Active vs. Passive Real Estate Investing – Which One Is Right For You?
If you’ve landed on this website, I’m going to go out on a limb here and say that you probably have a goal to get into commercial real estate investing, and potentially even own and operate commercial properties in the future.
However, for many people (even real estate professionals already in the industry), buying commercial properties on their own can seem pretty daunting, and rightfully so.
Seven and eight-figure price tags are common in CRE, and there tends to be quite a bit more complexity with commercial real estate transactions than with buying a single family home (which can also be a very stressful experience in its own right).
So, in case you’re looking to get into the industry and still deciding whether you want to take the active route of doing everything yourself, or the passive route by investing with an operating partner or private equity firm, in this article, we’ll walk through what I’ve seen (through experience) regarding the pros and cons of each path, and which one might be right for you based on your long-term goals and interests.
If video is more your thing, you can watch the video version of this article here.
Active Real Estate Investing vs. Passive Real Estate Investing
By active investing, I’m referring to direct ownership and management of commercial real estate, either through buying a property with sole ownership as an individual, or managing a property on behalf of equity partners who help you fund the deal.
And by passive investing, I’m also referring to direct ownership of commercial real estate, but as a passive, non-controlling limited partner, through real estate joint ventures or syndications managed by another active operating partner in the deal.
As much as most people have the ability to become an active real estate investor with practice and training, while it can be a lucrative business to get into, not everyone should (or wants to) spend their working years identifying, purchasing, and managing commercial real estate deals.
And fortunately, not everyone needs to be an active real estate investor, with limited partnership opportunities allowing would-be real estate investors to reap the benefits of direct investments in commercial real estate, without dedicating their entire careers to the business.
So, which one is right for you, and what are the pros and cons of each strategy?
Let’s start with active real estate investing first.
What Is Active Real Estate Investing?
Active real estate investing is obviously the more hands-on approach, which is a positive for some, and a drawback for others.
The Downsides of Active Real Estate Investing
Direct ownership in and management of commercial real estate requires property management oversight, leasing and construction management, and also the time-consuming (and often costly) process of finding profitable deals to buy in the first place.
For many commercial properties with a significant value-add component or lease-up strategy, asset management can be an extremely large workload, which can be very difficult to manage if you’re doing everything yourself (or doing this on the side of another full-time job).
Since the total dollar amounts on commercial real estate deals are often well into the seven-figure range, this also may require raising third-party equity from investors to capitalize the deal, since even a 70% LTV loan on a $1,000,000 deal requires at least $300,000 of equity to fund the project.
Raising capital brings along a whole new level of complexity and additional responsibility in managing the asset, and investor management can sometimes be as challenging (and time-consuming) as managing the deal itself.
The Benefits of Active Real Estate Investing
With all of that said, active ownership also has some significant benefits, one of the biggest being that this gives you the maximum level of control over your investment.
As an active sole owner or managing partner in a syndication, you get to make the decisions around when to sell the property, when to perform renovations, how much cash to keep on hand, when to hire (or fire) a property manager, how much cash to distribute, and when to distribute that cash.
In sole ownership scenarios without third-party investors, this can also free you up to search for smaller properties in the $1,000,000 to $5,000,000 range, which tend to be far less efficiently priced than the $10,000,000+ market, where institutions and private equity firms start to become your competition.
These smaller properties tend to be owned by “mom and pop” investors, and because larger, more sophisticated private equity firms tend to go for bigger properties with higher fee and profit sharing potential, this often results in overlooked opportunities in this space that can be capitalized on by a smaller, savvy investor.
Minimize (or Benefit From) Fees
Active ownership also minimizes fees to you as the investor, which can be a significant drag on long-term returns in any asset class, real estate included.
Even though you may pay a property manager to oversee the day-to-day operations on the deal (which is well worth it, in most cases), you’ll still be able to reduce your up-front and ongoing costs on the investment by eliminating acquisition fees, asset management fees, and construction management fees that you would otherwise be paying to an operating partner as a passive investor in the project.
Also, if you do decide to raise capital from equity investors, these fees will be going to you rather than being paid by you, which can provide an additional income source or even help you start your own real estate firm once you have a few successful deals under your belt.
Additionally, the benefits mentioned above often don’t even come close to the potential upside of many real estate equity waterfall structures (which we cover in more detail in this article).
This mechanism allows the managing partners on a real estate deal to receive additional cash flow distributions (which would have otherwise gone to the passive partners) over and above their initial equity interest when certain return hurdles are hit, which can significantly boost returns for the operating partner on the investment.
What Is Passive Real Estate Investing?
There are a ton of benefits to active real estate ownership, but for many people just starting out, the entire process of investing in a commercial real estate deal can be extremely intimidating.
So, what do you do if you don’t have the experience, the time, or most importantly, the desire to actively invest in real estate deals?
Enter passive real estate investing.
For the purposes of this article, the passive real estate investing I’m referring to involves making a direct investment in a partnership entity that owns and operates a real estate property (commonly referred to as a real estate syndication), that is managed by another active manager within the partnership (not you).
The Benefits of Passive Real Estate Investing
The biggest and most significant benefit of passive real estate investing is that, as a passive capital partner on a deal, you won’t be responsible for the acquisition, operations, construction management, or sale of the property you’re investing in.
Wiring money, collecting distribution checks, and handing your K-1 forms over to your accountant at tax time are really going to be your biggest to-do list items when investing passively in a real estate partnership.
Participate in Real Estate Investing Tax Benefits
By investing directly in a single-purpose entity (SPE) to acquire a commercial property, you’ll also be able to participate in many of the tax benefits available to real estate investors, including realizing significant passive losses from things like depreciation (including bonus depreciation) and interest expenses, which together can often result in $0 of taxable income on cash flow distributions to the partners in many years before the property is sold.
With other popular passive investing options like publicly-traded REIT stock, these dividends tend to be taxed at ordinary income levels, which can mean a substantial tax savings for high-income earners in high income tax states who decide to go the direct passive investment route.
Leverage The Experience (and Time) of Others
Especially for busy professionals with limited time to search for deals, tour properties, and close on transactions, the tax benefits (coupled with the lack of time commitment that passive real estate investing offers) can make this a much more preferable option for these people than actively searching for and managing their own commercial real estate deals.
Passive investors are also able to leverage the experience of other seasoned investment professionals who have honed their real estate investing skill sets over time, which is tremendously helpful in the prevention of costly mistakes, especially on larger deals where misses can have significant financial downsides.
The Downsides of Passive Real Estate Investing
With essentially no work, no time commitment, and huge tax advantages, there has to be a catch to passive investing, right?
One of the biggest downsides for individual investors, especially for young professionals early on in their careers, is that there can be a significant barrier to entry in passive real estate investing for people looking to break into the CRE investment space for the first time.
High Investment Minimums and Net Worth Requirements
Active managing partners of real estate syndications generally require minimum investments of anywhere between $25,000 and $100,000, and for would-be investors without extremely high annual incomes, writing a check of this size can be a significant challenge.
Many real estate private equity firms and syndicators also require investors to be accredited investors, which essentially means that the investor has over $1,000,000 in net worth (not including their primary residence), or they’ve had an individual income of at least $200,000 for single tax filers (or $300,000 for married couples) in each of the two most recent years, with a reasonable expectation of reaching that same level of income in the current year.
However, even for investors that aren’t accredited, there are generally still options to invest directly in a real estate partnership, assuming those investors are knowledgeable in the space.
Overcoming a Lack of Accredited Investor Status
For investments that are made under Rule 506(b) of the SEC’s Regulation D, active real estate investors can raise equity from up to 35 non-accredited investors, but those investors must be “sophisticated” in the eyes of the SEC.
This means that the investor needs to have the knowledge and experience necessary to be able to evaluate the potential benefits and risks of the investment they’re making.
Fortunately, is great news for you if you’re a current real estate professional and don’t fall into the accredited investor category quite yet, and this can open up a significant amount of investment opportunities for you (even without a seven-figure net worth).
Once you’re “in” with a private equity firm or syndicator by qualifying as an accredited or sophisticated investor, one of the largest downsides to investing passively in commercial real estate is the fee load you might be subject to on the deals you invest in.
This can vary a lot from company to company, and you’ll need to dig into the specifics within the operating agreement to understand what you’ll truly be paying as a passive limited partner in a real estate deal.
It’s extremely common to see an acquisition fee, an asset management fee, a construction management fee, and potentially even a disposition or refinancing fee in real estate partnership opportunities, to compensative the active managing partner for shouldering each of these responsibilities on your behalf.
These fees also don’t even include any sort of promoted interest due to the managing partner if the property exceeds return expectations at sale, which can often decrease passive investor annualized returns by anywhere from 1.5% to 3.0% or more, depending on how the partnership is structured.
Compare LP Returns To Other Investment Vehicles, Not Project-Level Returns
With all of that said, even though you might take a hit with fees and promoted interest as a passive investor, it’s also not uncommon for real estate deals to see annualized returns of 20% or more over a 3-7 year period, which is extremely difficult to achieve by investing in traditional paper assets like stocks and bonds.
And with that, even if the property as a whole generates a 30% annualized return over a 5-year period and you only earn 27% per year as a passive investor, 27% is still significantly better (on a risk-adjusted basis) than many other investment options out in the market.
Access Economies of Scale
By investing in a partnership on a larger deal, you’ll also have access to economies of scale not available to you by just investing in a smaller deal on your own. Properties often begin to get easier and less costly to manage as square footage or unit count increases, and in many cases, it’s a lot easier and more operationally cost efficient to own a $15,000,000 property than to own a $1,500,000 property.
Should You Be An Active or Passive Real Estate Investor?
If you want control over your assets, you feel confident in your abilities as a real estate investor, and you don’t mind managing properties or investor capital, direct ownership can be a significantly more profitable way to invest in commercial real estate, and can lead you down an exciting and lucrative career path in the industry.
The fees you can earn for the work you perform to acquire, manage, and sell the property, coupled with the back-end upside if investor return expectations are exceeded, make this a great option for people able to put the work in to find and manage profitable deals, and willing to take the risks associated with this process.
However, on the other hand, if you don’t mind taking more of a backseat approach to your investments, you have large chunks of capital to invest at one time, and you have other time commitments or lack the expertise to make active investing a worthwhile strategy for you, passive investing can also be an excellent way to build wealth over time, participate in the tax benefits of direct real estate ownership, and diversify your investment portfolio to bring real estate into the mix.
The trade-off here will likely be that you’ll see slightly lower returns than if you bought those same deals yourself, and you’ll lack control around the decision-making process on the property itself, but if you’re able to invest with a managing partner you know and trust, passive investing can be a great way to break into CRE.
There Is No Such Thing as a Free Lunch
It’s important to note here that neither of these options come completely without work.
Even in the passive scenario, you’ll need to do the leg-work to find a firm or individual to invest with that you know and trust, you’ll need to analyze each deal as it comes your way, and you’ll need to carefully read through the operating agreement to be aware of fees and promoted interest that will come out of your pocket as a passive investor.
And if you think you might fall into the passive investor category and want to make sure you know what to look out for in the next passive real estate deal that might come your way, I’d highly recommend checking out our How To Analyze Passive Real Estate Investment Opportunities course, which walks through how to choose a sponsor to invest with, how to analyze markets, and things to look out for from a finance perspective to make sure your investment returns are likely to be as advertised. You can find all the details on our Courses page linked here.
And if you’re thinking you might want to go the active route, either investing in your own deals or working for a private equity real estate firm, make sure to check out our premium training platform, Break Into CRE Academy.
A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, access to our entire library of pre-built acquisition, development, and waterfall models for multifamily, industrial, office, and retail deals, and you’ll also have direct access to private, one-on-one, email-based career coaching to help you navigate your next steps in the industry, or break into the commercial real estate business for the first time.
Thanks so much for reading, and I hope you find this helpful in choosing how you want to jump into the real estate investment world, and which path is right for you.