Most people who are new to real estate investing think only in terms of buying their own properties and renting them out. In the real estate world, if you personally own property and manage it (even if you hire a property manager), you are an active investor. If you own a fractional share of a real estate property or project, but do not have responsibility for any of the typical landlord worries, have no real say in how the property is managed and are not directly responsible for debt repayment, you are usually a passive investor.
While the type of investing you do is mostly a matter of personal choice, it’s important to understand that you may be able to achieve some of your goals related to real estate investing by doing either active or passive investing or a combination of the two. Some people prefer to own property directly while others prefer to sit by and let others obtain financing, negotiate deals, manage properties, deal with tenants, and the other things associated with real estate investments. Still others do some of both to expand the number of possible deals they can look at and to allow for diversification within their portfolios.
Here are some key points to consider with active versus passive real estate investing:
- If you have good credit, enough cash for a down payment (or access to cash), and a stable employment situation, there’s a decent chance you’ll qualify for financing to purchase a rental property. Of course, the price of the property will need to be in range that matches your ability to qualify and your bank will delineate specific qualification criteria.
- Banks and other lending institutions can be a bit picky when it comes to financing rental properties to novice investors. They will want to know that their loan is well collateralized with enough cash infused by you plus a good property that appraises at a market price to support the loan.
- As an active investor, you will most likely be taking advantage of a concept you may be familiar with. That concept is OPM or other peoples’ money. An important distinction to note is that, as a passive investor, you will also most likely be taking advantage of OPM, but in an indirect manner. More on that later. Staying with active investing, suppose you purchase a duplex for $300,000 and put $75,000 down. In this case, your loan to value ratio (LTV) is $225,000 ($300,000 purchase price minus your $25% down payment) divided by $300,000 or 75%. Since you (or your newly formed investment company) own the property, you are leveraging your ability to make bigger cash-on-cash returns and build equity by having tenants effectively make your loan payments.
- As a passive investor, you generally will not have your signature on mortgage loan documents. As already mentioned, you will be buying fractional ownership in deals (properties) usually sourced, negotiated, financed and managed by a general partner. In this case, a separate LLC is often formed for each deal (could include multiple like-kind properties) and your ownership percentage will be based on how much you invest relative to the general partner and other members of the investor group. You become, in most cases, a limited partner (LP) in the deal.
- Passive investment is similar to how companies sell stock. They sell stock to raise capital. A real estate general partner does something very similar. They need to raise capital in order to get deals done. So, they put up some money of their own and invite others into the deals usually with a minimum investment required. And the general partner usually borrows money to finance the rest of the deal. For example, suppose a general partner wants to acquire a 100-unit multifamily apartment complex for $9,500,000 and will finance 70% of the deal or $6,650,000. But they don’t want to put their own cash up for all of the other 30%. They will, however, put up 15% or $427,500. So, since the total equity “raise” is $2,850,000 ($9,500,000 – $6,650,000), they will need to raise $2,422,500. This is where the passive investor (limited partner) comes into the picture. The general partner will open up the deal to other people usually with a minimum investment required. That minimum can range all over the board depending on how badly they want to limit the number of passive investors. That minimum may be $5,000 or it may be $500,000, for example. Every deal tends to be different.
- There is good news and not so good news about passive investing. The good news is that you may be able to own a piece of a property or group of properties without having to jump through all the hoops to get a property acquired. The not so good news is that the minimums mentioned above may be more than you have available. The other piece of not so good news is that many deals require an investor to be accredited. To be an accredited investor in 2020, you must have earned a minimum of $200,000 ($300,000 for joint income) in each of the previous two years and expect to earn at least that much in the current year. Or, the investor must meet the net worth requirement of $1,000,000 (either individually or jointly with a spouse) excluding the equity/value of their primary residence. Both requirements do not have to be met…only one. To make matters even more hairy, some sponsors require investors to meet higher standards. This isn’t as all that common in real estate investing, but it does happen. Sometimes the sponsor will require the investor to be qualified. Since this tends to be less common in the type of real estate investing this book is focused on, we won’t spend much time on this increased requirement.
This brief introduction to active and passive investing is important to any discussion of investing in real estate. Because both exist, you have some options relative to how you invest your money. While passive investment may require somewhat higher qualification standards (not always the case, however), it can offer some advantages.
Sponsors Versus Syndication Groups: What Is the Distinction?
You may have noted that both sponsors and syndication groups were mentioned above even though a more common designation for both tends to be general partner (GP). Let’s take a minute to address those just a bit more for clarification.
This article may be creating more delineation between a sponsor and a syndication group than others might or that might be necessary. This article differentiates a sponsor from a syndication group based on a few things; 1) the size of the overall portfolio, 2) the level of sophistication, and 3) the number of investors involved. A syndication group (by our definition) tends to have smaller portfolios, be less sophisticated in the various aspects of sourcing, evaluating, managing and reporting on investments, and has a limited number of well-known or referred investors that participate in most or all deals. A sponsor tends to be a larger real estate investment group that has a large number of real estate assets in its portfolio (perhaps hundreds of millions to billions worth), are sometimes more sophisticated in nature and more thorough in their due diligence when vetting prospective deals, and have more investors in each deal many or even none of whom are not personally known by the sponsor. Again, this is how we perceive the distinctions, but others may view it somewhat differently. We don’t want to confuse the issue, but do want to provide some clarifying information that may be helpful in understanding what type of passive investor groups are out there.
It’s important to note that it’s not uncommon for sponsors and syndication groups (GPs) to take a fee for their efforts at sourcing and managing properties. Those fees will vary, but are generally in the 1 to 2% range. Note that not all take fees or they may take smaller or larger fees.
Regardless of whether a large sponsor or smaller syndication group is involved, every deal should have a detailed description of the property and the market or sub-market (neighborhood or suburb within a larger market) coupled with a detailed financial analysis associated with them including projected return numbers by year over the hold period (expected time to own the property). General partners may take fees from each deal, but still generally offer decent returns on their investments. Of course, not all deals work out as planned and some may underperform relative to underwriting (projected returns).
Here are a few possible advantages to connecting with sponsors and syndication groups (general partners) assuming you can meet their qualification and participation criteria:
- Deal flow refers to the number of deals (properties) that you have at your disposal to potentially invest in. If you’re an active investor and sourcing deals yourself, it can sometimes be difficult to find good properties that can generate an adequate return. Sponsors/syndication groups are motivated to look at as many good deals as possible and select the best ones to invest in. Those that are sourcing and bringing to investors good opportunities on a consistent and regular basis are considered favorable to investors (everything else being equal). As an active investor trying to source your own properties, you may be frustrated at how difficult it is to find attractive investments. One challenge you face as an individual investor is that you’re often competing with people (e.g, real estate agents) who have access to the multiple listing service (MLS) and pocket listings (properties they are made aware of or have a private agreement on before they hit the MLS).
- Reputable sponsors and syndication groups have (or should have) expertise and a fiduciary responsibility to be good stewards of your money. They take investing very seriously and most are very thorough with their due diligence. They have certain hurdles that must be met for properties to qualify as a prospective investment. Larger sponsors in particular have people who are skilled in real estate and real estate finance and property evaluation and management and may focus on specialized tasks.
- Most sponsors and syndication groups focus on maximizing both cash returns and appreciation over the hold period. Depending on experience, they usually have a good feel for how to increase value in properties by increasing rents, upgrading properties to make them more attractive to tenants thereby increasing occupancy (decreasing vacancy rates), decreasing maintenance costs, collecting additional fees and generally making the property attractive to prospective buyers at the end of the hold period (every deal usually has its own unique hold period based on various factors).
And here are a few possible advantages to being an active investor sourcing and managing your own properties:
- You own and control the property. While experienced sponsors and syndication groups generally know what they’re doing, they also make all management and operating decisions. If you own the property, you make those decisions. While some would rather outsource the decision making on their investments, many people want to have control over those decisions. If you fit that profile and enjoy operations and decision making, then active investing may appeal to you.
- The qualification standards may be lower. As mentioned, many or perhaps even most passive investment sponsors and syndication groups require you to be an accredited investor and/or make a somewhat large minimum investment. If you’re investing actively in your own properties, you only have to qualify to meet your bank’s requirements. Most banks don’t require you to be an accredited investor to buy a property. They do, however, expect you to qualify based on income, debt, property appraisal, credit rating and the usual mortgage related requirements.
- You decide the hold period. When you’re a passive investor, the sponsor/syndication group will decide how long they want to hold a property and when to go to market to sell it. That’s not necessarily a bad thing since they generally do a good job of trying to maximize returns for investors. However, there are often tax consequences associated with the disposition of a property. The tax liability associated with a property sale can be significant if there is a sizable gain over the basis (cumulative capital investment in the property) of the property. Consult with your tax accountant to better understand how capital gains will impact your personal tax situation.
Capital calls are something both active and passive investors need to be aware of. For various reasons (e.g., excess vacancies, rent suppression due to oversupply, severe economic downturn), there are times when both active and passive investors have to kick in more cash to fund property operations. If you have a single property, you might have a period of time when the property sits vacant. Those expenses and mortgage payments normally paid for from rental income still have to be paid. Sponsors rarely, but occasionally, have capital calls as well. Both you and they should have cash reserves in place to cover those times when things slow down. Sponsors and syndication groups build those reserves into their projections. You should too.
Most people understand that investing in real estate has it’s benefits and risks. This article helps to better understand the differences between active and passive investing, but more importantly, what opportunities exist relative to investing in real estate. And most people also understand that investing in real estate often involves taking on debt to finance a good portion of their investment(s). Using debt to build wealth is a popular strategy and if you are looking to invest in real estate, its one you’ll need to consider before jumping in head first. Take the time to understand active and passive investing and do your research on all potential investment opportunities that might present themselves. Money can be made in real estate investing, but many an investor has made more than one mistake by not performing adequate due diligence.
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