It’s commonly known that it’s a good idea to distribute your investments across a range of opportunities in order to minimize your overall risk. For many, this means spreading their portfolio across common equity and debt instruments like those available through a stock broker. However, this can still leave you subject to exposure to macro-market trends. Diversifying further into real estate as an asset class can have many advantages with respect to managing risk and return.
In this article, we look at active vs passive real estate investing and understand the pros and cons of each approach.
Active real estate investing is what many people think of when they think of real estate investing. You directly own a property or properties with the intention of collecting rents and gaining equity. This can have many advantages, one of which is the ability to use leverage (debt) for the purchase. With real estate, you can get loans secured by the property (mortgages) to make the acquisition, meaning that you’re tying up less cash in a deal or you’re gaining control of a property that might be valued at more than you can pay in cash yourself. There are tax advantages available in real estate investing that aren’t available with other investments. You get the satisfaction of owning real property and it’s possible that you might increase the value of your property through sweat equity.
It’s quite often the case however that the downside of being a landlord isn’t fully understood until you are one yourself. It’s possible that you might think of owning your own investment real estate as a ‘passive’ investment, but the truth is that being a landlord is quite an active endeavor.
In a smaller real estate investment, you actually have a form of concentration risk. The income is predicated on the number of tenants that you have. In a two or three-unit apartment, the loss of one tenant can make a significant impact on cash flow. Lumpy and inconsistent cash flows impact the IRR (link to KPIs article) that you projected, and you often don’t get what you projected in your spreadsheets. Remember that debt is often used to acquire real estate. If your property has an issue and cash flow isn’t enough to pay your loan, you’re the one that’s on the hook for the debt that you’ve taken on.
Regardless of the size of the property, Do-It-Yourself (or active, or direct) real estate investing also means that someone needs to deal with leasing units, any repair calls, as well as ongoing maintenance and upgrades. This could also involve time-consuming and costly issues related to evictions or dealing with damaged property.
In a passive real estate deal, you’re one of a number of investors in any given deal. By pooling investment resources with professionals, you gain a number of advantages. While you’re still diversifying some of your investments away from traditional stocks and bonds, you’re not taking on some of the risks associated with owning a property or properties yourself. An obvious advantage is that you’re no longer on the hook for 3 AM plumbing calls or dealing with getting roofing estimates.
Scale - with a pooled investment model, you have access to much larger deals. A 400-unit apartment complex might turn over a unit per day, which on a percentage of overall rental income is small, vs a three-unit apartment that could have a unit or more sitting empty for a while. The cost of capital for large-scale deals also tends to be lower as financing entities understand the lower overall risk involved. We’re also able to create new deals (e.g. new developments) at a scale that most individual investors simply can’t.
Access - professional real estate investment firms like JLAM are known counterparties in the areas where we operate, so we often get a first or last look at larger deals as they’re coming on the market… and often are able to negotiate better terms given our reputation for closing transactions.
Lower Opportunity Costs - if you are considering diversifying your portfolio by using real estate investments, you likely have a sizable net worth. You probably used your expertise in a certain field to succeed. A question to ask yourself is: “Where is my time best spent?” Can I produce more value by investing my time in what I’m good at and turning to a team of real estate experts to handle my real estate investing?
Better Risk Management - if you buy a three-unit building, you’re probably signing personally on the loan - exposing yourself to personal recourse. Whereas, if you allocate $500K with a real estate investment group, the group is responsible for the debt and your exposure is typically capped at the capital that you committed. In addition, larger properties diversify rents over a much larger number of units as mentioned above.
In closing, just as you wouldn’t go to your mechanic to select a stock, or go to a doctor for legal advice, you can take advantage of the compelling risk-adjusted return opportunities in the real estate investment sector by selecting an experienced, trusted, and reputable partner. Savvy investors choose JLAM to provide them with exposure to a carefully selected set of passive real estate investing options.