Summary: There are numerous ways to invest in real estate. Options range from passive investments (REITS and syndications) to the more active (cashflowing rentals), with each providing a range of return and risk-profiles. In this post, we compare passive real estate (limited partner investing in syndications, REITS, crowdfunding) vs. active real estate (cashflowing rentals, sponsoring syndications as a general partner) investing and touch on the strengths and weaknesses of each of these investments.
[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
Kenji and I spend the majority of our time, effort, and money investing in cashflowing rentals, which are properties that we buy and rent out for profit. We have also led a couple of syndications as general partners. This means that we raised money from passive investors (called limited partners) to help us acquire large properties.
These are considered active forms of real estate investing. We do this because it offers a very high rate of return due to the stacking effects of cashflow, debt paydown, appreciation (immediate and forced appreciation), and tax savings. However, it also requires more time, energy, and effort than passive investing.
Some even view active investing as “hard.” Even worse, they prescribe that it’s “too hard for you.” Telling yourself something is too hard is the same as telling yourself to take the easy path, i.e., passive investing.
As a result, many are steered towards passive real estate investing. Syndications are a popular option for passive investors. We’ve covered the basics of syndications in detail before. REITs and crowdfunding are other passive options.
However, is passive real estate investing necessarily better? What are you giving up when you choose to invest passively? Do the pros outweigh the cons?
In this article, we’re going to cover these pros and cons. Our goal is to provide you with a deep dive into the various real estate investing options so you can see which is the right fit for you.
Investing in Cashflowing Rentals
What it is:
Investing in cashflowing rentals is exactly what it sounds like: you buy a property, you rent it out, and it generates cashflow (assuming you know what you are doing and you buy it right).
These rentals can range from single-family homes to large multifamily apartment complexes consisting of hundreds of units.
You usually rent these properties to the general public, but there are a lot of different niches. You can do short-term rentals like Airbnbs or VRBO. You can rent to people with intellectual disabilities in a program called supported living. There are also housing programs for sober living, respite care, veterans, and many other groups.
[If you want to learn how to buy cashflowing short-term rentals, CLICK HERE to join the waitlist for our short-term rental course, Accelerating Wealth]
Over time, many investors roll over their properties into larger and larger properties using tax-deferred 1031 exchanges. They take advantage of the incentives built into the tax code to grow their wealth efficiently.
Investing in cashflowing rentals unlocks other tax advantages like real estate professional status and the short-term rental tax loophole. Both give you a mechanism to shelter W2 or 1099 income. These specific benefits are not available to passive investors.
[Want to learn more about REPS? Check out our free guide below.]
What are the strengths/weaknesses of this type of investing?
The strength of this type of investing comes down to decision-making control, far superior returns, and tax benefits compared to passive forms of investing.
First, control. When you own a property, you make all of the decisions that impact the performance of the property. You can choose to make upgrades, raise rents, pick your tenants, and when to sell your property. This means you can increase profitability greatly (or drive it into the ground if you make poor decisions!).
Second, the financial benefits are significant and long-lasting. Between cashflow, debt pay-down, market appreciation, immediate appreciation, forced appreciation, rent appreciation, and tax write-offs, there are so many different ways to make money with cashflowing rentals. When you combine all of these benefits, you can achieve returns of greater than 25%.
Hate taxes? There’s no better way to shelter your income than with cashflowing rentals. This requires that you achieve real estate professional status or materially participate in a short-term rental but if you or your spouse make it a priority, you can save tens of thousands, or even over a hundred thousand dollars in taxes depending on your income level. Think about paying zero taxes on your income. That’s what we’ve done for many years and many graduates of our Zero to Freedom course have as well.
One other benefit of cashflowing rentals is the ability to pass down the property to your children in a tax-efficient way. This is called the stepped-up basis loophole. Direct ownership of rental properties forms the basis of much of the generational wealth in America.
The main downside of cashflowing rentals is the amount of time spent. Since you are making the decisions, you will need to devote some time to learning about real estate investing and to oversee the property’s performance over time.
However, you have to put this time into perspective. Relative to the amount of money you can make from these rentals, the time spent pales in comparison to the amount of time you would have to spend to make an equivalent amount in your day job. Also, the beauty of cashflowing rentals is that you can make it as passive as you want to make it. Most people don’t realize this because they don’t ever get past the fear that you’ll get called in the middle of the night for a leaky toilet!
Syndications
What it is:
A syndication is when you pool your money with other investors to purchase an investment property. This could be for a short-term flip project, new construction, or a longer-term hold. For the rest of this article, we’ll focus on long-term holds of multifamily properties. Multifamily properties are residential apartments and typically range in the 100-200 unit range.
Syndications are created by general partners, also known as deal sponsors, who do the bulk of the work. They find the deal, obtain financing, sign for the loan, and hire a property manager. In return, they get paid for their work. This comes in the form of fees and a percentage of the profit when they sell the property. Typically a multifamily syndication is held between 2-10 years, depending on the market and how much profit can be made at the time of sale.
Ways you can be involved:
You can be involved in a syndication as a passive investor (i.e., limited partner or LP) or in a sponsorship role (i.e., general partner or GP).
As a passive investor, you contribute a small portion of the initial investment needed to acquire the property, usually $50,000 or $100,000. From there, you sit back and collect a portion of the cashflow over time as well as a portion of the appreciation (if there is any) at the time of sale.
The return from investing passively in a syndication can vary, but a typical return is two times equity multiple in 5 years. This means that your money doubles in 5 years. So if you invest $100,000 in a syndication, you’ll get your original investment back plus another $100,000..
To invest passively in a syndication, you must be an accredited investor, meaning that you have a net worth of over $1 million dollars or an income of greater than $200,000 per year (or $300,000 if combined with a spouse’s income).
As a syndication sponsor, you are leading both the day-to-day management as well as investor relations. Being a general partner in a syndication may sound like a daunting task, but it can be juggled while working a full-time job.
What do the earnings look like for a deal sponsor? We covered this in detail before, but in short, the earnings can be very substantial. For example, leading one syndication can easily net you over a million dollars. The returns that you can see as a GP can rival those of owning your own cashflowing rental. However, on a percentage basis, it’s probably less because of the money you owe the limited partners who invest in your deal.
What are the strengths/weaknesses of this type of investing?
As a passive investor, the main strength of being part of syndication is the fact that it is considerably more passive. However, the truth of the matter is that it’s not completely passive because in order to do it right, you need to vet the deals and review their performance over time. When a deal closes and you get your payout, you need to quickly find another deal to redeploy the money you just earned. The other main benefit of investing passively in syndications is that you get to leverage the expertise of your syndicators to lower your risk (assuming that you’ve vetted them well!). You also get to learn something about how real estate investing works if you follow the investment closely.
However, the main weakness of this type of investing is the far lower returns compared to active real estate investing. We did an internal analysis and found that the difference in returns is easily over 10 times. So for each dollar you make, the general partner is making well over ten dollars. This is why we see many passive investors shift over to owning their own rentals down the road.
Another downside to being a passive investor is that your real estate activity is considered passive, so you only get passive tax losses, which are not nearly as useful as active losses. Only active losses offset active W2 or 1099 income.
Other Options: Crowdfunding and REITs (Real Estate Investment Trust)
What they are:
Crowdfunding and REITs are the most passive on the spectrum of real estate investing options. Consequently, they offer the lowest returns.
Investing in crowdfunding is similar to being a passive investor in syndications. You contribute funds towards the purchase of a larger property or towards the loan on a larger property and you get paid in return for your investment (assuming that the deal goes well). Most of the time, you must be an accredited investor to participate in crowdfunding.
Traditional REITs are companies that own real estate portfolios and are traded on the public exchange. Crowdfunded REITs are not traded on the exchange, but are funded privately instead. As an investor in a REIT, you own shares, so the initial investment can be much smaller than with any of the other options we’ve covered.
What are the strengths/weaknesses of this type of investing?
The major downside of both of these options is the lack of control, tax benefits, and lower returns. The upside is that they don’t require as much money upfront compared to syndications or direct ownership.
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So which is the best option for you?
If your goal is to get to financial freedom as fast as possible (we call this Fast FIRE), active real estate investing will get you there faster because of the superior returns and tax benefits.
If your goal is to do minimal work but gain some basic knowledge of real estate investing, then passively investing in syndications, REITs, or crowdfunding may be the right fit for you.
As your financial situation and goals change over time, you may find yourself switching roles too. If you do decide to make that jump to active investing, be sure to read this article to learn how to get started in real estate investing.
Do you want to learn how to creatively fund your real estate portfolio and achieve financial freedom? Join the conversation! Follow our Semi-Retired MD Facebook page and join our Physicians (for MDs or DOs only) or Professionals group!
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