Passive Investor Scenario Analysis
Multifamily real estate has several advantages that make it unique as an investment asset. It offers low volatility, reliable bond-like income yields and equity-like return potential. Another primary benefit of real estate investments is that they generate passive income. That income can be beneficial whether it flows back into an investment account to be reinvested, used to cover basic living expenses or seen as providing an income safety net to backstop regular employment income. In the scenarios that follow, we look at three different investors with different life situations in order to show how multifamily real estate provides benefits to each one. I hope you will find value envisioning these scenarios and considering the applicability of these ideas to your own situation. For simplicity, I have used similar assumptions in each scenario; that each investor can receive a 7% annual cash yield and an equity multiple of 2x. Other details vary for the purpose of illustrating different investment objectives and approaches.
Investor Scenario 1 - Investing within a Self-directed IRA to Maximize Compound Growth
Our first investor has $150,000 in an IRA from a previous employer. She already owns shares in publicly traded REITs in another account, but would like to diversify her real estate allocation with multifamily apartments that are less correlated to the general stock market. She doesn’t have the cash flow to invest after tax money so she considers using a self-directed IRA to be her best option. Since her account size is small, she wants to start with a single investment and keep it simple. She knows that the hold times for these investments can range from 5-7 years. Because she has a long-term view, she believes investing in a tax deferred account will allow maximum compounding. She plans to reinvest the proceeds at the time of sale. If she can invest to receive a 7% cash on cash return, she will have $10,500 flowing back into her IRA each year. If the property is sold in year 5 for an equity multiple of 2x, her equity will have increased from $150,000 to $247,500 and she would have received $52,500 in cash flow. Her account size is now $300,000 and she can deploy that into three different apartment investments at $100,000 each. Using the same assumptions, she can double her account size in another 5 years to $600,000. In the meantime, she would have also received $105,000 in passive cash flow.
Investor Scenario 2 - Investing Taxable Income in a Tax-advantaged Way
Our second investor can allocate $75,000 annually to private real estate because he and his wife are both physicians and they live well below their means. He can expect to receive an average yield of 7% annually from each investment. He plans to make this allocation for each of the next ten years and he invests such that he can 1031 exchange into a new property at each exit. This will provide $5,250 of passive income from each investment per year. By the end of year 5, our investor can expect $26,250 of passive income annually and by the tenth year, $52,500. Keep in mind that due to the depreciation offset effect it is possible that this income is shielded from taxation at he and his wife’s high marginal tax rate.
The initial investment made in year 1 has now doubled in value. The equity in property #1 is now $150,000 less the capital received as income ($52,500), or $97,500. If that property is sold and the equity is rolled into another asset through a 1031 like-kind exchange, then our investor avoids paying taxes on the capital gains and can continue to receive income on a larger equity interest. An annual yield of 7% on the still invested $97,500, will provide an annual passive income of $6,825. Our investor can then repeat this process with each of the properties as they are sold and effectively increase his cashflow without allocating any additional capital. In another 10 years he will expect $68,250 of passive income from real estate annually and the currently invested equity will be $975,000. In addition, this investor would have received distributions of passive income totaling $900,375 over that 20-year time frame.
Investor Scenario 3 - Investing near Retirement for Cash Flow
This investor is nearing retirement and concerned about stock market volatility. He wants to decrease his exposure to market volatility, but remain positioned to generate solid returns on his capital. He is also concerned about bond returns going forward because of the historically low interest rate environment. He would like to generate income from his investments since he will be living off his assets in the near future. He believes there is an opportunity to take advantage of low interest rates by using long term debt to buy cash flowing real estate. He is going to reallocate $500,000 from his paper asset portfolio to direct real estate investments in $100,000 increments. In this way he can diversify among different properties and markets. If he can invest for a 7% yield, once his capital is allocated, he will be receiving $35,000 of passive income each year. If he is able to double his investment in 7-years he will be able to reinvest equity totaling $755,000 in new real estate opportunities and will have benefitted from $245,000 of tax-advantaged cash flow while he held those investments. If he does reinvest in five new properties when the original five are sold, then his annual cash flow will increase to $52,850. He believes this will go a long way toward covering his basic living expenses in retirement.
In summary, the benefits of investing in private real estate syndications are available to investors with different circumstances, goals and capital constraints. If you think your portfolio could benefit from exposure to this asset class, please let us know.