Investors seeking reliable recurring income and capital appreciation frequently turn to investment real estate such as residential rental property or special purpose commercial real estate like self-storage.
Owning real estate may generate higher risk-adjusted returns than other traditional investment options. Real estate has a low correlation to volatility in the broad stock market, and historically is a hedge against inflation.
The two main strategies for investing in real estate are passive and active. In this article we will examine how each strategy works, to help you understand the difference between passive and active real estate investing.
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What is Active Investing?
Active real estate investing occurs when an investor is hands-on. Active real estate investors research different markets to invest in, identify specific properties that meet the investment objectives, and negotiate a deal with the seller.
After escrow closes, an active real estate investor may also directly handle the property management. They will market the property for lease, screen tenants, draw up and execute the lease, handle rent payments and repairs, and be available 24/7 if repair issues ever arise.
Benefits and Disadvantages of Active Investing
Real estate investors who like the idea of being a landlord may find active real estate investing exactly what they are looking for, or maybe not. Here are some of the benefits and disadvantages of active real estate investing:
Benefits
- Maximum control over the real estate investment
- Tax benefits flow directly to the investor
- Minimum fees since a leasing agent and property manager isn't being paid
Disadvantages
- Investors must understand the ins and outs of managing rental property
- Requires detailed knowledge of the market, including growth trends and landlord-tenant laws
- Least liquidity because large amounts of capital are tied up in the property down payment
- Difficult to scale up and diversify a real estate portfolio when every investment is actively managed
Active Income Investments
Active investors are responsible for a variety of tasks, including analyzing deals, purchasing the property, updating the property, renting and dealing with tenants, and ensuring that all of the housing, zoning, and other regulatory laws are followed.
Two examples of active income investments are property flipping and short-term rental investments.
Property flipping
An investor has to find an owner willing to sell below the market price, accurately estimate the cost of repairs and renovations, and flip the property fast enough to make a profit before market conditions change.
Short-term rental investments
Short term investments can include activities such as renting out a room, owning and managing a vacation rental property where tenants turnover quickly, or even owning a rental property where the tenant is on a month-to-month lease.
Gross rental income can be higher with short-term rentals, the landlord isn't saddled with the same tenant, and repairs can be easier to stay on top of because the owner is inside the property more frequently.
However, short term investments also require more work. That's because owning a short term rental property is similar to being in the hospitality business. An investor is constantly looking for the next guest, making sure the place is fully furnished and clean, and doing everything possible to make sure a short term tenant leaves a good review.
Self-storage investing
Self-storage is an attractive investment due to potentially high gross revenues combined with low operating expenses. Smaller self-storage properties require a low level of ongoing property management, making the asset class a potential option for active real estate investing. Investors can develop a self-storage project from the ground up, or invest in an existing property.
However, although profit margins on self-storage investments can be high, many investors choose to passively invest in a self-storage project as a limited partner. That's because successfully developing a self-storage facility requires a high level of experience and knowledge.
Land must be purchased in markets where demand is high and supply is low, developers need to understand local municipal zoning procedures, and construction costs and timelines must stay at budget so that the property can be quickly leased-up.
"Though it may appear easy, self storage management requires experience and knowledge."What is Passive Investing?
Passive real estate investing occurs when an investor puts capital into an investment such as self-storage but has a third-party who does the majority of the work.
Property managers or sponsors of a private real estate investment will develop and execute the business plan, identify and acquire property that meets the investment criteria, obtain favorable financing, and handle the day-to-day operations of the property.
However, even passive real estate investors need to be active to some degree, such as analyzing the offering memorandum for a crowdfunding or private equity self-storage opportunity, and reviewing regular financial performance reports.
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Benefits and Disadvantages of Passive Investing
Passive real estate investing can be the perfect match for investors who want to realize the benefits of owning real estate without having to directly manage or own the property. Here are some of the benefits and disadvantages of passive real estate investing:
Benefits
- Requires minimal knowledge of managing investment real estate
- Easier to diversify by investing small amounts of capital in multiple projects
- Access to investment-grade properties that are difficult for smaller investors to purchase on their own
- Liquidity may also be greater when investing in publicly traded REITs
Disadvantages
- Much less control over the real estate investment
- Not all tax benefits may flow directly to the investor
- More overhead and fees paid to third parties who oversee the investment and share in the profits
Passive Income Investments
Passive real estate investors outsource the majority of the investment process to a fund manager or general partner of a private equity investment. These professionals literally see hundreds of investment opportunities each year and can select deals that offer the highest potential return while working to minimize risk.
Two examples of passive income investments are investing in long-term rental properties and REITs.
Investing in rental properties
Investing in long-term rental property is one of the most common types of passive real estate investing. In residential real estate, long-term tenants typically sign a 12-month lease, while tenants in commercial properties often have lease agreements of 5 years, 10 years, or more.
Because residential rental property is in short supply in most markets across the country, tenants often renew their lease. Recent research reports that the average U.S. renter stays in a building 27.5 months. This means that investors who own long-term rental properties spend less money on tenant-turn expenses, such as marketing, leasing, and repairing the property each time a tenant leaves.
Special use property such as self-storage exhibits similar characteristics. The average rental duration of a self-storage unit is 14 months, with nearly 50% of self-storage customers renting for more than one year. With about 13.5 million households - or 10.6% of all households in the U.S. - renting a self-storage unit, the industry generates annual gross revenues of $39.5 billion, according to SquareFoot Storage Beat.
Self-storage investors may also see better returns than owners of residential rental property. The national average cost per square foot of a self-storage unit is $0.91 per month, which is about the same cost to rent an apartment in some cities. Owning and operating a self-storage facility is also much less labor intensive. With a national average occupancy of about 92%, the average profit margin of self storage operators is 41%, roughly double the average profit margin of all industries.
REITs
Real estate investment trusts (REITs) are an easy way to own shares of income producing real estate. Many of the largest REITs such as American Tower, Prologis, Public Storage, and Equity Residential are publicly traded on the major stock exchanges.
REITs are highly liquid, because shares can be traded just like any other stock or bond. Many REITs focus on specific real estate asset classes, such as single-family rental property or self-storage.
There are some potential drawbacks to investing in a REIT as well. For example, dividends are taxed as regular income, and there may be multiple levels of management and transaction fees. With that being said, investing some capital in one or more REITs may be a good way to diversify an investment portfolio.
Factors in Deciding on Your Investment Strategy
Real estate investment strategies tend to be either active or passive. Both active and passive investment strategies have their benefits and disadvantages, and the strategy that is right for one real estate investor may be completely wrong for another.
To help determine which investment strategy is right for you, it is important to understand the following five key factors: Risk, level of control, time commitment, finding the right property, and diversification.
Risk
Your personal tolerance for risk is the first factor to consider when deciding on your investment strategy. Examples of lower-risk investments include government bonds and passive real estate investments such as self-storage.
To be sure, all investments carry a certain amount of risk. However, investing in passive real estate can be similar to receiving regular coupon payments from a highly rated bond, such as self-storage property that historically performs well through all economic cycles.
Investors who are willing to accept a higher level of risk may opt for active real estate investments such as short-term rentals or property flipping. The potential profits are higher, but so is the risk of losing some or all of your investment capital.
Level of control
In exchange for a lower level of risk, passive real estate investors have minimal direct control over the investment property. For example, in a private equity deal, passive investors are limited partners who contribute capital to a more experienced general partner qualified to manage the property.
On the other hand, active real estate investors retain as much control over the property as possible. They create an investment business plan, execute the plan by acquiring and renovating the property, marketing and leasing to the best tenants, and managing the day-to-day operations of the property.
Amount of time commitment
Being an active real estate investor requires a much greater time commitment than passively investing in real estate. In fact, being an active real estate investor is like having a second full-time job.
The investor must learn the quirks of the market and property they are investing in, assemble a team of trusted professionals, negotiate deals and arrange financing, and work with tradespeople to make sure renovations are done properly and come in on budget.
Passive real estate investing requires much less of a time commitment. By delegating control to more qualified professionals, the passive investor can spend more time scaling up and growing an investment portfolio while leaving the daily details of managing the project to others.
Finding the right property
Not all real estate investments are created equal. Planning and zoning challenges, environmental issues, competing properties coming to market, and higher than anticipated operating expenses can all reduce the anticipated ROI on investment real estate.
By selecting a general partner with a proven track record of success, passive real estate investors can leverage the knowledge and experience of a sponsor to find the right property and participate in the best investments.
Sponsors of private equity real estate such as self-storage already have teams in place to scour the market and locate potentially profitable investments. This helps passive investors to maximize potential returns while minimizing downside risk.
Diversification
While there is no such thing as a "free lunch," diversifying an investment portfolio comes pretty close. As U.S. News & World Report notes, the benefits to diversification include:
- Minimize risk of loss to your overall portfolio
- Access new investment opportunities for more return
- Protect against adverse market cycles
- Reduce volatility
Most investors do not have access to unlimited amounts of capital. Active real estate investing means tying up large amounts of money in a single property. Passive real estate investors are able to more easily diversify - and potentially earn larger returns - by investing small amounts of capital in multiple projects such as multifamily rental property, industrial buildings, and self-storage property.
Crowdfunding
Real estate crowdfunding pools money together from a large number of investors to raise capital for high-quality investment projects such as new home developments, mixed-use projects with a combination of residential and commercial space, and special purpose opportunities such as senior living centers or self-storage facilities.
The minimum investment for a real estate crowdfund begins at just $500, though for accredited investors, such as those who invest with Reliant, the minimums are much higher. This makes crowdfunding an attractive option for passive real estate investors seeking to diversify capital across different property types in various markets across the U.S.
According to NerdWallet, the best real estate crowdfunding investment platforms include Fundrise, CrowdStreet, and Equity Multiple. Most real estate crowdfunds accept both high-net-worth accredited investors along with non-accredited investments. However, sometimes the most attractive deals with highest potential returns are limited to accredited investors only.
Conclusion
Real estate crowdfunding pools money together from a large number of investors to raise capital for high-quality investment projects such as new home developments, mixed-use projects with a combination of residential and commercial space, and special purpose opportunities such as senior living centers or self-storage facilities.
The minimum investment for a real estate crowdfund begins at just $500, though for accredited investors, such as those who invest with Reliant, the minimums are much higher. This makes crowdfunding an attractive option for passive real estate investors seeking to diversify capital across different property types in various markets across the U.S.
According to NerdWallet, the best real estate crowdfunding investment platforms include Fundrise, CrowdStreet, and Equity Multiple. Most real estate crowdfunds accept both high-net-worth accredited investors along with non-accredited investments. However, sometimes the most attractive deals with highest potential returns are limited to accredited investors only.
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