Passive Investing in Commercial Real Estate - 2020 Part One of Four

Part One: The Basics

2020 has turned out to be a shocking year for many investors worldwide. Before COVID-19, there was a general sense that the markets needed a correction – few anticipated such a rapid, global economic decline. One of the best parts of investing in real estate is its ability to weather market downturns. Real estate is safe and stable and has historically offered strong returns.

With the recent market turmoil, more investors are turning to me, interested in moving money to various property types. This book evolved out of a common question I’ve heard in the past year: Is it possible to be a successful passive investor? This series will discuss passive investing in commercial real estate, and will focus on the following property types:

• Industrial
• Medical
• Office/Work Buildings
• Loft
• Storefront/Retail

A key part of this series will be understanding the many different commercial real estate property types, and how passive investors can get involved. Multifamily real estate is the major commercial property type not on the above list. For those investors interested in multifamily, visit my website and download my eBook, The Multifamily Passive Investor: a 4-Step Primer.

Part one of this series will focus on the basics of passive investing in commercial real estate. This includes the basics of passive investing, advantages, understanding commercial real estate, and commercial real estate deals. For investors familiar with the basics I encourage you to skip ahead to part two.

Passive Investing Defined

Passive investing is a popular term these days. A dream for many investors is to make the correct investment decision and to sit back and enjoy returns and appreciation. Passive investing is anything but minimal effort, and requires skill, commitment, planning, and a good eye for sound real estate investments.

To begin with, I prefer the Internal Revenue Service’s definition of passive investing: “rental real estate and businesses where a person does not materially participate in regular, continuous, and substantial basis.” Without going into detail, material participation refers to the amount of time and effort you dedicated to the activity. In the case of real estate, passive investing is best defined as an activity where you are not involved in the day-to-day management of the real estate property.

Passive investors are those most interested in avoiding material participation – the day-to-day management of a real estate property. Passive investors work with other investors and property management specialists to generate revenue from commercial real estate property. Passive investors may own or share ownership in a property, but are careful to outsource the management of the investment and property to others.

Advantages of Passive Investing

The number one advantage of passive investing is that you get to avoid a common problem of active real estate investment: tenants, toilets, and trash. I would add to this a fourth problem: timelines. Timelines refer to the business of managing investment decisions, expectations, and the logistics of coordinating investing in a property. Passive investing means you are not materially engaged with the property nor the investment. All of this is outsourced, freeing you to focus on selecting the best commercial real estate investment.

In general, passive investing has a number of advantages over active investment styles:

• Lower time commitment versus active investing
• Loss exposure limited to the investment amount
• No day-to-day involvement
• Diversification of investment dollar by geography, building type, investment amount, etc.
• Revenue, appreciation, and tax benefits

Advantages of Commercial Real Estate Investing

Future investors often ask me why both real estate and commercial real estate specifically are good investment options. These are the four core reasons why I believe real estate is a superior investment choice versus other forms of investment, such as stocks or bonds.

1. Physical asset
2. Cash flow
3. Equity
4. Tax advantages

I’ve placed physical asset first on the list to highlight that owning property has important, intrinsic value. Owning any real estate gives you access to both the structure and land itself. A hard asset is stable and secure, and is resistant to market fluctuations that can tank stocks and other intangible assets. Real estate is well-known for offering monthly or yearly cash flow payments from tenants. Also, properties appreciate through external factors, such as market demand, or internal factors, such as proactive management. Last, real estate investors gain access to the many tax benefits of real estate.

Commercial real estate is different in many ways than resident residential real estate. Below are the four specific benefits to owning and investing in this property type.

1. Strong annual returns
2. Objective price evaluations
3. Professional relationships
4. Net lease, or triple net leases

#1: Strong Annual Returns

A 2020 Forbes article reported commercial real estate average annual returns for the past 20 years at “roughly 9.5%, nearly 1% greater than the S&P 500's average annual return of 8.6% over the same period of time”.

#2: Objective Price Evaluations

It is easy to let emotions distract from the true quality of an investment. Commercial real estate investors can often, but not always, get a better gauge of the price of a property. Known income statements and area cap rates, among other factors, help to prevent prices from going into irrational territory.

#3: Professional Relationships

Tenants for commercial real estate property are most often business professionals with a vested interest in their business and the community. This creates a business-to-business relationship where mutuality is an important driving factor. Tenants also have a good reason to maintain the property and, in general, to build and maintain strong relationships.

#4: Net Lease, or Triple Net Leases

Property management firms can and do create leases that require the tenant, not the owner, to pay all expenses on the property. A triple net lease stipulates the tenant will pay property taxes, insurance, and maintenance fees. Companies that lease property, such as Walgreens, will prefer these leases to keep the building in line with their corporate style.

Passive Investing – The First Steps

Passive investing in commercial real estate can generate substantial wealth over the long-term. In the wake of the 2020 economic changes, more investors will look to real estate, and commercial real estate specifically, to create safe, stable, and secure wealth. Passive investing ensures that investors don’t have to learn much about the day-to-day management of the property, and can instead focus on the deal, partners, and their overall portfolio.

Before starting, I recommend investors answer these three questions:

• Do you have a background in commercial real estate or the time to educate yourself?
• Do you have sufficient capital and enough liquid assets?
• Are you an accredited or sophisticated investor?

Now that you have an understanding of the basics, stay tuned for part two on how to get involved with passive investing in commercial real estate.