There is a lot of work that goes into managing a commercial real estate investment. For example, repairs need to be made, rent needs to be collected, and leases need to be negotiated. The question of who does this work is the primary determining factor between an active investment and a passive one.
In this article, we will define what passive income is, why it is important, how it can be obtained, and what mistakes to avoid in pursuit of it. By the end, readers will have the information needed to determine if a commercial real estate investment that produces passive income is a good fit for their own objectives.
First National Realty Partners is a private equity commercial real estate investment sponsor who partners with investors seeking passive income. To learn more about our current investment opportunities, click here.
What is Passive Income?
As the name suggests, passive income is money that is earned with minimal effort and/or participation. In investing, it can be earned from a number of popular asset classes like stocks, bonds, mutual funds, or real estate deals.
As the introduction described, there is a lot of work that goes into managing a commercial property on a day to day basis. For example, the owner of an apartment complex has to maintain the landscaping, collect the rents, give property tours to prospective tenants and repair broken appliances. In a large property, this is a full time job that requires specific expertise to execute at a high level. For this reason, commercial real estate investments that produce passive income often involve two parties, sponsors and investors.
The “sponsor”, usually a private equity firm, real estate investment trust (REIT), or individual real estate syndicator, handles the work of finding the property, performing due diligence, arranging financing with a lender and managing it once the transaction is closed. In other words, they do all of the heavy lifting.
Investors provide capital, but have no involvement in the day to day management of the property. The income earned from their investment is considered to be passive because the sponsor is doing all of the work to manage the property.
The Importance of Passive Income
For individual investors, commercial real estate passive income is important for three reasons.
First, owning and managing a commercial property takes a significant amount of experience, expertise, and time to do it effectively. These are not things that individual investors always have. So, they can outsource these tasks to a professional firm who completes them for a fee.
Second, passive income allows individual real estate investors to focus on other income generating activities, which have a compounding effect on their total income. To demonstrate this point, consider two scenarios. In the first scenario, an individual pays $25,000 for a property that produces $500 in monthly distributions, but they have to spend 15 hours a week managing it. In the second scenario, the individual takes the same $25,000 and invests it with a sponsor. This investment produces $400 in monthly income (net of fees), but doesn’t require any time to manage.
Instead the individual can devote that 15 hours a week to other income generating activities that produce $800 per month in income. So, in the second scenario, the individual earns $400 per month from the investment and $800 a month from their other income generating activities for a total of $1,200 per month. By letting the sponsor do the hard work of property management, they can devote their free time to activities that compound their income.
Third, passive income can be reinvested into other income generating investments, which also has a compounding effect.
The bottom line is, earning material amounts of passive income is an important step towards financial freedom because it is, in effect, earning money for doing nothing.
Investing in Real Estate For Passive Income
As it relates to commercial real estate, there are three vehicles through which individuals can earn passive income: private equity, real estate investment trusts (REITs), and buying property directly. Details on each are below.
Commercial real estate investors who partner with a private equity firm achieve passive income through the scenario described above. The private equity firm acts as the transaction sponsor and they do the hard work of finding, financing, and managing the property. Individual investors commit a certain amount of capital to an individual deal or a “fund” that entitles them to their share of proportionate cash flow produced by the underlying property.
Under existing securities laws, investors must be “accredited” to work with a private equity firm, which means they must meet certain income/net worth guidelines. So, not everyone is able to participate in private equity investments. For non-accredited investors, a more accessible option is to achieve passive income through a REIT investment.
Real Estate Investment Trusts
A Real Estate Investment Trust (REIT) is a specialized type of investment company that owns, operates, or finances commercial real estate. Under IRS rules, a REIT is not taxed at the entity level, as long as they pay out a high percentage of their income and profits in the form of dividends to their shareholders. These dividends form the basis of the passive income produced by REIT investments.
Many REITs are publicly traded, which means that their shares can be bought and sold with ease on major stock exchanges. In addition, there are many different types of REITs, who follow a variety of investment strategies so there is usually an option that meets the needs for each type of investor. For example, some REITs may focus on the purchase and management of multifamily apartment buildings while others may focus on office buildings or other investment property types.
When it comes to passive income, investors should pay special attention to each REIT’s “dividend yield” which is a measure of the total dividend paid annually to the price of a share of stock. For example, National Retail Properties (Ticker: NNN) is a large REIT that invests in tripled net leased properties across the United States. At the time of writing, it has a stock price of $45.50 per share and each share pays a dividend of $2.12 annually. As such, the dividend yield is 4.73% ($2.12 / $45.50). In other words, an investor could expect to earn 4.73% on their money annually, assuming no change in the stock price. But, the stock price and yield are inversely related. When the share price goes down, the yield goes up. For example, if the share price declined to $40, the same $2.12 dividend results in a yield of 5.3%.
Bottom line, REITs are an excellent way to earn passive income from real estate assets while achieving portfolio diversification and maintaining some degree of liquidity. They are also a low cost way to gain exposure to commercial real estate properties because their shares prices are relatively inexpensive.
Buying Property Directly
There may be some debate as to whether or not direct ownership is truly a passive commercial investment. But, for the purpose of this article, we will consider it so.
Purchasing a property directly means that an individual, or group of individuals, comes together to purchase a piece of income producing real estate. In doing so, they own 100% of the property, take 100% of the risk, and earn 100% of the rental income and profit. As described above, it takes a lot of work to manage a commercial rental property, but in a direct ownership scenario much of this work can be outsourced to a third party property management company. Doing so reduces the workload on the CRE property owner which can get a direct purchase pretty close to a passive investment.
Mistakes to Avoid with Passive Income
There are two common mistakes that should be avoided in passive real estate investing.
First, is not completing enough due diligence on the transaction sponsor. In a passive real estate investment, it is the sponsor who may have the biggest impact on the success of the deal. As such, it is critically important to perform due diligence on their track record, experience, expertise, and fee structure to ensure they are suitable. The best sponsors have a verifiable track record of performance over a long period of time.
Second, is not doing enough due diligence on the fee structure of the deal. Sponsors charge fees, which typically consist of some nominal upfront amount plus some share of the transaction’s profits. The structure of every deal is unique so it is important to read all of the disclosures, fee schedules, and offering documents to make an accurate comparison of real estate investment options. For example, investment A may advertise a high return, but may also come with higher fees. If investment B offers a lower return, but lower fees, the net result of the investment may actually work out better. It is also worth noting that fees aren’t the only metric that potential investors should review. They should also look at things like net operating income (NOI), allowable depreciation, property values per square foot, and whether or not there are plans for renovations.
Misconceptions About Passive Real Estate Income
There are two common misconceptions about passive income generated by real estate assets.
The first is that it takes a lot of money to get started. In some cases, this is indeed true, but not always. With the REIT investments described above, investors can start earning passive income for as little as a few hundred dollars. As a general rule, investors who have a smaller amount of capital may be a good fit for REITs as a way to earn passive income.
The second is that income is truly passive in a direct ownership scenario. While a property owner may be able to outsource much of the day to day property management to a third party, there is still a tremendous amount of work to be done negotiating with lenders, creating reports for investors, and keeping tabs on the local market. This may not be a truly passive investment.
Summary & Conclusion
Passive income is money that is earned without any involvement in the activity that earns the money. Passive income can be earned from a variety of sources like stocks, bonds, and real estate.
For investors, passive income is important because it has a multiplying effect. If an investor is able to earn income without any effort, they can generate multiple passive income streams, which is an important step towards financial freedom.
There are three major types of real estate investment vehicles that produce passive income, REITs, private equity, and direct ownership. Each has their own pros and cons.
When working with a transaction sponsor to generate passive income, there are two common mistakes that should be avoided. The first is not doing enough due diligence on the transaction sponsor to ensure they have a verifiable track record of success. The second is not comparing investment options net of fees.
The bottom line is that investors should complete a significant amount of due diligence on potential real estate investments to ensure they are a suitable fit for risk tolerance, time horizon, and return objectives.
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 would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.