WHAT IS PASSIVE REAL ESTATE INVESTING? HOW TO HAVE AN INVESTMENT AS A PASSIVE INVESTOR
Investment real estate is a very attractive asset class to investors for the array of benefits it offers. This includes; consistent income, tax benefits, and long-term capital appreciation. To take advantage of these benefits though, most investors believe they must actively purchase and manage the properties. This assumption diminishes the attractiveness of this asset class for most would-be real estate investors. A common misconception however is to be a real estate investor, you need to actively purchase and manage the properties yourself. That being said, real estate investing does not need to be a hands-on investment. Over the past decade, passive real estate investing has gained popularity, and for good reason.
What Is Passive Real Estate Investing?
Passive real estate investing is an investment strategy that consists of two groups of people. The passive investors (also known as the limited partners) and the operators (also known as the general partners). The passive investors are only responsible for supplying the capital; while the operators manage the project in its entirety.
Passive investors have no involvement or responsibilities after they have completed their investment of capital. They will perform their due diligence at the beginning of the deal and decide whether to invest or not. Passive investors are not involved in; purchasing, managing, or selling the properties.
Passive investing is very similar to investing in the stock market, except in most cases, your gains are often more consistent. Once the investor makes their purchase of the stocks or mutual funds; they are a passive investor. They have no other responsibilities once their investment is finalized. The company will never contact the shareholder to perform any tasks or do any work.
The operators are a group of professionals that will oversee the entire passive real estate investment. They will research the market, identify the specific property, use their funds to secure the property, raise funds from investors, purchase the property, instill new management, and renovate and resell the property. In most instances, the property will be managed by a professional third-party management company however; the operators will be reviewing their progress on a weekly basis and working to implement the business plan which will include minimizing expenses, increasing revenue, and maximizing efficiencies.
What Are the Benefits of being a Passive Real Estate Investor?
Many investors have considered investing in real estate but do not necessarily have the time or the experience to manage properties themselves. The main advantage of passive real estate investing is leveraging the experience of professional operators and managers in order to increase the profitability of the asset. Passive investors do not really need to know what they are doing to invest passively in real estate. Investors just need a basic understanding of investment analysis.
Passive real estate investing requires a much shorter time commitment than active real estate investing. Most real estate investors underwrite dozens of properties before purchasing one, and then they need to manage the property. Passive investors do not need to make this level of time commitment. They are mainly reviewing deals and sponsors, investing funds, and reviewing the progress of their investments.
Real estate investors are able to invest smaller sums of money when passively investing. Active real estate investors normally spend thousands of dollars in due diligence, inspections, and loan fees while also making a down payment of normally 25%. Next, they need to perform renovations and pay legal fees for evictions in addition to funding a reserve account for future issues. On the other hand, passive investors are usually able to invest in large commercial properties and apartment complexes with as little as $50,000 in most cases.
Is Passive Income Realistic from Real Estate Investing?
If you are investing as a passive investor in a real estate syndication or into a Real Estate Investment Trust (REIT); passive real estate investing is assured. This is one of the main reasons that syndications have become so popular over the past decade. Investors want diversification of their portfolio into real estate but, do not want to actively manage the properties. In many syndications, there are dozens, if not hundreds of passive investors. Without the syndication structure; these investors would never be able to efficiently manage the investment property if every investor had an active role or responsibility. A more effective approach is when passive investors who believe in the deal and their operators give full control to the professional management team in order to reposition the asset.
On the other hand, some investors might consider their active investment into real estate as a passive one since they have enlisted the services of a third-party property manager however; the manager needs to be managed and there will routinely be issues that require the input of knowledge (and money) from the owner. When there are expensive repairs that are required or major issues with tenants; the property manager is going to pull in the owner to help correct the problem. This form of investing is semi-passive at best.
Pros and Cons of Real Estate Investments
- Lower Upfront Investment: You do not need to invest hundreds of thousands of dollars to experience the benefits of passive real estate investing. Most real estate syndications have minimums as low as $25,000-$50,000.
- Less Time Required: Passive investors do not need to find, purchase, renovate, manage or sell any properties. The operators will fully manage the property while overseeing the implementation of the business plan. Allowing passive investors to avoid; advertising vacancies, vetting applicants, signing leases, making consistent repairs and updates, responding at all hours to maintenance requests along with hours of bookkeeping, paying bills, and managing the back office.
- Larger, Institutional Grade Properties: Most active real estate investors will purchase smaller, less desirable properties. When passively investing, investors are able to invest in large, institutional-grade commercial properties in great locations. These properties are much more desirable to investors and are more liquid since there are always qualified buyers for these assets.
- Minimal Experience Required: It is important that passive investors have an understanding of the real estate market; however, you do not need to be a professional investor or expert. You are simply investing alongside professional operators.
- Tax Benefits: Unlike other investment strategies and structures; passive real estate investing through a syndication, passes the tax benefits along to the passive investors. This helps defer income and gains for years into the future (and possibly forever).
- Direct Real Estate Investing is Semi-Passive (at best): Many new investors believe that by hiring a property manager, all of their property issues will be handled. Nothing could be further from the truth. Yes, many day-to-day activities will be offloaded to the manager; but the owner still needs to manage the manager (commonly referred to as “asset management”). Owners must consistently monitor bank accounts, vendor bills, insurance policies, mortgages, rent collection, expenses, capital expenditures (roofs, decks, parking lots, etc.), and more. Regular visits to the properties are also a requirement so owners are able to review the actual condition of their assets.
- Less Control: Passive investors have less control over the day-to-day property operations. The operators have the power to make decisions on behalf of the investors. It is important that passive investors trust the operators to make the best decisions and handle any issues that arise. Vetting operators prior to investing is a critical component of being a successful passive real estate investor.
- Illiquid Investment: When you passively invest, your investment is illiquid. You are typically unable to sell your shares in the project and if the project is held longer than expected (possibly due to a recession); investors are unable to exit the investment early. It is important that passive investors do not need the funds they are investing in during the anticipated hold time.
- Fees and Splits: Since passive investors are partnering with a team of operators in order to reposition the asset; these operators get paid once the investment has returned a predetermined amount of money to the passive investors (called the “preferred returned”). Typically, the preferred return is 7%-8%. In other words, once the investment returns the preferred return to passive investors; the operators will start taking a percentage of the return. For example; if a property with an 8% preferred return starts returning 13% per year; passive investors will get their 8% return and then afterward there is a split (typically 80/20); with 80% going to passive investors and 20% going to the operators (above the preferred return). In this scenario, passive investors would receive 12% and operators would receive 1%. Sophisticated investors prefer this structure since it incentivizes the managers to maximize the profitability of the investment.
Investment Opportunities for Passive Investors
Real Estate Investment Trusts (REITs)
REITs own nearly $4 trillion in U.S. real estate assets and are one of the easiest ways of investing passively in real estate. The minimums to invest in REITs are very low and REITs allow you to choose the type of real estate classes you would like exposure to. The process to invest in REITs is very simple; similar to investing in a mutual fund or exchange-traded fund (ETF).
One of the drawbacks of REITs is their very inefficient taxation. Nearly all income from REITs needs to be distributed to shareholders. These shareholders are then taxed at ordinary income tax rates. This loses one of the main benefits of investing in real estate; its tax effectiveness.
A second drawback is their regulation. Public Traded REITs are listed on a national securities exchange, where they are bought and sold by individual passive investors. They are thus regulated by the U.S. Securities and Exchange Commission (SEC). The costs involved with being compliant are paid from the returns generated by the REIT; which otherwise would have been paid to passive investors.
Real Estate Syndications
Real estate syndications have become more and more popular over the past decade. These investments allow passive investors to easily invest alongside professional operators and managers. Also known as a private placement; it is an offering of unregistered securities to a limited pool of investors.
The private placement/carried interest structure has been a successful investment structure going back to the 16th Century when European ships were crossing from Asia to the Americas. Ship captains would receive a 20% share of the profits from the carried goods to cover transport and risk. This is exactly how the structure is set up today; instead of captains and ships, it is operators and commercial real estate assets. This includes everything from multifamily properties to self storage facilities to other investments. This complete alignment of interest is why this structure has survived and is commonly used in; private equity, hedge funds, and venture capital deals.
Real estate syndications are extremely tax efficient. Allowing investors to defer their income and gains for years into the future. This normally is not a possibility with other passive real estate structures.
How Passive Do You Want to Be? What is Your Ultimate Goal for Investing?
When deciding what is the best real estate investing path for you; first determine what your ultimate goal is. Do you want to be a landlord with many properties? Running a business that revolves around overseeing managers, contractors, tenants, and properties? If so, the active approach might be best for you.
If you are like most investors, you want to diversify your portfolio into real estate without actively managing the properties. For these investors, passive real estate investing is a better choice. Usually, these investors have a high-paying full-time job or run a business. Their time is typically worth more than what it would be driving from property to property or handling an endless number of phone calls throughout the day.
Reasons To Take a More Active Approach
There are a few main reasons to take a more active approach when starting to invest in real estate.
The first is a lack of initial capital. Many new real estate investors will lack enough capital to passively invest in real estate. They would rather invest more sweat equity than dollars into their real estate projects.
The second is a higher return potential. If you are performing fix-and-flips or acquiring rental properties as long-term rentals; when you own the property yourself, there is a higher reward potential than with most passive real estate investments. This also requires the investor to be knowledgeable and have free time to devote to purchasing and managing the properties.
The third is having full control over your real estate investments. As the sole owner, you make the decisions when it comes to your properties. What the business plan will be, who to rent to, where to advertise, what you will rent for, who you will hire if there is an issue etc. If you understand real estate investing and have a team to assist you; active real estate investing might be the best choice for you.
There is no best answer for every investor. The majority of investors would make better passive investors since they lack the expertise to analyze, purchase, renovate and manage investment real estate. Other investors, do not have the time required to actively manage their real estate investments.
Before you define your real estate investment plan, consider all of your investment goals, your expertise, and your time availability. Understanding these factors will assist you in choosing the best real estate investment strategy.
How to Passively Become Involved in Real Estate Investments
Passive real estate investing is a superior investment opportunity for new investors, who are interested in receiving passive income from real estate; without the hands-on work that is regularly involved with traditional real estate investing. Unlike real estate crowdfunding schemes like realtymogul, investing directly with the partners allows investors to build trust and long term investment relationships.
Becoming a successful passive real estate investor, may not require you to search real estate listings or speak to contractors but it will require you to review and correctly analyze different passive investments. It is important to understand that passive real estate investing calls for the careful vetting of both opportunities and operators.
When determining your passive real estate investing strategy; determine what your risk tolerance is in addition to your diversification needs, along with your ultimate investment goals. Are you more interested in regular cash flow? Or are you more interested in having a larger overall return when the property sells? Determining these goals now will make it much easier to analyze deals.
If you are interested in learning more about Harborside Partners and our passive real estate investing opportunities; please visit Invest With Us page.
Make sure to also check out our Passive Real Estate Investing Podcast.