Passive Investing in Multifamily Real Estate Part One

Part One: The Basics 

As interest in real estate continues to grow, I want to focus on passive investing in multifamily real estate.

This series evolved out of the conversations I was having around the country. Owners and investors continue to ask me how to get access to multifamily real estate returns without active participation. They wanted a more hands-off approach. Not everyone is a landlord. Naturally, some investors want to sidestep the tenets, toilets, and trash problems.

This is our first article in the series that will walk you through passive investing in multifamily real estate. In this series, you’ll learn everything you need to know: the fundamentals, how to make money, expected returns, how the business works, and the structure of deals. Let’s begin with an introduction to passive investing.

Passive Investing Defined

The Internal Revenue Service (IRS) defines passive investing as “rental real estate and businesses where a person does not materially participate on a regular, continuous, and substantial basis.” Material participation is the key term here. What is material participation? The IRS has seven tests listed in Publication 925 each of which would qualify an activity for material participation.

Without going into detail, material participation requires a certain amount of work. This is usually over 100 hours or 500 hours, depending on the exact nature of the work. What I like about the IRS’s definition is that it creates a distinction between day-to-day work and hands-off work.

Using the IRS’s guidelines as a foundation, we can examine which activities usually qualify as a passive investing activity. These can be divided into two types of activities:

• Rental businesses for equipment and real estate
• Business structures in which a person doesn’t materially participate, such as partnerships, limited partnerships, S-Corporations, and limited liability companies

Importantly, working as an investor does not count as material participation unless there is direct day-to-day management of the activity. As a passive investor, your effort will center on identifying the most attractive multifamily real estate deals for investment.

Advantages of Passive Investing

While passive investing does not share in some of the tax discounts afforded by active participation, it does have a number of important advantages.

• Limited exposure to loss
• Lower time commitment versus active investing
• Limited effort and no involvement with day-to-day management
• Investment flexibility
• Diversification (geography, building type, investment amount, etc.)

In this series, we will dive into these advantages more as we look at how investors should begin to invest in multifamily real estate.

Single-family or Multifamily?

If you’ve decided on passive investing, the next question is: Should I focus on multifamily or single-family? While many investors get their start in single-family real estate, multifamily real estate is where real wealth is built. Below are two reasons single-family real estate is a less desirable investment.

Single-family disadvantages:

• Lack of economies of scale. This is a critical point that many investors overlook. Capital items, like roofing, are shared across many occupants in a multifamily unit. A multifamily unit with 10 occupants may require a roof three times as large as a single-family home. $10,000 in roof damage to both units is less costly given the economies of scale in housing more people under one roof.

• Occupancy Rate. Each month a single-family home is unoccupied reduces the occupancy rate by 8.3%. That equates to a 92% occupancy rate if just one month is missed. Multifamily occupancy rates are usually around 95% in most markets.

As an asset class, multifamily is one of the most misunderstood and one with a tremendous upside. I’ve met many investors who got stuck in the single-family trap. For many investors, single-family homes become a business instead of an investment. This is a bad outcome for those looking to go the passive investing route.

Multifamily advantages:

• Invest in Net Operating Income (NOI) and not just the market. While single-family homes often generate income, investors usually purchase them for the mid-term appreciation. A multifamily unit is different. Multifamily real estate runs on the NOI, which pegs the asset value at both the NOI and the broader market. This means that your return is not solely based on appreciation, and can generate income in the short-term, long-term, and in any market condition.

• Investing with professionals. As we discussed earlier, the core of passive investing is forming a partnership with other investors. In a past article, we reviewed how to form partnerships for raising capital. As an investor, your job will be to find the right professionals to invest with, including those who can handle the day-to-day management.

• Limiting your loss. As an investor, your liability will be capped at the amount you invest. Limiting your downside is a big advantage over single-family units, which often pull owners into unexpected expenditures.

• · Diversification. Multifamily investment opportunities come in all different types. You can select the geography, business plan, and asset type you prefer.

Passive Investing in Multifamily: Syndication

So far, we’ve established that passive investing is hands-off and has some important advantages for investors. Investors will place their capital in certain multifamily investments with little to no material participation. So what does passive investing in multifamily real estate actually look like? In the world of multifamily real estate, this is done through syndication.

For those new to real estate investing, syndication is an important term. Most purchases of multifamily properties are done through syndication. Syndication is a collective of investors who aggregate capital managed by a sponsor. The sponsor is a real estate investment firm with experience in raising funds to purchase high-value multifamily properties. After purchase, the sponsor will hire a full-time property management firm to manage the property.

Importantly, each investor assumes a limited amount of liability while part of the syndication. Syndication also allows investors to gain the other three passive investing advantages: hands-off, flexibility, and diversification. Later in the series, we will look closer at syndication – how it works, what you need to know, and how to be a profitable investor.

Taking the Step Towards Investing

Passive investing in multifamily real estate offers a powerful opportunity to build wealth. As an investor, you get to limit your loses, while gaining access to strong returns, all without the day-to-day management.

Before starting, I recommend investors answer these three questions:

• Do you have the time to educate yourself on investing in multifamily real estate?
• 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, check back tomorrow for my upcoming articles in the series.