PASSIVE INVESTOR GUIDE by Rob Beardsley

PASSIVE
INVESTOR
GUIDE
Rob Beardsley
 PASSIVE INVESTOR GUIDE by Rob Beardsley

FOR MULTIFAMILY REAL

Rob Beardsley

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 PASSIVE INVESTOR GUIDE by Rob Beardsley

Introduction

Passively investing in multifamily real estate is anything but passive! There is a lot of effort
involved with educating oneself about markets, strategies, and risk as well as building
relationships with sponsors who you can trust to take care of your capital. Additionally, there is
some heavy lifting involved with sourcing and evaluating deal flow.

However, in this eBook we will share valuable insider expertise which will equip you with the
skills and confidence necessary to passively invest in multifamily real estate like a pro. Not only
will we teach you the steps to be a savvy investor but also share insights on how to save time
while doing it. After all, our goal is passive income that is truly passive, rather than a second
job. If you’re looking for a side hustle, this is not the guide for you! However, feel free to reach
out to see how we may work together to accomplish your goals.

First, let’s cover the roles and responsibilities of sponsors versus passive investors. Sponsors,
also known as the GP (general partner), syndicator, or manager, oversee sourcing strong
investment opportunities, putting them under contract, performing due diligence, raising debt
and equity, implementing the business plan, and running the property operations. Passive
investors, also known as LPs (limited partners), have far less responsibility and risk in a
sponsored investment. An LP’s work is essentially all upfront as it relates to sponsor and deal
selection. Once the passive investment is made, investors don’t have any ongoing
responsibilities.

As far as risk is concerned, sponsors are responsible for signing on the debt associated with the
investment property and are subject to liabilities associated with the operations of the
property. Meanwhile, passive investors have no personal liability nor risk associated with the
investment outside of the capital they contribute.

To gain clarity on your passive investor journey, you should outline a high-level strategy to
guide your investment decisions. Investors should take the time to research various investment
strategies to determine which types best fit their goals. While there are many strategies, for the
purposes of this discussion, we’ll outline the three most common: core-plus, value-add, and
development. Core-plus refers to investments which have strong in-place cash flow, no
significant opportunity to increase income through renovations, increasing occupancy or
improved management. Instead, core-plus investments are usually focused on higher quality
assets and locations. Value-add investments offer more upside through business plan execution

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but can have a range of little to modest cash flow. Lastly, development is a construction project
where there is zero cash flow but offers the highest potential returns.

These three investment strategies have been presented in order of risk (low to high). Core-plus,
value-add, and development follow the classic “risk curve” which slopes upward from left to
right, indicating that prospective returns and risk are positively correlated. The other distinction
between these strategies are the associated cash flows. Some investors place a greater
emphasis on cash flow and risk than others which will cause them to screen deals more heavily
based on cash flow metrics and downside protection. While taking a deep dive into each
strategy is outside the scope of this eBook, it is important to thoroughly understand each of
them and develop your own personal allocation strategy within the real estate passive investing
world and stick to it. For example, your strategy may be to invest 25% of your allocation to
passive real estate investments in cash flow focused core-plus investments and the remaining
75% in value-add opportunities. If you’d like to further discuss your investment goals and
strategy, set up a call with our investment team here:
https://calendly.com/dashabeardsley/investor-intro-call

After developing your strategy, you now must fill up your pipeline with deals that fit your
criteria. However, before rushing out and investing in as many deals as possible, it is important
to take a step back and focus on the sponsors which you are planning to invest with.
Irrespective of the strategy and opportunity, the sponsor is the most important aspect of the
investment. As discussed previously, the sponsor is responsible for sourcing the best
opportunities from the market and have the right team in place to execute the business plans
set forth. Furthermore, the sponsor will be providing you with distributions (monthly, quarterly,
or worse!) as well as communications (monthly, quarterly, or worse!). Lastly, and arguably the
most important point, the best sponsor is one that acts decisively in the investors’ best interest
in difficult situations. Deals never go exactly to plan so the best sponsors really differentiate
themselves when dealing with a bad situation or when it is necessary to pivot.

Investors usually prefer sponsors that are focused by geography and strategy so that the deals
they are doing are rinse and repeat rather than trying to recreate the wheel each time. You
should always do due diligence on a sponsor’s track record to see how their historical returns
match up to their projections and what caused deviations to both the upside and the downside.
It helps tremendously if a sponsor has professional case studies providing these details. To
review Lone Star Capital’s case studies, Click Here.

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Investors should seek out sponsors which are vertically integrated, which means they have an
in-house property management company which operates their assets rather than outsourcing
to a third-party management company. While there are varying opinions on this topic, most
investors argue that sponsors have a better ability to bring strong operational value to the table
when they manage the operations in-house. At a minimum, in-house management provides the
sponsor with more transparency and control over the properties in their portfolio.
Furthermore, most vertically integrated sponsors choose to manage only their own properties
while some also utilize their management company to provide other sponsors with
management for a fee. This is often viewed negatively since third-party management business
distracts the sponsor’s management team and can spread them thin.

Lastly, sponsors strongly differentiate themselves via their customer service and investor
satisfaction. My friend who is a seasoned passive investor told me about a deal he invested in
that turned out great from a returns standpoint, but because of the poor communication and
customer service by the sponsor, none of the investors in the deal wanted to reinvest with the
sponsor. You want to ask sponsors about their communication routine. As mentioned before,
monthly or quarterly communications are fine but more importantly, the content of the reports
must be high quality and transparent. By asking for sample communications, reports, and
investor references, you can get a solid picture of the quality of the sponsor’s customer service.

Within the reports, you should look for standard key metrics such as occupancy, leasing trends,
collections, and any important operational trends/occurrences. Most importantly, you should
look for budget vs actual financial reports which detail how the property is performing relative
to the plan. Specifically, the financials should be compared to the acquisition underwriting
(financial analysis made to derive projected returns from the outset of the project) as well as
the up-to-date management budget. It is normal for the original underwriting and the
management budget to deviate beyond the first year of ownership since management budgets
are updated yearly while the historical underwriting remains the same. The sponsor should
provide upfront or upon request full financial data such as the general ledger, profit and loss,
rent roll, and balance sheet. We provide this information monthly as a full financial package.

Here is a video by Rob sharing more insights about what makes good quarterly reporting: Click
Here.

Reaching out to investors for references can be a good source of information about the
sponsor’s responsiveness via phone and email as well as the speed, skill, and attentiveness with

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which the sponsor’s team addresses any issues that inevitably come up in these complex
investments and partnerships. I encourage you to have a pre-packaged list of questions you can
forward to the references a sponsor gives you.

You may be wondering, “how do I go out and find quality sponsors to partner with?”. There are
many good sponsors out there and some have stronger brands or social media presences than
others. Just because a sponsor has really great marketing and many followers doesn’t
automatically mean they are a good sponsor. Conversely, a sponsor that is relatively unknown
could still be a great sponsor but just doesn’t have a built-out marketing foundation and team.
Nevertheless, sponsors can be found through conferences, word of mouth, and social media.
You can also join in-person or online investor groups which can be a wealth of relationships and
knowledge.

It can take time to vet and build trust with a sponsor, so it pays to establish a good relationship
with a small group of sponsors to fulfill your various investment strategies rather than placing
many small bets in a multitude of sponsors. To make your passive investing more passive, a
trusted sponsor relationship will save you time by not having to repeat sponsor due diligence
for each and every deal as well as make it so you don’t have to vet deals very closely since you
have trust and familiarity with the types of deals your sponsor relationships present to you.

Deal Structure

Another extremely important factor to vet and consider is the structure which sponsors offer
their deals for investment. Starting at a high level, most multifamily passive investment
opportunities utilize an SEC filing exemption under Regulation D (either 506(b) or 506(c)
offerings) to solicit investment. 506(b) offerings allow accredited and non-accredited investors
to participate. The current requirements to be considered an accredited investor are to either
have earned income in excess of $200,000 ($300,000 with spouse) or have a net worth in
excess of $1,000,000 (excluding the value of your primary residence). Meanwhile, 506(c)
offerings only allow accredited investors and, they must verify their accreditation status
through a 3rd party. Investors are allowed to self-verify their accreditation status in 506(b)
offerings, which provides for a slightly simpler subscription process.

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Being accredited opens more doors for investors in terms of investment opportunities. If you
are a business owner or entrepreneur, it may be difficult to show earned income above
$200,000 and therefore a letter from your CPA can often be a much simpler method of verifying
accreditation status for those individuals.

Another legal structuring factor to be aware of is the opportunity to invest via a tenancy-in-
common (TIC) structure. TICs are a slightly more complex legal structure incorporating the usual
506(b) or 506(c) offering structure but also structured to allow passive investors to 1031
exchange into the investment as well as 1031 exchange their ownership share out of the
investment upon sale. Not all sponsors offer TIC structures so it is important to have a
conversation about this with sponsors as early as possible in order to be able to set up the
structure properly. To learn more about 1031 exchanges in syndications, watch Rob’s recent
webinar on the topic here: Click Here.

A major consideration for passive investors is the illiquid nature of these investments. While
you’re technically able to sell your partnership interest via a secondary sale, there is no
guarantee of a price or a buyer. It is best to view these investments as medium to long-term
investments which have the potential to payout much sooner if the business plan goes well and
the market is hot. I believe patience is one of the most valuable traits of an investor especially
in these types of deals. A patient investor is well-suited for the duration uncertainties typically
associated with multifamily investments.

The last important point to note about legal structure is the tax implications associated with
passively investing in multifamily syndications. Sponsors should do everything they can to make
the investment as tax efficient as possible. An important nuance to ask is how distributions are
treated. The optimal treatment of distributions is as return of capital, which makes them not
taxable. Instead, this treatment reduces an investor’s capital account which means the tax will
be owed upon sale but likely at a lower tax rate and of course provides a valuable deferral.

Most deals are set up to pass through depreciation to passive investors which can not only
shelters the income produced by the investment, but also can be used to offset passive income
in other areas of your portfolio (real estate, stocks, etc.). For even better tax benefits, an
investor may be able to elect Real Estate Professional designation on his or her tax return which
allows depreciation to offset any form of income, including W-2 income. This tax strategy even
applies to couples, whereby one spouse’s Real Estate Professional designation applies to the
other spouse, who then can offset a high-income W-2 salary at Apple. This is a hugely powerful

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tax savings strategy. To quality as a Real Estate Professional, a person must perform 750 hours
per year of real estate related activity and must constitute at least 50% of a person’s work time.
This is not tax advice. Please contact your CPA to discuss this further.

After becoming comfortable with a sponsor/deal’s legal structure, the next thing to analyze is
the economic deal structure, which includes the fees charged and the profit sharing terms. The
standard set of fees is acquisition fee, asset management fee, refinance fee, and disposition
fee. Other fees may include capital placement fee and loan guarantor fees. When starting out it
may be difficult to establish a good sense of what is normal/appropriate for fees as fees can
vary widely across different asset classes and investment strategies.

For multifamily investments, acquisition fees are usually 1% to 3% of the purchase price of the
asset but may sometimes also include the total capitalization of the project (purchase price plus
budgeted capital expenditures). Capital placement fees are essentially another form of
acquisition fee so it must be understood within the context of the entire fee schedule to
determine whether the structure is competitive or simply unattractive. Asset management fees
are collected monthly/quarterly and are usually 1% to 2% based on the property’s revenue.
Make sure to confirm that the deal’s asset management fees are in fact based on revenue and
not equity, which is a much larger number. Refinance fees and loan guarantor fees are usually
1% of the loan amount. These fees are not very standard and may be indicative of a high fee
load. Disposition fees are paid at sale and are usually 1% of the sale price.

Profit sharing is usually outlined through what is called a waterfall. Most deals have a preferred
return at the start of the waterfall which stipulates investors are owed a minimum rate of
return prior to any performance compensation is paid to the sponsor. For the few deals which
do not include a preferred return, I recommend immediately passing on them. There are too
many good sponsors and opportunities to choose from which DO offer a preferred return. Not
having a preferred return is simply uncompetitive and, in most cases, is a sign of the sponsor
attempting to take advantage of unwitting passive investors.

Furthermore, not all preferred returns are created equal. Aside from the base rate, which is
typically 6% to 9%, preferred returns can differ mechanically. Preferred returns can be
compounding or non-compounding. Compounding means that shortfalls in preferred return are
not simply accrued but are accrued with interest at the preferred return rate. This protects
investors in the event of cash flow distributions less than the preferred return. Non-
compounding preferred returns really carry no “penalty” for the sponsor not meeting the

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preferred return distributions. A sponsor offering a compounding preferred return can be a

Beyond the preferred return, profit sharing kicks in. 60% to 80% of profits above the preferred
return are typically paid to passive investors and the balance paid to the sponsor. Depending on
the other deal structure factors, 60% to 80% can be appropriate. The uniqueness or difficulty of
execution of an opportunity sometimes justifies a more favorable profit split for the sponsor.
There are also often secondary hurdles which increase the sponsor’s profit split as the returns
increase for passive investors. You can see an example of this below.

To put it all together, here is a common Lone Star Capital deal structure:

• Acquisition Fee – 2% of purchase price

• Asset Management Fees – 2% of revenue

• Preferred Return – Compounding 8% plus 100% return of original investment

• Profit Split – 70% to investors up to 15% IRR, 50% to investors above 15% IRR (IRR
stands for internal rate of return and is the standard compounding return calculation
methodology accepted in private equity investments)

I hope you enjoyed this guide to passively investing in multifamily syndications. Our goal is to
make passive investing truly passive and make your life easier through monthly distributions,
transparent communications, and tech-savvy customer service.

Next Steps

• If you would like to learn more about investing with Lone Star Capital, Click Here.

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• To learn more about multifamily underwriting, get Rob’s book, The Definitive Guide to
Underwriting Multifamily Acquisitions.

• Connect with us on social media – YouTube, LinkedIn, subscribe to our Capital Spotlight
podcast.

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