Real estate investing has many benefits, from monthly cash flow to appreciation, tax benefits and more. “Buy rental property, then just sit back and collect passive income!”, people are told. A well-intentioned investor who follows that advice might turn around and buy a single-family rental property, only to realize it is a lot more work than they had anticipated.
And therein lies the difference between active and passive real estate investing – a distinction that many people overlook when investing in rental property for the first time.
Today, we look at the difference between active and passive real estate investing, including the different types and some of the pros and cons of each.
Active real estate investing is when a person, entity or fund is directly involved in the investment process. In short, active real estate investing requires YOUR time, YOUR capital, and YOUR risk. An active investor is fully engaged in the process, either entirely from beginning to end, or heavily in parts of the process (such as acquisition or renovation). The level of commitment that is required by active real estate investors often equates to a full-time job.
Active real estate investing can take different forms, from wholesaling to fix-and-flips.
Wholesaling is when a person ties up a piece of real estate – through a purchase and sale agreement, option to purchase or otherwise – and then sells the rights to that property to someone else. In this case, you are not actually investing in or exchanging real estate. You are purchasing and selling contracts associated with that piece of real estate, usually for an assignment fee. This is how many first-time real estate investors get started if they do not otherwise have access to capital.
Property flips are when an investor finds a property, usually off-market for a below-market price, and then quickly renovates the property and sells for a profit. This can be lucrative, but it also requires a lot of work. Finding properties to flip is the biggest challenge and can be incredibly time-intensive, particularly for someone without much real estate experience. Any unforeseen renovation, complication or delay can quickly eat away at the profits of a property flip.
At the other end of the spectrum is value-add real estate investing and ground-up development. These tend to be the most complicated real estate projects. Value-add real estate investing is the process of making either light- or heavy-renovations to a property before releasing the units and stabilizing the property. Ground-up development entails building a new property from scratch (or “from the ground up”). Both value-add and ground-up development have a lot of moving parts, from negotiating land contracts to permitting, design, and construction. Once the project is built or rehab complete, the property still needs to be leased up before generating any income. This can take months to years, depending on the nature and scale of the project. Given the many unknowns associated with value-add and ground-up development, these investment strategies are considered riskier than investing in already stabilized, cash flow-generating assets. You must have an experienced team in place to be successful with these real estate investing approaches.
An alternative form of active real estate investing is to “buy and hold” property. Buy and hold investors will typically buy stabilized property with the hope of generating consistent monthly cash flow and then ideally, their properties will increase in value over time. Many will hold property until they are ready to pass on to the next generation or they will sell through what’s known as a 1031-exchange (a process that involves investing the proceeds of the sale into another real estate asset to defer paying capital gains tax).
Many high-net-worth individuals will begin their real estate investing journeys by purchasing single-family homes or duplexes as part of a buy-and-hold strategy. This can be very profitable, but it also requires a lot of work. This is especially true as the investor looks to grow their portfolio one property at a time. Moreover, Fannie Mae, one of the federal agencies that insures mortgages for most single-family homes, has recently capped the number of properties that can be financed by a single individual. Therefore, anyone looking to grow their real estate portfolio one single-family rental at a time will eventually need to utilize commercial loans as their portfolios grow (which carry higher interest rates and require more substantial down payments).
One of the biggest hurdles high-net-worth individuals face with active real estate investing is the strain on their time. It’s not that they’re incapable: HNW individuals are usually highly educated, incredibly motivated, and can identify the resources needed to succeed. It’s a matter of whether someone wants to use their precious time to personally own and manage real estate instead of passively investing and allowing someone else to oversee the day-to-day on their behalf.
Passive real estate investing, as its name would imply, is a way of generating passive income through real estate. There are a few ways to passively invest in real estate.
Investing in a REIT is similar to investing in a mutual fund. Essentially, you are buying stock in a real estate portfolio that is actively managed by the REIT. According to federal regulations, REITs are required to return 90% of profits to their investors. The benefit of buying into a REIT is that you can buy and sell shares at any time, which is a way for investors to preserve liquidity in a way that cannot be done by directly investing in real estate.
Another approach is to buy into a real estate investment fund, a process often referred to as syndication. Don’t let the fancy name throw you off – most people have participated in a syndication at one point or another. Anyone that has ever purchased an airline ticket has participated in a syndication. You paid for your seat; others paid for theirs. The total revenue generated by each ticket sale is used to pay the airline, pilot, government fees, etc.
Real estate syndication is similar.
You invest in a real estate deal alongside several others. Each project may have a different minimum requirement, say $75,000 or $100,000 per person. Investors share in the project’s risk and reward, with each being paid out a share of the profits accordingly. The project sponsor will take a small administrative fee, but that sponsor usually falls at the bottom of the equity waterfall, meaning they are repaid last, only after investors have been repaid their equity stake at the agreed upon terms. Any profit above that threshold will disproportionately go to the project sponsor.
One of the benefits of real estate syndication is that you, as an individual investor, are considered a “limited partner”. The only responsibility of an LP is to bring capital to the table. Meanwhile, the “general partner,” or GP, takes responsibility for finding and managing deals. The GP brings their real estate expertise in exchange for a share of the profits, but is paid out only after the LPs have made their profits. This structure ensures that the GP/LP’s interests are aligned.
Similarly, a real estate fund will pool investors’ resources and then can deploy that capital across an array of real estate projects depending on the goals of the fund.
After you invest in a REIT, real estate fund or syndicated deal, there’s not much more you need to do. Sit back, relax, and collect income accordingly. This is what most people have in mind when they decide to invest in real estate.
There are advantages to both active and passive real estate investing. It’s up to each individual investor to consider their specific circumstances.
Active real estate investing is incredibly time intensive. You might have time to manage one or two rental units, but as an otherwise busy professional, can you realistically manage more than that? If not, passive real estate investing may be a better way to create both scale and sustained wealth through real estate.
Active real estate investing tends to carry more substantial risk than passive real estate investing. Unless you are experienced and knowledgeable about real estate investing, you might want to stick with passive real estate investing where a team of professionals will spearhead all active real estate activities, from acquisition to construction and ongoing property management. Moreover, with passive real estate investment, any risk is shared across multiple parties. If something goes wrong, you are not solely responsible for identifying and funding a resolution.
Before investing in a real estate deal, calculate the anticipated cash flow, cap rate, internal rate of return and cash-on-cash return. Not sure what these terms mean? That’s a sign that you might want to start with passive real estate investing.
Most real estate cycles last +/- 10 years. Real estate values will ebb and flow during this time. How you invest should depend on where we are in any given market cycle. For example, many house flippers lost their backs in the run up to 2006-2007 when the market peaked, only to see values come crashing down. They were left underwater with half-complete projects that wound up sold at auctions. Investors with a longer-term investment horizon might be more drawn to funds or syndications, which have a longer life cycle and therefore, where we are in the market cycle may not have as big of an impact on the investors’ returns.
While the market cycle can affect both active and passive real estate investors, active real estate investors carry more risk. Active real estate investors tend to have more of their own capital tied up in projects. They are responsible for mortgage payments and taxes. They bear the costs of project over-runs. They must still pay brokers’ commissions, even if selling at a loss.
When the market contracts, it is much safer to be a passive investor than an active investor because the risk – and by extension, any potential losses – is shared across multiple parties.
At the end of the day, real estate investing is about generating additional income. People wrongly assume that all real estate investing is passive. That is simply not the case. Too often, those who make this assumption will quickly realize that buying, owning, and managing real estate directly is a lot more complicated and time-intensive than they had anticipated.
Ready to stop working so hard for your cash? Contact us today to learn how we can put your cash to work for YOU through our passive real estate investing opportunities.