Active vs Passive Real Estate Investing - What's The Difference?

Being a landlord isn't for everyone. It requires constant work on your property to protect it from damage. In fact, most landlords would rather have a tenant pay rent late rather than have the tenant damage the property, which explains just how costly it can be when a renter destroys a rental home. Take a moment to consider the time and cost of drywall, electrical, plumbing, or HVAC problems because of one negligent or malicious tenant.

Additionally, as a landlord, you can expect to spend time locating and qualifying tenants, which can be challenging, especially in a renter’s market. Let's face it. Some people don't want to deal with applicants who have criminal records, low credit scores, or evictions on their credit reports. Being a landlord makes real estate an active investment. But what if you prefer to grow your money passively?

In this case, passive real estate investing is one way to build wealth without the hassle of tenants, property damage, or vacancies. Here's what you should know about active vs passive real estate investing. What's the difference? Let's jump right in.

What's an Active Investor?

What's the first thing that comes to mind when you hear the words "real estate investor"? If you're like most people, you probably think about an individual that purchases single-family properties, locates renters, and collects rent checks.

This description of a landlord only explains part of the activities these investors complete day-to-day. Being a real estate investor requires a lot more hands-on work and is less about sitting back while rent checks pile up.

Because landlords can receive calls from tenants at 2:00 am about a burst pipe, you can consider renting and managing rental properties to be the actions of an active investor. There's always something a landlord should be doing, even when they employ help from a professional property management team.

Sure, the property managers can respond to problems with tenants as they arise and sometimes even prevent more significant property issues from occurring. But the landlord still has the final say on which tenants to evict and to file insurance claims. Plus, investors regularly pay out of pocket to cover surprise maintenance and repair expenses that often occur in older rental properties.

Now that you understand how real estate investing can play an active role let's discuss investing in real estate passively. If the thought of tenants, toilets, and termites doesn't excite you, perhaps being a passive investor will.

What's a Passive Investor?

Being a passive real estate investor is for people who look at real estate as a long-term game. Some people flip properties by purchasing an affordable home that needs work, making improvements, and selling for a profit. Yet, investing in fixer-uppers is incredibly active and comes with significant risks for new investors.

On the other hand, passive investors set and forget their investment, hoping to generate positive returns, and rarely move their money to different securities. Simply investing your money with a team of real estate professionals with experience managing successful properties can grow your money passively, without the hassle of managing buildings and tenants yourself.

And if you prefer for others to actively manage your investment portfolio while building your wealth, then you'll enjoy being a passive investor in a real estate syndication deal. However, it isn't for everyone, especially if you prefer taking a hands-on approach to real estate investing. As a passive investor, you give up control to your Sponsor, who organizes the deal and executes the real estate syndication business plan.

So, if you're comfortable relinquishing control, allowing a team of professionals to manage a property on your behalf, and taking a hands-off approach to real estate investing, then being a passive investor might be right for you. But what are some other ways to determine whether active or passive investing is best for you and your family?

Should You Be An Active or Passive Investor? Here's How To Tell

Several signs can help you decide whether to be an active or passive investor. Here are some main points to consider while choosing:

The Truth About Being a Landlord

As you can tell, being a landlord is a lot of work. A majority of investors live within 20 miles of their investment homes, for a good reason. Even one investment property requires ongoing maintenance. Your tenant can call about a major issue at any time, which could require immediate repair.

Additionally, there are more protections for tenants in some states than there are landlords, and one bad tenant can be devastating to a small-time landlord. Consider COVID-19's federal protections for tenants who cannot pay their rent due to job loss or lost hours. Small-time landlords take a significant risk since one renter being unable to pay can mean foreclosure.

Participating in a large-scale syndication deal mitigates risk, as one tenant being unable to pay rent will likely not impact a well-formulated commercial agreement. Therefore, there are different benefits and risks to being either an active or passive real estate investor.

Time Obligations for Active and Passive Investors

As an active real estate investor, you make all the decisions. Therefore a successful deal relies on how hard you work. You'll find the right property, locate tenants, complete repairs, and price to earn a fair-market rent. Since most of these tasks are ongoing, your work as a landlord never ends.

Conversely, becoming a passive investor requires more up-front work but less work after the syndication group completes the deal. During the research phase, you'll conduct your due diligence to determine if the syndication group has the right property and a solid team that can bring the deal together.

As a passive investor, your ongoing work will collect checks and review your taxes at year's end. The syndication team completes the day-to-day maintenance tasks and works with tenants on behalf of the investors. Therefore, becoming a passive investor is best for those who are too busy to manage a rental property by themselves.

Let's Get Real About Profits

As an active investor, you keep all the net profits from your investment properties. If your rental rate covers maintenance costs, property management, taxes, and insurance, then what's leftover is net profit. Plus, because of appreciation and paying down the principal of your mortgage each month, you might earn additional profits once you sell your property.

Passive deals, however, have different structures where everyone earns their portion of profits. The Sponsor, who organizes the deal, invests anywhere from 5 to 20%, while investors fund the remaining amount of the total. In return, the Sponsor and passive investors earn payments from rental income once the investment matures and earn greater profits once the property sells.

Instead of being liable for financing one or several single-family homes, passive investors in real estate syndication deals can expect average annual returns, generally between 5 and 10 percent on the investment amount. Investors receive profits as a preferred return, which pays out before a Sponsor gets their share of profit from managing and promoting the deal.

Because these two investment strategies differ enormously, there's no way to determine whether one method will lead to higher returns than another. Instead, investors must compare each deal individually while deciding which one makes more sense for them.

Consider Expenses for Active vs Passive Investors

Landlords in most states handle repairs and insurance claims for their properties. However, some repairs are incredibly costly, especially if an insurance company considers the damage normal wear and tear. In this event, investors should expect to pay expenses out of pocket throughout the time they own their property.

Conversely, passive investors make an initial investment and receive payouts after a maturity period. The maturity period of a syndication deal can take anywhere from a few months to several years. During this time, the Sponsor and their team will work to make the deal profitable.

Even during the maturity period, investors will never make additional capital investments for property expenses. Instead, they invest their initial capital and earn rental income until the property sells.

Personal Liability and Other Property Investing Risks

Depending on how you structure your deal as an active investor, one wrong incident at your rental property could put your other assets in danger. If you don't hold your property in a limited liability company (LLC) or a corporation, then you'll be personally liable for your real estate investment business.

On the other hand, with a group real estate investment deal, the Sponsor is liable for the agreement. And even then, most syndicates form an LLC or limited partnership, which protects passive investors from being personally responsible for business debts. Thus, passive investors are only liable for the amount they invest.

Your Investing Team Matters

Building a team to support your active real estate investing strategy is vital. You'll need to locate reliable team members that include an attorney, accountant, property managers, contractors, and real estate salespeople. Their expertise can help you whenever you have a question or need assistance managing your rental properties.

However, as a passive investor, your Sponsor's team is your investment team. Your Sponsor's connection with commercial real estate agents, a network of contractors, and property managers will be available for your syndication deal. Therefore, you don't need to struggle to find reliable people to join your team since your Sponsor is already prepared with a group that can complete a deal and manages the property.

How Well Do You Know Your Investment Area?

Yet, your ability to build a knowledgeable and experienced team isn't the only prerequisite to being a successful active investor. You'll also need local knowledge of your area, the overall market, and real estate as an asset class. You must understand where you're purchasing investment properties, significantly if you're investing outside your local area. The best active investors experience the neighborhoods they have properties in, visit at different hours to ensure that it's a good location, and always understand the area they're investing in.

However, these are not significant concerns for passive investors since the Sponsor, and the Sponsor's team does background research on every area before conducting a deal. They use local expertise from real estate professionals to find bargains for passive investors who can diversify their real estate investments throughout the nation, rather than focusing solely on deals within a local area. By working with a team, you can take advantage of their local expertise and existing connections.

Doing Taxes as an Active vs Passive Investor

Another factor to consider while deciding between being an active vs passive investor is how you pay taxes. Active investors must complete their bookkeeping and stay ahead of IRS payments. Typically, they'll work with a CPA to ensure they're following all real estate tax rules and depreciating their property values each year.

Passive investors have a lot less to worry about during tax season, as there's no bookkeeping to do for their real estate syndication deals. Instead, Sponsors send out Tax Form K-1, which shows the income, expenses, and losses for passive investor's real estate property. All the hard work is taken care of for passive investors without needing ongoing bookkeeping services.

In Conclusion, is Active or Passive Investing Right for You?

Overall, there are many pros and cons to being either a passive or active investor. If you prefer to stay hands-on, you'll perhaps enjoy being an active investor who controls all your investment properties. Or maybe, being hands-off is more your style, and you don't mind giving up control of an investment to achieve a more significant deal and receive an annual return on investment. There’s not a right way or a wrong way, since it depends on your preferences and investment strategy on a deal-by-deal basis.

And those who want to diversify their portfolios have the option of maintaining a local portfolio while investing in syndication deals in other neighborhoods. It's an incredible way to grow your wealth long-term while building a team that manages large commercial properties on your behalf.