Investing in real estate offers many benefits, from portfolio diversification and risk mitigation, to earning tax-advantaged passive income and more. High-net-worth individuals are often encouraged to buy rental property with the promise that, after doing so, they can simply sit back and collect passive income. Those who proceed accordingly will soon find that individually owning real estate requires much more work than they had expected.
Therein lies the difference between active and passive real estate investing – a distinction that many people overlook when investing in real estate for the first time.
What is Active Real Estate Investing?
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’s 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 aren’t actually investing in or exchanging real estate. You’re purchasing and selling contracts associated with that piece of real estate, usually for an assignment fee.
Then there are property flips. Investors often find an off-market deal, purchase the property at a discount, renovate the property and then immediately sell for a profit. This can be lucrative, but it also requires a lot of work. Finding properties to flip is the biggest challenge, and is incredibly time-intensive, particularly for someone who doesn’t have much real estate experience or who lacks local connections.
On the other end of the spectrum are major real estate acquisition, value-add, and development projects. These tend to be the most complicated types of active real estate investing. There are a lot of moving parts, from negotiating land contracts to permitting, design, and construction. Once a project is built, and in order for a value-add strategy to be fully executed, the project still needs to be leased and stabilized before it generates any cash flow for investors.
Large commercial real estate projects tend to have many unknowns. These projects, which can range from 50 to 300+ unit apartment communities and multi-tenant retail centers, to office, industrial and hospitality properties, are best suited for only the most experienced real estate sponsors. Few individuals will be able to manage the complexities associated with large-scale real estate development projects.
What is Passive Real Estate Investing?
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.
You can invest in a real estate investment trust (REIT), which is like 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. The asset class is more liquid than traditional real estate.
Another approach is to invest in a real estate syndication. A real estate syndication is an investment vehicle in which a sponsor makes a property or properties available to individuals in exchange for a minimum investment. That minimum investment can vary, from as little as $50,000 to $250,000 or more. Those who invest in a syndication are co-investing alongside other individuals, who then collectively share in the project’s risk and reward, with each being paid out a share of the syndication’s profits accordingly.
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 make the minimum capital contribution. Meanwhile, the “general partner,” or GP, takes responsibility for executing the asset’s business plan. The GP may or may not invest equity in the deal. Nearly all will take an administrative fee for their work, but that fee is generally only paid out after the LPs have been repaid to a certain degree, thereby ensuring all parties’ 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. The primary difference between a syndication and fund is that syndications tend to have pre-defined time horizons and hold periods, whereas funds can be open ended and may or may not have a mandate to invest capital by a certain date (or at all).
Those who invest in a REIT, syndication or fund will find there’s not much more to do after their initial investment has been made. The sponsor takes over the day-to-day responsibilities on behalf of investors, and investors are freed to go about their business while cash flow distributions roll in.
This is what most people have in mind when they decide to invest in real estate.
Active vs. Passive Real Estate Investing – Which Strategy is Right for You?
There are advantages to both active and passive real estate investing. It’s up to each individual investor to consider their specific circumstances.
- How much time do you have?
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.
- What level of risk are you willing to accept?
Active real estate investing tends to carry more substantial risk than passive real estate investing. Unless you’re 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 won’t be solely responsible for identifying and funding a resolution.
- What are the potential returns?
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.
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’s simply not the case. Owning a property outright can be much more time-intensive than people realize.
Contact us today to learn how we can put your hard-earned capital to work for you by passively investing in real estate.