Most people inherently understand the benefits of passive investing: you provide money, other people manage that money, and you collect a return on your investment. Great system! This passive investing model exists in real estate, as well. And, we often receive questions about the best passive investing strategies. As such, we’ll use this article as a guide to passive real estate investing.
Specifically, we’ll cover the following topics:
- The Benefits of Passive Real Estate Investing
- Passive Real Estate Investing Guide
- Final Thoughts
The Benefits of Passive Real Estate Investing
Overview
Passive investors seek a return on investment as a result of the managerial efforts of others. In other words, passive investors contribute money to a deal. But, someone else manages that deal, with investors collecting some return on their contributed capital.
In real estate, passive investing often occurs when an experienced real estate investor finds a solid deal but lacks the cash necessary to make that deal happen. To meet the deal’s cash requirements, these individuals seek passive investors. The passive investors contribute the necessary funds, and the experienced individuals handle the underwriting and day-to-day management of the deal.
From the perspective of the passive investor, this model has several key advantages:
Benefit #1: Limited Time Required
As a passive investor, you don’t manage a deal’s day-to-day operations. Instead, you entrust this role to the managerial efforts of others. This system means that passive investments generally require far less of your time than an active enterprise (e.g. starting your own business).
Yes, passive investors need to take the time to find and vet potential investment opportunities. But, once they commit to an investment, they have limited (or no) time requirements – typically just monitoring regular performance reports issued by management. For self-employed and W-2 employees with significant income, passive real estate investments allow you to generate a return on this excess income without sacrificing your day job.
Benefit #2: Don’t Need to be an Expert
Successfully planning and executing a commercial real estate requires a ton of knowledge and experience. Frankly, you can’t just dive into running your own deal from scratch. But, as a passive investor, you don’t need to be an expert, because you’re entrusting the planning and managerial efforts of the deal to someone who is an expert.
However, this fact shouldn’t be interpreted to mean you should blindly trust someone else. As a passive investor, you still need to have enough financial acumen and foundational real estate knowledge to review potential deals. That is, if someone proposes a passive investment opportunity, you still must conduct your due diligence in reviewing the proposal, its associated risks, and your own investment objectives.
Benefit #3: Ability to Pool Capital
In addition to requiring more experience than residential real estate, commercial real estate also typically requires far more capital. Most deals don’t have a single equity investor. Instead, many commercial real estate professionals solicit passive investors as a means to pool capital. For instance, in a deal requiring $1,000,000 in cash, the deal’s sponsor may put up $100,000 and raise the other $900,000 from passive investors.
For the sponsor, this system helps make the deal happen. For the passive investors, you gain an opportunity to join a commercial real estate deal without needing to contribute 100% of the capital yourself.
Benefit #4: Potential Depreciation Benefits
When you directly invest in income-producing real estate (i.e. own a portion of an income-producing property), you gain the benefit of depreciation. As a “cashless expense,” depreciation reduces your tax bill without a corresponding cash outlay. Accordingly, many rental properties generate positive cash flow with taxable losses. (NOTE: The IRS claws some of this depreciation benefit back when you sell a property through a tax called depreciation recapture. However, strategies like Section 1031 like-kind exchanges can defer this tax hit).
As we’ll outline below, not all passive real estate investments offer you direct ownership in a deal, meaning you won’t receive depreciation benefits. But, it’s important to recognize the role depreciation plans when analyzing different passive opportunities.
Benefit #5: Potential for Downside Protection
Many real estate deals grant passive investors preferred equity positions. Preferred equity falls immediately below common equity on the capital stack. This position means that these investors receive slightly lower returns, but they also have greater protection than common equity holders – typically in terms of minimum required returns. In other words, preferred equity provides downside protection. Before common equity holders receive any return on investment, most deal structures require that the preferred equity holders reach their minimum required return.
This preferred equity model doesn’t eliminate a deal’s risk. But, it does provide downside protection, which helps mitigate the risk inherent to any deal.
Passive Real Estate Investing Guide
Passive Strategy #1: Invest in Real Estate Deals as a Limited Partner
Many commercial real estate deals are structured as limited partnerships. At the simplest level, a limited partnership has two partners. The general partner manages the partnership and handles its day-to-day operations. The limited partner contributes capital and receives an ownership interest in the partnership but doesn’t have any managerial role. In other words, the limited partner serves as a passive investor, receiving the benefits of direct ownership (i.e. a share in profits/losses and depreciation) without any day-to-day responsibilities.
Many real estate developers want to bring limited partners into deals to A) raise cash, while B) not giving up any managerial control. As a result, establishing relationships with local real estate developers can be an outstanding way to learn about passive real estate investment opportunities.
Passive Strategy #2: Invest through a Crowdfunded Real Estate Syndication
Unfortunately, investing as a limited partner depends on your ability to actually find a general partner willing to bring you on as a partner. Real estate syndications, on the other hand, offer the benefits of limited partnerships without these same relationship requirements.
In a syndication, a deal sponsor (or syndicator) finds, underwrites, and manages the day-to-day operations of a deal. To raise money, the sponsor markets the deal to investors through a pooled capital model called syndication. Typically structured as LLCs, the deal sponsor serves as the managing member, and the passive investors act as investor members.
While structurally similar to a limited partnership, real estate syndications often include more opportunities for multiple investors to join a deal. With the passage of the 2012 JOBS Act, deal sponsors (with certain restrictions) can “crowdfund” syndications online. This has created a number of websites connecting sponsors with passive investors. Accordingly, people looking for passive investment opportunities don’t need to know experienced real estate professionals – they just need to vet potential deals through one of these syndication portals.
Passive Strategy #3: Buy Shares in a REIT
Both of the above options include direct ownership of investment properties. Real estate investment trusts, or REITs, offer passive investment opportunities without the associated direct ownership. And, as many of these REITs trade publicly, they offer far more liquidity than syndications or limited partnerships. If you want to invest in a debt, equity, or hybrid REIT, it’s as easy as buying shares through your online brokerage.
However, this lack of direct ownership means that, when you hold REIT shares, you do not receive pass-through depreciation. Rather, the REIT itself uses this depreciation to reduce its taxable income. By law, REITs must then distribute 90% of their taxable income to shareholders in the form of dividends. And, these dividends are typically taxed at your ordinary income tax rate (i.e. your marginal tax rate) – not the more advantageous long-term capital gains rate.
These characteristics make REITs a solid choice for investors looking for reliable fixed income from tax-advantaged retirement accounts. But, for passive investors seeking the tax benefits of depreciation, REITs may not make sense.
Passive Strategy #4: Become a Private Lender
This option involves directly investing in a deal, but with debt, not equity. Private lenders provide debt financing alternatives to conventional lenders (e.g. banks and other financial institutions). In scenarios where one of these conventional lenders wouldn’t approve a borrower – or simply requires too long of a closing process – private lenders often provide short-term financing solutions until borrowers can secure a permanent mortgage. And, due to this convenience (and increased risk), private lenders command higher interest rates.
So, how is this passive investing? When you issue a private loan, you don’t manage the deal – you simply service the debt and collect interest income. However, before taking this approach, passive investors need to consider three realities. First, to lend money, you actually need to have money. Second, while you may not be involved with a deal’s day-to-day operations as a private lender, you do need to have enough real estate and financial knowledge to underwrite the deal from a lender’s perspective. Lastly, private lenders still need to service this debt, a not altogether passive undertaking.
Passive Strategy #5: Invest in Publicly Traded Companies Related to Real Estate
You can also passively invest in real estate via publicly traded companies related to real estate (e.g. institutional landlords, construction companies, supply-chain companies, etc). This model provides fully passive exposure to real estate, albeit without the direct ownership depreciation benefit.
And, it has a couple advantages for novice investors. First, publicly traded companies must meet SEC requirements in terms of regular audits and reporting, limiting the potential for fraud and misleading private deal offers. Second, like investing in REITs, owning shares in publicly traded companies provides far more liquidity than directly investing in a deal. For novice investors not ready to commit to a long-term deal horizon, this liquidity provides significant financial flexibility.
Final Thoughts
As we’ve illustrated, passive real estate investing offers a number of benefits. Furthermore, a variety of passive strategies exist. Understanding these different strategies – and their associated pros and cons – will provide new investors the foundation necessary to make sound passive investment decisions.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.