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, and this is why is is often referred to as active real estate investing. 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.
In order to understand the concept of passive income, it is important to also understand how residual income works in the context of a commercial real estate portfolio.
Residual Income Defined
In a broad sense, the term residual income refers to income that is left over after expenses have been paid.
To illustrate this point, consider the strategy that we pursue. We purchase a grocery store anchored retail center, which produces a significant amount of rental income. We use that income to fund the property’s operating expenses like taxes, insurance, and maintenance.
Income, less these operating expenses equals a metric known as Net Operating Income (NOI). From this metric, the loan payments are made and any money left over is residual income that is distributed to our commercial real estate investors. These distributions produce a passive income stream, which is a major benefit of investing in a real estate deal.
Based on this description, it is easy to think that residual income and passive income are the same thing. They aren’t, but the distinction is very slight.
Residual income is the metric that is calculated by subtracting an investment property’s operating expenses (including debt service) from rental income. This amount of money is then distributed to investors, which produces passive income for them.
When evaluating a potential addition to a real estate investment portfolio, calculating residual income is one of the most important metrics because it informs how much passive income an investor can earn.
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.
Commercial Real Estate Passive Income Options
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.
Another option for investors interested in earning passive income is known as real estate crowdfunding. In a crowdfunding scenario, one individual or company takes the lead and does all of the legal and regulatory paperwork necessary to create a limited liability company (LLC). Then, they sell shares in that LLC to individual investors in much more manageable increments, say $25,000 or $50,000, until they reach the target amount of equity capital.
In a traditional scenario, an investment partnership that needs to raise $5MM for a down payment to buy a portfolio of multi-family properties might have five investors who each contribute $1,000,000, while the crowdfunded scenario could have 100 investors who contribute $50,000 each.
It’s important to know that a crowdfunded real estate transaction typically involves two groups of investors, each with a distinct role to play.
The first is the deal leader, sometimes referred to as the “General Partner” or “GP.” Their responsibility is to find the property, underwrite the cash flows, perform all due diligence, set up the LLC, find investors, and collect rent and manage the asset once the transaction is closed. This is a significant responsibility and their stewardship of the deal can be a major factor in the returns that it delivers.
The other major role belongs to individual investors, sometimes referred to as “Limited Partners” or “LPs.” In a real estate crowdfunding deal, their role is to provide investment capital. They typically have no say in the day to day management of the property, so this role is considered to be passive.
How to Invest for Passive Real Estate Income
There are a few steps that investors need to take in order to be sure that passive real estate investing is right for them. Let’s take a look at some of the most important steps and how investors should go about them.
Determine the Best Option
The first step to get started with investing for passive real estate income is to decide that it is the right path to pursue. Each investor has different areas of specialty. In real estate investing, some investors focus on owning and managing single-family homes, some focus on short-term rentals popularized by Airbnb, and others enjoy rehab projects that often use the buy, rehab, rent, refinance, repeat strategy, which is also known as BRRRR.
On the other hand there are many investors who have busy, full-time jobs and other responsibilities that make it near impossible for them to be active real estate investors. These investors often choose to pursue a passive investment approach. There are few important steps that a passive investor needs to take in order to get started.
Decide on Involvement
Once an investor understands the investment options available to them, it is up to the investor to decide how much time and effort they want to spend managing their real estate portfolio. Investors who want to be active investors and have the time to do it, can begin to search for properties to purchase directly. They can also partner up with other investors to create a small investment partnership focused on buying deals in the local market.
Investors who choose to be passive investors can research options like real estate investment trusts, crowdfunding, or private equity commercial real estate firms like ours.
Analyze Profitability & Returns
The most important step that a passive investor can take is actually an active one. It is critical that all investors perform an adequate level of due diligence before allocating capital to an investment or a private equity sponsor.
For a particular deal, due diligence includes ensuring that the property is safe for occupancy, that its title can be cleanly transferred to the buyer, and that its finances meet the investor’s return requirements. To verify these, it is important to invest a significant amount of time and resources in a detailed due diligence process prior to closing on a deal.
For investors who choose to invest with a Private equity sponsor it is important to vet them for experience level, transparency, and organizational capacity to manage funds with proficiency. This will give the investor the confidence to take a passive role going forward.
Benefits of Passive Real Estate Investing
Passive real estate investing has many benefits. The major one is that investors(s) receive periodic distributions of cash without having to take ongoing action 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, they may receive significant tax benefits and participate in the upside of the property if its value appreciates.
The income received from a passive investment can be redeployed into other, income producing assets that will compound over time. For investors with full-time jobs, passive income can also supplement a salary to help the investor achieve financial independence. Most importantly, it does not require much incremental work to achieve, which allows the investor to focus on what they do best.
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.
Can Real Estate Investors Really Earn Passive Income?
Passive real estate investing represents something of a unicorn in commercial real estate investing, more myth than reality. Successful commercial real estate (CRE) investing, in particular, requires careful, value-oriented asset selection, strong local market knowledge, sophisticated lease negotiation skills, a strategically-sound tenant mix, meticulous attention to maintenance and cap-ex, and hands-on management to keep properties performing at an optimal level. It’s not really the passive endeavor that so many real estate gurus make it out to be.
To achieve consistent, market-rate returns on commercial real estate investments, someone has to do the hard work. Investors who choose to put money directly into a commercial property are the ones who will be responsible for putting in the effort to make sure the asset performs to its potential.
This is not to say that investors can’t earn income passively from a portfolio of rental real estate assets. It is possible, usually through an investment vehicle such as a private equity commercial real estate partnership. In a partnership, investors pool their assets in a fund formed and managed for the purpose of investing in commercial real estate. Sophisticated teams of seasoned commercial real estate professionals deploy the funds by purchasing and managing a portfolio of real estate assets. They earn a fee for doing this work, while investors can build wealth and reap the benefits of passive income and exposure to the real estate market.
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 firstname.lastname@example.org for more information.