Commercial real estate investing comes with a variety of benefits including income, capital appreciation, tax benefits, and portfolio diversification. Depending on the individual needs and desires of each investor, there are two avenues through which these benefits can be obtained, active investment or passive investment.
The Difference Between Active and Passive Investment
As their names suggest, the key difference between an active and passive investor is the amount of involvement they have in the day to day management of the property.
Typically, an active investor will form a single purpose entity, like an LLC, and use it to purchase a commercial property directly. This means that the active investor is directly involved in the property identification, selection, due diligence, financing, and closing processes. It also means that they are directly involved in the day to day property management activities once the purchase has been completed. An active investment tends to work well for individuals who have a desire to be involved in the minutiae of acquiring and managing the property because their decisions can ultimately have a direct impact on the property’s cash flow. But, active investment requires a high degree of operational expertise and years of experience to do it effectively. For this reason, it may not be the best option for many individual investors.
A passive real estate investor is one who seeks all of the benefits of ownership in the commercial real estate asset class, but without the time commitment or expertise needed to operate it. In most cases, this is achieved when an individual places their investment capital with a third party manager and outsources the task(s) of identifying, selecting, and managing the property. Often, the manager will combine the investment capital from many individuals and use it to purchase large, institutional quality assets (e.g. 400 unit multifamily property) that would otherwise be unaffordable for any one individual. The benefit of this arrangement is that the individual can earn passive income through real estate while leveraging the operational expertise of the manager to deliver strong returns. For individuals without the time or expertise needed to manage a commercial asset, a passive investment opportunity may be their best option.
Passive Commercial Real Estate Investment Vehicles
Broadly, passive real estate investment options can be grouped into two categories, Real Estate Investment Trusts (“REITs”) and Private Equity. Additional information on both is below (NOTE: An investment made on a crowdfunding platform is another example of an indirect investment, but not considered relevant for the purposes of this article).
Real Estate Investment Trust
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Because REITs are formed as corporate entities, investors are able to purchase shares in them, providing access to the rental income and profits produced by the underlying real estate assets. In addition, there are some tax benefits to the REIT structure as long as it meets certain requirements. REITs can be publicly traded, which allows investors to buy and sell shares like stocks or mutual funds, providing a high degree of liquidity. Or, they can be private, which provides less liquidity, higher management fees, and a longer term commitment.
Generally, passive commercial real estate investors who prefer the REIT structure can choose from one of four types:
- Equity REITs: Equity REITs are publicly traded companies (their shares can be bought and sold in the stock market) that own or operate income-producing real estate for the purpose of distributing dividend income to their shareholders. The majority of REITs fall into this category and are considered attractive because of their liquidity and high dividend yields. REITs can specialize in specific property types like apartment complexes, office buildings or single-family homes.
- Mortgage REITs (mREITs): Mortgage REITs (mREITs) provide financing for income-producing real estate by originating mortgages or purchasing mortgage-backed securities. They earn income from interest on the loans and/or dividends from security investments.
- Public Non-Listed REITs: Public, non-listed REITs (PNLRs) are registered with the SEC but do not trade on national stock exchanges. However, they follow the same philosophy of investing in income-producing properties for the purpose of distributing dividends to their shareholders.
- Private REITs: Private REITs are exempt from SEC registration requirements and their shares do not trade on national stock exchanges. To invest in a private REIT, an investor must meet income and/or net worth hurdles or demonstrate that they are sophisticated enough to understand the risks of investing in non-publicly traded securities.
Given the number of REIT categories, there are enough options to meet the needs for nearly all investors. However, one of the major drawbacks to investing in a REIT is that an individual has little to no say how or where their capital is deployed. They just contribute funds to a “pool” and it is up to the asset manager to choose the properties and/or loans for investment. For those individuals who want to know exactly what property they are investing in, a private equity commercial real estate investment may be a better fit for their objectives.
Private Equity
Private Equity Real Estate firms and REITs have a similar mandate, to pool investor money and deploy it into real estate assets. However, the securities offered by Private Equity Real Estate firms are not publicly traded and they are only available to accredited investors.
Because they aren’t bound by the same regulations as publicly-traded REITs, private equity real estate companies have wide latitude to invest in a variety of real estate asset classes, which may or may not include income-producing rental properties. In addition, the legal structure may differ significantly from a REIT and they are not required to pay out a high percentage of their income in dividends. Instead, the majority of private equity returns are derived from profitable investment exits in the form of capital gains and carried interest.
A private equity investment comes with a series of impressive benefits:
- Acquisition and Operational Expertise: The identification, selection, acquisition, and operation of a commercial real estate asset requires deep expertise and significant experience, which a private equity real estate firm specializes in. This type of expertise allows the manager to keep a close eye on key operational metrics like: leasing activity, Net Operating Income (NOI), vacancy rates, operating expenses, and real estate taxes.
- Tax Efficiency: Private Equity Real Estate investments are structured in a tax-efficient manner, allowing investors to reduce taxable income through depreciation.
- Flexibility: Because they aren’t as heavily regulated, private equity firms can be flexible in their investment strategy, giving them the freedom to pursue profitable deals where available.
- Incentive Alignment: Because private equity firms themselves are also invested in their deals, their incentives align with those of the investor in that they both want a profitable outcome.
- Exit Plan: Private Equity Real Estate firms enter an investment with the exit in mind giving investors a roadmap to a successful outcome.
- Clear Fees and Compensation: The fee and profit participation structure is clear from the outset and closely correlated to performance, which means that all parties are working together towards a profitable outcome.
Like REITs, there are different types of private equity real estate passive investments that an investor can choose from. There are two main categories to be aware of:
- Fund vs. Deal: Some private equity firms offer “blind fund” investment opportunities that are similar to a REIT in the sense that an investor contributes capital to the private equity firm and the firm decides where, when, and how the capital will be deployed. Or, and this is the case with our firm, an individual can invest in a specific real estate deal. In such cases, they would be able to know exactly which property is going to be purchased, where it is, who the tenants are, what the income statement looks like, and what the business plan is post-purchase. We believe this is the superior option for most individual investors.
- Specialization: Commercial real estate is a broad category so asset managers tend to specialize in certain segments of it. For example, some firms specialize in industrial space, some in office space, some in multifamily, or, as is the case with us, retail assets. There are enough options that an individual can choose one that aligns with their investment objectives, risk tolerance, and time horizon.
A commercial real estate asset requires active involvement in the day to day operations of the property. However, from an investor standpoint, the answer to the question of whether the income produced is truly passive is determined by who actually does the work of managing the property. Individuals who place their capital with an asset management firm, are rewarded with all of the benefits of property ownership without the hassle of actually managing it.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 Investor and would like to learn more about our triple-net leased investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
