Passive Real Estate Investing 101
Dr. Joel J. Napeñas
10 minute read
What most associate real estate investing with is buying and owning your own properties, or being an active investor. While the upside and advantages are great, it is an intimidating venture because it requires a lot of capital to do it, and there are a number of potential pitfalls, which are the ‘terrible T’s’ of real estate: tenants, toilets, termites, trash and taxes. When you are an active investor, you are responsible for finding the property, getting it under contract, assuming the responsibility and liabilities of the loan, operating it, and paying for the expenses associated with maintaining it. It is a lot of work, takes a lot of time, and it is not for everyone.
However, there are plenty of other ways to invest, without being an active investor. If you are a busy professional or business owner, you can be a passive investor. You do not have to buy the property, secure and assume the risk of the loan on the property, nor operate the property (let alone deal with the terrible T’s). The only risk that you assume is the return of your investment. All you have to do is identify who or what vehicle to invest in, put your money in, and let the deal sponsor or fund manager operate it while you collect your ‘mailbox money.’ This frees you up to do other things like focus on your job or business, or spend time with your family and friends, while your money works for you.
With the emergence of many options to invest in real estate passively, it can be confusing to the novice investor. You are probably inundated with Facebook ads and emails touting the latest crowdfunding site, investment opportunity, or investment fund. To sort through the noise and confusion, here is a primer on the different types of passive investment opportunities.
Syndications
Real Estate Syndications involve the pooling of capital from a group of investors to invest in a real estate opportunity, which is usually the purchase of a property. This makes it possible to purchase a larger property (for instance, an apartment building) that one person or a small group of partners may not be able to do on their own.
It is organized or managed on behalf of the investors by Sponsors, who, depending on the legal structure, are also known as General Partners (GPs). They are responsible for finding the property, securing and backing the financing, acquiring it, and managing the property during the period of ownership. They are also responsible for ensuring that investors receive their share of the profits on their investments.
The passive investors are generally known as Limited Partners (LPs). They are only responsible for providing the funds for the deal, with partial equity ownership of the asset with their shares. They do not have to deal with the upkeep, expenses and maintenance of the properties. And in most syndication structures, they are not personally liable for any losses beyond the principal amount they invested.
The advantage of investing in a syndication is that the barrier to entry (i.e.: amount you need to invest) is lower than buying a property on your own. You are investing in a share of something that takes advantage of economies of scale such as a large apartment building, versus one single family home. If you had a vacancy in a single family home, or something happened to it like a fire or flood, it has a great impact on your total investment. Whereas if one unit of a large apartment building is vacant, or something happens to it, the impact on the bottom line is lower.
In addition, such private equity investments have greater upside and potential returns for the passive investors, with less fees and costs associated with the operation of the underlying assets. Also, there is a lot of transparency when investing in a syndication. You have direct access to the deal sponsors, good sponsors will give you the specifics of their business plan prior to investing with them and they will update you on a regular basis (usually monthly) on the performance of your investment or the assets. When you invest in a syndication, you are investing on your knowledge of, relationship with and trust in the sponsors.
Because it is a private equity investment, most syndication opportunities are only available to institutional and accredited investors, and not the general investing public, with certain minimum investment requirements. A typical syndication would have a $25,000 to $100,000 minimum investment. In addition, the funds are not liquid, in that once you invest your principal, it is generally locked into the investment until the sponsors return it to you. There is less diversification as you are generally invested in one property, asset or sponsorship team.
Real Estate Funds
A real estate investment fund is an entity formed to pool investor money and collectively purchase a share of ownership in a single or portfolio of real estate properties. Thus, a real estate investment fund is a combined source of capital used to make real estate investments. These are generally private equity funds, which are not available to be publicly traded on an exchange. Such funds are actively managed and also target institutional investors and high-net-worth clients, therefore also only available to institutional and accredited investors. Such funds are also illiquid throughout the term of the investment. They have the same advantages as investing in a syndication, with the potential for more diversification in that the fund may invest in several properties as opposed to one single property. Many of the advantages and disadvantages of these are similar to that of syndications.
Crowdfunding
Real estate crowdfunding uses social media and the Internet to connect investors to investments. Real estate crowdfunding is similar to syndications and real estate funds, in that an investor can buy into a property and become a shareholder. Generally, crowdfunding opportunities offer more access to opportunities to the public, in that one does not have to be an institutional, high net worth or accredited investor, and the minimum investment requirements are lower (for instance some can be as low as $1000). There are crowdfunding opportunities that are only offered to accredited investors and have higher minimum investment requirements. Just as in the case of syndications and funds, the funds are illiquid for the term of the investment. The other disadvantages of crowdfunding are the same as those of syndications and funds.
When compared to syndications and funds, there are disadvantages. First is the lack of transparency. Generally, less specific information is available to investors about the investment opportunity, including the business plan on the assets prior to investing, and its performance during the investment. As opposed to syndications or funds, investors do not have direct access to the people running or overseeing the investments or assets. Lastly, since crowdfunding sites are a relatively new phenomenon, there is less of a track record on them to evaluate them by, and there have been a number of sites that have come and gone over the years.
REITs
A real estate investment trust, or a REIT is a corporation, trust, or association that invests directly in income-producing real estate and is traded like a stock on public exchanges. The main advantages of REITs is that they have a lower initial investment threshold (which is the cost of 1 share of the REIT) which provides investors with a much lower entry point than if they bought individual properties or invested in a syndication, fund or crowdfunding opportunity. They also offer investors broad exposure to the real estate sector. An individual REIT can own many properties or property types, or one can invest in several different REITs. That diversification helps reduce risk, though it can also lower an investor’s return potential.
REITs must distribute 90% of their taxable income to shareholders to maintain their tax-advantaged status with the IRS. Syndications, real estate funds and crowdfunding don’t have to comply with those rules, therefore many earn returns for their investors via capital appreciation instead of dividend payments. This can be both an advantage and a disadvantage. If a REIT is forced to distribute most of its profits to shareholders, it has less leeway to reinvest its profits to generate greater returns for the shareholders in the future. REITs, because they are larger, have more costs associated with their operations, which means that lesser proportion of their profits go directly to the shareholders.
The main advantage of REITs is their liquidity, since they are publicly traded on stock exchanges. If you wanted to free up your money, you can instantly sell your shares. However because of all the liquidity, it is much more volatile in terms of its value, despite the performances of the underlying assets or properties that it holds. So if you had a time in which the overall stock market dropped significantly, like how it dropped by 20% in March of 2020 during the onset of the pandemic, the REIT’s share prices are more likely to drop in a similar fashion.
Other investment vehicles
Among the other publicly available investment vehicles, there are also real estate exchange traded funds (ETFs) and mutual funds that are more available to investors on the public market. These generally hold a larger portfolio of assets or properties. Their characteristics are similar to those of REITs, and conventional mutual funds and ETFs that invest in other asset classes.
There are other types of real estate assets that all these different vehicles can invest in. For instance, one can invest in a syndication, fund or REIT that lends the money to a real estate developer or owner and earns a return on lending the money. Instead of owning equity in the underlying property, you own the debt in it and earn return on the interest the borrower pays on that debt. That can be akin to owning a bond.
Conclusion
As opposed to actively investing, the main disadvantage of being a passive investor is your lack of control in the investment. Limited partners or shareholders have limited say into the affairs and operation of the property, assets or funds, as you rely on the sponsors or fund managers to make the best decisions and execute in order to provide the best return on your investment.
However, you do not have to buy a property directly to benefit from the advantages of investing in real estate. You can do so passively in a number of ways, each of which have their advantages and disadvantages.
We personally are invested in and benefited from all of these passive investing options, in addition to the properties that we actively own and manage.
Knowing about the different options that you can passively invest in real estate can allow you to make your money work for you in a less risky fashion without dealing with the ‘terrible Ts,’ so you can have more time to focus on things that matter to you.
Dr. Napeñas, a practicing academic dental specialist in Oral Medicine, is founder and managing partner of 5DH Partners, a real estate investing firm that educates and helps dentists and other professionals generate passive income and build wealth through investing in real estate.
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