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Passive investments in real estate are a great way for busy professionals to enjoy the appreciation, cash flow, and hedge against inflation. Investors looking to passively invest in real estate have 3 primary options
- Real Estate Investment Trusts (REITs)
- Purchasing through TURNKEY providers
- Commercial Real Estate Syndications
This article will briefly talk about each and explain why Commercial Real Estate Syndications are often the best option.
Real Estate Investment Trust (REIT)
REITs are a solid option for people looking to effortlessly diversify their portfolio with real estate. This asset class is the most passive of the three mentioned above. Not only does require it no work from you, the investor, after properties are acquired, you also don’t even have to shop the properties, housing markets, nor the individual teams charged with managing the asset (investment property). Just to be clear, investing in a REIT means that you are investing in the company that is purchasing a certain type of commercial property in various markets throughout the country. REITs function exactly like any other stock. You can trade them freely and your shares increase based on how the real estate owned by the company performs.
A couple of notable upsides to REITs are liquidity and investment minimums. Much like individual stocks an investor can sell their interest in the company with a click of a button and have their capital returned the next business day. Second, there are usually no or very low investment minimums for REITs, making them a viable option for a younger professional looking to invest $100 here and there.
REITs are truly passive, but the investors lack many of the benefits offered through real estate syndications. To mention a couple, choosing the property and enjoying all of the tax benefits. Also, many in real estate like to see the assets they own, they like to track its performance beyond just a line graph. They usually prefer seeing performance in the form of property specific related income and expenses.
Turnkey Providers
Truly passive income is simple to define. It means income that does not require active participation from you, the investor. I know this seems straight forward and your wondering why even address it instead of getting right into the labyrinth and complicated requirements of real estate investing. Well, first there is nothing complicated about real estate investing, in fact, it may be the simplest investment class to understand. Second, you would be surprised how often operators pitch deals to investors as truly passive income, while requiring invesotrs to complete the acquisition process and manage the property manager. These operators are usually selling you on a TURNKEY property, almost always single-family or residential multifamily (duplex, triplex, or quadplex). You will typically be dealing with someone who has connections with property flippers in any number of housing markets across the country.
The benefit to these investment opportunities is you are the sole owner. In addition, you can take advantage of the favorable lending offered to residential-class real estate. The catch is…well there are a few.
The TURNKEY company has completed their transaction with you at close.
This should almost be a given. The TURNKEY companies are not contractually obligated to continue working with you after you have closed on the property. Nonetheless, many of them will at least stay in contact to provide consulting on issues to keep your business in the future.
Managing Property Management
Maybe the most glaring catch of all, owning residential property is never truly passive in the most logical sense. You are still required to spend hours of your valuable time. You must manage the property managers. This can include things like ensuring that they are not over screening tenants and not overcharging you for utilities or other fees. These two are critically necessary, property managers make financial errors all the time and do not care how long your residential property sits vacant. They get the bulk of their return on leasing fees and have no problem waiting for a perfect tenant to come along in a C+/B- property at your expense. Everyone in the housing business wants the perfect tenant, but the only ones who can afford to hold out until the perfect tenant comes along are the property management companies. They will place a Registered Nurse or a Lawyer in a C+/B-, but it will cost you 6 or more months mortgage to get there. These waiting periods chew away future cashflow needed for routine maintenance and “make ready” expenses.
Vacancy Means Your Investmentis is Not Performing
In real estate, your two largest expenses are taxes and vacancy. The former isn’t going anywhere, but the latter can be tempered with good property management. Nonetheless, even with the best property management turnover and economic vacancy as a tenant falls behind on rent are inevitable if you remain in real estate investing for any significant length of time. With small residential properties, vacancies mean you are losing. You will typically buy a property with at best $100 to $300 cashflow per month. If a resident is no longer paying then not only are you not receiving the cashflow that you were expecting, you are also paying the mortgage out of pocket or using reserves from previous months of cashflow to cover down. The same cannot be said for commercial multifamily which will be explained below.
Commercial Real Estate Syndications
Commercial Multifamily Real Estate is a residential building with 5 units or more. The type of deals that are syndicated usually start at around 75 -100 units and go higher, anything smaller usually requires less capital to close and can be covered by the general partners. These numbers can differ depending on the specific market. Real estate syndications are structured to allow investors to enjoy all of the benefits of property ownership without the headache of landlording and maintaining the property. When investing in a real estate syndication you become a Limited Partner (LP), while the individuals that are charged with operating the asset and ensuring that you get a return on investment are called General Partners (GP). A common structure is 70/30. That is 70% ownership to you and other investors, which make up the LPs, and 30% to GPs. In addition, most are structed to allow for a preferred return to the LPs, which means the investors get all of the return up until a certain amount before the 70/30 split takes effect.
Real estate syndicators (or operators) are typically pooling together large amounts of capital to afford a down payment on a commercial property worth millions of dollars which the syndicators or GPs cannot afford on their own. I think I’m speak for most operators when I say, if they can do it without your capital they would. This is in contrast to financial managers who primarily make money on fees charged to invest your capital and turnkey providers who get a fee from flippers and move on the next investors. These two are selling you something that they do not want. While a syndicator needs your help to purchase something everyone wants. The operators in syndications are with you until the property is sold and most of them have their own money invested.
Unlike the companies you can invest in through REITs, syndicators spend months or years building relationships with brokers and reaching out directly to sellers to find a needle in a haystack deal that can yield strong returns. REIT companies are usually purchasing or developing class A complexes that have high occupancy with low risk, but yield little return. In other words, they can always find or develop such assets to invest your money, while for many syndicators finding and sourcing the deal is the most challenging part of the business. I like to compare the two between fishing with a line and casting a net. Casting net will yield more fish, but often of lower quality and the more nets you have the more fish. Similar to REIT companies the more capital they have the more investments they can make, but that does not necessarily mean that a higher number of properties will increase your return. When fishing with a line, more lines in the water does not really help your odds of catching a fish, but when you do catch a fish it is typically larger than the fish hauled in by net. Similarly, more capital won’t help a syndicator find a deal with the coveted 20% IRR, they need to be patient and skillful. When syndicators are moving forward with a deal and calling on investors to raise capital it is because the hard work is already done and in the case of experienced operators with years of success, the investment opportunity is often fully subscribed and unavailable after 1 to 2 weeks. Going back to the fishing analogy, syndicators are bringing you the high-quality fish after the hard work is done versus using your capital to cast more nets.
Scalability
This is often the big reason residential investors wish they would have made the leap to commercial multifamily assets early in their investing careers. As mentioned earlier residential properties are drastically affected by vacancy. No matter how well the property is managed vacancy is inevitable if you are in the business for any significant period. The same cannot be said for multifamily.
Unlike residential, multifamily operating plans are designed to perform at about 95% occupancy. That means they have budgeted and underwritten the property to generate returns as advertised at 95% occupancy. The general rule is if you are above 95% occupancy then your rent is too far below market. Lower than 90% for a long period, can mean poor property management or rents are too high and you adjust accordingly.
