Introduction to Passive Real Estate Investing
Passive real estate investing is all the rage. Go to a dinner party, a country club bar, investing forum, or personal growth conference and sooner or later you’ll find that the conversation turns to real estate. As a country we’re fascinated with real estate investing. A bankrate survey shows real estate as the number one favorite long term investment vehicle.
Turn on the TV, your favorite podcast, or go to the bookstore, and you’ll find all sorts of real estate content with tips and tricks from every single angle and niche. You’ve undoubtedly heard the late night infomercials on tv or the weekend seminars promoted on the radio explaining the latest and greatest way to get rich with real estate.
With so many either looking for a side hustle to bring in some extra passive income or trying to find an alternative to the stock market for both diversification and extra sources of income.
While it seems like everyone is interested in real estate, most people don’t simply because it’s hard to get started. Our goal with this guide is to help you get a better understanding of the different options that are available and make you a more informed real estate investor to choose the path that’s best for you.
It doesn’t matter if you want to grow your income or you’ve already earned it and now want to preserve and diversify your wealth, passive investing in real estate can help achieve your goals.
Why do I Want to Passively Invest in Real Estate Anyway?
Financial Advisors and Investment professionals suggest that anywhere from 20-50% of an individuals net worth should be invested in real estate. The right mix will differ for everyone but its had to deny that passive investing in real estate should absolutely be on your radar for a significant portion of your investment portfolio for a number of reasons.
Inflation Hedge:
Remember when the cost of gas was under $1 a gallon? As inflation causes the cost of goods and services to go up, the buying power of your dollar goes down. Average inflation for the past 20 years is around 2% and current savings account interest rates are under 0.01%. This means that your idle capital is is slowly being eaten away. Real estate assets, especially those with short term leases like multifamily or self storage and also long term commercial leases with built in rent bumps are a great way to offset the negative effects of inflation. As your expenses are increasing, so are rents that you can charge. Active and passive investors alike will benefit from the inflation hedge that real estate provides.
Leverage:
When you buy $100,000 worth of stocks you need $100,000 in cash (ignoring margin, as most don’t advise using margin for a long term hold position). Real Estate on the other hand is largely a game of other people money, namely the lender’s. A typical real estate transaction might see 60-80% of the purchase price funded by a mortgage, needing only $40-60,000 for that same $100,000 investment. The use of debt allows an investor to control real estate worth far greater than than the cash used for the down payment. As income and values move the effects on the original cash are amplified. A real estate deal with rents offering an 8% return on purchase price, when purchased with a 50% loan will see total cash on cash return doubled to 16% (double check the math)
Diversification:
Real estate is not directly correlated to the stock and bond markets. The economic and demographic drivers underlying stocks and bonds don’t necessarily mean that real estate values will follow. In fact, certain forms of real estate perform surprisingly well during a recession and stock market pullback.
Stable Growth:
Just as real estate is not tied to the stock market, real estate values don’t move like stock values. Anyone invested in the stock market knows that it’s a back and forth game. Up one day and down the next. The illiquid nature of real estate means that asset pricing can’t and doesn’t move like the stock market. When passively investing in real estate there’s no need to constantly check the markets to determine asset valuation.
Appreciation:
Real estate tends to generally appreciate over the long term, and an active operator can force short-term appreciation. Increases to rental income and reductions in operating expenses all result in a higher net operating income which is the main factor in determining what a property is worth.
Equity Buildup:
One benefit unique to real estate purchased with leverage is equity build up. Each month as income is received and the mortgage is paid down your equity in the investment increases which means the windfall you get when selling goes up. This basically amounts to a savings account that your tenants are contributing to for you.
Passive Real Esate Investment Tax Benefits:
Passive Real estate investing has a number of tax implications and depending on the form of the investment, most of benefits are passed on to the passive investor.
Real estate is taxed like a business so all expenses related to the operation of the real estate can be deducted. This includes property taxes, insurance and interest, as well as operating expenses such as repairs, payroll and advertising. A passive investor in real estate benefits from all of these deductions.
Depreciation
Depreciation offers an incredible tax benefit for both active and passive real estate investments. In a nutshell, depreciation is the concept of deducting as a loss a portion of an asset’s value as it physically deteriorates or becomes obsolete. This is true even if a property is appreciating and becoming more valuable!
Depreciation expense is a direct offset to income for tax purposes, even when there is no cash outflow related to depreciation expense. These expenses can be so large that the property reports a net loss for tax purposes, while being cash flow positive for investment purposes.
Try doing that with stocks and bonds!
Pass through losses
If your passive real estate investment generates passive losses, those losses can directly offset passive gains that you may have from other investment activities. The Tax Cuts and Jobs act of 2018 allows for additional passthrough deductions for business owners with Qualified Business Income (QBI).
Capital Gains
Sellers of real estate are taxed on any profits from the sale, called capital gains tax. If the property was purchased and sold within one year (Short Term Capital Gains) then the gains are taxed at the investor’s regular tax bracket. If however, the property was held for more than one year Long Term Capital Gains rates apply, which can be significantly lower rate than ordinary income tax rates.
1031 Exchanges
Beyond already low long term capital gains tax rates, Investors can further reduce their tax burden with a 1031 exchange. An entire book could be written on this subject but the basic premise is that as long as a new real estate investment is made immediately following the sale of a previous one, the capital gains tax can be deferred to a later date. Of course there are many guidelines to follow with this so be sure to consult with an expert when considering a 1031 exchange.
Each of the above tax benefits could be explored deeper and would warrant an in depth discussion, but suffice it to say that tax benefits are one of the core components of a passive real estate investment.
Real Estate is a Tangible Asset
Investing in real estate is tangible and easily understood. The psychological benefit of being able to see or touch your investment shouldn’t be overlooked. While this doesn’t help the bottom line, it’s comforting knowing you can drive by an investment to check on it.
Why Passive Real Estate Investing is Better than Active Investing for Most Investors
Do you plan to buy rentals and then sit back while the passive income hits your mailbox every month? Don’t get me wrong, that’s one of the best perks of investing in real estate, but it certainly isn’t passive. Direct ownership of real estate has a number of benefits, but passive income is not one of them.
Active real estate investing requires more homework. You’ll analyze dozens of deals and conduct market research. You’ll decide which deals to invest in, and more importantly, which ones to pass on.
Active investing is tough. Passive investors get most the benefits of investing in real estate without all of the downsides.
Passive Real Estate Investors don’t have to be a landlord
Passive real estate investing takes you out of the most time consuming, but also most critical aspects of the business. You won’t be involved with the hassle of screening and managing tenants. As a passive real estate investor you also wont be chasing down past due rent. It doesn’t matter how good your tenants are, an active investor at some point has to chase down rent.
Even if you hire a property manager, as an active investor you’ll put in work. You’re managing the manager. That means monthly or even weekly calls. Reviewing and authorizing capital improvement plans or ongoing financials. You won’t deal with the day to day problems, but you’ll hear about them. Expect constant discussions with your property manager on how to handle problems or improve operations.
Still Get Tax benefits
Depending on the form of your passive real estate investments, many of the tax advantages of active ownership carry over. When investing in real estate syndications, for example, you receive most of the tax benefits of direct ownership.
Don’t have to find deals
Finding deals is hard. Active investors often have dedicated acquisition teams tasked with sourcing attractive opportunities. Active investors need to have close relationships with sellers, brokers, and property managers. You want to be the first person these people think of when an opportunity arises. An active investor will review dozens or even hundreds of deals before finding one to fit their predefined criteria. As a passive investor, you only need to review the attractive opportunities that were filtered out.
Don’t have to get financing
Real estate is expensive. If you can’t afford a $20,000,000 real estate purchase then you don’t get the associated benefits. Passive real estate investments allow groups of investors to purchase a large asset that might otherwise be unattainable, individually.
Passive investing in real estate also allows investors to remove their names from the loan documents and guarantees. This is something that shouldn’t be overlooked from an asset protection standpoint. If you a sign a recourse loan guarantee, all of your personal assets are at risk if the deal goes bad. Passive investors don’t have to deal with that risk unless they choose to and are compensated accordingly.
Leverage Experience of the Professionals
Real Estate Investing is like any other business with opportunities, daily operations, and administration. Treating your investment portfolio as a business is crucial for success as a real estate investor. You need systems in place to manage the day to day and KPIs to track performance. The best investors have a rigid structure to their investments and how they operate them, leaving nothing to chance. If you’re not willing or able to put these systems in place then you’re better of investing passively with a someone who is.
Direct, active ownership of real estate is a great path to creating considerable wealth. Just don’t confuse it for for passive real estate investing. Most investors who directly invest eventually leave their main careers to focus on real estate full time. Without focus you can run yourself too thin. It’s best to focus on your core competency and outsource the rest. If you’re a doctor, lawyer or business owner, your time and resources are best spent on your day to day while investing passively in real estate with a professional operator.
One of the biggest mistakes that investors make is direct ownership with a passive investors mindset and approach. Direct investments require constant oversight and attention. Neglecting to operate or maintain a property is a recipe for disaster and often leads to distressed sale situations.
Options for Passive Real Estate Investing
If you’ve made it this far you’ll agree that passive investing in real estate is a great addition for an investment portfolio. Let’s explore some of the options you have to make it happen.
Passive Real Estate Investing in REITS
Introduction to REITS
A REIT, or Real Estate Investment Trust is probably the easiest way to get started investing passively in real estate. Most accessible are publicly listed REITS which are traded just like stocks and you can buy or sell into a REIT immediately. It’s important to note that a REIT is not direct ownership but rather investing into a company that owns real estate. This makes a difference when it comes to tax and other considerations.
Equity REITs which are companies that buy or invest directly in ownership positions of real estate. Mortgage REITs are less direct buying debt or debt securities tied to real estate. REITs can further be broken down to target specific property sectors. REITs are available targeting office, industrial, residential, self storage, or even infrastructure, data centers and timberland.
To qualify as a REIT, a real estate investment company must be owned by more than 100 shareholders, have more than 75% of its assets invested in real estate and is required to pay out 90% of their taxable income to shareholders in the form of dividends. Due to this requirement REITs usually offer higher income than most stocks.
If the REIT meets these requirements, dividend payments can be deducted from taxable income. This allows REITs to pay little to no income tax and instead increase cash flow available for distribution to shareholders.
Pros of REITS
Easy to get started:
If you have a brokerage account you can log in and buy REITs or REIT index funds immediately. Just like buying stocks.
Highly liquid like stocks:
If you need cash quick you can sell REITs immediately. This makes REITs good for short term exposure to real estate if you need money back soon.
Diversification:
Since REIT investments are actually investments in the company, you get the benefit of diversification across all the individual properties that the REIT has invested in.
Cons of REITS
Don’t get choice of property
When investing passively in real estate via a REIT, an investor has no input over the properties that constitute their investment. With direct investing or investing passively in a real estate syndication, an investor can choose individual properties and deals that work for their goals.
Not all Tax Benefits Apply
Dividends from REITs are taxed as ordinary income which is the worst income type for tax purposes. A good strategy is to only hold REITs in a tax advantaged account retirement account such as an IRA. REIT investors cannot use losses from operations or depreciation to offset income, arguably the largest tax benefit of real estate.
Fees
Some REITs have an efficient structure but you’ll see many with complicated layers of fees built into the offering as a primary income source to the manager.
Valuations Follow the Stock Market
REIT prices are more closely correlated to the stock and bond markets than direct investments in real estate. As stock market confidence and valuations move, so can REIT share pricing.
Passive Investing in Real Estate Syndications
Introduction to Real Estate Syndications
Real estate syndications have become mainstream in recent years, but they are nothing new. A syndication is simply a group of people pooling money together to buy a large commercial or multifamily asset. Syndications have been a primary way of funding deals for real estate investment companies and developers for decades. In the past, getting access to one of these alternative investment opportunities was hard to come by. Regulations stated that sponsors could not openly talk about or advertise a deal outside of their preexisting network. The only way in was to know someone or be referred in. Deals would get funded at country clubs and social circles all over the country.
With recent regulation changes, deal sponsors are now allowed to openly discuss and advertise their offerings. As such, familiarity with this type of investment has become more widespread.
Passive Investments in Real Estate Syndications can be as diverse and widespread as you can imagine. Syndications offer opportunities for every investor preference, risk profile or target returns. Deals range from relatively safe and low return stabilized deals with rent payments guaranteed by investment grade corporations all the way up to opportunistic and speculative hotel developments chasing 30% returns.
Syndications can be single asset investments or funds pooled to chase multiple opportunities across a predefined investment thesis.
Pros of Syndications
Potential for greater returns than REITS.
Syndications typically offer the highest return profile of any passive real estate investment option. You can frequently see value add renovation deals with returns targeting 15%+ IRR. Ground up development deals often project 20-25% + annual returns to investors.
Access to larger deals that you couldn’t do by yourself
Part of the appeal of real estate syndications is the access that it gives individuals to institutional quality real estate. $10-50,000,000 syndications for class A properties aren’t uncommon. Syndications provide access to quality assets that you won’t find on your local MLS.
Liability protection
Even if you could do the larger deals yourself, doesn’t necessarily mean that you want to. When you invest passively in a syndication your liability ends with the dollars you’ve put in. If the asset holding company is sued or a loan guarantee enforced, that liability won’t pass back to passive investors.
Leverage Expertise of Professionals
When investing in real estate syndications a passive investor need not be an expert. You’ll rely on a professional to operate the property and investment strategy. Even if you fancy yourself a skilled investor, having a professional involved will give new perspective and implementation to help increase returns, or more importantly, to lessen the chances of a deal going bad.
Tax benefits of direct ownership are passed through to passive real estate investors
One of the big advantages of syndications is getting the same tax benefits you would as a direct owner. This is because you’re actually an owner in the real estate holding entity. You’ll be able to use paper losses against gains from other passive investments. If you can claim real estate professional status then you can also use losses to offset active income.
Cons of Syndications
Not liquid
Don’t invest with money that you’ll need back quickly. Passive syndications typically have 3-7 year hold periods. With many deals you’ll get distributions along the way, but Investors are not paid back until the property sells.
Large Investment
A typical syndication will have investment minimums of $50-100,000. While many will go down to $25k, some deals have minimums exceeding $1,000,000.
What about Crowdunding?
Not a different type of offering, just a different way of marketing syndications, though online portals.
Regualtions have allowed certain portals to market to non accredited investors with some allowing small investors to start with less than $500.
High fees because the portals are effectively middle men between investors and deal sponsors.
No diversification with sponsors, only those with agreements with the portals
Passive Real Estate Investing Through Private Lending
Intro Private Lending
Private lending is any time that the lender isn’t a traditional bank, credit union or other institutional lender. It involves an individual or group of individuals directly providing the funding to a real estate investor.
Private loans are typically short term bridge financing. The value add nature allows paying back the loan quickly either through sale or refinance. Private loans are relatively secure investments that use the property as collateral. If not paid, the lender can foreclose and sell the asset to recoup their investment.
Pros of Private Lending
Can benefit from leverage
Many private lenders will borrow against a home equity or other line of credit at low rates and then lend to real estate investors at a much higher rate. Additionally you can use retirement funds as a Private Lender. These accounts couldn’t otherwise be accessed for direct real estate investing.
Short term investments
Private loans are typically one year or less. This gives more liquidity than a typical syndication, though not as much as a REIT.
Good risk to reward ratio
Private lending returns range from 5-12% annually. This is decent by itself, then you get the added security of a mortgage tied directly to the asset. Many stabilized equity investments have similar returns with out a collateral backstop.
No paperwork or fees
Generally speaking an attorney will create all the necessary documents to protect your investment before cash is transferred to the borrower. Lenders almost universally pass on the attorney fees to be paid by the borrower at closing.
Cons of Private Lending
Tough to find constant deal flow.
The bulk of passive investing though private lending happens in the single family fix and flip market. While there are opportunities to privately lend on commercial and multifamily real estate transactions, they’re harder to come by. If you have a sizable capital allocation to invest then you might have trouble placing it all through private lending. With many house flippers doing only a few deals a year, you’ll have network hard to find investors who can bring you deal flow.
Requires active participation and oversight.
Private lending is less active than direct ownership but requires more upfront and ongoing effort than passive investments in real estate syndications or REITs.
Passive Real Estate Investing in Notes
Intro to Investing in Real Estate Notes
Passive investing in real estate notes is similar to private lending. With notes, instead of originating the loan, you’re buying from the original lender. Investors buy notes for a number of reasons. Maybe you want to be a debt investor but don’t have adequate deal flow. Or, maybe you could see lending opportunities but they don’t match your deal profile.
A passive investor in real estate notes can buy both first and second position notes. First position gives the most security and accordingly, the lowest return. Anything behind first position is less secure and often means higher returns. Second position notes are sometimes available at a discount to face value.
As a passive note investor you can also choose your risk/return profile. Both performing and nonperforming notes are available for purchase. Performing means the borrower is either paying and current. Nonperforming means they’re not.
Performing notes will sell for close to face value. Non performing notes can be acquired at massive discounts to the unpaid balance, depending on the details of the delinquency. When buying a non performing note you can make it performing through a workout agreement with the borrower. If that doesn’t work you can foreclose and take control of the property. Buying non performing notes is a much more hands on and active strategy. Usually note investing is more work than a passive real estate investor is looking for.
Where to Buy Notes
Seller financed sales are the main source of opportunities for note investors. These people sold their property on extended terms to the buyer and now want to cash out. Selling their note provides an upfront sum of cash rather than residual income over the life of the loan.
Real estate notes can be found on markeplaces such as notes direct or paperstac. You can also source deals through referrals from real estate attorneys. Direct mail also works. You can compile lists potential note sellers through a data company like listsource.
Banks and Credit unions often sell off their mortgages to meet regulations and improve liquidity. It used to be very common for individual investors to purchase these passive investment opportunities. Now it’s unlikely for an individual to buy direct from a bank. Institutions will usually pool loans into a large portfolio and sell to hedge funds.
Pros to investing in Notes
Potential for Higher Returns
If you can buy performing notes at a discount to face value then returns are amplified. Many times a note seller just wants upfront cash, so this can be more common than it sounds.
Backdoor to Property Ownership
Many note investors focus exclusively on distressed notes. The thinking is that they can buy a note at a deep discount to the property value. They’ll then foreclose and own the asset at a discounted basis. This is a great strategy but far from passive.
Cons to investing in Notes
Limited Deal Flow
Unless you’re very active on a marketplace it’s tough to get started finding deals and deal flow. Note investing is a specialized niche and takes considerable upfront homework to get started.
Speciality Knowledge
Investing in notes requires some specialty knowledge. You’ll need to learn how to underwrite a loan like a bank. Many notes available for sale are from mom and pop sellers who didn’t originate the loan on attractive terms. Like all real estate, just because a note is for sale, doesn’t make it a good investment.
Not liquid
Real Estate notes are tough to sell quickly if you need your cash back. They are typically longer term than the notes in private lending. If you need to sell fast, you’ll likely take a haircut and won’t get back your full investment. When foreclosure is the goal going in, that can take quite a while.
Turnkey Properties
Intro to Investing in Turnkey Properties
Turnkey investing is direct investing and ownership in real estate via a third party who does all the heavy lifting. Providers find the deals, hire contractors, rehab, lease up and manage the property. You own the property, they do all the work. This sounds great in theory but it doesn’t always work.
Pros to Investing in Turnkey Properties
Direct Ownership
You’re the direct owner with turnkey properties. This means you get all the benefits including equity buildup, taxes, ect. It also means you need to be more active.
Low Investment Amounts
Turnkey investments are normally single family house rentals. These are usually lower cost than large multifamily or commerical deals. You can also use traditional financing, further stretching your investment dollars.
Cons to Investing in turnkey properties
Lack of control
Turnkey properties are not truly passive if you want the investment to perform well. You have to manage the manager.
Overpaying
Many times the biggest issue with turnkey properties is paying too much. Turnkey providers sell properties that they already own and renovated. They’re using the marketing to bring a steady stream of buyers. That’s good for them, but not always for the buyer. Many times the comps don’t support the asking prices.
Usually Single Family Only
A major benefit of passive investing in real estate is the ability to participate in larger deals and scale up. Turnkey properties are almost always single family rentals.
Is passive real estate investing right for you?
If passive investing in real estate is something that you’d like to explore further, we’d love to chat. Schedule a call with us today to share your investment goals and learn if our investment opportunities are a fit.