Active vs. Passive Real Estate Investing: Which one is better?
Active vs. Passive Real Estate Investing: Which one is better?
Real success in real estate investing is shaped by the level of commitment for sourcing, purchasing and managing the process to reach a specific investing goal. In my experience, whether you choose to be an active or passive real estate investor is based on one important question:
Do you have the time, energy, knowledge and skills to effectively take care of all aspects of your real estate portfolio?
This month, I’d like to discuss the risks and the rewards of each approach and how you can decide which real estate investing approach is right for you. Regardless of your methodology, knowing your level of skills and commitment is essential in developing the right plan to reach your real estate investing goals.
Active Real Estate Investing
For some investors, active real estate investing is an invigorating and rewarding process. Researching different markets and areas, locating and identifying the right investment, conducting due diligence on the property, putting in an offer and following up with the right tenant and renovation is a balance of timing and insight.
By taking control of the process of investing and managing the details effectively, active investors can save money on many of the expenses that arise throughout the acquisition and operation processes and one of the biggest if the investor has the right skills is property management. As a result, investments can generate additional income each month – improving your return on investment.
Active individual investors can still benefit by having a team of experts to assist in his/hers success. Mortgage brokers, realtors, lawyers and a renovation team are some of the experts that can assist during the process.
Being an active investor doesn’t always mean that it’s just one person investing. Rather, some active investors build an investment group of like-minded individuals to divide the significant work responsibilities to improve economies of scale.
To be successful as a group investor, I believe the key is setting up clear investing responsibilities – not only the financial responsibilities, but carefully considering the skill set of the members of the group.
Also, as an active real estate investor, it’s critical to give some thought to both short and long term real estate investing objectives. Some investors focus on the immediacy of cash flow for their investments, while others look longer term to capital appreciation or to build a legacy for their children or trust/estate. As I have mentioned in previous newsletters, identifying your overall goal of being an investor will determine your approach and the size of your portfolio you hope to achieve.
For example, consider the following scenarios:
Scenario 1 – Buy, Hold and Rent
If one is investing in properties to keep them long term, then the r objective most likely is to build cash flow. Each investment can be considered from the how the property performs from the “rent per purchase price” perspective.
Within this scenario, market fluctuations had can have significant impact.
Interest rates and employment opportunities are two important factors in determining rental demand. These leading market influencers are central to real estate investing strategies.
Higher interest rates can slow the housing market – causing some people to look to renting rather than purchasing. Similarly, lower employment can impact the number of people looking to rent. If there is less employment opportunities, people may consider moving out of an area, but if the employment changes are minimal, then they may consider looking to rent instead of buying. Even if a community experiences a temporary economic or employment downturn, staying put and renting may be the best temporary option - due to the longer term commitments of family and school.
Setting the right expectations and building contingency into your plan is an important part of weathering these market changes.
Scenario 2 – Flipping
If one is looking to purchase properties for in order to improve and sell them, then there is the need to consider market growth. By researching areas that show increasing demand and continued growth, the investments will be well positioned for a better return. Again, understanding market influences is very important to an investor’s overall real estate investing success.
Trying to sell when a market is or is in the process of turning is a much riskier scenario. This strategy is best done in a rising market.
Both of these real estate investing strategies involves a high level of reward and involvement. As I mentioned earlier, understanding your skills, personality and level of patience will determine how you decide on your tolerance for risk. The determination of risk and your toleration of risk is the key to deciding the mix of active vs. passive real estate investing.
Managing investment real estate involves organization, focus and the willingness to maintain quality relationships with tenants. It requires making sure that rents are paid on time, the property is well maintained and that the taxes are paid every year. Simply put, some investors are not cut out to be landlords.
Based on my experience, there are always opportunities for mistakes, challenges and human errors. You really can’t control everything, but having systems to manage the process can go a long way in identifying and correcting issues before they become significant or too large.
It’s also important to look at what your time is worth. Consider:
- What is your hourly rate – what are you actually getting paid per hour?
- Are you happy with that hourly rate?
- How much time do you have to devote to the process of real estate investing?
- Does it make sense for you to manage them?
If your property is the nest, then your tenants are the golden goose. If they are unhappy, they are going to “vote with their feet” and leave you with no rent!
Passive Real Estate Investing
Just as there are various levels of active real estate investing, passive investing means that you, as an investor have less “hands on” involvement with your assets. Although you are not 100% involved with every aspect, passive real estate investing still requires paying attention and having a solid understanding of what’s actually happening with your investment.
In most cases, passive investors outsource researching and managing properties to reduce time involvement in a portfolio of real estate investments. In the end, it is still your responsibility to track results to ensure that the net cash flow is operating within your desired tolerances.
The lender doesn’t care if your cash flow isn’t working, they are just interested in receiving the mortgage payments to pay off the principal and pay them their interest. If and when vacancies happen and should interest rates increase (as they should over the next few years) ensuring that you can handle the mortgage payments is critical to your investing success.
Like other investments, passive real estate investors rely on professionals to manage the process, process and systems that generate your return on investment. For the services provided, each provider requires a fee, which ultimately reduces your ROI. Whether you are managing or someone else is managing the asset, these jobs still need to get done.
“Turn Key” real estate investment opportunities offers a way for you to access the power of leveraging your funds while your tenant pays off your mortgage. Simply put, some people don’t want to manage tenant issues. In an earlier newsletter, I discussed the three T’s of real estate investing:
These three elements are a major reason investors decide to consider property management and passive real estate investing.
The investing style also comes down to the type of investment you are purchasing.
Single Family Homes
If you’re buying a single family home, then active investing is a great way of knowing what’s going on with your investment. You still may wish to hire a property management firm especially if you can’t look after your property due to its location. Property management firms typically charge between 8 & 10% of the gross rent and may include a number of additional costs such as advertising and lease up fees to manage it for you.
If you own several homes in one or more locations, having a property management firm manage your properties can still be a great way to be an active investor. You may even be able to negotiate a better deal depending on the number of homes they manage for you.
Bear in mind the risk is entirely yours if you have a vacant single family home, as you do not receive any income. Also you will need to check on it more often, because the home is more vulnerable to undesirable individuals who wish to occupy or vandalize it.
For multi-family investments like condominiums, investors can influence return on investment through taking advantage of better economies of scale.
When it comes to property management for multi-family, if the property management is managing most of the units in a property, there is usually an economies of scale gained for the investor owners in relation to the management fees. The management fees for the rentals are usually significantly less than the 8 to 10% fee charged on single family dwellings.
Similarly, being part of a rental association program or rental pool can mean that if your unit becomes vacant, you still achieve a percentage of your rental income based upon the rents and number of units in the pool.
Multi-family real estate investments also allow you to share costs across the owner pool. For bigger repair items, like exterior building repairs or upgrades, the fee is shared for each unit based upon the proportionate share of the common property allocated to the specific unit.
In addition, passive real estate investment allows you to not only share the costs, but also the control of the building. The best way to understand what is happening with investment is to get involved with your condominium and rental association board. You will understand what is happening with any scheduled renovations, rental vacancies and what the property management is putting in place to improve your return on investment.
As an active member of several condo/strata/HOA and rental association boards, I highly recommend getting involved. For a minimal involvement – you have extensively more access to the entire operation of the property as a whole complex as well as your particular unit and can really gain an understanding of what is happening with your investment.
In the end, the real question is if the price you pay is in an acceptable range for you. Knowing what your time is worth and your real estate investing objectives will set a path for the right mix of active and passive real estate investments.