Active Vs. Passive: Which Is the Superior Real Estate Investment Strategy?
When the average person thinks of real estate investing, they might imagine a billionaire who develops massive commercial properties, or an HGTV fix-and-flipper who turns a profit by converting a run-down property into someone’s dream home. With this mental representation, it’s no wonder more people aren’t real estate investors.
Obviously, this isn’t the case in reality. There are thousands of different real estate investing strategies from which to choose. The difficult part — aside from shedding the false belief that real estate investing is only for the rich — is identifying the ideal investment strategy that fits one’s current economic condition, abilities and risk tolerance level.
Generally, entry-level investment strategies fall into two categories: passive and active investing. The question is, which one is best for you?
For our purpose here, I will define active investing as the acquisition of a single-family residence (SFR) with the goal of utilizing it as a rental property and turning over the ongoing management to a third-party property management company. Alternatively, passive investing is placing one’s capital into a real estate syndication — more specifically, an apartment syndication — that is managed in its entirety by a sponsor.
In order to determine which investment strategy is best for you, it is important to understand the main differences between the two. Based on my personal experience following both of these investment strategies and interviewing thousands of real estate professionals who have done the same, I’ve discovered that the differences between passive and active investing fall into three major categories: control, time commitment and risk.
As a passive investor, you are a limited partner in the deal. You give your capital to an experienced sponsor who will use that money to acquire and manage the entire apartment project. You have no direct control over any aspect of the business plan, so you are putting a lot of trust into the sponsor and their team. However, this trust is established by not giving your money to a random, unqualified sponsor but through an alignment of interests. For example, the sponsor will offer you a preferred return, which means that you will receive an agreed-upon return before the syndicator receives a dime. Therefore, the syndicator is financially incentivized to achieve a return above and beyond the preferred return.
As an active investor, you can directly control the business plan. You decide which investment strategy to pursue. You decide the type and level of renovations to perform. You decide the quality of tenant to accept and the rental rate to charge. You determine when to refinance or sell. With for passive investing, all of the above is determined by the apartment syndicator.
As an active investor, the advantage of more control comes with the disadvantage of a greater time commitment. It is your responsibility to educate yourself on the ins and outs of single-family rental investing. Then, you have to find and vet various team members. Once you have a team in place, you have to perform all the duties required to find, qualify and close on a deal. After closing, as long as you have a good property management company, it should be pretty hands-off. Although, if (really, when) something unexpected occurs, you’re responsible for making those decisions, which can come with a lot of stress and a lot of headaches.
Of course, it is indeed possible to automate the majority, if not all, of the above tasks. But that requires a certain level of expertise and a large time investment to implement effectively.
Passive investing is more or less hassle-free. You don’t have to worry about any of the actions described above. You just need to initially vet the apartment syndicator and vet the deal. From there, you simply invest your capital and read the monthly or quarterly project updates.
You are exposed to much less risk as a passive investor. You are plugging into an already created and proven investment system run by an experienced apartment sponsor who (preferably) has successfully completed countless deals in the past. Additionally, there is more certainty on the returns. You will know the projected limited partner returns — both ongoing and at sale — prior to investing. And assuming the syndicator conservatively underwrote the deal, these projected returns should be exceeded.
Active investing is a much riskier strategy. However, with the higher risk comes a higher upside potential. You own 100% of the deal, which means you get 100% of the profits. But, you also have to bear the burden of 100% of the losses. For example, a turnkey rental will likely cash flow a few hundred dollars a month depending on the market. The costs associated with one large maintenance issue or a turnover could wipe out months, or even years, of profits. A value-add or distressed rental has a huge upside potential. However, a common tale among distressed or value-add investors, especially the newer or less experienced ones, is projecting a certain renovation budget but finding an unexpected issue during the rehab process that drastically increases their budget, resulting in a lower or negative overall return.
Additionally, failing to accurately calculate a post-renovation unit’s rental premium will also result in the reduction or elimination of profits. While these profit reduction or elimination scenarios could technically occur with a passive investment, the risk is spread out across many investors, and a sponsor with a proven track record and a qualified team will mitigate these risks.
Real estate investing is for everyone, not just the moguls of the world. However, not all investment strategies are the same. It’s important to understand the pros and cons associated with each to determine which strategy will set you up for success.