The Beginner’s Guide To Passive Real Estate Investments

Passive real estate investment

Even if you’re new to real estate investing, you’ve probably seen the success stories touted on social media. Real estate entrepreneurs with private jets boasting a glamorous lifestyle and “guaranteed returns.” Newbie investors extolling the virtues of “mailbox money,” passive income that flows in with minimal effort.

Over the last decade, the SEC has loosened restrictions on crowdfunding real estate deals, giving non-accredited investors access to deals that were previously only available to accredited investors. The upside of this change is that it opened up new real estate opportunities, within certain limitations, for the average investor. The downside is that the average investor often goes into these deals with rose-colored glasses, believing the hype of a surefire success without understanding the fine print or the real risks involved — until the company folds abruptly and the phone number is discontinued.

There are many paths within real estate investing, all with their risks and rewards. Some offer great potential for steady wealth building, but remember: those that seem too good to be true probably are. If you’re thinking about getting your feet wet in passive real estate investments — including REITs, crowdfunding and syndications — here are some important steps to take and factors to consider before you hand over a check.

Three Popular Types Of Passive Real Estate Investing

In an active real estate investment, you take a hands-on role in purchasing a property, usually renting it out for ongoing income or selling it for a profit. According to the IRS definition, an active investor spends 750 hours per year working in the real estate industry and can offset income with passive losses.

A passive real estate investment requires much less involvement once you research and select a deal, but it doesn’t grant the same tax benefits. Three popular types of passive investing are:

• REITs: Buying shares of real estate investment trusts, companies that own income-producing properties, on the stock market

• Crowdfunding: Using a crowdfunding website to pool your money with other investors (most have minimum requirements, some starting around $500) to purchase properties or fund development projects

• Syndications: Pooling your money with other investors as a limited partner to invest in properties acquired and managed by a sponsor

I believe that REITs are often a good starting point for new real estate investors. REITs are legally required to distribute at least 90% of their taxable income as dividends to shareholders. They generally offer good diversification of asset classes, geography and property portfolio, providing liquidity and long-term growth, which can balance out their occasional short-term underperformance. Crowdfunding and syndication deals may promise higher rewards, but they are more difficult to understand and can carry much higher risks. Do your homework to avoid getting burned by a bad deal.

1. Don’t be afraid to ask questions.

Treat a real estate deal like any other investment. Don’t assume anything, do your own due diligence and read every contract and pro forma carefully. If possible, have a real estate attorney read documentation before making a financial commitment. Ask the sponsor a lot of questions, such as:

• Why did you choose this specific property and market?

• What experience do you have with similar projects? What were your results? In what timeframe?

• What is your strategy for this project? How will you execute it?

• How is the deal structured? Who is managing it? What does the debt look like?

• What are the projected returns? In what timeframe? What are these numbers based on?

• What are all the fees that investors are responsible for (acquisition, management, asset management, broker, construction, exit fees, success fees, etc.)?

• Is there a preferred return?

• What is the “net” split of returns after fees?

• Are there risks of capital calls?

• Are there dividends (yearly payouts), or are profits dependent on a final sale?

• Are these terms “market”?

2. Look at best- and worst-case scenarios. 

No one has a crystal ball, so take all projections with a grain of salt. Whoever is pitching the investment wants to show you the best-case scenario, if you achieve X% rent growth or Y% internal rate of return within Z years. But what if the market takes an unexpected dip? What if an unforeseen event, like the pandemic, upends these projections?

Look at projections with clear eyes and calculate more conservative estimates. If nothing goes as planned, what’s the worst-case scenario? What does that mean for your investment? What about rising costs, like insurance, building repair costs or property tax increases?

3. Vet the sponsor. 

Know who is acquiring and managing the project, and examine their track record. Ask for references, and speak with other investors who have worked with them on comparable projects.

Compare apples to apples. If they bought a multifamily property in Denver, renovated all of its units to add value and resold the building for healthy returns, and they are pitching a similar project in the same area, managed by the same team, that’s a good sign. If they want to take on a completely different property type or move from Denver to Kansas City, it’s no longer a fair comparison.

What’s their plan for this property? Understand why they chose this one in particular. Is it a great deal or an off-market opportunity? Do they have a value-add approach in mind, or do they simply hope they can sell it for more than the purchase price? What economies of scale do they have in place? Are they investing in the deal themselves?

Is there a short fuse on investing in the opportunity, or competition for your space? Don’t be afraid to say “no.” If the sponsor is truly in this space, there should be similar opportunities in the future. This isn’t a clearance sale on a vacuum cleaner; this is a real investment.

Passive real estate investments can enhance your overall financial portfolio, but only if you approach them with a healthy dose of caution. When you have thoroughly vetted a deal and a sponsor, you can move forward with confidence.

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