Active vs. Passive Real Estate Investing, Which is Better?

Whether at work, a cocktail party, or even around the Thanksgiving dinner table with family, we have no doubt heard someone talking about how they have successfully invested in real estate. The conversation usually goes something like this: “I bought this property for $400,000 4 years ago and now it’s worth $650,000, you have to start investing in real estate!” Good for them, but do they have a repeatable investment strategy or did they just get lucky and buy at the right time? Conversely, you have also probably heard the exact opposite story from someone who bought an investment property, rented it out to nightmare tenants and after a few years of constant aggravation, ended up selling the now destroyed property at a loss. When considering an investment in real estate one should determine their investment goals and decide if they want to be an active or passive investor. Let’s examine the differences between actively investing and passively investing in real estate.

Active Real Estate Investing

Active real estate investing is when an investor personally purchases a property for rental cash-flow or to fix and sell for a profit. The property could be anything from a single-family home to a multifamily property or even an office building. Active investors are involved in every aspect of the deal from finding it, obtaining financing, personally guaranteeing the loan and subsequently managing the investment. The process of identifying the correct market, property, financing and closing the deal can be arduous, but it can also be very rewarding. If it all goes well, an active investor gets to reap the lion’s share of the returns. Furthermore, by actually owning the property the investor could be entitled to certain tax benefits, which in some instances are very helpful in reducing taxable income.

For many investors, the basic strategy is to use their savings, investment portfolio, or self-directed IRA/401k and buy a single family or multifamily property and rent it out. The general concept is to buy a property that will cash flow in order to create additional monthly income. There are many investors who have successfully executed this strategy, repeated it and parlayed large rental portfolios into substantial wealth. So, what’s the catch?

The first issue is the lack of “economies of scale.” For example, let’s say an active investor purchases a 3-unit property. Let’s assume that after all expenses and debt service the property will cash flow $400 per unit/month or $1,200/month and thus $14,400 per year. Who wouldn’t want an extra $14,400 per year? Now consider if all of a sudden, the investor gets a call from the top floor tenant saying their ceiling light is filling with water and dripping into their unit. It turns out the roof has sprung a major leak and the only remedy is to completely replace the roof. On top of that, the ceiling and insulation in their unit needs to be replaced and painted and they are left with a $15,000 bill when all is said and done. What was originally looking like a $14,400 profit, in a span of 24 hours has turned into a $600 loss for the year, assuming nothing else goes wrong. The challenge with actively investing in small multifamily properties, is that larger capital repairs or improvements can eliminate cash flow as there is not enough income to endure larger expenditures. 

The second major component of active real estate investing is time. Unlike purchasing an ETF or mutual fund, the active investor is involved in managing the investment so that it is profitable. Even if a third-party property manager is involved, the investor will still need to oversee the property and make sure things are running smoothly so that money isn’t evaporating. Furthermore, it is unlikely that any investor will be able to retire off of just one investment property, so the active investor will need to buy more properties to make enough monthly income to reach their investment goals. Time spent dealing with, bookkeeping, taxes, property management, and maintenance headaches increases with each additional property added to her portfolio.  

Passive Real Estate investing

The main difference between active and passive investing is that passive investing allows a hands-off approach. This does not mean passive investors should not pay attention to what’s happening with their money, but rather they should be comfortable with entrusting a competent third party to invest it wisely on their behalf. Therefor passive investors need to be prepared to give up some control over their investments. There are many different forms of passive real estate investing but two of the most common are REITs and Syndication.

Real Estate Investment Trusts (REITs), are companies that own, operate or finance income-producing real estate.  Similar to mutual funds, they offer investors a dividend produced by rental income of the underlying asset in the REIT’s portfolio. REITs must meet stringent SEC regulations in order to be publicly traded. Most REITs will focus on a specific real estate asset class and own many properties within that class; whether it be industrial, office, multi-family etc.

One of the main benefits of investing in a publicly traded REIT, is the investment position can be liquidated quickly in the same way a stock would be sold. Furthermore, the investment is spread across a portfolio of properties and thus has some diversification built in. If one property is underperforming, it does not necessarily mean that the investment will not produce a return. On the contrary, the main drawback to REITs is that while the dividends can be strong, they provide little to no capital appreciation. Additionally, the dividend income an investor receives could be taxed at an individual’s income tax rate and doesn’t allow for the tax incentives associated with actually owning the property such as depreciation or participating in a tax-deferred exchange.

Syndication is another common investment vehicle. A syndication deal is when a group of investors pool their money together in order to purchase an asset that has a greater value than each investor could have afforded to purchase or manage on their own. Typically, a real estate investment firm, commonly known as a sponsor, will lead a syndication deal. The sponsor finds a deal, exercises due diligence, organizes the bank financing and then raises money from private investors in order to cover the equity required to purchase a property. After the deal closes, the sponsor acts as the asset manager and makes all decisions related to property management, capital improvements, refinancing and or disposition. The sponsors will have a solid business plan in place in the onset with a timeline of how long they will want to hold the asset before a planned refinance or exit.

Real Estate syndications are commonly found in the purchase of large-scale apartment communities, industrial parks, or office buildings. A sponsor will identify a property that fits the desired investment criteria.  For example, say a sponsor finds a 200-unit apartment community for sale for $10MM and a bank who will lend at 65% loan to value. The sponsor will look to private investors to raise the other 35% or $3.5MM needed to close the deal. Now, the private investors own a portion of the property alongside the sponsor. For their capital contribution, investors generally receive a preferential return along with an equity split of the remaining monthly cash flow and a portion of the proceeds from a liquidity event like a refinance or sale.

The advantage to investing in a syndication deal is the investor has visibility into the specific opportunity and the ability to vet the deal on its own merits. This is unlike a REIT where their investment is at the discretion of the fund manager to allocate towards a number of different properties. A further benefit of a syndication deal as compared to a REIT, is that they allow for the passive investor to enjoy some of the tax benefits of owning real estate without the headache of actually managing the asset. Typically syndications are structured as limited partnerships or LLCs and are treated as pass-through entities. This allows investors to claim depreciation and loan interest deductions to shelter their portion of the distributed cash-flow. Furthermore, upon the sale of the asset, passive investors have the opportunity to execute a 1031 exchange. This allows them to purchase another like-kind property, or participate in another syndication without paying the capital gains tax at the time of the sale. By deferring the taxes on the capital gains the investor’s capital is compounded tax-free.

While syndication may seem like a great investment opportunity for passive investors, it's not right for everyone. One of the main drawbacks of a syndication deal is that they are much less liquid than a REIT. The money is typically tied up for anywhere between 3-10 years depending on the intended hold period. It’s not always easy to sell a share in the deal to another investor if you want to get out early. Therefore, syndications are not a good investment vehicle for investors that need quick access to their principal investment.

Now that we’ve outlined some of the pros and cons of both active and passive real estate investing, which one is better?

The answer is... it completely depends on the individual investor’s situation and specific investment goals. Active investors will need to have the time, skillset and experience to effectively manage and control all aspects of his or her portfolio. Whereas passive investors, who do not have the time or desire to manage and grow their real estate portfolio on their own, can let their capital and a syndicator do the work for them.

Instinctively, most people want as much control over their money as possible. However, full control doesn’t always equate to better results. It is important for investors to look critically at their goals, time, and lifestyle to determine whether active or passive real estate investing is a better fit for them. 

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