2022-01-03 | Co-investment as an interesting alternative to building up your wealth
Co-investment as an interesting alternative to building up your wealth
What is a co-investment?
Co-investment is when two or more people invest together in a property with the aim to create rental income and appreciation of real estate value. Typically, we are looking at small or medium-sized multi-family homes. It is often the case that one partner provides the money for the financing and the other finds, renovates, develops and optimises the property. We call the partner who provides capital (20% or more of the property purchase price) a co-investor and the partner who drives the development of the property an entrepreneur. The investors setup a property company, which now owns the property, the investors are owners of the company, thereby owners of the property.
How does a co-investment work?
One partner contributes capital, the other finds the property, sets up a "property company" which then buys the property and develops the property further. Advantage: know-how meets capital. Both partners profit from each other. Without capital, no property can be bought; without know-how the property cannot be found and developed.
What shares do the partners get?
It’s different for every co-investment, because it depends on who puts in the time and money.
Let's take a simple example:
The traditional investor invests €200,000 in a €1,000,000 apartment building. With this sum, the property can be bought and partly developed (renovation, refurbishment, conversion, extensions, energy modernisation, rent increases, etc.). The remaining purchase price is financed by a bank. If capital is only provided once by the investor, the investor receives a share in the company that owns the property of about 30 %. The entrepreneur-partner who has found the property, does the management, secures the financing, manages the development - i.e. renovation or refurbishment -of the house, increases the rents and adds value to the property. In other words, he takes over the entire development process. In return, he gets more shares than the pure investor. More company shares mean correspondingly more shares in the profits.
What yields can the investor expect?
For a apartment building, about 3 - 5 % yield per year. This is the rental return, which only results from the rents in relation to the purchase price. In our example, this means 30,000 - €50,000 per year. The possible increase in value is not considered here, nor is the leverage effect on equity via debt financing.
What happens to the return?
The return is used to service the interest and the repayment of the loan. In our example, €800,000 must also be repaid to the bank. In addition, property management, maintenance, tenant charges, etc. have to be taken into account.
Good investors will see better results over a longer period of time. That means there will be no distributions in the first few years, but the property itself improves over the years. Once the property is in better condition you can increase the rental income as well.
Who invests in such apartment buildings?
Private individuals who earn above-average income or have inherited money invest in such apartment buildings. Most of our investors invest between €150,000 and €400,000 per property. They think long-term, and expect not to use the invested capital for other things for the next 10 years or longer.
How does such an investment pay off?
You will see that investing into real estate is particularly lucrative when they are being upgraded, renovated or refurbished. Modernising heating systems, adding balconies, improving the bathrooms and the windows, and creating better and modern floor plans are important. Once the standard of living is raised, the tenants feel valued, and a rent increase can be implemented.
Higher rental income means that the repayment of the loan can be made faster, and the value of the property itself will increase further. The more that can be repaid, the less money must be paid back to the bank. This surplus can be used for your own living expenses, upgrade the investment property further or invest in additional properties.
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What annual profits can a co-investor expect?
In the first 10 years, no distributions can be expected, because the "surpluses" remain in the company to develop the property and pay off the debt. After that, the shareholders (i.e. the investor and the entrepreneur) decide together whether to sell the property at market value or to refinance it and keep it in the portfolio. Until a few years ago, most investors wanted to sell, as the prices for such apartment buildings had doubled and even tripled in some cases, depending on how long they have owned their property. After 10 years a fairly large chunk of money comes in at once, but in return the investor has not received any distributions for 10 years and has been saving and investing into the property.
If we look at this retrospectively, the co-investors have "earned" you approx. 10% per year if the purchase price doubles, i.e. 100% plus, at 3% repayment p.a., another 30% in total. That would be approx. 133 % in 10 years or 13.3 % per year. The "return on equity" is many times higher with approx. 20% invested capital. If you want to know more about the leverage effect please contact us directly or visit our youtube channel.
The following must be considered: There is no guarantee for a positive performance of a property. We always reckon with very conservative growth rates between 3% to 5% increases in value per year. In recent years, however, we have had value increases of 8-15% per year in some regions. However, other times will come, and every serious businessman should expect this. A realistic goal should be to have a stable positive cash flow after the first 10 years, even with rising interest rates. If the investment works out, the best scenario is always never to sell the property because the cash flow is so good.
Notes: Of course, the company as the owner of the property earns directly and not the investor. The distributions are then more of a tax issue. Loan terms must also be considered to avoid possible early repayment penalties in the event of premature repayment of the loan, and current legislation in the housing market also plays an increasingly important role, especially in metropolitan regions.
What risks should be considered as an investor in an apartment building?
First and foremost, the location of the properties is key. What is hip today may still be hip tomorrow, but it doesn't have to be. The price you pay a location today and could differ in 10 to 20 years. Are there locations that are not trendy today but will be in 10 or 20 years? If so, how high is the risk? 70% of decisions are based on the ratio of location to price. This is where most things can go wrong as well. What percentage of their income will people be willing to spend for rent or purchase price in two decades?
For us, rents are always more important than purchase prices. What is the point of renting out an apartment building in a perceived great location if we don't get enough rent to maintain and develop it? Properties must pay for themselves. Anyone who expects prices to continue to rise and "injects" additional money into the cash flow to make it work needs very convincing arguments or be able to afford it. But we don't want these kinds of deals. Instead, we make sensible investments even with "normal" value development. The next 10 years will clearly have a lower price growth potential than the past 10 years.
We are approached by families who are thinking more about securing a future for their children, retirement, or extra income than those who want to achieve maximum profits in short periods of time. Our job as entrepreneurs in partnership with the investor is to address this realistically, to understand the expectations and to point out potentials.
People's need for modern and affordable housing will always exist. Hence, we are not building an investment decision on special rental models or luxury refurbishments, we concentrate on the majority of households who generate realistic income with normal jobs. Therefore, we are willing to invest into areas that we see as promising. We know that today's AAA-locations will only be affordable for a small part of the population in the future. We also expect increasing regulations in these areas, which will drive even more people out of these locations and cause prices to rise further. However, we do not have to be a part of this political game but are happy when our concepts and investments with normal rents in normal locations work out and our co-investors secure their income.
What securities does the co-investor have when buying an apartment building?
First, the co-investor owns shares in the property through the real estate company - usually always more than 25%. Therefore, nothing significant can be decided without the co-investor's consent as owner and shareholder. The shareholder charter also regulates further details. In addition, there are monthly reports and fixed meetings in which both partners discuss current developments and make decisions. The banks also evaluate the property themselves when they buy it and check the creditworthiness of both partners. You can't buy a reputation; our co-investors usually know us through transactions they have already completed with us as brokers or advisors or have friends and acquaintances who did. It is important to agree on clear goals before the start of a cooperation and to write them down.
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What can happen on the "investor journey"?
This is an often-underestimated topic. Issues such as job loss, illness, death, divorce, inheritance disputes, etc. should be regulated in the contract. Goals can change at short notice. There must therefore be a clear provision for this case - wanted or unwanted – and fair exit option of a partner. The valuation method of the property at the time of a partner's exit is particularly important.
What forms of partnership are there?
The type of partnership is very important. Should it be a classic asset-managing limited liability company, do you work with bullet loans, holdings, are international companies involved or not? Or do you prefer a private investment without a company registration? Or as a private individual in your name? These are all topics that need to be clarified by lawyers and tax advisors. At the beginning and at the end of the partnership, only one question counts: What do the partners want to achieve with their investment in time and money? Where do they want to go? How do they want to achieve their goals? Who should be liable for the risks? Who should profit from the opportunities? This then leads to the forms of partners and shares.
What is our advice to potential co-investors?
Our advice is to approach an investment with less "greed" and more time, and to be relaxed. This does not only apply to the profit expectation, but also to the personal lifestyle. Yes, there are investors who "double" their capital in a few years. Yes, there are investors who have returns of 10-20% per year. But why and for what? These are full-time investors who do nothing else. These investors don't need partners like us.
Our co-investors and partners want to earn money in peace by making good housing available to other people and want to live off the difference between rent minus management costs minus costs for debt service or want to open sources of income for their families in the future.
In this process, investments are made in the property and rents are adjusted fairly so that no tenant has to fear displacement. In rent negotiations, each individual case is considered. There is also life outside of Excel spreadsheets and scalable business models 😉
What are the advantages of a co-investor?
- The co-investors "only" need to invest capital and do not have to do any additional work to make their money work. The entrepreneur-partner does all the work and manages the investment. However, supervision and control of the common goals and their achievement always remain the responsibility of the co-investors.
- As a partner in the property company, they always have the necessary security and control over their property or their shares under German real estate law. They can intervene at any time.
- There are clear budgets, shareholder agreements and loan agreements. Success can therefore be planned.
Co-investors have access to save yield properties that they would not have without the partner.
- Due to the track record of the partner, the co-investors get access to financing opportunities that he would not have on his own or would have to build up over the years.
- Co-investors save considerable time in setting up the investment structure, as they can access existing networks and contacts. This creates space for them to deal with other things or to invest elsewhere.
- Co-investors can optimise tax aspects, realistically plan income in the future because they have the know-how even if they have or haven’t any experience in real estate before.
- Co-investors can "leverage" their capital. Banks are very motivated to give low-interest loans on cash-flow positive apartment buildings. Thus, the real return on invested equity increases substantially.
- The Co-investors do not have to worry about refurbishment, renovation, workmen, tenants, tenancy agreements, settlements, etc.. This is managed of by the partner.
- The Co-investors can sell or finance their shares in the company or the entire property at market value after 10 years, and then earn part of the income from a normal clear positive cash flow without having to work for it. Classic old-age income, protection of family planning, tuition fees of the children, regulation of estate planning, etc. are thus realistic.
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