There is a common misconception that becoming a real estate investor is limited to purchasing a single-family home, renting it out, and becoming a landlord. However, there are other options available to investors.
Some examples include active investing, such as the scenario mentioned above, but another option, with the same tax benefits, includes investing capital passively in real estate deals.
There are many considerations when making this decision to be an active or passive investor, including weighing the pros and cons of both. In this article, you’ll learn what passive real estate investing means and find out whether you should be an active or passive investor.
Active Investor Insights: Key Attributes and Strategies
Active investing requires more than just financial resources; it demands your time, commitment, and acceptance of the risks involved. But with that commitment comes many rewards.
Pros and Cons of Active Investing:
- Control Over Management Decisions- Active investors enjoy the autonomy to make key decisions regarding their investments, allowing for strategic maneuvering and easily adapting based on market conditions.
- Keep All Income Produced From The Property- Unlike passive investment models, active investing enables you to keep all income generated from the property, maximizing your returns.
- Flexibility to Acquire and Dispose at Your Discretion- One of the significant advantages is the freedom to buy and sell properties as you see fit, providing flexibility and responsiveness to market changes.
- Tax Benefits –Active investors can leverage various tax benefits, optimizing their financial position through deductions and incentives.
- The Risk is Completely Yours- The responsibility for the success or failure of the investment falls squarely on the shoulders of the active investor, amplifying the stakes.
- Must Provide All Capital Needed for the Project-Funding the entire project is a prerequisite, demanding a robust financial commitment from the investor.
- High Time Commitment- Active investing equates to a full-time job, demanding a substantial time commitment for property management, decision-making, and strategic planning.
- All Deferred Maintenance and Expenses Fall on You- The burden of property maintenance, repairs, and unforeseen expenses rests solely on the active investor.
- Must Handle All Renovations or Upgrades- Active investors are responsible for overseeing the financing and/or facilitation of any necessary renovations or upgrades, adding to the workload.
- Direct Interaction with Tenants- Unlike passive investments where property management is outsourced, active investors deal directly with tenants, managing tenant relations and property issues.
The Advantage of Active Investing:
The key distinction in active investing is the timeframe within which financial gains are realized. Active investors have the potential for a higher upside because they can dispose of properties at their discretion, providing increased liquidity. Unlike long-term investment holds, active investing allows for quicker cash realization.
Choosing the short-term rental strategy is a popular route for many investors due to its potential for significantly higher returns. However, it comes with the inherent challenge of unpredictability, exposing you to a riskier floor. In this approach, vigilance is key—keeping a close eye on current market dynamics and seizing optimal opportunities is imperative. Be mindful of potential dry spells in vacancy, as they can render this strategy less reliable as a consistent source of income.
The Core Principles of Being a Passive Investor
Passive investing is a long-term strategy. It involves holding onto an asset with the expectation that its value will appreciate over time. This often results in significant profits upon its sale. This approach is generally more hands-off and is employed by investors who seek to build long-lasting wealth that can be passed down to future generations. By investing alongside other limited partners (LPs), investors can participate in projects with less capital, making it an attractive option.
Pros and Cons of Passive Investing:
Passive investing has gained significant popularity as a strategy for wealth-building, offering an alternative to the more hands-on approach of active investing. While it comes with its own advantages, it’s essential to understand the potential drawbacks before diving in.
- Less Capital Needed to Get Started- One of the primary attractions of passive investing is its accessibility. With lower entry barriers, individuals can initiate their investment journey with a modest amount, making it a viable option for those who may not have substantial capital to spare.
- No Time Commitment for Asset or Property Management- Passive investors enjoy the luxury of a hands-off approach. Unlike active investors who constantly monitor and manage their assets, passive investors can relax, knowing that their portfolio is designed to weather market fluctuations without their constant attention.
- More Advantageous Capital Gains Taxes- Passive investing often involves a long-term investment horizon, translating to more favorable capital gains tax rates. This can lead to potential tax savings compared to short-term, active trading strategies.
- Passive Income Through Investment Returns- One of the main benefits of passive investing is the potential for regular passive income. Dividends, interest, and rental income from investments contribute to a steady cash flow, providing financial stability over time.
- Scaling Your Portfolio- As your financial situation improves, passive investing allows for easy scalability. The lower initial investment amount creates more liquidity for investors to divert their funds into multiple investments.
- Risk Diversification- Passive investing often involves diversified portfolios, spreading risk across various assets. This risk mitigation strategy can be particularly appealing for investors looking to shield themselves from the volatility associated with the stock market.
- Forced Appreciation- Passive investors benefit from the overall growth of the market, leading to forced appreciation of their assets over time. This appreciation occurs organically, driven by broader market trends rather than active management decisions.
- Shared Profits- One of the downsides of passive investing is the sharing of profits. Investors may have to split returns with fund managers or other stakeholders, reducing the overall share of profits compared to a solo venture.
- Less Control Over The Investment- Passive investors relinquish a degree of control, entrusting their funds to fund managers or predefined investment strategies. This lack of control may be a drawback for those who prefer a hands-on approach or wish to shape their investment outcomes actively.
- Long-Term Commitment- Unlike more fluid active trading strategies, passive investing typically requires a long-term commitment. Investors must be patient and resilient, as market fluctuations may take time to yield positive returns.
- Must Be an Accredited Investor- Some passive investment opportunities are restricted to accredited investors. This limits access for those not meeting specific income or net worth requirements.
Active vs. Passive Real Estate Investing: Which Is Right for You?
Here are 10 considerations to help you decide which path you should choose:
#1 – Approach: Hands-On or Hands-Off
Consider your skills and experience level. Are you prepared for the physical demands and commitment involved in actively managing and enhancing a real estate investment?
#2 – Time Commitment
Active investments demand ongoing attention, from acquisition to project completion, while passive investments require upfront research. Assess your bandwidth for dedicated time throughout the investment lifecycle.
#3 – Property Management
Evaluate your capability to manage tenant requests, maintenance, and repairs. You must also determine whether you prefer a hands-on role or the convenience of delegating responsibilities is crucial.
#4 – Profits Distribution
Active investing often means sole ownership of the property and all net profits. Passive investing distributes profits among multiple investors. Compare deals to determine which offers better returns.
#5 – Expenses Management
Active investors handle insurance claims, emergencies, and repairs, potentially requiring additional funds. Passive investors make an initial capital investment with fewer ongoing financial responsibilities.
#6 – Risk and Liability
Active investors face personal liability, risking both the property and other assets. Passive investors’ liability is limited to the capital invested, often protected within an LLC or LP structure.
#7 – Documentation Burden
Active investments involve extensive paperwork, from property purchases to ongoing documentation. Passive investments typically require signing a single PPM, minimizing paperwork and administrative tasks.
#8 – Team Building
Active investors assemble their team of brokers, property managers, and contractors. Passive investors leverage the expertise of an existing deal sponsor team, already equipped to manage the property effectively.
#9 – Diversification Opportunities
Active investing demands expertise in specific markets and asset classes, requiring thorough research and team building. Passive investing allows easy diversification across markets with established expert teams.
#10 – Tax Considerations
Active investors manage bookkeeping and depreciation, collaborating with a CPA to ensure accurate financial reporting. Passive investors receive a Schedule K-1, simplifying tax reporting without the need for ongoing bookkeeping.
In conclusion, when deciding which path to take, isolate the key differences. Comparing how they align with your investment goals to help decide the investment strategy that would benefit you most. For some, diversifying with both active and passive investments is the right choice. While for others, one approach may be better than the other.