In our last post, we explored investing in real estate debt by becoming a private lender. Today we will look at investing in real estate by taking and equity stake and becoming a limited partner.
Why use Equity Financing?
As we discussed in our last post, real estate is commonly purchased by using a mixture of debt and equity.
In most cases, banks and financial institutions require a buyer to put a down payment when purchasing a property. And on larger properties, such as the multifamily properties we invest in, these down payments can be substantial.
As syndicators, we raise the capital for the down payment and renovation from private investors who take an equity stake in the property.
A syndicaton group finds a property that meets their investment criteria and has a purchase price of $3,000,000. With about $350,000 worth of renovations, the property’s value can be pushed to $3,950,000.
The bank is willing to lend $2,250,000, which represents 75% of the purchase price. The syndicator has $100,000 of their own capital, but needs to raise the other $1,000,000 for the down payment and renovation budget in order to complete the deal.
The syndication group offers the opportunity to their list of qualified private investors, who invest the remaining $1,000,000 needed to complete the deal. These investors take an equity stake in the property.
Becoming an Equity Partner
By choosing to invest in equity, you will become a limited partner that owns a portion of the property.
As a limited partner, you will participate in the profits and losses of the property in proportion to your share of equity. Being a limited partner limits your potential loss to the amount of your investment and also protects you from liability.
In addition to receiving a piece of the profits and losses, limited partners can also receive the tax benefits of real estate ownership, as the profits and losses flow through to the investor via a K-1 which is issued at the end of the tax year.
Potential Tax Benefits
It is important to note that real estate investments often show a “paper loss” caused by depreciation. This “paper loss” is not a real loss because deprecation is a non-cash expense so the cash is still available.
For example, the net loss of a property is $29,000 for the year, but the depreciation expense was $94,000, so in reality the property produced a cash profit of $65,000.
This “loss” flows through to the investors in proportion to their investment in the property. In some cases, this loss can be used to offset other income, and reduce your tax liability.
You know the syndication group that is putting together the deal mentioned above. One of their members offers you the opportunity to invest in the deal.
You understand fundamentals of the market where the property is being purchased and the plan to renovate the property, and decide to invest $200,000.
Because the deal is being syndicated, the sponsorship team will receive a 15% stake in the property, and the investors will receive the remaining 85%, in proportion to their investment.
Your $200,000 represents a 15.45% stake in the property (($200,000/$1,100,000) x 85%). Because you own 15.45% of the property, you will receive 15.45% of the profits and losses.
Advantages & Disadvantages of Being an Equity Partner
- Typical investor returns exceed those of stocks, bonds, and mutual funds.
- Potential returns are uncapped (Unlike private lending where there is fixed rate of return, if the property performs at a high level, you will also participate in the upside as an equity partner)
- Potential tax benefits
- Potential loss of capital
- Investment is typically illiquid
- Returns can vary
Who Should Consider Becoming an Equity Partner?
Becoming an Equity Partner is best suited for risk tolerant investors who are interested in the benefits of owning real estate, without the hassle of managing it themselves.
Because of the time horizons of such investments, this strategy works well for investors with large amounts of money in retirement accounts and want to diversify their portfolio outside of traditional assets such as stocks and bonds. A portion of these retirement accounts can be self-directed and used to invest in real estate.
Also, investors with passive income from other investments benefit from equity investments as the “paper losses” produced in the first years of ownership can be used to offset passive income from other investments, which reduces their tax liability.
A major factor to understand is unlike private lending, there is no collateral when making an equity investment, and although unlikely, can result in a total loss of invested capital.
Babylon Property Group, LLC provides private investment opportunities for qualified investors looking to diversify their portfolio outside of traditional assets found in typical 401(k) and IRA plans. For a FREE consultation, please fill out our investor questionnaire, or contact us directly by phone at (631) 253-1609 or email at firstname.lastname@example.org.