Individual investors looking for a steady income stream often turn to real estate and face the same age-old question: Is it better to be an active or passive real estate investor?
Because real estate investments provide passive income — steady cash flow from rents — plus some very generous tax benefits they are a popular investment vehicle. There's also a worthy prize at the end too; the potential to realize substantial capital appreciation and double or even triple your investment! The combination produces higher risk-adjusted returns rather than traditional passive income sources such as dividend-paying stocks, bonds or annuities.
When private investors decide whether to pursue real estate investing on either an active or passive basis, they need to consider the pros and cons of each strategy. In order to determine which investment strategy is best for you, let’s look at active vs. passive real estate investing to understand the main differences between the two.
Active investing is when an investor personally purchases a property for rental cash-flow or to fix and sell for a profit. The property could be anything from a single-family home to a large multifamily property. Active investors are involved in every aspect of the deal from finding it, obtaining financing, personally guaranteeing the loan and subsequently managing the investment. The process of identifying the correct market, property, financing and closing the deal can be arduous, but it can also be very rewarding. If it all goes well, an active investor reaps the lion’s share of the returns.
Passive investing is a hands-off approach which allows an investor to place one’s capital into a real estate syndication — more specifically, an apartment, self-storage or mobile home park syndication — that is managed in its entirety by a sponsor. Investing passively in private real estate means investors outsource the selection and management of investment properties to a sponsor. These sponsors pool funds from many investors to buy larger or an entire portfolio of properties, then execute specific business plans, run day-to-day operations and report back to investors.
Based on my personal experiences of being both an active and passive real estate investor and working with hundreds of other investors through my syndication business McKenna Capital, I've seen 5 important factors to consider when deciding which investing strategy is best for you. They are: control, time commitment, diversification, deal flow and risk.
#1 Control
I consider an opportunity to be active or passive depending on the level of control you have. As a passive investor, you are a limited partner in the deal. You give your capital to an experienced sponsor/syndicator who will use that money to acquire and manage the entire commercial real estate project. When you give up control you're putting a lot of trust into the sponsor and their team to execute on the business plan.
When vetting a commercial real estate sponsor, make sure proper due diligence is done so there's an alignment of interests. For example, the sponsor will offer you a preferred return, which means you will receive an agreed-upon return before the syndicator receives a dime. Therefore, the syndicator is financially incentivized to achieve a return above and beyond the preferred return.
As an active investor, you can directly control the business plan. You decide which investment strategy to pursue. You decide the type and level of renovations to perform. You decide the quality of tenant to accept and the rental rate to charge. You determine when to refinance or sell. With passive investing, all of the above is determined by the syndicator.
Normally from a personality fit someone is either active or passive, but not both, and it usually comes down to whether they want to have control or not.
#2 Time Commitment
Many real estate investments require improvements, and all require oversight to maintain the property, collect rents and handle issues that arise.
As an active investor, the advantage of more control comes with the disadvantage of a greater time commitment. Active investors become landlords, which is grueling and time-consuming work — especially if renovations or construction is part of the business plan over and above maintenance or rent collection. It is your responsibility to educate yourself on the particular asset class you'd like to invest in. Then, you have to find and vet various team members (broker, property manager, attorney, accountant, etc). Once you have a team in place, you have to perform all the duties required to find, qualify and close on a deal.
After closing, even though you may have a good property management company, your investment is not completely hands-off. When something unexpected occurs, you’re responsible for making decisions and fixing the problem, which can come with a lot of stress and headaches. For example, if a toilet breaks someone is going to call you to approve the spend, ask which toilet to buy and from where, etc.
Of course, it is indeed possible to automate the majority, if not all, of the above tasks. But that requires a certain level of expertise and a large time investment to implement effectively.
One major difference in looking at active vs. passive real estate investing is that passive investing is more or less hassle-free. You don’t have to worry about any of the actions described above. Once you've vetted the syndicator/operator and the deal, you simply invest your capital and are kept in the loop with monthly or quarterly project updates all the way up until there's an exit/sale.
#3 Diversification
It's much harder to become more diversified when you're an active investor because so much time is spent becoming an expert in your particular market and/or asset class. Most active investors stay close to home because it offers them easy access and that’s where they’re most familiar with the local market. But what’s the likelihood that the best deals in the country are within a mile or two of where you live?
As a passive investor, you trade control for diversification. When you invest in a real estate syndication, you're a small piece of a bigger deal and it's much easier to diversify your investments over many deals when you're investing a smaller amount. If you're an active investor purchasing a single family home by yourself you're typically putting a larger portion of your capital into that one particular deal.
I'm very comfortable handing over full-time day to day control to an experienced operator. In exchange for that I’m able to spread my capital across more investments in more markets, which allows for much better diversification. Three things I focus when diversifying across many investments are: real estate asset classes, geography and operators/sponsors.
Real Estate Asset Classes
Many investors consider investing in real estate syndications in order to get better diversification within real estate asset classes. (multifamily, self-storage, office, retail, industrial and manufactured home parks, etc) Typically each sponsor has a specialty in a specific type of asset class that they have a competitive advantage in. One should be cognizant of diversification in your real estate portfolio, so spreading investments amongst many asset classes like apartments, self-storage and manufactured home parks is a great way to achieve this. In fact, these three asset classes are considered "all weather" assets because they tend to hold up well during all market cycles.
Geography
Another form of diversification within real estate syndication is geography. Actively investing out of state can work, but passive investing in real estate through syndication deals is ideal for out of state investors looking for better value in top markets. Some of the best deals are out of state in growing markets. It can be very difficult trying to be an active out of state investor due to competition, relationships, market knowledge, etc but if you align yourself with a reputable, successful operator in that local market you can gain access to some great deals you otherwise wouldn't have had access to.
Sponsor/Operator
Vet sponsors carefully and don’t feel you need to stay married to one sponsor forever. Ensure they are growing their depth with key management for continuity and that they are staying true to their philosophy and model which should be conservative and tested. When you invest with multiple sponsors you'll get to see many deals and gain a much better perspective on the overall market.
#4 Deal Flow
Locating the right property and determining the right price takes real estate acumen, local knowledge and financing. Active investors should consider taking a “boots on the ground” approach and be ambitious and disciplined in their pursuit of information about the market or markets where they invest. Successful investing starts with having high-quality deal flow and deals don’t just fall into one’s lap. Investors must constantly look at properties and their various features so they’ll know a good deal when they see one. It can take years to get a sense of a market and what kind of properties perform well.
Passive investors outsource the acquisition process to syndicators who uncover quality deals. Most syndicators partner with experienced operators who employ a team of deal sourcing professionals looking at hundreds of deals a year across many markets. By owning a share in many properties, passive investors’ fortunes don’t rise and fall with those of any single asset, and they don’t need to answer the phone in the middle of the night when the toilet gets backed up in a tenant’s apartment.
#5 Risk
You are exposed to much less risk as a passive investor. You're plugging into an already created and proven investment system run by an experienced sponsor who (preferably) has successfully completed countless deals in the past. Additionally, there is more certainty on the returns. You will know the projected limited partner returns — both ongoing and at sale — prior to investing. And assuming the syndicator conservatively underwrote the deal, these projected returns should be exceeded.
Active investing is a much riskier strategy. Buying properties directly can also open an investor to unlimited risk exposure through loan guarantees, which increases your exposure to risk. However, with the higher risk comes a higher upside potential. You own 100% of the deal, which means you get 100% of the profits. But, you also have to bear the burden of 100% of the losses.
Conclusion:
In the end there are many ways to become a successful real estate investor. Not all strategies are the same, so it's important to understand the pro's and con's and to identify which path (active or passive) is best for you.
For those that have a lot of time, access to deal flow, and can build out a solid team, active investing might be the best route. If you're a busy working professional or business owner with limited time, partnering with a syndicator and passively investing in deals is a great way to diversify your investment portfolio and generate passive income with very minimal effort. I have found the returns will be comparable than if you do all the work yourself, but the risk profile is considerably lower. It is for that reason that I'm a huge advocate of the Passive Investing Strategy.
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