Investing in Real Estate - Active or Passive?

INVESTING IN REAL ESTATE - ACTIVE OR PASSIVE?

by Don H Konipol

Many investors are turned off by real estate because they do not have the time or inclination to become

landlords and property managers, both of which are in fact, a career in themselves. If the investor is a

rehabber or wholesaler, real estate becomes more of a business rather than an investment. Many successful

real estate “investors” are actually real estate “operators” in the real estate business. Fortunately, there are

other ways for passive investors to enjoy many of the secure and inflation proof benefits of real estate

investing without the hassle.

Active participation in real estate investing has many advantages. Middlemen fees, charged by

syndicators, brokers, property managers and asset managers can be eliminated, possibly resulting in a

higher rate of return. Further, you as the investor make all decisions; for better or worse the bottom line

responsibility is yours. Also, the active, direct investor can make the decision to sell whenever he wants

out (assuming that a market exists for his property at a price sufficient to pay off all liens and

encumbrances).

Passive investment in real estate is the flip side of the coin, offering many advantages of its own. Property

or mortgage assets are selected by professional real estate investment managers, who spent full time

investing, analyzing and managing real property. Often, these professionals can negotiate lower prices than

you would be able to on your own. Additionally, when a number of individual investor’s money is pooled,

the passive investor is able to own a share of property much larger, safer, more profitable, and of a better

investment class than the active investor operating with much less capital.

Most real estate is purchased with a mortgage note for a large part of the purchase price. While the use of

leverage has many advantages, the individual investor would most likely have to personally guarantee the

note, putting his other assets at risk. As a passive investor, the limited partner or owner of shares in a Real

Estate Investment Trust would have no liability exposure over the amount of original investment.

The direct, active investor would likely be unable to diversify his portfolio of properties. With ownership

only 2, 3 or 4 properties the investor’s capital can be easily damaged or wiped out by an isolated problem

at only one of his properties. The passive investor would likely own a small share of a large diversified

portfolio of properties, thereby lowering risk significantly through diversification. With portfolios of 20,

30 or more properties, the problems of any one or two will not significantly hurt the performance of the

portfolio as a whole.

Types of Passive Real Estate Investments

REITs

Real Estate Investment Trusts are companies that own, manage and operate income producing real

estate. They are organized so that the income produced is taxed only once, at the investor level. By law,

REITs must pay at least 90% of their net income as dividends to their shareholders. Hence REITs are

high yield vehicles that also offer a chance for capital appreciation. There are currently about 180

publicly traded REITs whose shares are listed on the NYSE, ASE or NASDAQ. REITS specialize by

property type (apartments, office buildings, malls, warehouses, hotels, etc.) and by region. Investors

can expect dividend yields in the 5-9 % range, ownership in high quality real property, professional

management, and a decent chance for long term capital appreciation.

Real Estate Mutual Funds

There are over 100 Real Estate Mutual Funds. Most invest in a select portfolio of REITs. Others invest

in both REITs and other publicly traded companies involved in real estate ownership and real estate

development. Real estate mutual funds offer diversification, professional management and high

dividend yields. Unfortunately, the investor ends up paying two levels of management fees and

expenses; one set of fees to the REIT management and an additional management fee of 1-2% to the

manager of the mutual fund.

Real Estate Limited Partnerships

Limited Partnerships are a way to invest in real estate, without incurring a liability beyond the amount

of your investment. However, an investor is still able to enjoy the benefits of appreciation and tax

deductions for the total value of the property. LPs can be used by landlords and developers to buy,

build or rehabilitate rental housing projects using other people’s money. Because of the high degree of

risk involved, investors in Real Estate Limited Partnerships expect to earn 15% + annually on their

invested capital.

Real Estate Limited Partnerships allow centralization of management, through the general partner.

They allow sponsors/developers to maintain control of their projects while raising new equity. The

terms of the partnership agreement, governing the on-going relationship, are set jointly by the general

and limited partner(s). Once the partnership is established, the general partner makes all day to day

operating decisions. Limited partner(s) may only take drastic action if the general partner defaults on

the terms of the partnership agreement or is grossly negligent, events that can lead to removal of the

general partner. The LPs come in all shapes and sizes, some are public funds with thousands of limited

partners, others are private funds with as few as 3 or 4 friends investing $25,000 each.