The Anatomy of an Apartment Deal and How Risk is Allocated
Apartment deals are business transactions that acquire, own and operate commercial, multifamily real estate for profit. These deals are executed by businesses that carry the risk of the property’s performance, profit and loss. Many apartment deals, as with most commercial real estate deals, are executed by raising capital due to their high value. Raising capital introduces investors into the deal that share the opportunity of profit and risk of loss. So how is the risk between the business owner and the investor different and how should that risk be allocated through returns?
Investments in apartment deals fall into the category of alternative investments along with private equity, hedge funds, managed futures, commodities and derivatives contracts. They are typically not an offer to investors to share in the entrepreneurial ownership of the real estate business, which may be a point of confusion to some investors. They are investments that own a share of profit rights for a specific property or properties, normally without voting rights. The investments are mostly held by accredited, high-net worth individuals due to their complex nature and limited regulations.
The objective of an apartment deal includes making profit from revenues (mostly rent) and any appreciated value upon sale or cash proceeds from refinance. The first objective is to return invested capital to the investor as quickly as possible and then to maximize the investment’s return above the invested amount. Profit is shared between the real estate business owner and investors based on risk assumed by each party in the agreement and not solely by the amount invested by each investor. This is one of the most difficult things to quantify, but the industry has normalized some generally accepted formulas.
A percentage of profit interest in apartment deals goes to investors based on the amount of their investment against the total invested capital. In some cases, all invested capital comes from investors with the real estate business providing the opportunity, sweat equity and its own resources. The business is subject to overhead cost and expenses to acquire and manage the deal and may not have capital available to invest in the deal. Because of this, it is difficult to quantify its profit interest. Traditionally, the business takes a share of profit that is often called carried interest, carry or promote. A good explanation of promote and why it is a win-win for investors is given by Ian Formigle of CrowdStreet.
The origin of carried interest can be traced back to the 16th century when ship captains assessed a charge to ‘carry’ cargo across oceans to Asia and America. The captain would take 20-30% of the profit from carried goods to cover his costs and risk of ocean sailing. In a similar fashion, carried interest in apartment deals is a percentage of profit where profit is only limited to the amount of effort provided by the business. The better the performance, the more potential return for all parties.
If the business has available capital, it is common that it will be invested as part of the investment capital. It is rare that a business would not take advantage of a deal’s opportunity if it had the money to do so. It also gives investors more confidence that the business believes in the deal, is willing to risk their own capital and it has a good chance to meet it’s forecast profit. Only in cases where the business has working capital just to stay afloat and nothing available for investment that they are unable to invest.
So what risk does the real estate business take on if it doesn’t have capital invested in the deal? Running a business has expenses that must be recovered through revenue or equity or else the business is not sustainable and will eventually fail. This is a huge risk for business owners, especially entrepreneurs that have put their life savings into it and devoted a great amount of time without pay. For them, it’s negative cash flow until a deal comes through. But maybe a bigger risk is that the business must put up its own money to secure the deal with the seller. This money is the prepaid closing cost (earnest or hard money) that is not refundable if the deal fails to close for reasons agreed to with the seller. This is normally much more than the minimum investment amount.
While there are various fees paid to the business to recover expenses, the only real payday for the business is the proceeds from the carried interest realized after sale of the property. This could be 5 to 10 years after closing the deal and is a very long time for the business to wait for returns. To protect investor interest and ensure the best performance from the business for maximum returns, the business needs a strong incentive to continue motivating it until the end. The best way is to extend a healthy promote at the end of the life cycle. After all, good performance will result in even higher returns for the investor.
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In what ways are risks shared equitably in your investments?
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