Did you know that you could invest in real estate without the headaches of tenants, toilets, and termites? It’s true – you can get all the benefits of investing in real estate, without any of the challenges of being a landlord.
In this article, you’ll see what passive real estate investing means and find out if you should be an active or passive investor.
What It Means To Be An Active Investor
When most people think of real estate investing, they think of rental property investing – buy a single-family home, find a renter, and collect monthly rental income. Sounds easy enough, but the reality can be quite different.
Even with a professional property management team on board, you as the landlord still have an active role in the investment.
The property managers may take care of the day-to-day issues, but you will still need to be involved in strategic decisions, including whether to evict tenants who aren’t paying; filing insurance claims when unexpected surprises happen; and sometimes having to put in additional funds to cover maintenance and repair costs.
What It Means To Be A Passive Investor
On the flip side, you have passive investing, which is the “set it and forget it” type of real estate investments. You invest your money, and someone else does all the heavy lifting.
The great part about passive investing is that it’s totally passive – you don’t get any calls from the property manager, you don’t have to screen any tenants, and you don’t have to file any insurance paperwork.
However, being a passive investor also means that you relinquish some of your control in the investment and trust someone else i.e., the sponsor team, to manage the property and execute on the business plan on your behalf. The sponsor team is the one who manages.
My First Passive Investment Using Retirement Funds
Through a series of real estate networking events, I met an operator who specialized in turnkey single-family homes in Memphis, Tennessee. A complete turnkey typically means the operator acquires the property, manages the rehab, rents out the house, interfaces with the tenant, collects the rent, and distributes the income to investors. They do all the heavy lifting. There are different levels of turnkey, depending on the operator. Some only acquire the property and manage the renovations then sell the investment to an investor to manage their investment.
After conducting my own due diligence on the operator and the market, I decided to invest in my first turnkey out of state. First, I opened up an account with a Self-Directed Individual Retirement Account (SDIRA) custodian. Self-Directed IRA accounts allow you to invest in alternative assets, i.e., real estate, small businesses, cryptocurrency, etc.
Next, I rolled over a portion of my retirement money from former jobs, which was invested in stocks and mutual funds at a discount brokerage firm, to fund my new SDIRA account. There’s no penalty with rolling over your money, because the SDIRA is a retirement account… you’re rolling money over from one retirement account to another retirement account, that can invest in a number of options to diversify your portfolio.
My SDIRA custodian then wired $25,000 to the operator managing the turnkey investment in Memphis. I then sat back and collected $315 in monthly rental income, while the operator did everything. Quite honestly, I pretty much forgot about my investment, except when I received my monthly notifications about the deposit into my retirement account. A few years later, the property was sold to another investor.
Upon the sale, I received the remainder of my initial investment of $25,000 and 75% of the equity and appreciation, minus fees and commission. My annualized return on investment was a little over 11%. Everything was seamless, and I never lifted a finger to do any work. I was hooked on earning mailbox money!
Should You Be an Active or Passive Real Estate Investor?
Here are 10 factors to help you decide which path is right for you.
#1 – Tenants, Termites, and Toilets
If you’ve dreamt of becoming a landlord, having tenants, and making improvements, then consider an active investor role.
Otherwise, if the title to this bullet point makes you want to knock your head against a wall or make you cringe about flushing termites down the toilet, you should go the passive route.
#2 – Time
Active real estate investments require more time, during the initial acquisition and throughout the project lifecycle, while passive investments only require your time upfront. During the research phase is when you dedicate the most time.
#3 – Involvement
How hands-on do you want to be? Do you want to manage the property yourself, field tenant requests, and schedule maintenance and repair appointments? Or do you want to sit back while someone else does the work?
#4 – Profits
With active investing, you would likely be the only owner of the property, so you would get to keep any net profits. With passive investing, the profits are distributed among many investors.
This doesn’t necessarily mean that one type of investment will net you higher returns than the other; you’ll need to compare one deal to another.
#5 – Expenses
Active real estate investors should plan to handle insurance claims, emergencies, and repairs, which may require additional money at times, whereas passive investors only make an initial capital investment.
#6 – Risk and Liability
With active investing, if things go south, you are personally held liable, which means you may not lose just the property but also your other assets.
With passive investing, your liability is limited to the capital you invest. Typically, the asset is held in an LLC and you invest as a Limited Partner… If anything goes awry or not according to plan, the sponsors are held liable, not the passive investors.
#7 – Paperwork
Active investments are paperwork-heavy, from the initial purchase of the property to tracking purchase and rental agreements, bookkeeping, and legal documents throughout the project.
With passive real estate investments, on the other hand, you typically sign a single private placement memorandum (PPM) to invest in the property. No need to fill out lender paperwork, file for insurance, or do any bookkeeping.
#8 – Team
As an active real estate investor, you will need to build your own team, including brokers, property managers, and contractors.
As a passive investor, you rely on the shared expertise of the existing deal sponsor team. The sponsors are experts in the market and typically already have a team set up to manage the property.
#9 – Diversification
With active investing, you yourself would need to be an expert in the market and asset class you’re investing in. If you’re investing outside your local area, you would need to research the market, find a “boots on the ground” team, and possibly visit the area.
With passive investing, it’s easy to diversify across different markets, since you don’t have to start from scratch with each market. You are investing with teams that have already taken the time to research those markets and build strong local teams.
#10 – Taxes
As an active investor, you’ll be responsible for the bookkeeping, meaning that you will need to keep track of the income and expenses. You’ll also need to work with your CPA to make sure that you are properly depreciating the value of the asset each year.
As a passive real estate investor, you don’t need to do any bookkeeping. You receive a Schedule K-1 every spring for your taxes, which shows the income and losses for that property. No need to track income and expenses throughout the year.
Conclusion
If you’re ready to roll up your sleeves and get involved in the various aspects of being a landlord, active investing just might be the perfect adventure for you.
However, if your time is limited but you have capital to invest, you might want to consider being a passive investor.
If you’re hoping for a middle ground option, turnkey rentals and buy-and-holds may provide some control without the huge time investment.
When determining which is the right path for you, be sure to factor in your unique situation, goals, and interests.