The Big Difference in Passive vs. Active Investing

[Don Konipol]

I used to think that the “big difference” , The “great divide” in investments was between equity and debt.  A number of years later I revised my thinking and thought “business vs real estate”.  Then I came to the conclusion it was “risky vs safe”.  While all these are “dividers” they are not the ultimate divide.  After 45 years investing across many asset classes, many investment types, and everything from lowest risk to outright gambles, I think I finally know the answer.

The biggest divide is between investments in which operational control over that investment is with the investor, and investments in which control rests with another party.  The only “control” an investor has when he invests in REITS, (or any stocks for that matter), mutual funds, real estate syndications, whether debt or equity, or minority shares in a business, is whether to keep or to sell his investment, and often not even that.  When things go wrong the “passive investor is helpless to do anything about it; sure he can display his displeasure by emailing the “sponsor/manager”, complaining on BP or Facebook; report his frustration to a governmental agency.  But, he has no ability to take any corrective action he feels is necessary or beneficial.  He’s at the mercy of someone else’s expertise, motivations, personal interests, perception, and knowledge.  

I’ve heard investors on this forum describe investing in notes (directly) as a passive investment.  BS!.  

Nothing could be further from the truth.  The most obvious example is when a borrower misses a payment, or two, or three.  The note investor has many choices of action to consider.  He can try “cajoling” the debtor into making payments.  He can initiate foreclosure proceedings.  He can try to work out a modification of the loan in some way, and there are literally dozens of different types of modification that may be appropriate for any given situation and may prove beneficial for both parties.  He can extend an additional loan to the borrower, especially if the borrower has additional collateral to put up.  And he can purchase the property himself from the defaulting borrower, or purchase a (majority) ownership in the subject property.  I have used all of these to deal with a loan in default.  Not anywhere close to a “passive” investment. 

But, the note doesn't have to be in default for the note holder to engage in actively "managing" the note. If the note holder purchased the note at a discount he can accelerate his profits and increase his ROI by offering the borrower an incentive to pay off the note early, or to make e extra payments. The note investor can set up a deal where the borrower deeds part of the property to him for cancellation of a certain amount of principal. Or where the borrower sells the property to a third party with the assumption of the note - at an increase in interest rate. No, note investing is not passive at all.

I was seriously contemplating moving a large share of my investment portfolio into “passive” type investments, where I left the management of the investment up to someone else.  But, for me, something didn’t sit right.  So I got to thinking about it, and hence my thoughts that led to this post.  Along the way I remembered something the great note investor and early real estate investing teacher Jimmy Napier said to me.  I had asked him why he never invested in syndications, REITS, or minority interests.  He said it was because he didn’t want anyone else to VOTE on his money.  

So, what do YOU think?  

[Jonathan Greene]

Quote from @Don Konipol:

Quote from @Jonathan Greene:

This is a great discussion point. I just started investing in syndications last year for the first time because I wanted to give up operational control and I had fully vetted the operators based on my network and own interviews. I find that syndications are truly passive, but nothing else is. Everything else is a level of passivity vs. how much management and oversight you want.

I will still have more active investments as well, but I think it's silly when passive income is referred to as part of say, multifamily. If you put landlording next to exercising, exercising might be more passive as an activity. I also think a lot of people think hiring a manager makes something passive, but we know it doesn't. If the manager works directly for you, you still have to manager the manager. It's more passive, but not passive.

Jonathan, can you share the process you use to “vett” potential syndication investments? 

Yes, for sure. I learned many of my techniques from Brian Burke and The Hands-Off Investor. For background, since last year, I have invested $250,000 into three different multifamily syndications in Chicago, DFW, and Madison.

1. I do full due diligence on the operator as a person. What is their background? How did they find real estate? I search them on LinkedIn, Facebook, and all social media. (Because of my podcast, I have access to many of them for one-hour discussions, but I know all of them would give a qualified investor 30 minutes at any time.) If they pass the personal smell test, I go to step 2.

2. I do full due diligence on the company. I ask for a record of past deals that went full cycle and deals that are pending and deals in the pipeline. I always ask for one deal that didn't perform as they expected and the results of that. If someone doesn't have an underperforming deal, I don't want to be their first one.

3. Now, I review the current offering. First, I check if the city is a city I am interested in investing in. That comes before the asset for me. As someone in the game for more than 30 years, there are cities I have always been interested in, but have no interest in a one-off for myself so this is a great opportunity to get exposure in a market without any of the operational pain.

4. Next, I review the asset. For me, it has been multifamily for these three, but I am also interested in self-storage and hotel conversion, maybe industrial flex in the future. I look at their experience with the asset class (looking for an operator who only does this asset class) and in this market. If they have multiple properties in the same area, I know this gives them operational acumen and discounts across the board. I check if it's value-add (get paid later) or turnover/freshen up/up rent (get paid sooner) and see if that fits the next rung on my ladder.

5. Next, is the debt. This is VERY important to me. I don't want floating or bridge or any movable debt. I want fixed rate for at least 5 years and at a good rate that gives the operator a lot of leeway to succeed.

6. Last, I make a list of questions. I go back to the PDF first to see if they are answered to make sure I don't waste their time. Any unanswered questions, I email in. The good operators respond quickly with great answers.

7. I am in or out. I am out much earlier a lot of the time.

I may have missed a few, but I just sprayed this out off the top of my head. I hope this helps anyone looking to get into it. This is truly passive for me and it's a very smart and important strategy and diversification for me now that I am over 50.