Do you want to invest in real estate and join the ranks of the wealthy? There are many paths to take, and many of you may be at a major fork in the road. Do you take the passive investor route? Or drive full steam ahead as an active investor? Perhaps you think it is time to stop, set up shop, and become a landlord.
If you want our two cents, you are in the right place. Read on to find out why we think passive investing, for the vast majority of folks, is a better option than active investing or becoming a landlord.
10 Reasons Passive Investing Beats Active Investing, Every Time
1. Free Your Time
As a passive investor, your only responsibility is to review opportunities presented by your sponsor(s), perform your own due diligence, and select the investments that are right for you. Once that is done, you will not have to lift another finger (except for checking progress reports and your returns). Spend your time however you so choose, instead of wrangling brokers, banks, sellers, and other investors to find and purchase real estate. Leave that to the sponsor.
2. Have Peace of Mind
Not only will you avoid negotiations, but passive investors also do not have to manage tenants, toilets, trash, or tirades. You are not tasked with monitoring cash flow, managing contractors, paying bills, and providing reports to the bank or investors.
3. Scale Larger, Faster
So, you dream of owning a real estate empire of 10,000 units—but how do you get there? Well, it takes millions of dollars and years of work to actively build this kind of portfolio. And you must start small, working your way up from 50 to 100 to 150 units until you are ready to compete in the big leagues. However, by investing passively, you can lean on sponsors who already have skin in the game. They have made (and learned from) the rookie mistakes. All the grunt work it takes to build and scale a successful enterprise is done, so you do not have to do it.
4. Achieve Diversification
One of the best hedges against large portfolio losses, diversification spreads risk across multiple investments. Generally speaking, you lose this risk deflection as an active investor. By investing with multiple sponsors in a variety of real estate sectors and locations, you can grow and protect your wealth without—and please pardon the cliché—putting all your eggs in one basket.
5. Avert Legal Liability
As a limited partner in a syndicated real estate opportunity, you are not liable for any legal claims against the business or its owners. Quick explanation: there are typically two types of players here: (1) the general partner/sponsor, who is the active manager and business decision-maker; and (2) the limited partners/passive investors, who bring capital to the table and realize returns. Without any decision-making authority, the limited partners hold no liability for any actions of the general partner. While legal action is rarely taken in or against syndications, it is by no means unheard of. But passive investors get to sit back and relax, knowing they won’t face any legal paperwork, litigation, or court hearings.
6. Employ Expert Knowledge
Experienced sponsors already have all the tools in place to maximize your returns. As a passive investor, you get an access pass to the sponsor’s highly specialized team. Everyone has already been hand-selected and vetted to handle every aspect of the business, from acquisitions to dispositions and lease management.
You also get to take advantage of the time-tested systems, processes, and strategies that have proven successful. Sponsors have developed networks for identifying lucrative markets and assets; procedures for performing due diligence; methods for operating, managing, and maintaining the property; and skills for evaluating when to sell and refinance. And once again, they have done this, so you do not have to.
7. Create Tremendous Leverage
When you invest in a syndication, you earn access to the sponsor’s creditworthiness, and thus, their ability to create immense financial leverage. Sponsors typically have access to better loans than individuals and can place much more beneficial debt on the real estate asset when purchased. This increases the leverage investors achieve and potentially magnifies the returns as well.
8. Avoid Loan Guarantees
Speaking of leverage, passive investors enjoy the benefits of financial leverage without the personal guarantees that come with most debt. When you become a limited partner, the largest amount you can lose on an investment is the cash you originally invested. The general partner is the party who may have to guarantee the loan and/or become personally liable in the event of a default. Therefore, your downside risk exposure is skewed to the upside since positive returns are theoretically unlimited and losses are capped at your initial investment.
9. Invest in Smaller Increments
By pooling capital with other passive investors in a syndication, you can invest smaller amounts into more opportunities. This both reduces your risk of exposure to any one investment and allows you to make investments over different time periods. Both are key strategies to maximizing long-term portfolio returns.
10. Collect Stable Returns with High-Quality Assets
Beyond allowing you to invest in more opportunities with exceptional sponsors, syndications also provide access to higher-quality assets. These properties typically generate more predictable, stable cash flows for distribution to the passive investors. High-quality assets also have a better chance of retaining or increasing their value over time to produce good exit prices for investors.
Bonus! 11. Tax Benefits
There are many tax benefits for passive investors, some more complex and nuanced than others. These are the ones to pay close attention to:
· Depreciation, which typically offsets most (if not more) of the rental income generated and reduces your overall tax liability.
· When assets are sold, they are usually taxed at long-term capital gains rates, which are usually lower than the income tax rate.
· You may be able to take advantage of 1031 exchanges that defer capital gains taxes into the future, maybe even indefinitely.
10 Reasons to Skip Becoming a Landlord
To landlord or not to landlord: that is the question so many investors face. Let’s discuss some of the main reasons people opt to not. (Heads up: we are not here to sugarcoat it.)
1. You will be stressed out
The phone will ring in the middle of the night. No, it is not an emergency: your tenant wants to let you know that the lightbulb in the storage closet just burnt out. But when the roof leaks, you will not hear about it for years. Oh, and the toilets—there is always something with the toilets. Does this sound frustrating or make you cringe? You should pass on being a landlord.
2. You are not into DIY
If you have never swung a hammer, replaced a faucet, or unclogged a drain (let alone replaced cabinets or appliances), you are probably not ready to directly own and manage real estate.
3. You do not like to argue
Most people do not have the debate skills to negotiate late rent payments and tenant demands. If the thought of imposing late payment penalties and fees for lease violations makes you uncomfortable, then you should consider another path to owning real estate.
4. The learning curve is too steep
As a landlord, you get to undertake all parts of your business until you have scaled it enough to delegate. That means you are the customer service representative, marketer, designer, copywriter, leasing agent, tenant-screening professional, bookkeeper, tax preparer, handyman, property manager, and inspector. Yes, you are going to be wearing a lot of hats. If you are not familiar with the systems, processes, legal obligations, and other activities required to manage a rental property, you may want to look at other options.
5. You do not have enough money
We all know it takes a lot of money to purchase rental real estate. Down payments typically range anywhere from 20–40 percent of the purchase price. Unless you have a lot of spare cash collecting dust, you will only be able to purchase a few units when you get started. The cash flow may not be enough to offset your time commitment.
6. You do not have enough time
Oh, about that time commitment. Yes, you will need to find time to perform all those aforementioned activities, from leasing to bookkeeping and everything in between. If you let any balls drop, you are at risk of losing sight of what is happening on your property—and you are at risk of losing money.
7. You do not have access to quality opportunities
You will need to build a network of brokers who believe that you are going to buy real estate from them. This will take time. You will not be on the “buyers list” when you first start in this business and, therefore, will not get access to the best opportunities. You may also need to develop systems for directly approaching current owners through mail or cold calls. All of this takes enormous effort (and time) to uncover truly worthwhile opportunities.
8. You are afraid of the legal liability
When you are the owner/operator of a property, in personal name or not, you are exposed to legal liability. Whether someone slips and falls, finds mold, or violates the lease, you could be exposed to lawsuits. No matter if you think a legal matter is frivolous or not, it cannot be ignored, or it will only get worse.
9. You do not like to deal with bureaucracy
From construction permits to rental assistance, there are an untold number of government agencies you will encounter while owning and operating a rental property. If the thought of getting a call from the city health department or dealing with the zoning committee sends you spiraling, you are not ready to be a landlord.
10. You are afraid of making mistakes
Finally, you must be confident in yourself and your ability to manage all the moving parts described above. Landlords need to be ok with making mistakes, because they will happen, and should be flexible enough to fix them accordingly. Yes, you could hire staff to help in areas where you are less-than confident, but that will hurt your returns. You can hire property managers, but they may not treat your residents—or your property—as well as you would.
There are tradeoffs with every decision you make as an active investor and/or landlord, and the best decision may be to avoid becoming one. If you already have a stable income and enjoy your work, you may be better off by simply becoming a passive investor. Or at least start as one until you’re ready to take on the challenges of being a landlord.