There is a lot of time and work that goes into finding, purchasing, and managing a commercial rental property. There is no question that it needs to be done, but there may be questions about who is going to do it.
In this article, we are going to describe the differences between active and passive real estate investing. We will discuss how each strategy works, who it is most suitable for, and the risks and benefits of each. By the end of the article, the goal is for real estate investors to identify which strategy might be the best fit for their own unique investment preferences.
At First National Partners, we do all of the hard work of finding, purchasing, and managing commercial real estate assets so our investors don’t have to. If you are an accredited investor and would like to learn more about how our investment opportunities can potentially produce passive income, click here.
Differences Between Active and Passive Commercial Real Estate Investing
As the introduction mentioned, there is a significant amount of work that must be done to find, purchase, and manage a commercial investment property. The person(s) who complete this work is the main differentiator between active and passive real estate investment. Generally, there are four drivers behind responsibility for it:
1. Control Over Management Decisions
In an active real estate investment, an individual or group of individuals purchase a property directly. As such, they have complete control over day to day management decisions.
In a passive real estate investment, individual investors purchase shares in an LLC that owns the property. In the corporate structure of the LLC, there is a “general partner” who controls the asset while passive investors – known as “limited partners” – have no control over management decisions. They provide capital only.
When deciding between an active and passive investment, individuals should consider their own preference for control in the deal.
2. Skill Level Required
Analyzing commercial property cash flows and making day to day management decisions designed to maximize investment return takes a tremendous amount of skill and experience. As such, active investors need to be skilled financial analysts and knowledgeable in property management best practices.
Passive investors do not necessarily need to be an experienced real estate professional. Instead, they allocate capital to those whose full time job is to find, analyze, and manage commercial real estate. These individual(s) could include private equity firms – like ours – or real estate investment trusts (REITs). In return for their investment, passive investors receive regular distributions derived from the property’s rental income.
When determining whether to participate in an active or passive investment, individuals should take stock of their own ability to analyze cash flows and make management decisions to determine which is most suitable.
3. Time Commitment
Active real estate investors must make a significant time commitment to find and manage their properties. Again, these investors could be individuals or professional firms built for just this purpose.
Passive investment does not require a major time commitment because all of the work is done by someone else.
When deciding between an active and passive real estate investment, investors should consider how much time they have available to commit to it and choose the most suitable option.
4. Risk
To be clear, there is risk in both passive and active real estate investment strategies. In an active approach, the risk is borne by the investors who purchase the property – they get all of the upside, but they also take all of the risk.
For passive investors, the risk is still there, but it is spread across the general partner, and the other investors in the deal. So, there may be slightly less risk for each individual.
Takeaways
The broader point here is that each investor has their own investment preferences, objectives, risk tolerance, time horizon, and return objectives. They must consider these and choose the strategy that is the best fit for their needs.
Who Is Active Investment a Good Fit For?
As a general rule, an active real estate investment strategy tends to be more suitable for those with significant amounts of investable capital, a long investment horizon, plenty of time to manage the property themselves, and the skill/expertise to do so.
Who Is Passive Investment a Good Fit For?
At the other end of the spectrum, a passive real estate investment strategy tends to be most suitable for high income earners – like doctors, lawyers, or architects – who have the funds to invest, but not the knowledge, time, and/or network to find, purchase, and manage a commercial property on their own. These tasks are outsourced to an expert like a private equity firm or REIT.
Benefits & Risks of Active vs. Passive Investing
There are benefits and risks to both active and passive investing approaches.
Active Investing Benefits
The major benefit of an active approach is that the investor(s) get to keep all of the income that the property produces. They don’t have to split it with anyone else or pay a fee to a general partner. As such, their returns may be slightly higher. In addition, they have complete control over all property identification, purchase, and management decisions – which some may find more preferable over the alternative.
Active Investing Risks
While control and 100% of the income produced may sound attractive, it also means that investors take 100% of the risk. If the transaction goes south, they bear the entire burden – there is nobody else to spread it amongst. In addition, active investors also have to do 100% of the work, which means they have to do their own property due diligence, and they are in charge of collecting rent, handling maintenance requests, and making sure the lawn gets mowed. It is called active investing for a reason – it involves a lot of work and can be a major hassle.
Passive Investing Benefits
In many ways, the benefits and risks of passive investing are the opposite of an active real estate investment.
The major benefit is that investors(s) receive periodic distributions of cash without having to do anything to get it. In other words, they get all the benefits of ownership without the hassle of developing a business plan for a property and managing it on a daily basis. In addition, passive investors may receive significant tax benefits and participate in the upside of the property if its value appreciates.
Passive Investing Risks
The downside is that passive real estate investors have no say in day to day property management decisions. In addition, the general partner or investment manager may charge a fee for their stewardship of the property, which can dilute investor profits.
Again, there are risks and benefits to each approach. Each investor should consider them carefully and choose the approach that is the best fit for their personal circumstances. Want more information? Listen to FNRP’s podcast on the pros and cons of active vs. passive CRE investing.
How To Determine Whether To Choose Active or Passive Investing
For individuals interested in a commercial real estate investment, there are a number of factors to consider when trying to choose between a passive and active investment:
1. Capital Available To Invest
Generally, an active approach requires more capital because investors must fund the entire down payment on their own. The individual amount required may be slightly less in partnerships, but the group must come up with it collectively.
2. Time
It has been established that an active investment requires much more time than a passive one. So, individuals should consider how much time they have to dedicate to the management of the property.
3. Expertise
Likewise, it has been established that an active investment requires a lot more operational expertise. Those that have it may be more suitable for an active investment. Those that don’t may be a better fit for a passive strategy.
4. Risk Tolerance
Again, both active and passive strategies involve risk. But, it tends to be more concentrated in an active approach. To illustrate this point, imagine a scenario where four partners come together to purchase an apartment building – these four individuals carry the entire risk burden in this transaction. Compare this to a passive structure, real estate syndication, or real estate crowdfunding deal. In such a scenario, there could be dozens or even hundreds of investors in the deal so the risk for each one of them is less concentrated.
5. Personal Preference
Finally, each individual has their own preferences. Some may like single-family rentals, others may like the retail asset class. Some may want to be very involved and have direct input in management decisions while others may not care.
When these factors are considered, the most suitable approach usually becomes apparent to most investors.
Passive Investing Through Private Equity Real Estate
For investors who have determined that a passive approach is most suitable for their own preferences, one option worth considering is partnering with a private equity firm to invest in an individual deal or a real estate fund.
In such a structure, the real estate investor benefits because they are able to partner with a professional firm who has the relationships, expertise, resources, and time to find, purchase, and manage institutional quality commercial assets. In return for their capital, the investor gets fractional ownership of a high quality asset and periodic distributions of cash. For those that like the passive approach, it can be a very beneficial partnership.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
