over time. Honestly, it’s a bear to understand, and most passive investors are just fine using the =IRR function on a spreadsheet app.
For the investment we have been using as an example, here’s how the IRR would shake out:
- -$500,000 (purchase price) – Year 0
- $30,000 (cash flow) – Year 1
- $35,000 (cash flow) – Year 2
- $30,000 (cash flow) – Year 3
- $40,000 (cash flow) – Year 4
- $790,000 (cash flow + sale proceeds) – Year 5
See how it’s a little lower than that raw ROI of 17%? That’s the time value of money at work. You can use that number to compare this investment, apples-to-apples, with any other asset you might consider buying.
You can do the IRR calculation with just your passive income portion as well.
Tax Savings — The “X” Factor
Big cash flow and refi checks are the fun part of real estate investing … but they’re not the only reason to invest. One of the biggest incentives to choose real estate over other investments is the preferential treatment at tax time.
The US tax code has huge benefits written into the tax law for real estate investors. The government benefits hugely from private investment in real estate improvement, and they reward private investors accordingly with numerous opportunities to lower their tax burdens.
Unfortunately, this is hard to project or put an exact dollar figure on. Every passive investor’s tax situation is different, and you often don’t know the outcome until after the return gets filed. As such, deal sponsors usually don’t factor them into their projections.
But that doesn’t mean they are not a big deal! Talk to your tax advisor about the possible tax implications of a real estate investment you are considering.
Tax advantages available to passive real estate investors for participating in a syndication may include:
- Deductible Expenses. W2 employees usually can’t deduct business expenses … but real estate investors can. As a passive investor, you can deduct a portion of the expenses incurred by the property proportional to your ownership interest. If you have 20% of the equity, you get to deduct 20% of the expenses.
- Depreciation. Depreciation is an especially fund deduction because we don’t have to spend any money to get it. It’s an estimate of the loss of value of the property due to wear-and-tear. By law, you can deduct the value of your property down to $0 over a set schedule.
Of course, we know that real estate usually grows in value, and the IRS expects you to recoup depreciation if you sell for a profit … but there are ways around that too.
Apartment syndicators like us also take accelerated depreciation, a technique to depreciate some improvements quicker than others, so you can take the maximum amount of depreciation in the early years of the investment.
As a passive investor…
You also get to deduct depreciation on your taxes proportional to your ownership interest. With accelerated depreciation, it’s not uncommon for this write-off to be so big that it eliminates most or all of your tax bill. I.e. you get every dime of withholding refunded by the IRS.
- Pass-Through Deduction. Syndicators usually hold apartment complexes in the name of an LLC (limited liability company), which the IRS considers a “pass-through” entity. You are allowed to deduct up to 20% of “qualified business income” (QBI) from a pass-through entity. Since apartment cash flow qualifies as QBI, you can deduct 20% of the cash flow you receive, no questions asked.
- Lower Tax Rates. As long as the property is held for at least one year, profits from the sale are taxed as long-term capital gains, at a lower rate than short-term capital gains or ordinary income. Cash flow is taxed as ordinary income at the higher rate, but it is exempt from payroll taxes unlike wages.*This is not tax advice, as we are not tax professionals or advisors in any way. For more clarification and specific answers to your questions, please consult a tax professional.*
It’s a lot to take in, especially for a newcomer to the syndication world … but these are big deals, and a lot of money is out there to be made. If you need more help understanding the income potential of an Investor Boardroom passive investment, please don’t hesitate to reach out to us! We value our investors and the trust they place in us, so we’re here to answer any questions you might have.
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