Active vs Passive Investing
Active investing and passive investing are both essential roles in an apartment syndication deal. While they both play a key part in the success of a property, the roles and responsibilities of each vary drastically. In today’s article, we’re doing a deep dive into the differences between active investing and passive investing. By the end, you’ll have a better understanding of both options, and you’ll be equipped with the information you need to decide which is a better fit for you.
What is Active Investing?
Active investing involves buying a property for profit or income. Active investors are able to earn a profit from a deal. They put in their time, knowledge, and resources to get the deal done. Most apartment syndications include a general partner who fulfills multiple roles in order to oversee the business plan of a deal and ensure its success. Active investors source deals, conduct due diligence, build the team, raise the needed equity, communicate with brokers and property owners to negotiate favorable terms, and get the deal across the finish line. Active investors have all of the responsibility that comes with making sure the deal succeeds, and this requires a heavy time and energy investment. It’s also important to note that the legal liability is placed on the active investors. Active investing requires strong communication skills, underwriting knowledge, and the ability to manage other people when dealing with property managers.
Active investors are also responsible for obtaining financing for the deals they find. In many cases, they personally guarantee the loan and manage the investment, or oversee a third party property manager.
Finding the right deal at the right price in a strong market is not easy. In fact, active investors often look at hundreds of deals before finding one that meets their investment criteria. Then, when they do find a deal, they submit a Letter of Intent, and if they’re lucky enough to get the deal under contract, they have to negotiate with the seller, raise capital, conduct due diligence, and more. The active investors execute on their business plans, oversee day-to-day operations at the property, and provide updates to their passive investors.
Because active investors put in so much time and effort into getting these deals done, they often have equity ownership in the deal.
What is Passive Investing?
Passive investing is a hands-off approach to investing in real estate. Passive investors benefit from having access to exclusive investment opportunities. They place their money into an apartment syndication that is completely managed by the active investor. The passive investor doesn’t have to worry about sourcing deals, or managing the property during the hold period. As mentioned previously, this responsibility falls upon the active investor.
In an apartment syndication deal, passive investors put their money together in order to fund the purchase of large apartment complexes. Their capital is the main value passive investors bring to a deal. Passive investors do not have control in the deal, but this also means they don’t have any of the liability associated with the deal.
Unlike active investors who put in a lot of time and effort into the deal, passive investors can benefit from real estate without the time drain. This is ideal for busy professionals or people who just don’t have any interest in real estate operations. Passive investors get to make money through their investment without the hassle that comes with day-to-day management. Passive investors should assess the credibility and track record of the active investors they’re trusting with their capital.
Control in the Deal
Control is an important factor to consider when you’re deciding whether to invest as a passive or an active investor. The level of control is very different between the two. Passive investors are limited partners in the deal. This means that they are trusting the active investors with their money to operate the deal and implement a successful business plan. Passive investors do not have any control over the deal or the business plan during the asset’s hold period.
This is why it is so important for a passive investor to vet the active investors they work with before investing. Due diligence should be conducted on the active investor by passive investors similar to how active investors conduct due diligence on properties. During this process, passive investors should look for an alignment of interest between themselves and the active investor. If the deal offers a preferred return, for example, this means that the passive investors get a predetermined return before the active investors are paid. This structure incentives the active investor to ensure the property performs well so they can get paid.
Active investors oversee and implement the business plan. They determine what investment strategy will be used in order to achieve their investment objectives. They also choose the kinds of tenants that will be living at the property, and how much the property will charge in rent. It is up to the active investors to decide when is the right time to refinance or sell the property. Active investors have the most control in the deal, which is the top reason why active investing is chosen over passive investing.
If you want control in a deal, and the responsibility and commitment that comes with it, active investing may be a good option. However, if you don’t want the time or energy commitment, then passive investing is probably the best fit for you.
Commitment of Time and Energy
We’ve already touched on this, but it is important that we highlight how much commitment is required to be an active investor. Yes, as an active investor, you get more control over the deal. But this comes with a requirement of time and energy. Active investors need to either become property managers, or oversee their property managers. Managing people and being involved in the operations of an apartment complex is demanding, especially if the business plan involves property improvements or construction. Active investors need to be educated on the specifics of overseeing an apartment complex, and understand how to analyze markets, build relationships with brokers, how to determine justifiable rent increases, and more. They also need to build a team of trustworthy members, including commercial brokers, property managers, lawyers, and an accountant.
Once the team is built, active investors can spend weeks, months, or even years looking for a deal. Once they find one, an active investor is not hands-off. Even if they outsource property management, they are responsible for making certain decisions and finding solutions to problems that come up during the hold period. This can lead to stress and anxiety for some. Scaling your business so that you can outsource all of these tasks is possible, but it takes business savvy and time.
Passive investors, on the other hand, vet the active investor and the deal before investing. Once they invest their money, they can sit back and receive their distributions and monthly or quarterly updates until the end of the hold period.
Ability to Diversify
Active investors face more challenges when it comes to diversifying their portfolios than passive investors do. This is because each deal they do requires a heavy time investment. They spend extensive amounts of energy and time learning their market, and building relationships within it in order to win deals.
Although passive investors do not have control, they have the ability to diversify their portfolio across multiple active investors and different markets. Passive investors are only a small part of a larger deal. Rather than putting all of their time and energy into one deal, they can spread their capital across multiple.
Diversifying across multiple investments also allows passive investors to invest in different asset classes within real estate, different market locations, and different active investors.
Passive investors can invest in apartments, self-storage, retail, and mobile home parks. Since active investors tend to specialize in one particular asset class, they don’t benefit from asset class diversification like passive investors do.
Passive investors can also diversify across different markets. While active investors tend to focus on one or a few specific markets so they can become experts there, passive investors can invest in multiple different states and regions. Active investors might struggle to invest outside of their home market because of a lack of market expertise, relationships there, and competition. But passive investors can leverage multiple experienced active investors to invest in various geographical areas.
Passive investors should conduct due diligence on the active investors they place their capital with. Investing with multiple different active investors allows passive investors to learn how different active investors work, and what they like to see in an active investor. It also spreads risk between different active investors.
Access to Opportunities
Taking down a deal as an active investor takes extensive real estate knowledge, time, access to capital, and dedication. Active investors have to underwrite hundreds of deals to find one that works for them. When they do find one that meets their investment criteria, they submit a Letter of Intent that competes with multiple other investors interested in the same deal. Assuming they make it through the multiple stages of offers and succeed in getting their LOI accepted, the process is just starting. Due diligence, negotiations, obtaining financing, and capital raising can be time consuming and mentally taxing.
Passive investors essentially outsource the process of sourcing investment opportunities to active investors in exchange for the equity they bring to the table.
Passive investors face less risk than active investors. They are able to get access to experienced active investors who have a proven business plan. They are also often offered a preferred return, which means that they will be paid before the active investors are.
Active investors are the ones who guarantee the loan needed to purchase the property. This means that this active investor is responsible for paying back the loan should the property ever be unable to make the payments. This is a risk that passive investors do not take.
There is no one direct path to building wealth in real estate. There are many different methods, and each investor will have different needs and levels of flexibility that may make one option a better fit than another. This is why every investor should weigh the benefits and downsides of investing as either an active or a passive investor. This will allow you to determine which one is a better fit for your specific needs.
If you have more time flexibility, are able to find deals, and know how to build a team, active investing can be a great option. Or, if you’re busy with your job and don’t have the time or interest in building a real estate business, partnering with an active investor as a passive investor may be the right path to take. At the end of the day, it’s up to you to determine which path you want to take as a real estate investor.