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?  

[Jay Hinrichs]

100% agree.. especially with syndication once your money is in their account you have zero control.. your not on the checking account your relying on either sponsor prepped financial although some are audited which is better of course.. But you cant dictate being paid back or selling etc etc.. One must have ultimate faith in the sponsor that is critical .. But bottom line money is out of your account and into an account you cant access or influence.

To me NO real estate is passive other than your  home you  live in..  not rentals not notes not syndication  etc etc.

But end of the day you simply have to make a choice and hopefully do the best you can choosing wisely what works for your personal situation and personality.

The Norada thread was a perfect example of investors all over the map on how they react when a note payment is missed .. Some are hey lets see if he can work it out.

Others jump right to they were all crooks lets fry them.. No those who took that tac obviously could have done better due diligence so its their own fault basically.

[Evan Polaski]

@Don Konipol, I guess my only real challenge to your thoughts are the definition of investments.  To me, by definition investments can be broken down in the financial side and the time side.  

But, typically, when I think investments, I think financial, meaning I am putting money in with the intent of creating income and/or appreciation on the money.  

By having control, that means I have work.  More control means more work. If I am putting in work, there needs to be additional compensation beyond any returns from the financial investment.  

I think the truth that your post brings is in the level of sophistication and market insights of the investors and investment sponsors that are prevalent on these forums, the amount of money we are talking about, and the general idea that real estate, even when directly owned, is passive in nature.

[Chris Seveney]

Quote from @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?  

 I always laugh when I see the guru "talk about investing in notes (directly) as a passive investment." aka "mailbox money.

Can it be passive at times yes, but it is still active. 

I think the passive vs. active investor boils down to expertise and time. Those that own real estate will want to be active, those who are limited experience and time look at it as an alternative investment and want an expert to manage it just like some hire a financial advisor for their stock portfolio. Neither one is right or wrong, its more what is best for you.

[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.

[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? 

[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.

[Jon K.]

Quote from @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?  

I've been an active investor for years and will continue to be for the forseeable future. I just this year began investing in more passive things such as syndications as well. Control is a variable to consider, but not the only variable. I am willing to give up control to benefit from the experience and efforts of a good operator that I trust when I have the capital to deploy.

The main reason for this has to do with time. I still work a full time W-2 job and have three relatively young children. It takes me more time to find and manage active investments than it does to find a good passive opportunity. I realize I have less control over what happens to my money when I deploy it in this way, but my time is more valuable to me at this point.

[Todd Dexheimer]

If you own the real estate, you own a business. You need to actively participate in order for it to be successful. The risk of the business is on you and whether you have the expertise to pick the right asset, in the right location, and operate it properly. When looking at the profit to be made, consider your time and what you're worth. You can make more money if you have full control, but your time needs to be considered. 

Passive real estate is investing. Way less time and no control after you make the initial investment. 

It really comes down to your goals. Are you looking to invest in real estate to gain passive income or are you wanting to buy a real estate business and be in charge of operations? 

[Ian Ippolito]

@Don Konipol , Investing in notes can also be a completely passive thing. 

If the investor chooses to invest in a notes fund, then the manager is doing all the work you described rather than the investor.

And if the investor chooses well, that manager will have years more of experience than the investor can hope to ever attain (and will not make rookie mistakes which they might). Additionally, a fund allows for diversifying much quicker into a larger number of notes (and which also can be further diversified by geography, underlying real estate asset type, strategy etc.)

The downside is that the investor has to feel comfortable vetting sponsors (and not everyone does). Plus there is no ability to make an extra return from sweat equity (which is what some investors want while others don't)