The Truth About Real Estate Investing for Passive Income
The Truth About Real Estate Investing for Passive Income
Updated on July 15, 2020
Real estate investing has an unwarranted reputation as a relatively low-effort source of passive income. Buy a property, set aside some maintenance reserves, sign up some tenants, and sit back while a steady stream of cash rolls in, right?
In fact, passive investments of the type we just described represent something of a unicorn in our business, more myth than reality. Successful commercial real estate (CRE) investing, in particular, requires careful, value-oriented asset selection, an insider’s level of local knowledge, sophisticated lease negotiation, a strategically-sound tenant mix, meticulous attention to maintenance and cap-ex, and hands-on management to keep properties performing at an optimal level. Nothing about it is “passive.” Not by a long-shot.
Why The DIY Passive Income Myth Persists
Real estate investing has what business economists call a “low barrier to entry.” Broadly speaking, access to capital constitutes the only absolute requirement for buying property. For that reason, many people who have succeeded in other professional or business pursuits see real estate as a safe, potentially tax-advantaged, place to park their accumulated earnings in anticipation of retirement. They often perceive real estate as a ready means of diversifying an otherwise capital markets-heavy investing portfolio. They feel reassured, too, by solidity and permanence of property; it’s a tangible asset they can (literally) see and touch.
In other words, an idealized notion of real estate drives the investment decisions of many intelligent, successful people; which can make encountering the reality a somewhat rude awakening.
What It Takes, Really
We focus here on CRE investing, since that is our business niche. What does it take to succeed in that world as an owner and investor? Constant hard work, diligence, and attention to subtle detail. In other words, the opposite of passivity.
Value-Focused Asset Selection Informed by Deep Local Market Insight
Profitable CRE investing in our space begins with understanding value on a local level and executing on deals at favorable purchases prices. Even the most prime location with the most marquee tenants will not post adequate (or any) returns if you pay too high of a price-per-square-foot. That’s just math.
The trick is in knowing the price that defines value, which takes local market knowledge to pin down. You need sensitivity to variables like zoning ordinances, traffic patterns, demographic shifts, and the prerogatives of local leadership; differences subtle enough to make two otherwise identical shopping centers, at identical square foot pricing and on the same stretch of state road, radically different value propositions. Even the most sophisticated “hobbyist” CRE investors struggle to spot these distinctions with the limited time they have to put into their investment decisions.
Choosing and Retaining the Right Tenants on the Right Terms
In CRE investing, targeting and achieving an ideal tenant mix pays substantial dividends, provided you do not sacrifice too much to get it. Finding that mix requires careful analysis, taking into account factors like local consumer demand and the complementary aspects of different tenants. Nailing down the mix means negotiating terms that balance financial and retention goals, and constantly monitoring for the need to readjust. Does across-the-board triple net leasing suit investment priorities and the market realities of a given asset? Can (and, more importantly, should) you stomach some flex in leasing terms to lock down an anchor tenant? Experienced CRE investors constantly review these and similar questions as part-and-parcel of operating any commercial property.
Smart, Performance-Oriented Spending on Well Managed Projects
Lease terms typically define the broad parameters of maintenance expenditures a CRE owner may need to make, and the extent to which the owner may dictate the nature, quality, and scope of spending by tenant. Maximizing NOI, by definition, means making sure that no dollar gets wasted, and that no essential maintenance goes ignored. Successful CRE investors identify these needs and priorities by taking a hands-on approach at their properties. It is one thing to field a tenant’s complaint about a leaking skylight. It is quite another to know, first-hand, the appropriate steps to fix it, and to have a skilled, responsive contractor on-call to fix it.
In the same vein, anyone knows that cap-ex should ideally enhance property value while providing a depreciation benefit. Diligent CRE investors, however, go the extra mile to obtain premium rates of return on those expenditures by selecting and financing them strategically. This, too, requires gumshoe-type attention to detail by a management team that communicates to its vendors, tenants, and contractors that it is on-the-ball. There is nothing passive, for example, about teasing out balance sheet and cash flow implications of your options for resurfacing a parking lot, and then once you’ve pulled the trigger, making sure construction crews prioritize your project, respond to your needs, and do quality work.
Passive Income Is Possible…By Putting Active Investors to Work for You
The long and short of it is this: obtaining truly passive income from direct CRE investing is, by-and-large, a pipe dream. To achieve consistent, market-rate returns on commercial real estate investments, someone has to do the hard work. If you choose to put your money directly into a commercial property, you had better be prepared to put in that effort yourself, or to suffer the costly consequences.
Which is not to say that you cannot ever hope to earn income passively from a portfolio of real estate assets. You can, principally through an investment vehicle such as a private equity CRE partnership. In a CRE partnership, investors pool their asset 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 while investors reap the benefits of taxable income-offsetting depreciation and, yes, truly “passive” income. Oftentimes fund managers align their own incentives with those of their investors by investing in the fund themselves.
Want to hear more about our sophisticated, strategic approach to CRE investing? Create an account here to read about our deals and to see the opportunities our firm offers to invest in value-focused, well-managed commercial real estate.
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