The COVID pandemic has caused unprecedented economic and emotional destruction. Lives and livelihoods have been lost all across the globe with many of the livelihood losses permanent. We hope that mass vaccinations campaigns underway in the US will go a long way in terms of building herd immunity and finally bringing an end of the biological crisis. Albeit, there is another crisis whose end is not so near and one which may just be rearing its ugly head. That crisis is inflation. Central banks all across the globe and especially in the US have pumped trillion of dollars in the economy. That jolt was needed to push the economy back on the path of recovery. However, they say there are no free lunches in economics. One of the downsides of this unprecedented amount of spending is a risk of inflation.
What is inflation?
Inflation in simple terms is a rise in prices of good and services in the economy. Loosely speaking when there is an imbalance between the amount of money and the goods and services that the money chases, often it leads to rising inflation. The surge in money supply as a result of the Fed spending has that balance heavily lopsided right now. If for anything, a testament to the theory of rising inflation has been a surge in bond Yield we saw in the recent weeks. The price of a bond (or any fixed income instrument) is negatively correlated with inflation as inflation eats into the real purchasing power. Yields move inversely with prices and with the rising fear of inflation, have been climbing up in the recent past.
Why is inflation a risk?
One wonders what inflation has to do with real estate especially income producing real estate. Real estate of often touted as one of the best inflation hedge plays out there. Why is that? Its rather simple to understand that. Income producing real estate derives its value from its income producing potential or rents. Rents are very strongly correlated to rising inflation and typically outstrip inflation in terms of their year over year increase. As rents increase, the value of income producing real estate tied to those rents also increases. Some indirect ways of increase are related to a rising cost of replacement in an inflationary world. Simply speaking, it costs more to build and replace the asset. Rising inflation often has a pretty dramatic impact on the valuations of income producing real estate.
While time will tell how high inflation rises to in the US or the magnitude of its impact, it sure is a clear and present danger. We opine that now may be a great time to diversify into income producing real assets, which as we discussed, are structured to do well in an inflationary world.
Opportunity zones – What are they?
According to the IRS an Opportunity Zones (OZ for short) is an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. OZ’s were added to the tax code under the Tax cuts and Jobs act under the Trump administration in 2017. Investors need to invest in a qualified investment fund, which is a special purpose investment vehicle, or a Qualified Opportunity Fund (QOF) designed to invest in a qualified OZ (QOZ). OZ investing, if and when done right are a phenomenal way to shield capital gains, especially given the recent stock market appreciation. The common perception that OZ projects happen to be markets and sub-markets in decline isn’t true either. The COVID pandemic has dramatically changed the OZ landscape and there are some truly compelling opportunities in OZ’s!
Opportunity zones – Tax advantages
· Defer capital gains on recently sold assets until the earlier of the sale or the exchange date of the QOF investment and Dec 31st, 2026 a.k.a 1031 on Steroids
· 10% exclusion on the deferred gains on a QOF investment held for 5 years or more
· 15% exclusion on the deferred gains on a QOF investment held for 7 years or more
· No capital gains on the OZ investment after 10 years by virtue of a stepped up basis
Opportunity zones – Things to be mindful for
Opportunity zone – Recap
We found the following schematic to be a good representation of the high-level workflow when it comes to OZ investing. Please check it out here.
We answer many questions to our first time and also existing investors. We want to take some time to list most frequently asked questions here. We will improve this blog post overtime to include more and also some pictures/ videos to understand the Apartment Syndication world better.
1) What is real-estate syndication?
Syndication is a way to create a structure to pool money to buy an apartment building. Typically, we have GP’s (general partners) who are deal sponsors and LP’s (limited partners) who are passive investors. The GP’s conduct the due diligence, bring the deal to the LP’s and raise the equity required to close the deal. They also manage the asset on a long term basis.
2) Do you invest in your own deals?
Absolutely we do! We invest anywhere from 5% to as high as 20% equity in the deal. Also, bear in mind that the initial capital needed to pursue the deal is ours and is at highest risk. We can lose all that money. Also, we guarantee the loan. Hopefully, you can see that we have enough skin in the game.
3) Who is an accredited investor?
Regulation D of the SEC (Securities and exchange commission) act of 1933 defines an accredited investor as (OR)
4) Do I have to be accredited to participate in an offering?
Not necessarily. Our offering typically fall in two SEC regulated exemptions, 506b and 506c. While a 506c offering is limited only to accredited investors, a 506b is not.
5) What kind of returns can I expect and how do you calculate them?
Good question, especially given that there are a lot of different ways to measure performance. Our typical cash on cash return (the yield on your cash investment) range from 7-9% (varies from deal to deal). Our AAR (average annual return), which simply is the total return on your investment divided by the hold-time typically ranges from 16-20%. You may have heard of IRR or Internal rate of return which is yet another metric for measuring return. An IRR simply measures the rate of return you would sustain while staying invested in the project. An IRR is typically a better measure of performance and looks at both the cash flow and the time of investment, albeit is slightly more complex than the AAR. We do publish IRR’s metrics as well for all our projects.
6) What are your investment minimums?
50k is a good benchmark to go off of, although the minimums can change (go up for a particular deal). We like to start with a reasonable minimum to give folks a chance to participate.
7) What is your hold time?
Typically, we shoot for an average hold-time of 5 years. This could go up or down depending on market conditions. 5 years is overall a good ballpark which gives us enough time to execute our forced value strategy as well as leverage principal pay-down, in order to get a superior equity multiple on the investment.
8) What are the investment risks?
All investments carry risk, anyone who says otherwise does not know what they are doing, in our opinion. Real estate investments are also risky and are subject to a host of macro-economic factors. Albeit, multi-family apartments esp class B product in select US mid-western markets have demonstrated extraordinary resiliency to major economic storms, such as the 2008 mortgage crisis as well as current pandemic related economic damage. There is a lot of data that supports that claim and at a high level it is connected to a strong demand for rentals across the US, a perennially low interest rate environment fueling asset valuations as well as a under-supply of class B apartments in the US. We would be happy to talk in detail about these macro-variables and share data and reports corroborating these claims.
9) When will I get paid?
We do quarterly payouts which are typically direct deposits into the investors account.
10) How often do you communicate?
We send monthly updates on the investments progress. We share data on current execution plan progress and other performance metrics. As always, we are always happy to answer questions so as to ensure that you continue to be comfortable and happy with your investment.
11) What are the tax-implications of an investment like this?
Real estate is a tax advantaged investment. The cash on cash return that we generate is shielded by depreciation often resulting in a paper loss. There are strategies for deferring gains on capital on the asset sale (1031 exchange). We suggest talking to your CPA to leverage these strategies fully.
12) What is a sensitivity analysis?
We want to conservative in our forecasts and show investors what factors that can cause our performance to be better than our expectations or worse. A sensitivity analysis elucidates these range of outcomes. Often the variables that can cause these fluctuations are outside our control, albeit we try our level best to influence what we can.
13) Can I use a SD-IRA (Self Directed IRA) or solo 401K to participate?
Yes, please check out our blog on this:
14) What happens in the case I want to liquidate my investment?
The investment should be considered an illiquid investment. That said, we understand that life happens. We will consider each request in its own merit and will attempt to best accommodate you.
15) What fees do you charge?
Typically we charge 1% acquisition fee (on the gross asset value) and anywhere from 1-2% on the management side (on the gross rents). Our fee are meant to compensate us for the time/risk we outlay as we bring these investments to you.
To you health and wealth,
Risk and return go hand in hand. Typically return expectations of investors increases as risk of the investment increases. Investors seek to reduce the risk by diversifying across industries, asset classes and investment horizons. Whilst diversification is a great way to reduce portfolio risk, often times macro events which cause drastic and severe corrections. The 2008 mortgage crisis was a classic example of that. While the crisis emanated in the housing market, the contagion spread to most public markets in the US and worldwide almost causing a collapse of the US financial system. Nonetheless, the power of diversification cannot be understated regardless of portfolio size and composition.
What makes a portfolio diversified:
Knowing the benefits of portfolio diversification, one may ask what makes a portfolio diversified. The key idea behind portfolio diversification lies in “correlation”. Correlated investment themes tend to perform similarly. By virtue of that, they would tend to do well under similar conditions and on the flip side do poorly under certain other conditions. One can achieve portfolio diversification by investing in assets that have low to a zero correlation among each other.
Swensen’s 20% rule and Real estate’s superior diversification potential:
The 20% rule created by David Swensen, the Chief investment officer at Yale endowment is a popular portfolio risk mitigation strategy and calls for allocation 20% of the portfolio towards alternative investments – one’s that have low correlation with traditional and publicly trades asset classes as as stocks and bonds. We argue that Real estate happens to one of the best choices to achieve near complete portfolio diversification. Some of the top reasons are:
1. Correlation advantage:
Real estate has a low correlation with stocks and bonds. Historically the correlation has been as low as 0 in the early 2000’s to as high as 0.8 during the mortgage crisis. The average correlation across the previous 4 decades has been around 0.3 or so. This is great news from a portfolio diversification standpoint.
2. Inflation advantage:
Real estate acts as a natural inflation hedge. Inflation hedge investments are investments that are expected to increase or at-least maintain their value over a period of time. The most typical example of that fact is the rising rental rates in most major sub-markets in the US. The sheer shortage of housing and the home affordability crisis has further caused an upward pressure on rents.
3. Illiquidity and market inefficiency:
Real estate is an illiquid investment. While that fact could be construed as a negative, there are studies conducted that demonstrate the fact that retail investors don’t make money over the long run in liquid markets. This if often attributed due to “market-timing” tendencies of retail investors and quite to the contrary Real estate’s relative illiquid nature helps more than hurts. Illiquidity often also leads to market inefficiencies which sophisticated market participants can exploit.
To your health and wealth!
It is often said that Real estate is not a “get-rich quick” scheme. Whilst we agree with that, it surely is a “get-rich consistently” scheme. What do we mean by that? Well, consistently investing in Real estate can produce some stellar effects. It takes times to build the momentum but once the flywheel is up and running, it sure as heck runs! And if one is smart about it, one can program the flywheel to keep on running without putting in a lot of effort or even no effort.
It is illustrative to look at some numbers. The attached spreadsheet walks through one hypothetical 10 year investment horizon and showcases the power of real estate investing. First, some assumptions: We assume that every year we initiate a fresh investment amount of 50k, a cash on cash yield of 8% on any investment and a 16% annualized return realized at exit. Please note that these numbers are very typical of the offerings we bring to our investors.
Monthly cash flow is calculated as an 8% yield on the cumulative investment (net worth) in any given year. For instance, in the first year one starts with 50k leading to an annual cash flow of 4k (50k*8%) and a monthly cash flow of $333.33. As time passes and as one’s investment amounts grow, the monthly cash flow and the net worth grows. For instance, in year 6 the monthly cash flows stands at $2333.30 and the net worth at 300k. Here is where the magic happens now!. Come end of year 6, the investment we made in year 0 matures and so does our net-worth. In year 7, we invest 50k as usual but we get a 100k bump from that exit leading to a cash flow of $3000 and a net-worth of 400k. This repeats in the subsequent years as we reap the fruits of our investments. By the time year 10 ends, we stand at a monthly cash flow of $5000 and a net-worth of 800k!
In the same phenomenon, If you invest 100k per year instead of 50k, at the end of Year 10, you will get 10k per month of cash flow and Net worth of $1.6 MM.
Now, that is some snowballing! The question is if you are ready to take that first step. We cannot wait!
Take the calculator for a spin and give us feedback.
To your Wealth!
- Zovest Team
We now know why expected returns is only half of the story and its crucial to incorporate risk in the investment a.k.a. Sharpe ratio. Armed with our new knowledge of bench-marking investments on the basis of the their Sharpe ratio, we can find out which investments are truly the outperforming ones. The data is clear, Real estate (esp yield producing Real estate) was the best performing asset class over the past two decades. This may come as a surprise to many and it was clearly to us as well.
Perhaps a picture is worth a thousand words. The plot below shows the annual return on the y axis and annualized standard deviation on the x-axis for a variety of asset classes such as stocks (large cap, small cap), commodities, bonds etc. NPI is an index that tracks “operating” private commercial real estate properties held for investment purposes only. Its an index that is managed by NAREIT (National associated of Real Estate Investment Trusts). Whilst NPI includes most yield producing real estate such as office buildings and retail, multifamily apartments are a significant portion of the constitution of the index.
Its interesting to see that NPI outperforms all the other asset classes. NPI index has a stock like return with a bond like risk characteristic. It is even more interesting that NPI handily beats down listed REIT’s. We will expound on the reasons in a later blog post, so stay tuned. Overall, this is great validation for us as acquirers of yield producing assets.
This is part 1 of a series of blogs on measuring risk adjusted return of a Real Estate portfolio. In this blog, we will focus on a fundamental concept around adjusting for risk to measure the performance of an asset – The Sharpe Ratio.
What is Sharpe Ratio:
As investors, obviously we care about expected return on say a given asset or across a given portfolio. Keeping everything else constant, higher expected return is better than lower, for instance. But just looking at the expected returns masks an important fundamental concept around the risk that we take to sustain that return. One way to measure the risk is to measure the standard deviation of the expected return. Without going into too much detail in this post, one measure of risk is the standard deviation of the return. An asset with a lower standard deviation has a more consistent return than the one with a higher standard deviation. A question arises, whether an investment in an asset with a expected return of 20% and a standard deviation of 10% is better than an investment with 30% expected return and 30% standard deviation. The second investment has a higher expected return but also a much higher standard deviation. This is where the notion of Sharpe comes in.
Developed in 1966 by Nobel prize winner William Forsyth Sharpe, the Sharpe ratio measures the expected return of an asset relative to its risk.
where E(r) = asset expected return, rf is the risk free rate and σf is the standard deviation of the excess return. As we can see expected return increases the Sharpe but standard deviation reduces it. In our contrived example, option one is a better investment despite having a lower expected return. This is due to the lower standard deviation of option one.
Limitations of Sharpe Ratio:
The benefits of Sharpe ratio are obvious. Its a dimensionless way to compare asset returns paying regard to their risk. It establishes a benchmark across different assets and facilitates an objected comparison of return adjusted for risk. As it turns out, there are some limitations as well. One of the biggest limitations of the Sharpe ratio is that it assumes “normality”. Without going into too much detail this means that the return distribution is expected to follow a normal or a “bell-curve” distribution. While this is practically not true (asset returns need not be normal), it still isn’t too much of a limitation. There are other limitations of the Sharpe ratio as well related to the time-structure of the returns. We will not go in too much detail on those for the sake of simplicity.
Suffices to that the Sharpe ratio is a great tool for the modern Real Estate investor to compare the relative performance across different investments properly accounting for the underlying risk and penalizing riskier investments versus lower risk ones and favoring investments with a higher expected return over the ones with a lower value.
1. Taxes will increase after stimulus bills.
During the last two months, Congress has passed more than $4 trillion in stimulus spending, with more probably on the way. Taxpayers will end up paying for this at some point. Medicare, the health insurance program for seniors, could run short of money in 2023 or sooner, as the payroll taxes that finance the program plunge amid record unemployment. Also the future retirement benefits people receive might shrink.
Apartment investment is one great way to get long term tax free income and also help in offsetting your current income with the depreciation (Check with your CPA before taking tax decisions).
2. People will move from primary to secondary markets due to de-urbanization
In view of future pandemics, due to social distancing requirements, cost of living de-urbanization from the high population density might happen even though its too early to predict. If you see current number of covid infected cities, they all are high population density metros/ cities.
3. Apartments fared better than other asset classes
As per latest article from NMHC (National Multifamily Housing Council) the rent collections for Apartments in April are at 92% by April 26th. So Apartments which come under basic necessities fared better than other asset classes like Retail, Hotel and office which suffered really bad.
4. Stock market will have long period of volatility and low returns
Top wall street forecasters predict that stock markets will deliver lackluster results because of prolonged volatility for a long time due to uncertainties.
5. Less people buying homes
Because of strict criteria by banks like 700 credit score and 20% downpayment recently by Chase and other banks it will be difficult for a lot of people to buy homes. People want to have mobility due to employment shifts. New single family home constructions will slow down and other macro trends will shift people mindset to rent more. The demand for Apartments will increase a lot in future.
6. All time Low Interest rate environment
Interest rates will be low for a foreseeable future which enables to get good cash flow from the apartment investments.
We are carefully observing deal flow and capital markets and we hope there will be many deals that we can present to our investors. Please click on the button to view our investment opportunities so we can reach out to you and know each other and your investment criteria.
Note: I will expand and keep refining this post on a periodic basis so it's up to date
1) Low Income and Bad Demographics Mix
2) High Crime
3) Rent Roll Occupancy and Physical Occupancy don't match
4) Income in T12 and Actual Bank statements don't match
5) Flat Roofs
6) Window ACs or lack of Central HVAC
7) Wood construction issues like wood rot, decks not in good condition, WDO (Wood Destroying Organisms), Termite Damage, Stucco/ Siding issues. Overall be really careful with old wood construction. Prefer concrete block or masonry structures.
8) Water Damage inside units (Use Infrared Cameras to find out during unit walks)
9) Foundation Issues
10) Polybutylene Piping
11) Cast Iron Sewer Lines
12) Water leaks (See Pattern of water bills from past few months/ years)
13) Old Electrical Panels
14) Ignoring age of Water Heaters/ HVAC's/ Roofs while computing CapEx
15) Radon Gas
16) Retaining Walls
17) Water Intrusion
20) Asbestos and Lead Based Paint
21) Gutters, Down sprouts
22) Tree Trimming
23) They just fill in with people by giving concessions before selling. Tenants are not vetted properly and bad quality. See if there are many leases in last 3 months.
24) Always ask for seller story (We passed on several deals just because the story is not right)
25) Get Insurance Loss Runs to see any recent claims
26) Never assume existing LLC - Always do new entity
27) Go to FEMA website and verify if the property is in Flood Zone
28) Self direct IRA investments take time. So work on them first and get funds 2 weeks before closing
We at Zovest Capital, invest in value-add and new development of Apartments in growing markets to provide passive cash-flow to our investors.