Pros and Cons of Active vs. Passive Real Estate Investing

Individual investors looking for a steady income often narrow their focus to real estate. Property investment provides passive income — a steady cash flow from rents — plus a host of tax benefits. There’s a worthy end game too; the potential to realize substantial capital appreciation and double or even triple your investment. The combination produces higher risk-adjusted returns rather than traditional passive income sources such as dividend-paying stocks or annuities.

When private investors decide whether to pursue real estate investing on either active or passive basis, they need to consider the pros and cons of each strategy.

In active real estate investing, investors buy properties directly and their personal control over a property falls anywhere in a wide range between hands-on and hands-off work. It can take an enormous amount of work — or not. Owners can do everything themselves, or choose to delegate the time-consuming work of buying, maintaining, improving or selling the asset to hired contractors or management companies. Buying properties directly can also open an investor to unlimited risk exposure through loan guarantees, which increases their exposure to risk.

Investing passively in private real estate means investors outsource the selection and management of investment properties to a private REIT or private equity manager, and pay them a portion of the profits for their services. Managers pool funds from many investors to buy larger or an entire portfolio of properties, then execute specific business plans, run day-to-day operations and report back to investors. Better financing options are often available for investment-grade properties, which allow investors to tap into the non-recourse debt market and lower the risk for all investment partners.

Which way to go? Here’s more information about active and passive real estate investing to consider before making a decision.

Finding Properties to Acquire

Locating the right property and determining the right price takes real estate acumen, local knowledge and financing.

Active investors should consider taking a “boots on the ground” approach and be ambitious and disciplined in their pursuit of information about the market or markets where they invest. Successful investing starts with having high-quality deal flow and deals don’t just fall into one’s lap. Investors must constantly look at properties and their various features so they’ll know a good deal when they see one. It can take years to get a sense of a market and what kind of properties perform well. Most active investors stay close to home because it offers them easy access and that’s where they’re comfortable. But what’s the likelihood that the best deals in the country are within a mile or two of where you live?

Passive investors outsource the acquisition process to fund managers who uncover quality deals. Most fund managers employ a team of deal sourcing professionals who look at hundreds of deals a year across many markets. A private REIT or private real estate investment fund doesn’t allow an investor to approve each holding, but can limit risks by providing greater expertise, more thorough underwriting, financing relationships and ultimately a more diversified portfolio with investment-grade properties. By owning a share in many properties, passive investors’ fortunes don’t rise and fall with those of any single asset, and they don’t need to answer the phone in the middle of the night when the toilet gets backed up in a tenant’s apartment.

Minding the Properties

Many real estate investments require improvements, and all require oversight to maintain the property, collect rents and handle issues that arise.

Active investors become landlords, which is grueling and time-consuming work — especially if renovations or construction is part of the business plan over and above maintenance or rent collection. You may like to do work around the house, but do you want to be responsible for a property 24/7? Owning properties involves work that managers and handymen can do more easily, but the payout to these “helpers” will shave profit margins.

Passive Investors in private equity real estate funds or private REITs can rely on managers to oversee properties with the intent of increasing their value and selling them for profit. They have professional teams in place that provide an economy of scale for work that’s done on properties. Both vehicles charge fees that can diminish returns, yet still yield healthy returns. But private REITs and private equity real estate funds have different fee structures, and investors must weigh each one individually.

Making a Decision

Real estate investments have as much to do with tolerance for work as tolerance for risk. Many investors make the mistake of simplifying the real estate investment process to a few variables and jump in headfirst — only to find out how complex this investment arena can be. Every investor needs to factor in the amount of time they want to commit and the risk they are willing to take.

Active investors are often looking to maximize returns by saving on fees. They should think twice; there are countless do-it-yourself investors who find themselves not only underperforming the market in terms of returns but also working full time in a “new” profession they thought would be relatively passive. In most cases, investors should double it or triple the amount of time they think an active real estate investment will take because doing it right takes a real commitment. They should also understand that they could expend a great deal of time and money and still make expensive mistakes that professional managers know how to avoid.

Private investors can tap into the wealth-building advantages of office and multifamily real estate, which is not within reach of investors without the resources to tackle active management duties. The fees paid to a manager can be immaterial relative to the quality of life they can maintain with a passive real estate investment. Even so, choosing passive income sources still requires doing your homework. Private investors should be comfortable with their investment manager’s track record. The choice of the right real estate asset manager can help assure high returns with a less active approach.