There is a commonly cited belief among real estate investors that an investment in commercial real estate rental properties can provide passive income. This is only partially true. Yes, passive or “hands-off” income and cash flow is possible, but the property management for a commercial real estate asset is far from a passive endeavor.
All commercial properties, especially the larger ones like an apartment building or office building, require a significant amount of effort to manage things like lease renewals, routine maintenance, landscaping, renovation projects, rent collection, and vendor payments. These activities take a significant amount of time and are critical to the success of the investment, but they are not passive. They must be done. So, we choose to take a slightly different perspective. We don’t ask if an investment property produces a passive income stream, we ask who is doing the work to manage it.
Direct vs. Indirect Commercial Real Estate Investment
For individuals interested in commercial real estate investing and the portfolio diversification that it brings, there are two ways to deploy capital, directly or indirectly.
In a direct investment scenario, an individual or group of individuals forms an LLC or other entity to purchase a property directly. Using this as an investment vehicle allows the investor(s) to retain control over the property identification, selection, due diligence, financing, and closing processes. While some individuals prefer to retain this level of control, it also means they have to act as their own property management company once the purchase is complete. Doing so requires a significant commitment of time and a high degree of operational expertise to do it effectively. For individual investors looking for a truly passive commercial real estate investment opportunity, a direct investment is likely not the preferred option. They may prefer to go the indirect route.
In an indirect investment, an individual places their capital with a professional asset management firm (like ours) and outsources the property identification, selection, due diligence, financing, closing, and management processes to them. In doing so, they get all of the benefits of commercial real estate ownership (e.g. income and appreciation) without the hassle of managing the asset because someone else is doing the work. For individuals with capital to invest, but not the time and expertise needed to manage the property, an indirect investment is likely to be a better fit because it can be truly passive.
For those that pursue the indirect path, there are a number of different passive real estate investing options.
Passive Commercial Real Estate Investment Options
Broadly, passive commercial real estate investment options can be grouped into two categories, Real Estate Investment Trusts (“REITs”) and Private Equity transactions. Additional information on both is below.
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, which provide access to the rental income and profits produced by the underlying real estate properties. In addition, as long as the REIT meets certain requirements, there are some tax benefits to this structure. 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 and a longer term commitment.
Generally, passive 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. Some even specialize in residential properties like 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 the 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 with their investment objectives.
Private Equity
Private Equity Real Estate firms and REITs have a similar mandate, to pool investor money and deploy it in 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 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.
- 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. As a result, income and profit splits are often structured in a way that requires the firm to meet certain return “hurdles” before their profit participation kicks in, incentivizing them to manage the asset profitably.
- 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 could 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.
So, the point of the article is this. 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. 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.
Through our decades of experience, we’ve established a consistent and repeatable three-step investment approach:
- Buy It: We acquire high-quality, income-producing assets at a discount to replacement costs
- Fix It: We rapidly and proactively address any capital structure, physical, or operating issues pertaining to the investment
- Exit: Once the issues are addressed we refinance the debt and hold the asset for the long term.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
