May 13, 2021
Joe Fairless

When You Should NOT Passively Invest in Real Estate

Passive investing in commercial real estate can be a great investment strategy. But it is not for everyone. Many entrepreneurs elect to actively invest in commercial real estate instead and have made a lot of money in the process. They invest their own capital and/or raise capital from passive investors to buy, operate, and sell multifamily, self-storage, office, retail, etc.

There are major differences between being an active commercial real estate investor and passively investing with an active investor. Your personal investing goals and preferences will determine which is best suited for you.

In this blog post, I will provide four scenarios where passively investing in commercial real estate might not be the best option for you.

If you want control…

One of the biggest differences between active and passive investing is control. As a passive investor, you have no control over the investment. You can select who to invest with and what deals to invest in (unless you are investing in a fund, in which case you are automatically invested in any deal acquired by the fund). But once you’ve invested your capital with an operator into an opportunity, you have no control over any aspect of the business plan.

Therefore, if you want complete control over your investment, you should not passively invest in real estate. As an active investor, you decide which investment strategy to pursue, what type and level of renovations to perform, who to rent to, what rent to charge, when to refinance and sell, and everything else.  However, if you want complete control over your investment, you will need to know what you are doing. You must have the knowledge and an experienced team to ensure that the investment flourishes.

If you want the potential for higher returns…

You are exposed to much less risk as a passive investor. You are investing in a proven investment system run by an experienced commercial real estate operator who has successfully completed countless deals in the past. They use your capital to acquire and operate an investment and you receive a portion of the profits. Because passive investing is relatively hands-off and lower risk, the returns are typically lower.

Passive investing returns vary greatly based on the asset type, the operator’s business plan and experience level, the market, the state of the economy, etc. However, a great active commercial real estate operator will almost always receive a higher ROI than their passive investors.

Let’s say the commercial real estate operator acquires an investment and the compensation is structured such that passive investors receive 70% of the total profits and operators receive the remaining 30%. Even though the passive investors receive a higher overall portion of the profits, there are many more passive investors than operators, which means the 70% is spread between more individuals. The operators also likely collect other fees, like acquisition fees and asset management fees. Plus, the operators have much less than 30% equity in the deal. Because of these three factors, the overall return on investment is higher for operators than it is for passive investors. Depending on how much of their own capital they invest, their ROI can be well into the four figures (1,000%+ ROI).

Here is a very simplified example: The operators raised $3.8 million and invested $200,000 for a total investment of $4 million to acquire a $10 million apartment community. After 5 years, the apartment community is sold. The overall equity multiple was 2.0 to the passive investors, which means the total profit was $4 million to the investors. Let’s assume a 70/30 profit split. If 70% is $4,000,000, 30% is approximately $1.7 million. Since the operators invested $200,000 as passive investors too, they receive $200,000 of the $4 million in profits. Let’s also assume a 2% acquisition fee of the purchase price, which is $200,000. Between the return on their $200,000 investment as passive investors, 30% of the profits, and acquisition fee, they made $2,100,000 in five years. Based on a $200,000 investment, that is a 1,050% ROI (compared to the 200% ROI for the passive investors). And this is before accounting for other fees, like asset management fees, property management fees (if they have an in-house management company), disposition fees, etc.

The return on investment may be higher, but the return on time may not be. The operators invest a substantial amount of time acquiring, managing, and selling each investment opportunity whereas the passive investors are mostly hands-off.

If you aren’t an accredited investor (or don’t have a relationship with an operator)…

In order to invest in syndication deals, you must be an accredited investor. According to the SEC (Securities and Exchange Commission) definition of an accredited investor, in the context of a natural person, includes anyone who

  • earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR;
  • Has a net worth of over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).

There are other ways to qualify but these are the two most common ways an individual can qualify. The SEC does allow non-accredited sophisticated investors to invest in investment opportunities under the 506(b) exception. However, you must have a pre-existing, substantive relationship with the operator.

Therefore, if you are not an accredited investor or do not have a pre-existing, substantive relationship with an operator, you won’t be able to passively invest in commercial real estate deals.

If you enjoy being a business owner…

Operating a successful commercial real estate company is a full-time endeavor. Therefore, if you have a strong desire to create a commercial real estate business AND have the time to do so, you shouldn’t passively invest in commercial real estate. Or at least you shouldn’t only passively invest in real estate (here is a blog post about how passive investing can make you a better active investor).

When you should not passively invest in real estate

Passive investing isn’t the ideal investment strategy for everyone.

If you want complete control over and have the expertise to operate your investments, you shouldn’t passively invest.

If you are comfortable with more risks and want to potentially generate the highest return on your investment while also investing a lot of time into managing your investments, you shouldn’t passively invest.

If you are not an accredited investor or do not have a pre-existing, substantive relationship with a commercial real estate operator, you shouldn’t passively invest.

Bottom line: if you love the idea of operating a commercial real estate business on a full-time basis, you should not passively invest.

Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.

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