You may have heard multifamily real estate is a good source of passive income, but you may not know details about when investors get paid. This article addresses the various distributions an investor can expect with a typical private real estate offering.

Essential to this discussion is an understanding of the cycle of a multifamily investment, as there are several different income-producing capital events. Income is made during operations, during a refinance, and during a sale or 1031 exchange. I will provide a description of the various capital events in order to clarify the sources of “mailbox money”.

A common term used to describe a private real estate offering is a syndication, and the organizer is known as the syndicator. This article also addresses taxes related to the income made and highlights the advantages unique to commercial real estate.

Cash on Cash Return

When you invest in an apartment complex, the income generated from operations is known as cash on cash. In other words, the cash you invest generates cash from operations. This is also referred to as the yield. The main source of revenue is collected rent, and the yield is the revenue minus expenses, usually expressed as a percentage of your initial investment. As a fractional investor, you can anticipate receiving a cash distribution proportional to your ownership in the asset. The asset manager determines the cycle of yield distribution, typically either monthly or quarterly. Cash on cash is analogous to the dividend of a stock, although the income generated from real estate has significant tax advantages. It is beyond the scope of this article, but the accounting convention of depreciation offsets the income to significantly decrease your tax burden. It is typical in the first few years of a multifamily investment to have very little, if any, tax liability on the income generated from operations, due in large part to depreciation. In summary, cash on cash is the income paid from operations during the time period the asset is held.

Refinance

Income can also be generated from a refinance event. Many commercial property owners finance their purchase with a loan, often on the order of 75% loan-to-value (LTV). This means there is a mortgage on the property that is 75% of the value. In a typical syndication, a group of investors supply the remaining capital and reserves needed for purchase. Once there is additional value created in the property, the loan can be refinanced and capital returned to investors. In another article I discussed, forced appreciation, the process where increases in the net operating income (NOI) result in appreciation of the value. Renovations are made to the units, which allow higher rents to be collected, thus increasing the NOI and the value of the property. When the value of the property increases, the loan on the property can be refinanced. To demonstrate, suppose an investor acquires a small apartment complex valued at $2 million with a loan at 75% LTV. In this example the investor borrowed $1.5 million to finance the purchase. Suppose she increases the value of the property to $2.6 million through forced appreciation within a period of two years. If she decides to refinance with a new loan at 75% LTV, she can borrow $1.95 million. Assume also for this example she made interest-only payments in the first two years, and the principal balance remained the same. At refinance, the previous $1.5 million loan is paid off, and there is $450,000 to distribute to investors.

The general math is as follows:

Original purchase price $2,000,000

Equity at 25% - $500,000

—————-

Amount to finance $1,500,000

Refinance appraised value $2,600,000

New loan at 75% $1,950,000

Payoff existing loan - $1,500,000

—————-

Available cash proceeds $450,000

It is noteworthy that this distribution is tax free because the investor is not selling the property, but rather borrowing against it. One major advantage to refinancing is the investor has less capital at risk in the asset following the refinance. Capital can now be invested in another project, all while the initial investment is still creating income. This has the effect of multiplying returns for the investor.

Sale and 1031

The majority of the return on investment typically comes at the time of sale and disposition of the asset. If the syndicator executes the business plan, the net operating income increases, thereby increasing the value of the property. If the property is sold for a gain, investors are paid proportional to their ownership. The majority of equity gain is often returned at the time of sale. When there is an increase in the cost basis of a property, capital gains taxes are assessed at the time of sale. There is also a tax liability for the “recapture” of depreciation. These taxes can be deferred however through a 1031 like-kind exchange. Briefly, Section 1031 of the IRS tax code allows taxes to be deferred if the proceeds from sale are applied to another commercial property within a certain time frame. This increases the efficiency of the investment, as there are no capital gains taxes to be paid. Investors can apply 100% of the equity gain at sale to another investment and continue the trajectory of wealth accumulation.

If you are interested in learning more about the advantages of multifamily real estate, we would be happy to connect.