Why I made the switch from active to passive investing

[Sam Silverman]

#1 – Headspace and Mindshare

Last Tuesday at 2:13 PM in the middle of a client meeting, I received a call from the property management company that manages my three remaining single family houses -- I was asked to approve a charge for $2,314 without any further context.

Turns out, the tenant had run over a sewer line with their lawn mower. The expense ended up being billed back to the tenant after five hours of back and forth over the course of the next week, the larger expense here was the amount of mental energy, mindshare and headspace that this took up to get done.

As a passive investor, the operator has onsite professional management and an asset manager to manage the professional onsite management. I have invested into 15 passive investments (private placement -- syndications) and I have yet to receive a call regarding a tenant or property issue.

#2 – Time (Up to Close)

Situations like the example above are not uncommon, but there are other areas of the business that can take up even more time. Finding a deal (or many deals if you are working within single family) requires hours of research to understand a market, underwriting to ensure the deal has a high chance of being profitable, working with the seller to come to an agreement on price, getting outbid, securing financing, etc.

Once I have vetted an operator (links at the end of the article on how to do so), the time it takes to invest into one of their deals is sub one hour. Personally, I always bet on the operators over the specific deal. The process typically goes -- fill out a form, schedule a call, join their investor club or distribution list, receive email updates as to when upcoming investment opportunities are, review the deal and the webinar, submit a commit, fill out the PPM (private placement memorandum), then wire the funds.

#3 – Time (Post Close)

When I first started purchasing single family rental homes, I thought getting a property manager would magically bring the amount of time I spent managing the asset down to zero, wishful thinking right?

After three years of owning as many as eight single family rentals at one time, I calculated that I was spending an average of 90 minutes per property per week. While this may not seem like a significant amount of time, thinking of the end in mind (specific goal of passive income each month) and the amount of properties that I would need to get there -- this would turn into nearly two full time jobs.

After a passive investment closes -- the only time that I spend is reading through the investment update each month (this takes sub three minutes after the first month or two) then allow the distributions to be directly deposited via ACH into my bank account.

#4 – Risk and Liability

With active investing, if (and when) things go south, you are personally held liable, which means you may lose not just the property but also your other assets.

With passive investing, your liability is limited to the capital you invest -- for example, if your investment is $50,000, your entire liability is the $50,000 that you have invested. Typically, the asset is held in an LLC or LP. If anything goes terribly wrong, the sponsors are held liable, not the passive investors.

#5 – Economies of Scale

When investing actively, you are likely limited to the amount of capital that you personally have to invest. For example if you are purchasing single family houses and you have $50,000 to invest, you may be able to buy a house that is $250,000. When buying a single house, you are likely not receiving any type of discounts in regards to property management, materials, leasing etc.

Take the same $50,000 to invest into a passive deal, even though you may only own a fraction of the asset, you are achieving the scale of having many other investors invest along side you. For example, the leaky toilet that causes a plumber to have to drive and come on site when owning a property yourself may cost $200+. In a passive investment, due to having onsite management, this may take 10-15 minutes of a $20/hour employees time. When looking at property management, standard costs (from my experience) can be ~10% of gross rent collected + half of the first months rent to lease the property -- these costs can be anywhere from 2.5-4% in larger assets.

#6 – Valuation

Due to being the math and data nerd that I am, I have always loved things that were systematic and equation driven. Single family houses are neither, their value directly ties to the current state of the real estate market and future appreciation is based off of speculation.

When looking at passively investing in larger commercial (apartment buildings that are 5+ units), the value is based on an equation -- (net operating income)/ (cap rate).

To walk through an example: Say there is a 100 unit property that has a delta between current and market rents of $150/unit/month and there is an additional $50/unit/month of operational expenses that can be reduced, this would net out to a $200 net operating income difference/unit/month. $200 per month * 12 months = $2,400 per year * 100 units = $240,000 per year of net operating income uplift. Say the building trades at a 5 cap (this can be higher or lower depending on the exact asset), the $240,000 of NOI increase would be worth an additional $4.8M of increased property value. $200 per month can really go a long way here.

#7 – Diversification

With active investing, you yourself would need to be an expert in the market and asset class you’re investing in. This likely means that you may only be able to invest in one single asset class and one single area. While this can turn out great if the area performs well, this also puts all your eggs in one basket.

With passive investing, it’s easy to diversify across different markets, since you don’t have to start from scratch with each market. You are investing with teams that have already taken the time to research those markets and build strong local teams. Personally, I am invested into 15 different passive investments that are spread over five states, 11 cities, three different classes of multifamily apartments (A, B and C) and unit counts ranging from 104 to 447.

#8 – Risk

When actively investing into a single family rental, the property is either occupied or it is vacant -- there is no middle ground. If the property is occupied, there is likely cash flow, if the property is vacant, then it is bleeding money.

When investing passively into a 200 unit apartment complex, there are many different possible scenarios. On average the break even occupancy (percentage of units occupied to cover all expenses on the asset) is between 55-70% occupied. This means that anywhere from 60-90 units in the property can be vacant and the debt will be able to be paid.

#9 – Team

As an active real estate investor, you will need to build your own team, mine included people such as -- Brokers, Property Managers, Handymen, Accountants, Lenders and Inspectors etc.

As a passive investor, you rely on the shared expertise of the existing deal sponsor team. The sponsors are experts in the market and typically already have a team set up to manage the property. From my experience, many busy professionals don't have the bandwidth or desire to become a true expert in each area of real estate investing, they may like the asset class, but are inhibited from making this their full time focus.

#10– Capital Investments

Active real estate investors should plan to handle insurance claims, emergencies, and repairs, which may require additional money at times. Each month I had to set aside a portion of my cash flow to account for future expenses.

Over the last two years of passively investing into 15 different projects, I have only made the initial investment into each deal.

#11 – Back Office Paperwork and Taxes

Active investments are paperwork-heavy, from the initial purchase of the property to tracking purchase and rental agreements, bookkeeping, and legal documents throughout the project. You’ll be responsible for the bookkeeping, meaning that you will need to keep track of the income and expenses. Additionally, you will have to count on your CPA to properly depreciate the property each year.

With passive real estate investments, on the other hand, you typically sign a single PPM (private placement memorandum) to invest in the property. No need to fill out lender paperwork, file for insurance, or do any bookkeeping. At the end of every year, you receive a Schedule K-1 every spring for your taxes, which shows the income and losses for that property.