Introduction:
Most people recognize the advantages of passive investing: you contribute money, a sponsor (a real estate specialist) handles it, and you receive a return on your investment. Learn more about passive real estate here!
Passive investing necessitates less time commitment. With family duties, interests, and a full-time job, most people cannot afford to invest actively in real estate. When you’re a busy real estate investor, it can be challenging to discover a fair deal, arrange to finance, and deal with the inconveniences of day-to-day property maintenance. Passive investors gain from someone else putting that in place, and when a toilet breaks in the middle of the night or a unit requires repair, the passive investor sleeps quietly through the night while things are addressed.
Furthermore, being a passive investor necessitates less expertise and experience. It does not demand a thorough understanding of the real estate market and the asset class, whether single-family houses, apartments, retail, or other commercial or residential properties. Active investment requires a deep understanding of the market in which you intend to operate and the ability to discriminate between excellent and bad real estate transactions. Passive investment does not necessitate becoming a real estate specialist because the passive investor harnesses seasoned professionals’ talents, networks, and expertise.
Most people recognize the advantages of passive investing: you contribute money, a sponsor (a specialist) handles it, and you receive a return on your investment. Excellent system! This passive investing strategy is also used in real estate. In addition, we are frequently asked about the finest passive investment strategies. As a result, this essay will serve as a primer on passive real estate investing.
We’ll go over the following topics in particular:
The Advantages of Investing in Passive Real Estate
Passive investors seek a return on investment due to other people’s managerial work. In other words, passive investors provide funds for a transaction. However, that transaction is managed by someone else, with investors receiving a return on their investment.
In real estate, passive investment frequently occurs when an experienced real estate investor discovers a good bargain but lacks the funds to make it happen. These individuals are looking for passive investors to help them meet the deal’s monetary requirements. Passive investors contribute the money, and professional individuals manage the deal daily.
This concept offers three major advantages from the standpoint of the passive investor:
Benefit #1: There is a limited amount of time required.
You do not oversee the day-to-day operations of a deal as a passive investor. Instead, you delegate this responsibility to others’ managerial efforts. Because of this structure, passive investing often requires significantly less of your time than active ones (e.g., starting your own business).
Passive investors must devote time to locating and evaluating potential investment possibilities. However, if they commit to an investment, they have low (or no) time obligations, often consisting of only reviewing management’s frequent performance reports. Passive real estate investments allow self-employed and W-2 employees with considerable revenue to produce a return on this surplus income without compromising their day job.
Benefit #2: You don’t have to be an expert.
Successful commercial real estate planning and execution necessitates a wealth of knowledge and experience. Honestly, you can’t start your own business from the beginning. However, as a passive investor, you don’t need to be an expert because you’re entrusting the deal’s development and management to someone who is.
This truth, however, should not be taken as implying that you should blindly trust others. As a passive investor, you must still have sufficient financial acumen and fundamental real estate expertise to evaluate potential purchases. If someone suggests a passive investment opportunity, you must still undertake due diligence by analyzing the idea, its related risks, and your investment goals.
Benefit #3: The ability to pool capital.
Commercial real estate often necessitates significantly more capital than residential real estate and demands far more skill. The majority of deals do not have a single equity investor. Rather, many commercial real estate experts seek passive investors to pool capital. For example, in a $1,000,000 cash deal, the offer’s sponsor may put up $100,000 and raise the remaining $900,000 from passive investors.
This system assists the sponsor in closing the agreement. Passive investors receive the ability to participate in a commercial real estate transaction without having to commit 100% of the funds.
Benefit #4: Potential depreciation benefits.
You obtain the benefit of depreciation when you directly invest in income-producing real estate (i.e., own a piece of an income-producing property). Depreciation, as a “cashless expense,” reduces your tax bill without requiring a cash spend. As a result, many rental properties have positive cash flow while incurring taxable losses. (NOTE: When you sell a property, the IRS snatches back some of the depreciation benefits through a tax known as depreciation recapture). However, techniques such as Section 1031 like-kind trades can postpone this tax liability.
As we’ll see later, not all passive real estate investments provide you with direct ownership of the property, which means you won’t benefit from depreciation. However, when examining various passive options, it is critical to comprehend the role of depreciation programs.
Benefit #5: The possibility of downside protection
Many real estate transactions give preferred stock positions to passive investors. On the capital stack, preferred equity is immediately below common equity. As a result, these investors receive slightly lower returns but also have stronger safety than regular equity holders, often in terms of minimum necessary returns. In other words, preferred equity protects against losses. Most deal structures require preferred equity holders to meet their minimum required to return before common equity holders receive any return on investment.
This preferred equity concept does not eliminate the risk of a transaction. However, it does give downside protection, which helps to limit the risk inherent in any transaction.
Guide to Investing in Passive Real Estate
Passive Strategy #1: Invest as a Limited Partner in Real Estate Transactions
Many commercial real estate transactions are set up as limited partnerships. A limited partnership has two participants at its most basic. In other words, the limited partner acts as a passive investor, reaping the benefits of direct ownership (e.g., a portion of profits/losses and depreciation) while assuming no day-to-day duties.
Many real estate developers desire to bring in limited partners to A) raise finance and B) retain managerial control. As a result, networking with local real estate developers might be an excellent method to learn about passive real estate investment prospects.
Passive Strategy #2: Invest in a Crowdfunded Real Estate Syndication
Unfortunately, investing as a limited partner is contingent on your ability to find a general partner ready to accept you as a partner. On the other hand, real estate syndications provide the benefits of limited partnerships without the need for the same type of relationship.
A deal sponsor (or syndicator) identifies, underwrites, and handles the day-to-day activities of a deal in syndication. The sponsor advertises the deal to investors through syndication, a pooled capital approach to raise funds. The transaction sponsor is typically the managing member of an LLC, while the passive investors are investor members.
While similar in structure to a limited partnership, real estate syndications frequently feature more chances for many investors to participate in a project. With the adoption of the JOBS Act in 2012, deal sponsors can now “crowdfund” syndications online (with some restrictions). This has resulted in creating several websites that connect sponsors with passive investors. As a result, those looking for passive investment opportunities no longer need to know skilled real estate specialists; instead, they may sift through potential offers using one of these syndication portals.
Passive Strategy #3: Buy REIT shares
Direct ownership of investment properties is possible in each of the preceding alternatives. REITs, or real estate investment trusts, provide passive investing opportunities without the risk of direct ownership. Furthermore, many publicly traded REITs provide significantly more liquidity than syndications or limited partnerships. Investing in debt, equity, or hybrid REIT is as simple as purchasing shares through your online brokerage.
However, because of the lack of direct ownership, REIT shares do not receive pass-through depreciation. Instead, the REIT employs depreciation to lower its taxable income. REITs are then required by law to transfer 90% of their taxable revenue to shareholders in the form of dividends. Furthermore, these dividends are usually taxed at your regular income tax rate (i.e., your marginal tax rate) rather than the more favorable long-term capital gains rate.
Because of these characteristics, REITs are an excellent choice for investors seeking dependable fixed income from tax-advantaged retirement funds. However, REITs may not be suitable for passive investors seeking the tax benefits of depreciation.
Passive Strategy #4: Become a Private Lender
This approach directly invests in a transaction but with debt rather than shares. Private lenders offer debt financing options to conventional lenders (e.g., banks and other financial institutions). Private lenders frequently provide short-term financing alternatives until consumers can get a permanent mortgage in situations when one of these traditional lenders would not approve a borrower or requires too long of a closing procedure. Private lenders charge higher borrowing rates due to this convenience (and additional risk).
So, how does passive investing work? When you make a private loan, you do not manage the transaction; instead, you service the obligation and collect interest income. However, before using this strategy, passive investors must examine three aspects. To begin, to lend money, you must first have money. Second, while you may not be involved in the day-to-day operations of a project as a private lender, you must have sufficient real estate and financial understanding to underwrite the deal from a lender’s standpoint. Finally, private lenders must still service this debt, which is not an easy task.
Passive Strategy #5: Invest in Real Estate-Related Publicly Traded Companies
You can likewise invest passively in real estate through publicly traded real estate firms (e.g., institutional landlords, construction companies, supply-chain companies, etc.). This technique provides completely passive exposure to real estate, albeit without the benefit of direct ownership depreciation.
It also has a few advantages for new investors. First, publicly traded corporations must comply with SEC rules for frequent audits and reporting, limiting the possibility of fraud and deceptive private transaction offers. Second, having shares in publicly traded corporations, like investing in REITs, provides significantly more liquidity than directly investing in a deal. This liquidity provides great financial flexibility to rookie investors who are not ready to commit to a long-term deal horizon.
As we’ve seen, passive real estate investing has several advantages. There are also several passive strategies. Understanding these techniques and their associated benefits and drawbacks can equip new investors with the foundation they need to make informed passive investment selections.
We’d love to discuss other real estate investing opportunities for your specific scenario! Send us an email, and we’ll arrange a meeting to discuss available passive real estate investment opportunities.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.