Generally, the general partner (GP) in an apartment syndication has certain investment criteria to determine which deals to submit offers. These criteria could be as sophisticated as requiring a projected internal rate of return and cash-on-cash return above a certain threshold, which is what my company does, or as basic as a cash flow per door.
Regardless of their investment criteria, an experienced GP will perform underwriting on tens, if not hundreds, of deals before finding one that qualifies for an offer. And once they do, there is a four-step process for submitting an offer.
Understanding this process is obviously important for those striving to syndicate their own apartment deals in the future. But it is important for those passively investing in apartment syndications to understand as well. If they are entrusting the GP with their hard-earned capital, they should know how the offer price and terms are calculated.
Before completing the underwriting process and submitting an offer, the GP will likely need to reach out to the listing real estate broker and their property management company.
If questions arise during the course of the underwriting process, the GP will need to get the answers from the listing broker before submitting an offer. For example, there might be a discrepancy between the rent roll and the offering memorandum regarding the number of units renovated by the current owner. Or the properties used by the listing broker for the rental comparable analysis are too dissimilar to the subject property. Or the GP needs more information on the exterior capital expenditures completed by the current owner over the past few years. The GP should leave no stone unturned before determining an offer price.
Similarly, the GP should review the underwriting with the property management company that will manage the deal after the acquisition in order to confirm the assumptions that were made.
Additionally, the GP should visit the property in person. Ideally, the GP visits the property with their property management company and, if they plan on performing renovations after the acquisition, a general contractor. Together, they should look at the condition of the big ticket exterior items, like the roofs, siding, parking lots, clubhouse, amenities (pool, fitness center, playground, etc.), landscaping, and signage. They should interview the onsite property management company to understand the historical operations of the property. They should tour a handful of units, preferably the “best” and “worst” units. Then, they should leave the property and drive a two-mile radius around the property, making note of nearby retail centers, restaurants, employment hubs, and other apartment communities. They should visit these other apartment communities to gain an understanding of the local competition.
Based on the in-person visit and feedback from the real estate broker and property management company, the GP should update or revise any underwriting assumptions in preparation for submitting an offer. At this point, the GP will have better assumptions than those made by simply reviewing the rent roll and profit and loss statement. But, if they are awarded the deal, the GP will conduct more detailed due diligence in order to finalize their assumptions.
During the underwriting and pre-conversation phase, the GP will usually have an idea of the price at which the owner wants to sell. Sometimes the sales price is explicitly stated, but this is usually only the case for smaller apartment deals. For deals with 50 to 100 or more units, the listed purchase price will likely say “to be determined by the market.” If that is the case, the GP can usually get a ballpark number from the listing real estate broker or the owner. If not, they may use the current market cap rate and net operating income to get an estimated sales price.
However, the owner's desired sale price is fairly irrelevant when determining an offer price. Experienced GPs will set an offer price that results in projected returns that meet their investment criteria. For example, my company will set an offer price that results in, at minimum, an 8% cash-on-cash return and a 16% five-year internal rate of return to the limited partners.
If the GP’s offer price differs greatly from the listed, stated, or estimated sales price, it may be due to an error on the GP’s side or the seller making too aggressive of assumptions. If it is the latter, the GP can either walk away from the deal or submit their offer along with an explanation for why the offer is much lower than what the seller desires.
In addition to determining an offer price, the GP should also have a conversation with their lender or mortgage broker to obtain estimated loan terms to include in their offer.
At this point, if the results of the underwriting meet their investment criteria, the GP will submit an offer in the form of a letter of intent (referred to as LOI hereafter). The LOI should be prepared by the GP’s real estate attorney.
The LOI is not legally binding. Its purpose is to show the GP’s intent to purchase the apartment at the stated price and terms, which includes the purchase price, down payment amount, earnest deposit, and the due diligence timeline.
For the earnest deposit, 1% of the purchase price is standard and goes hard (i.e., is non-refundable) once the inspection period is completed (30 to 45 days). However, if the GP is in a competitive offer situation, the earnest deposit terms can deviate from the norm. This could mean a higher deposit amount and/or a shorter time frame before it goes hard. The most competitive offers have the earnest deposit go hard on day 1. For example, on a recent deal, my company had a $200,000 earnest deposit go hard on day 1.
The GP can have a conversation with their real estate broker about what they are seeing in the current market for earnest deposit and its terms. Or, the GP can base the earnest deposit amount and terms on their previous acquisitions in the same submarket.
After submitting the LOI, the GP may be invited to a best and final call with the sellers. This is when the sellers ask for the interested investors’ best and final offer. Then, the investors with the most competitive offers will be invited to a call with the sellers, which is basically an interview so that the seller can determine if the investor is capable of closing on the deal.
If the sellers accept and sign the GP’s letter of intent or award the deal after the best and final round, the GP will submit a formal offer in the form of a purchase sales agreement. Similar to the LOI, this sales agreement should be prepared by the GP’s real estate attorney. The purchase sales agreement is a detailed contract that outlines all of the terms of the sale.
In addition to the earnest deposit, the upfront bank fees are paid before closing. Since the earnest deposit is due soon after closing, the GP needs to know where these funds will come from before putting the property under contract.
The GP may front these costs and reimburse themselves at close. The GP could also ask an investor to fund the earnest deposit and upfront bank fees. In this case, the GP would create a promissory note to pay the investor back if the contract is canceled after the earnest deposit goes hard. Or, the GP could partner with someone on their team with those funds. Ideally, the party who funds the earnest deposit will fund the other upfront bank fees as well.
In terms of how much upfront cash is needed, a good estimate is 2.5% of the purchase price (1% for the earnest deposit and 1.5% for the bank fees). For example, a $10 million purchase price would require an estimated $3.5 million in equity (25% down payment, GP fees, closing costs, and cash reserves) at close. Of that $3.5 million, the GP would need approximately $250,000 in cash to cover the earnest deposit and upfront bank fees to get the deal to the closing table.
To learn more about the apartment syndication process from the perspective of a passive investor, visit my passive investor resources page here.
About the Author:
Joe Fairless is the co-founder of Ashcroft Capital, a fully integrated multifamily investment firm with more than $2.7 billion in assets under management, and the founder of Best Ever CRE. His podcast, the Best Real Estate Investing Advice Ever Show, is the world's longest-running daily real estate podcast with more than 500,000 monthly downloads.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.