I’ve invested both actively and passively in real estate. I owned 15 rental properties by myself and another dozen with partners. Today, I own smaller percentages in around 5,000 units.
By “passive real estate investing,” I don’t just mean syndications, by the way. I also invest via private partnerships, private secured notes, and the occasional fund.
Both strategies have their pros and cons. But which one will help you build wealth faster? What are the risks and returns? What kind of labor and skill are required for each?
I went from a net worth of just over $100,000 in late 2018 to over $1 million today. Real estate played a role in that, which I’ll also explain in more detail.
Returns
Any conversation around the speed of wealth-building starts with returns.
Single-family home investor Chris Bibey made a case on BiggerPockets that investors should aim for a 6% yield on rental properties. That sounds about right, plus a potential 3%-5% annualized appreciation rate. Combined, that makes for about a 10% annual return, not accounting for your labor (more on that later).
That’s not bad, in raw numbers. It’s comparable to the historical average stock market return of around 10% for the S&P 500. And while you can earn similar returns passively from REITs, you don’t get the diversification benefit, since REITs correlate so closely with the stock market at large.
Most passive real estate investments target annualized returns in the 10%-20% range. Some will underperform that, while others will overperform it. I practice dollar-cost averaging with my real estate investments, investing $5K-$10K a month in new passive investments through a co-investing club. Over time, my returns form a bell curve, rather than unpredictable data points from huge investments.
Some passive investments are income-oriented, others growth-oriented, and others combine both. I’ve made some investments that only pay income returns, such as a secured note paying 15% and a fund that pays a 16% distribution yield every quarter. Other investments don’t pay any income, but project hefty profits when the properties sell.
Still others pay a 4%-10% yield currently and aim for another 5%-12% (annualized) when the property sells.
Risk
“Yeah, that’s great and all, Brian, but what about risk?”
Different risks apply to active versus passive real estate investments. Both come with the following risks:
- Market risk: Property values and rents can drop, and vacancies and rent defaults can rise.
- Management risk: Whoever manages the property can do a poor job—and that goes doubly if you’re the one managing it.
- Expense risk: After buying a property, the investor discovers more repairs needed than expected. Or expenses like insurance or property taxes could rise faster than expected.
- Debt risk: Short-term loans could come due at a bad time for selling or refinancing, or variable interest loans could jack up monthly payments.
- Risk of total losses: If your equity in the deal is 15% and the property drops 15% in value, you can lose 100% of your capital.
Active investments come with their own unique risks:
- Loan liability: If you default on the mortgage, the lender comes after your personal assets (assuming a recourse loan, which most are)
- Legal liability: Tenants, neighbors, contractors, and anyone else under the sun can sue you at any time, for any reason. I was sued twice when I was an active landlord, and both times, they named me personally in the suit even though I owned the properties under LLC names. Don’t think that LLCs will protect you.
- Tax risk: You have to track all income and expenses, keep records, and report them accurately on your tax returns. Mess this up, and the IRS can come after you for civil or even criminal penalties.
And of course, passive investments have their own risks:
- Operator risk: The operator could mismanage the deal due to either incompetence or untrustworthiness.
- Timeline risk: Passive investors have no control over when operators choose to sell or refinance and return their capital.
Skill Required
Having done both, I can tell you hands down that active investing requires far more skill than passive investing, as in, an order of magnitude more.
Active investors need to master dozens of microskills to consistently earn 5%-10% annualized returns on their rentals, such as:
- Forecasting cash flow (it’s not the rent minus the mortgage!)
- Forecasting repair costs
- Building a “financing toolkit” of different lenders and loan types
- Screening, hiring, and managing contractors (a consistent challenge even for the best investors)
- Marketing vacant units
- Screening tenants
- Managing property managers, if you outsource.
And there are plenty of others.
Passive investors only need to learn how to vet operators and deals. And even then, they can lean on other investors to help them. My co-investing club meets once or twice a month on a Zoom call to vet new passive investments. We all grill the operator together about their track record, their mistakes, their current deal, the underwriting assumptions, and the risks and returns.
It takes years to master all the skills of active investing. You can get started with passive investing in an afternoon, especially if you join a community that vets deals together.
Labor Required
When I owned rental properties directly, my phone was always blowing up about something. The tenants clogged the toilet. The roof started leaking. Rent didn’t arrive, and I had to go through the tedious eviction process: the official warning notice, the waiting period, filing in rent court, showing up for the hearing, scheduling the eviction date with the sheriff, showing up with contractors, etc.
I kept folder after folder of expense and income records. And I still missed some of the expenses I could have deducted.
Buying properties also requires enormous work, including:
- Direct mail or other marketing campaigns to find good deals
- Walking through properties
- “Selling” the seller on selling to me
- Negotiating price
- Collecting quotes from contractors
- Arranging financing
And renovations? Fuhget about it. Contractors constantly blew their budget and their timeline, with shoddier-than-promised workmanship. City inspectors expected bribes. Everything about it was just miserable.
Everyone I worked with, from contractors to renters to property managers, overpromised and underdelivered.
In passive investments, I spend a couple of hours vetting the deal. The end.
Over the course of a year, each active rental property costs me around 30 hours between managing property managers, contractors, bookkeeping, accounting, etc. If I value my time at $100/hour, that’s $3,000 a year in my labor costs—per rental property.
Cash Required
A typical rental property requires $50,000 to $100,000 in cash. That goes toward the down payment, closing costs, initial repairs, permits, and so forth.
If you invest by yourself, a typical passive investment also requires $50,000 to $100,000.
I don’t like that. It’s hard to diversify your portfolio when you have to plunk down $50K per investment. And it’s nearly impossible to practice dollar-cost averaging. You’d have to be fabulously wealthy to invest $50K a month.
So? I don’t invest by myself. I go in on these investments alongside other members of my co-investing club. We invest $2,500 or $5,000 or more if we prefer, but collectively we’ll invest $500,000 or $750,000 or whatever the total ends up being.
That comes with an added benefit: negotiating power. We can negotiate a higher preferred return, a higher profit split, or a higher interest rate on a note investment.
Time Commitment
I know plenty of real estate investors who crave control over all else. They won’t invest passively. They refuse to surrender control.
They get to choose when they refinance or sell their properties. But if it’s a bad market for refinancing or selling, you shouldn’t do it anyway.
I’ve made passive investments as short as six months (a private note with a rolling six-month term). I’ve made others as long as 10+ years (syndications pursuing “infinite returns”).
For private notes and funds, you know the exact time commitment going into the investment. For private partnerships, you can negotiate the timeline before investing. Syndications will indicate the intended timeline while acknowledging “we’ll play it by ear based on market conditions at the time.”
Tax Benefits
For private notes, you get no tax benefits. The government taxes interest income at the same rates as regular income.
For private partnerships and syndications, you get virtually the same tax benefits as direct ownership. All expenses are deductible, as is depreciation.
There are two slight differences. Most single-family rental investors don’t bother doing a cost segregation study because it typically costs more than the tax savings. So they don’t get the same accelerated depreciation as syndication investors.
On the flip side, single-family rental investors get a little more leeway in using their passive losses to offset active income. If they “actively participate in passive rental real estate activity,” per the IRS, they can use rental losses to offset up to $25,000 of active income.
But by and large, you get the same tax benefits from passive and active real estate investing.
Verdict: Speed to Wealth?
I run a business, and I do some freelance financial writing on the side. And I have a 5-year-old daughter, a wife who works nights and weekends, and I’m writing a novel.
I don’t have time for another side hustle. And make no mistake: Rental investing is a side business.
I’ve known active investors who have built wealth relatively quickly with a rental investing business. Most of them did it as a full-time business, although some did it as a side business.
I went a different route. I went from barely over broke in late 2018 to a millionaire seven years later, without any rentals in that period. I invest passively in both stocks and real estate as a set-it-and-forget-it portfolio.
Some of those passive real estate investments generate a high income yield in the 10%-16% range. I reinvest that income for compound returns.
Some have gone full cycle, most recently an industrial property that paid out a 27.6% annualized return after two and a half years.
Most are simply in progress, paying a 4%-8% yield as they stabilize rents.
It takes a long time to build the skills you need to consistently earn decent returns on rentals. Most people either stand on the sidelines in analysis paralysis for years or just jump in headfirst and lose their shirt by not getting enough education.
I propose an alternative route: joining a co-investing club to start investing today, while leveraging the community’s knowledge. You don’t need much cash ($2,500) to get started, and you can start earning returns immediately.
Prefer to start a rental investing business? It’s a great business model. Just don’t try to tell me it’s “passive income” or compare it to true passive investments like stocks, syndications, or notes, because it’s not. It takes more skill, labor, money, and time to get started.
