Why are we underwriting a five-year hold for multi-family investments? You might have been investigating multi-family investments or apartment investing as a passive investor and seen a pattern of everyone saying, “We’re going to hold this for five years.” Why five years? Why not hold it forever if you’re adding value, if it’s creating cashflow? Or why not flip it in 18 months, right? And there are good reasons for both of those, for the flip in and out, and for the hold forever. I’ll touch on those in a minute.
But really, a five-year underwriting hold period gives us the opportunity to do a couple of things. The first thing is, it gives us the opportunity to go in and make some improvements. These might be slight operational improvements in terms of reducing expenses. They might be much heavier improvements in terms of spending $8,000 on every unit, doing a full gut job and totally turning the property around, or some variation in between there.
But you need some time to execute that. It might take a year. It might take 18 months, depending how many units and depending how quickly you’re going turn through them. It’s going to take some time to execute that value add. A cleaner property might happen quicker, where you’re just kind of making some improvements to your operating expenses. The name of the game here is improving the value of the property by improving its net operating income. That’s really all that matters at the end of the day, because the property is valued on its net operating income.
A rule of thumb for evaluating an apartment complex, net operating income divided by the prevailing cap rate gives you a value, okay? So slight increases to your net operating income can have massive impacts on your valuation, especially with lower cap rates that we’re seeing today.
So why the five-year hold? Because we need some time upfront to get some of the work done. Then we’re going to want to enjoy some of the cashflow once the property is performing correctly, right?
Another reason is that we’re going to be getting some, in many cases, massive depreciation passing through on this property, especially in that first year or two. So these are big losses, paper losses mind you, on your tax return that we can enjoy. So not only is it about money coming in, I mean, we all know it’s not about the money you make, it’s about the money that you get to keep, right? So multi-family gives us these oftentimes massive depreciation advantages in the first couple of years that we can take to offset our taxes, right? So that’s another reason why we want to hold it for a couple of years.
Now why do we want sell as early as five years and not just hold it in cashflow forever? Well, that is an option. And many times, if you’re looking at maybe more of a family kind of generational wealth type thing where it’s just you owning it, or maybe you and the bank, that could be a more viable strategy. Maybe on a cleaner, newer asset where you’re going to hold this forever, maybe pass it down to your heirs. Totally viable strategy.
But within a syndication, we are predicating our returns on really getting in, putting the money to work, and then getting it back to investors on some sort of reasonable, near-term horizon. So if we provide an 8% return to investors, okay, that’s great. But at some point, investors are going to want their capital back, and they’re going to want to see that big kind of pop at the end, right? Usually we project it at about 50% of capital. So if somebody invests 100K, they might get 50K back over the life of the project in distributions, but then at the end, they’re getting another 50K in proceeds plus their principal back, right? We shoot for like a 2X return on capital there over the whole period.
Another thing is, as you kind of approach that multi-year hold, you’ve done all these improvements on the front end. Let’s say it’s an ’80s property. At some point as you start to get a few years in the project, it’s going to need more capital. Now a lot of times we’re setting aside $200, $300, $400 a year per unit for capital reserves, whether we’re doing that as operators or the bank’s making us do that. But over time, these big commercial projects, they’re going to need some capital injection. And it might just be time to say after three, four, five years, “Okay, we’ve had a good run with this asset, we’re in a position now to sell and reap some of the rewards, and there’s some stuff left to be done for the next operator to go in and make some of those improvements with a fresh capital injection.” Usually the owner after kind of gone through that on the front end and held for a few years, the owner may not want to recapitalize and go through that whole process again on that asset. It just might be time to move on.
So there’s a number of reasons there that the five-year hold period is fairly common. That’s typically what we underwrite to. Although, oftentimes assets are sold in a shorter time period, that’s kind of some insight behind the five-year hold underwriting that you’ll see on a lot of multi-family projects.
Thank you and have a great day.