Which Real Estate Investment Method Is Best For You, Active Or Passive?
There are several advantages to investing in real estate, including monthly income flow, appreciation, tax savings, and more. People are advised, “Buy rental property, then sit back and receive passive income!” A well-intentioned investor who follows this recommendation may purchase a single-family rental home, only to discover that it requires far more labor than expected.
And therein is the gap between active and passive real estate investment – a distinction that many investors in rental property fail to recognize.
Today, we will examine the distinction between active and passive real estate investment, covering the many kinds and advantages and disadvantages of each.
Real Estate Investment Activity
When a person, corporation, or fund actively invests in real estate, they engage directly in the investment process. Active real estate investment demands YOUR TIME, money, and risk. An active investor participates in the entire process or for significant portions of the process (such as acquisition or renovation). The dedication needed by active real estate investors is often equivalent to that of full-time employment.
Active real estate investment may take several forms, including wholesaling and flipping.
Wholesaling
A person engages in wholesaling when he or she ties up a piece of real estate – via a buy and sale agreement, an option to purchase, or otherwise – and then sells the property’s rights to another party. In this situation, you are not investing in or trading real estate. Typically, you are acquiring and selling contracts related to real estate for an assignment fee.
Property Flips
A property flip occurs when an investor often purchases a property off-market for a price below market value, then swiftly renovates and sells it for a profit. This may be rewarding, but it needs some effort. Finding houses to flip is the greatest obstacle and may be tremendously time-consuming, especially for a novice in the real estate market.
Ground-Up Development or Value-Add Deals
Value-added real estate investments and new construction are on the other end of the spectrum. These are often the most complex real estate ventures. Several moving pieces include land contract negotiations, permits, design, and construction. Before the property may generate money, it must be leased and stabilized when the construction or renovation is complete. These tasks often include several unknowns. To be successful with these real estate investment strategies, you must assemble a knowledgeable team.
Buy and Hold
“Purchase and hold” is an alternate kind of aggressive real estate investment. Buy-and-hold investors often acquire real estate with the expectation of earning stable monthly cash flow, and hopefully, their properties would appreciate over time. Many people may keep their property until they are ready to pass it on to the next generation, or they may sell it through a 1031-exchange: This is a process that necessitates investing the yield of the sale into another real estate asset to defer paying capital gains tax.
Many wealthy people may begin their real estate investment careers by acquiring single-family houses or duplexes using a buy-and-hold approach. This may be pretty lucrative but needs a great deal of effort. This is particularly true if the investor seeks to increase their property holdings one by one. In addition, Fannie Mae, one of the government organizations that guarantees mortgages for most single-family houses, has lately reduced the number of properties that a single person may finance. As a result, anybody wishing to expand their real estate portfolio one single-family rental at a time will ultimately need commercial financing (which carries higher interest rates and require more substantial down payments).
When investing in real estate, time restrictions are one of the most significant barriers faced by high-net-worth individuals. It’s not that they lack ability: Wealthy persons are often well educated, highly driven, and able to discover the necessary resources for success. It is an issue of whether a person is willing to commit their valuable time to actively owning and managing real estate instead of passively investing and letting someone else handle the property on their behalf.
Passive Real Property Investment
As its name suggests, passive real estate investment is a method for earning passive income via real estate. It may take enough time to see a return on a passive real estate investment, particularly when compared to a fix-and-flip investor, but passive income is often provided more consistently over time.
There are many methods to invest passively in real estate.
Trusts for Investment in Real Estate (Reits)
A REIT investment is analogous to mutual fund investment. You purchase shares in a real estate portfolio actively managed by the REIT: REITs are obligated by federal rules to repay 90 percent of their income to investors. The ability to purchase and sell shares at any time is an advantage of investing in a REIT, allowing investors to maintain liquidity in a manner not possible when investing directly in real estate.
Syndications / Real Estate Investment Fund
Investing in a real estate investment fund, often known as syndication, is an alternative method. Most individuals have engaged in syndication at one time or another, so don’t be intimidated by the word’s vague term. Everyone who has ever think a plane ticket has engaged in a syndicate. You paid for your seat, just as others did. The actual income produced from the sale of each ticket is used to pay the airline, the pilot, and other government levies.
Syndication Of Real Estate Is Comparable.
You invest with numerous people in a real estate transaction. Each project may have varying minimum requirements, such as $75,000 or $100,000 per individual. Investors participate in the project’s risk and return, each receiving a proportional portion of the earnings. The project sponsor will collect a modest administrative fee, but they often fall at the bottom of the equity waterfall, meaning they are refunded only after investors have received their agreed-upon equity returns. Any surplus profits will be allocated disproportionately to the project sponsor.
As an individual investor, one of the perks of real estate syndication is that you are considered a “limited partner.” The only job of a limited partner is to provide funds. Meanwhile, the “general partner” (GP) is responsible for sourcing and overseeing transactions. The general partner contributes their real estate experience in return for a portion of the earnings but is only compensated after the limited partners have realized gains. This arrangement guarantees that the interests of the GP and LP are aligned.
Similarly, a real estate fund would combine the resources of its investors and then allocate that cash to various real estate projects based on the fund’s objectives.
After investing in a REIT, a real estate fund, or a syndicated transaction, there is nothing more to do. Take it easy and get revenue proportionally. Most individuals have this in mind when deciding to invest in real estate.
Which Strategy Is Best For You: Active Or Passive?
Both aggressive and passive real estate investment have their merits. It is the management of each individual investor to assess their own circumstances.
How Much Time Do You Have?
Active real estate investment requires an enormous amount of time. You may have time to handle one or two rental apartments, but as a professional with other responsibilities, can you realistically manage more? If not, passive real estate investment may be a more effective strategy for generating scale and lasting wealth via real estate.
What Level of Risk Willingness Will You Accept?
Active real estate investment often involves greater risk than passive real estate investing. If you lack expertise and understanding in real estate investment, you may stick to passive real estate investing, where a team of specialists handles all active real estate operations, including purchase, building, and continuing property management. Moreover, any risk associated with passive real estate investing is shared by several parties. You will not be exclusively responsible for discovering and paying a resolution if anything goes wrong.
What Potential Returns Are There?
Calculate the projected cash flow, cap rate, internal rate of return, and cash-on-cash return before investing in a real estate transaction. Not familiar with these terms? This indicates that you may like to begin passive real estate investment.
How Do the Current Market Conditions Appear?
Most real estate cycles endure between 10 and 15 years. Real estate values will fluctuate over this period. How you invest should vary depending on the current market cycle. Many property flippers, for instance, lost their shirts in the run-up to 2006-2007, when the market peaked, only to see prices plummet. They were left with unfinished projects that were ultimately sold at auction. Investors with a longer-term investment view may be more attracted to funds or syndications with a longer life cycle; hence, the current market cycle may influence their returns less.
Even though the market cycle may influence active and passive real estate investors, active real estate investors assume a higher level of risk. Active real estate investors often commit more of their own funds to projects. They are liable for both mortgage and tax payments. They are responsible for project overruns. Even when selling at a loss, they must still pay broker fees.
When the market contracts, it is considerably safer to be a passive investor than an active investor since the risk, and any possible losses, are spread over numerous parties.
Final Remarks
Investing in real estate is ultimately about producing more income. People mistakenly believe that all real estate investments are passive. That just is not true. Those who make this assumption soon discover that purchasing, owning, and maintaining real estate directly requires much more time than expected.
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