Among many of the factors to consider when considering investing in real estate, the consideration of whether to invest passively or actively is one important one. I have been giving a lot of thought to both options lately myself. Like most things in life, there are usually pros and cons to either choice. On the surface it might seem that being an active investor, owning your own individual properties might have more to offer and more to be gained. However, here are several reasons why a passive investment could be better than an active one.
1. PARTICIPATION WITH SMALLER CHUNKS OF MONEY
This might not always be true, but in a lot of cases the starting amount needed to invest can often times be more if you are individually buying a rental property compared to opportunities that are available for passive investing. Except for the most inexpensive of single family homes which you might be able to get into with as little as $15-20k, you’re likely looking at needing $30-40k (plus closing costs) to get into an entry level property.
Through passive investments in many crowdfunding sites you could be participating in some deals with as little as $5-10k per investment. For private syndications, you will again be looking at higher amounts in the minimum range of $25-50k, but that is still a relatively small amount compared to what you would have to come up with to participate in the same asset class on your own that you are tapping into via syndication.
2. LESS RESERVES…..MORE OF YOUR MONEY “AT WORK”
For pretty much any rental property that you own individually, it’s generally advisable to keep a reserve amount of liquid cash on hand for that property to deal with any unanticipated expense or capital expenditures that are needed. The amount that should be held in reserves for this purpose will depend on the property itself – age of the property, planned capital expenditures, number of units, any deferred maintenance, etc. You might have the reserve fund in a savings account accruing a nominal interest income, but in general that is money that is not exactly out there “working” for you generating a significant return to contribute to your personal cash flow. However, if your investment is in a passive deal, you would not need to keep this same reserve fund on the side to deal with a leaky roof or water line replacement. The result…..more of your money can be out there actually invested in something that is generating a healthy return.
3. LESS LIABILITY/CONTAINED RISK
When you are the owner of a property, the liability for anything that happens at that property falls back to either you as an individual or to the legal entity in which you hold that property. Of course insurance is there to help mitigate that risk, but your risk can still extend beyond the limits of your insurance in certain circumstances. In addition to liability of events which occur in or on your property, your assets could be at risk of attacks from outside creditors as well without strong asset protection planning in place. When you invest passively as a limited partner, for example in a syndication, the limitation of your risk is generally the extent of whatever capital you have invested in the project. For sure you should scrutinize the details of any passive investment to verify the extent of your liability, but this is the typical situation where your maximum loss would be the amount of money you have invested. That’s not to say that losing $50-100k in a deal would not be horrible, but relative to being at risk for several hundreds of thousands of dollars in a worst case scenario type event on an individually owned property your risk is relatively contained.
4. INCREASED EASE OF DIVERSIFICATION
One of the evergreen pieces of advice regarding investing – real estate or otherwise – is the recommendation to diversify your holdings. Diversification can come in many forms even within real estate – diversification of geographic location/metro areas, asset class, etc. It essentially amounts to how many of your eggs you are putting in one basket. If you have X amount of money invested in real estate, are you using that entire amount to be tied up in one property in one location or is that amount spread around into multiple properties in several markets? By choosing to participate in some passive investments you have the opportunity to invest in other markets outside of what is just in your own “backyard” and also typically allows you to invest in multiple asset types or sizes over time as you accumulate sums of money to put into deals.
5. OPPORTUNITY TO LEVERAGE MULTIPLE ANGLES
When I first got started investing in real estate, one of the concepts that really excited me about the potential in real estate was that of LEVERAGE. The smart use of leverage magnifies many of the already good benefits of investing in real estate. Beyond just the financial leverage of utilizing loans to purchase property, I have gained an appreciation for the use of other forms of leverage that are possible, especially by participating on the passive side of an investment.
When you participate passively, you are leveraging all of the relationships, team members, background/experience, credentials, etc. of the sponsor with which you are investing. Sometimes it boils down to an experienced sponsor having the right relationships and connections to even have access to the best investment opportunities. Or perhaps because of the sponsor’s collective business with a particular vendor they are able to get better pricing or terms of service on certain contracts. All of these kinds of things are ways in which you benefit from different forms of leverage when you are a passive investor investing with an experienced operator.
6. POTENTIALLY FEWER COSTS FOR ASSET PROTECTION AND ENTITY MAINTENANCE
Perhaps this point stands out to me in particular because I live in the state of California which is notorious for the fees charged for the opportunity of doing business in California. However, any state will have their state filing fees in addition to the costs of setting up and maintaining an LLC. If you are in a situation where you are using a separate entity to hold each property you own, this can easily become a significant expense each year just to operate multiple entities: initial set up costs, registered agent annual service, annual state filing fees, tax return preparation fees, etc. These fees can easily be a couple thousand dollars per year for each entity. With just a few entities in place this can really add up.
Everyone’s asset protection plan and strategy will be unique; however, it is worth considering that you may not necessarily need an entity (or separate entity) for each individual passive investment you are involved in. This easily has the potential to save you thousands of dollars each year. I am certainly not an attorney so am not in any way trying to provide any legal recommendations, but this is something worth asking your own attorney about to see how some passive versus active investments would impact your asset protection strategy.
7. NEVER ANY CALLS FOR TENANTS OR TOILETS
The seemingly obvious difference that is still worth pointing out is that as a passive investor you will NEVER be the one taking a phone call at 5:30 p.m. on a Friday afternoon before a long holiday weekend from the tenant that is having a problem with their toilet. That just won’t happen as a passive investor. Sure, toilets will have their problems, but you won’t get a phone call to hear about it. There’s something to be said about having the economies of scale within an investment that allow for you to remain the INVESTOR instead of the property manager and still continue to make healthy returns on your capital.
Feel free to share your thoughts on what you see as the pros and cons of passive versus active investing. Meanwhile, happy investing!