The Ultimate Guide to Passive Real Estate Investing

Imagine –

You’ve been traveling Europe for the past several months and while you enjoy living like the Parisians or the Italians, your bank account receives regular automatic payments from your passive real estate investments.

You check your account to make sure you received your distributions and maybe occasionally check in on your investment in the form of reading a quarterly report. Once a year you receive an email with your annual K1 tax document, and the real work begins. You forward your K1 to your CPA/tax professional and proceed to pop a bottle of Dom to celebrate a hard day’s work.

Now, imagine you are off in Europe and you receive another email. It turns out that the $40k house located in a supposedly “up and coming, gentrifying neighborhood” located in a Midwestern market you’ve never been to has some major issues. It was sold to you and managed by a turn key company you found on the internet and you’re now just finding out the property isn’t what you thought it was.

In fact, it’s much worse. The city has thrown a half dozen violations at you personally, some of which are serious since your manager went ahead and leased the house even though it was not habitable. Your renter moves out after living in horrendous conditions. You feel bad, and duped. The payments stop and you have to start writing checks to begin to dig yourself out of a hole. Now your turnkey provider is MIA as they’re being sued by other investors and it is rumored that they have fled to Portugal. Time to cut the trip short, roll up your sleeves and call your attorney and start looking for a contractor, manager and begin to do everything you were trying to avoid. Not exactly one’s idea of “passive investing.”  

Each of these examples can be true. Both illustrate that there are many shades of passivity when choosing how to invest in real estate with some strategies not being passive at all. There’s not one “right” investment vehicle, as every investor has their own preferences in regard to style, strategy, need for control, level of participation required and time available.

Many investors want to invest in real estate but simply don’t have the time. Whether they are busy professionals, retired, or not interested in the potential headaches, there are a variety of ways to invest without doing all (sometimes very little) of the work.

Let’s break down all the options.

We’ve arranged this list (14 strategies) in a relative order from most “passive” to least. We broke them down into two main categories: passive, and semi-passive. We also include some semi active and full time investing strategies and the businesses that go along with them. Below is an index if you want to jump ahead.

• Passive
  • REITs
  • Crowdfunding
  • Private Real Estate Funds
  • Single Asset Syndication
  • Performing Notes

• Semi Passive
  • Non-performing notes
  • Turn-Key
  • Guarantor / KP
  • Hard Money lender
  • Capital Raiser
  • Direct Owner Operator (SFR, small multi, NNN)

But first, let’s make it clear that there is no such thing as a totally passive investment. Even buying an S&P500 index fund still requires choosing a broker, setting your allocation strategy, choosing when to buy and when to sell, and understanding and dealing with any tax consequences. So, while there’s no totally passive investment, some investments require less work than others and it often comes down to how you value your time and how much time you have available.

 “Passive”  

These are some strategies that have the potential to be as passive as possible. Each requires some initial work up front, mostly in the form of conducting due diligence on the firm, strategy and investment vehicle. Additionally, like all investments, it’s up to the investor to monitor their investments’ performance by reading reports and asking questions. There’s also the step of deciding if one will invest as an individual, through an entity like an LLC, via a retirement account, a trust, etc.

1 – REITs

Real Estate Investment Trusts (REIT) were created by the IRS in 1960 to make it easier for the public to invest in companies whose primary purpose is to buy, hold, and sell real estate assets.

Most REITs invest capital in the form of equity into commercial real estate, others invest in real estate mortgages while others utilize a hybrid strategy of both debt and equity. Some REITs specialize in a particular asset class, strategy or market, while others are more diversified or agnostic. By charter, REITs must distribute 90% of their earnings to shareholders in the form of dividends. These dividends are taxed as ordinary income and do not pass on any tax benefits such as depreciation.

Publicly traded REITs can be bought and sold at exchanges such as the NYSE and are available to the general public and offer maximum liquidity. These paper assets are also more correlated to the overall public stock market compared to the private real estate market. This can lead to volatile swings in the valuation of the underlying stock – regardless if the properties themselves are performing.

Public non-traded REITs offer less liquidity than traded REITs but have less public market correlation.

Private REITs are the least liquid and are mostly limited to accredited investors. They also have less correlation to the public markets.

REITs are highly passive with the only active participation taking place in the choosing of a broker to invest through, underwriting the REIT, choosing the REIT(s) that fits one’s strategy, and choosing the preferred time to purchase shares and when to sell.

REITs can serve as an excellent vehicle to achieve exposure to real estate assets for investors who prefer paper assets for liquidity. Investors who aren’t as concerned with paying regular income tax on their dividend payments can use REITs as a hedging tool or to trade markets that are favorable to real assets such as an environment with lowering interest rates. The only element of control an investor has over their REIT investment is their choice when to buy and when to sell.

Advantages to REITs:

• Liquidity – ability to buy and sell positions more easily than most other forms of real estate, especially with publicly traded REITs.
• Diversification – REITs typically own portfolios of many different properties. Some are diversified across multiple markets and asset classes.
• Transparency – Public REITs have similar reporting requirements like other publicly traded securities and provide the public a significant amount of information into the companies activity.

Disadvantages to REITs:

• No tax advantages – unlike other forms of real estate investing that offer a full array of favorable tax treatments, REITs do not offer the same kind of benefits, such as sheltering income via depreciation or taking advantage of like kind exchanges (1031).
• Public market correlation
• Price volatility unrelated to underlying properties

2 – Crowdfunding

Crowdfunding is changing the way investors invest in real estate and how operators raise capital. In 2012 the JOBS act was signed into law that established the rules that allow companies to raise funds and syndicate projects from investors online. Since then, a plethora of portals, platforms and exchanges have emerged offering investors the ability to invest in anything from startups, one off projects, non-profits campaigns, to real estate deals. Many opportunities that were previously only available as private offerings to exclusive networks are now available to the masses because of the internet and crowdfunding.

Several crowdfunding platforms have emerged as dominant players; however, the new concept is not without some high-profile failures, defaults and even scams. The crowdfunding landscape is ever changing with the existing ecosystem allowing investors to invest in real estate through a variety of structures, vehicles, and across all asset classes. Crowdfunded real estate has the potential to offer one of the easiest access points to investors of all levels as they often feature low investment minimums and some Reg CF and A+ securities will allow non-accredited investors.

Crowdfunded offerings can also include, but are not limited to, 506(c) syndications, private real estate funds, eREITs, and more.

Advantage of Crowdfunding:

• Potentially large volume of deal flow
• Ability to diversify across assets classes, operators and markets
• Low minimum investment thresholds
• Some offerings available to non-accredited investors
• Potential tax benefits if structured as partnership

Disadvantages of Crowdfunding:

• Typically higher fees and less favorable terms
• Potential for opaqueness
• Separation between LPs and sponsor
• Some platforms have failed
• Difficult to underwrite sponsors

3- Private Real Estate Funds

Investing in private real estate funds offers an excellent way to achieve a degree of diversification without the additional effort of choosing specific assets. Typically RE Funds are structured as partnerships in the form of an LLC or LP that can offer the full advantages of asset ownership including the tax benefits derived from sharing in the paper losses from writing off depreciation, interest payments and other items.

Funds typically syndicate capital into a partnership entity managed by a sponsor that has some stated investment purpose or strategy. While some funds have specific assets identified for the fund to acquire, others are blind and have no specific assets identified. Blind funds can vary from being very specific, targeting a certain asset class, market, and strategy, while others can be open ended and leave a very wide latitude to the fund sponsor.

The most important task, and the one that requires the most activity for the LP investor, is the due diligence performed on the fund sponsor and the fund itself. It is also important for a fund investor to be sure to only participate in funds that are managed by sponsors with interest aligned with the investor. Not unlike single asset syndications, choosing the right sponsor team paramount. A bad sponsor can ruin a good deal but a great sponsor can turn a bad one around.

Advantages of private real estate funds:

• Diversification that minimizes single asset risk
• Partnership structure allows sharing of tax benefits
• Uncorrelated to public markets
• Variety of strategies and asset classes

Disadvantages of private real estate funds:

• No choice in asset selection
• Potential for opaqueness
• Higher fees than single asset syndication

4 – Single Asset Private Syndication

A real estate syndication is when a sponsor or real estate company aggregates a group of investors and their capital in order to collectively purchase real estate. Usually structured as a partnership in the form of a series of LLCs, this strategy allows investors to participate in the ownership of real estate that they would otherwise not have the ability or desire to do on their own. Syndications are usually assembled by a sponsor company or joint venture that handles the acquisition, management and operations of the asset. By investing in a syndication, a passive investor can leverage the experience of the sponsor and the resources at their disposal.

Private syndications are securities that must file a filing exemption with the SEC in the form of Regulation D 506(b) or 506(c) exemption. Syndications filed under 506(b) may not solicit or advertise the offering to the general public and are limited to accredited investors and 35 non-accredited but “sophisticated” investors. 506(c) offerings may advertise to the general public however they are limited to accredited investors only.

An accredited investor is an individual with an annual income of $200,000 or more, or a married couple with a combined annual income of over $300,00, or an individual or couple with a net worth of over $1,000,000.

A syndicated investment for a limited partner (LP) is passive after one conducts due diligence of a sponsor and after choosing the preferred investment strategy. Unlike private real estate funds, it is up to the investor to determine which assets to invest in in order to build a personal portfolio of real estate assets to avoid single asset risk. The added task of investing into multiple projects adds an element of control that is lost in a fund structure. After identifying a strategy, and a project to invest in, the only task left is to fill out a subscription agreement, and if the offering is a 506(c) exemption, provide accreditation verification. A good sponsor should provide regular updates on the project that include financial statements and other key project updates and highlights.

Advantages of Syndications:

• Partnership structure allows for maximum tax benefits
• Freedom of an investor to build a portfolio from multiple projects vs a fund
• Access to larger, more economical assets vs smaller direct projects
• Lower fees compared to funds
• Ability to scale a tailored investment portfolio of any size
• Leverage experience of sponsor to mitigate risk

Disadvantages of Syndications:

• Single asset risk
• Illiquidity
• 1031 or like-kind exchanges not always possible
• Potential for opaqueness

5 – Performing Notes

When purchasing a performing note, whether it is a first or subordinate position, you are essentially acting as the bank. By purchasing the mortgage associated with a piece of real estate you’ll receive regular payments, assuming the mortgage holder stays current. The mortgage, as a security instrument, is backed by the asset as collateral. Notes can often be purchased at a discount, offering a higher return than the original interest rate.

Alternatively, as an investor you can be the one who initially issues the note and be the bank for whatever terms that can be negotiated with a borrower. We’ve clarified this strategy from being a hard money lender who is usually doing a high volume of notes for shorter terms and charging higher interest.

While there are no toilets to fix in the middle of the night, or other management headaches associated with operating a real estate investment directly, investing in notes on your own requires more time than investing in a fund, direct syndication, or a REIT – although you can invest in notes and other debt instruments though those vehicles. The steps to investing in notes includes finding lenders who have notes to sell, analyzing the borrowers and assets, and managing the debt service from the note. Many of these tasks associated with the maintenance of a note can be automated or delegated and certainly requires less time than direct investments.  

Advantages of Performing Note Investing:

• No operational or management risk or headaches (no toilets to fix)
• Fixed regular passive return
• Asset as collateral in case of default
• Ability to purchase notes at a discount to drive returns

Disadvantages of Performing Note Investing:

• Return limited to fixed interest rate
• Requires systems to make truly passive
• No tax benefits associated with real estate ownership
• Situation can become complicated if borrower fails to preform

“Semi-Passive“

The following are strategies that are more time intensive than the ones above. Some are more of a potential headache, while others require you to be essentially passive but take on more risk which requires additional due diligence and requires the use of legal and professional services.  While some can be very passive, they have the potential to turn into a fully hands on and time-consuming operation if the investments goes south.    

6 – Non-performing Notes

Investing in non-performing notes involves taking possession of a mortgage in which the borrower has become more than 90 days behind on their debt service payments. Banks or lenders that don’t want to deal with the risk of a non-performer, or aren’t interested in the time it will require making the note perform again, will sell the note at a discount in order to remove the asset from their books.

Investors have an opportunity to purchase these notes at a deep discount compared to the remaining principal, therefore having the ability to achieve much higher cash on cash returns – if they can find a solution to the non-payment.  

The preferred method is to do a “work out” with the borrower in which the note buyer simply has a conversation with the borrower to find or negotiate a solution. In some cases, borrowers have given up if their home is underwater and they no longer see a point in making payments. If the note buyer is able to negotiate a new principal amount that is no longer underwater but still provides enough interest to make the investment profitable, a win-win solution can be achieved.

If a workout is not possible, the investor may have to pursue a Deed-In-Lieu, in which the borrower signs over the deed to the note holder. However, any subordinate debt/liens on the property will remain and become due to the note buyer and now property owner.

If there are no junior liens on the property, a short sale can also be conducted where the lien holders/note buyer agree to accept a sale price that will not cover the outstanding principal.

The last option, and most time and resource intensive, is to foreclose on the property. In this case the note holder will take possession of the property.

Advantages of non-performing notes:

• High cash on cash returns if note is made to perform
• Note collateralized by the asset
• Notes can be purchased at deep discounts to original principal
• Opportunity to help borrower maintain ownership via work out

Disadvantage of non-performing notes:

• Time consuming to find solution to make borrower perform or to take possession
• Pursuing foreclosure can be expensive and litigious
• No tax benefits unless asset is taken over via foreclosure

7 – Turn-Key

Everyone loves the idea of directly owning and controlling real estate without all the work of finding deals, buying the property, renovating, leasing, and managing them. For those who want to be an owner of single-family rentals and small multifamily properties without much of the work, turn-key investing can prove to be an excellent quasi passive solution.

Turn-Key investing is when an investor engages the services of a Turn-Key “TK” company to handle almost all aspects of the real estate investing process. The TK will find you a property to buy, sometimes wholesaling it to you or selling you a property they control, renovate the property if needed, lease the property, and handle all management and ongoing maintenance. In theory all one has to do is sign a few documents, maybe attend a closing, monitor progress and collect a check. Typical TK investments are single family rentals, duplexes and small multifamily assets.

If all goes well, turnkey properties can be great passive investments for those who want to directly control their real estate investments without being a full-time landlord.

Unfortunately, not all TK providers are created equal and there have been numerous cases of out of state investors thinking they were buying a straightforward conservative investment when in reality they were sold a problem property with negative cashflow. Investing with the right TK provider can be a good experience, but the wrong one can turn to a passive investment into a time-consuming mess – especially if you are investing remotely.  

Advantages of Turn-Key Investing:

• Direct control and ownership
• Ability to invest remotely
• Potentially very passive if all goes well and all systems are in place
• Professional management

Disadvantages of Turn-Key Investing:

• Provider/operator risk
• High fees, paying “retail”
• Passive activity can turn active if problems occur or provider fails
• Higher risk in single family and small multi unit compared to commercial

8 – Guarantor / Key Principal

In order to secure debt for large commercial real estate projects, lenders often require that there is substantial net worth involved in the deal to be confident that if the project goes south, there are enough deep pockets involved to make it right. Typically, but not always, the general partner (GP) of a syndication must have a net worth at least equal the initial balance of the loan. There also must be enough liquid assets of the GP ( to cover debt service over a certain period of time. Lenders refer to the sponsor group including the GP and all loan guarantors, as Key Principals or KPs. This group is also known as the sponsor.

In many cases, a sponsor may have a proven track record in addition to the capital required to acquire a property, but their current net worth or liquid assets may not be sufficient for the lender to make the loan. In this case a sponsor may bring on an individual into the sponsor group as a guarantor and KP who has either a high net worth or substantial liquid assets that will satisfy the lenders requirement. By simply putting up one’s balance sheet, one can negotiate compensation from the sponsor for taking on the risk of guaranteeing the loan.

The compensation for providing one’s balance sheet and being a KP varies depending on the needs of the sponsor, the type of debt being guaranteed and the requirements of the high net worth individual. Some forms of compensation include a percentage of the GP and/or a fee based on the total loan value.

If one has a strong balance sheet, is already comfortable investing in commercial real estate, a sophisticated investor and comfortable with the operator behind the project, then being a guarantor / KP can be an excellent way to accelerate returns for one’s investment. GP level returns combined with an equity investment can accrete significant upside from receiving a share of promote or receiving an upfront fee depending on what one negotiates.

If one is already a passive LP in a syndication, and has the opportunity to receive additional compensation of being in the sponsor group, one is essentially compensated like an active participant in a project for putting in only slightly more work than a purely passive LP.

There is no free lunch; however, and being a guarantor comes with additional risk. Even non-recourse loans can come with carve outs that become essentially full recourse. The actions of an unscrupulous operator may become a major liability if the lender decides to come after the guarantors. If you are the only guarantor with assets worth using as collateral, you may become the main target of a lender.

Before agreeing to be a KP/Guarantor one should be certain they conduct thorough due diligence of the operator, other KPs, the terms of the loan and the project, and the details of the project itself. It’s also always advisable to consult an attorney and CPA to make sure you understand exactly what you are signing onto.

Advantages of being a KP/Guarantor:

• Opportunity for accelerated returns
• Bonus depreciation provides additional tax benefits, more than LPs
• Sponsor experience counts towards future independent projects

Disadvantages of being a KP/Guarantor:

• Increased liability and risk by putting up balance sheet
• Severity of liability depends on loan terms, lender

9 – Hard Money Lender

When real estate investors need capital for projects on a short-term basis, hard money lenders, “HML”, are there to provide it at interest rates significantly above what a bank would charge. These loans are typically made during the rehabilitation or construction of a project before putting a permanent loan in place. Alternatively, hard money loans can sometimes be used to fill short term funding gaps.

Being a hard money lender is a relatively passive strategy to act as the bank and earn high interest rates on your capital. One must have the ability to underwrite projects and borrowers to ensure that they will be paid back. If the project defaults and the hard money lender forecloses on the asset, the investment turns from passive to active. In that scenario the HML is responsible for either completing a project and selling it, or selling it outright at a discount. If one is a seasoned real estate investor this might not be a problem, but if not, one might find themselves up river without a paddle.

Advantages of being a Hard Money Lender:

• Earn high interest, regular returns
• After underwriting, investment can be mostly passive
• Many systems can be automated

Disadvantages of being a Hard Money Lender:

• No tax advantages compared to ownership of real estate
• Possibility to require time and effort if loan does not perform
• Requires ability to underwrite projects and borrowers

10 – Capital Raiser

If you’re investing into syndications or funds as an LP, and you have the ability to raise a substantial amount of capital but don’t have the experience, or don’t want to put a deal together yourself, you might be able to partner with an operator or syndicator and earn superior returns.

It’s important to note that if you are raising capital for a syndication, you must be a member of the General Partnership for the project. If not, you may be acting as a broker dealer and must have a Series 7 license from the SEC or face fines/penalties. Consult your attorney for more information.  

The value of one’s ability to raise capital is wholly dependent on the needs of the partner operator and the underlying relationship. Additional roles, responsibilities and added value a capital raiser could bring to a project are: a commitment to additional investments over a period of time, signing as a guarantor, participating in management functions, marketing, administrative tasks and more.  

Usually, if the only thing of value being brought to the table is money, it then depends on the operators own ability to raise funds. If the amount raised by the capital raiser is substantially materiel and will allow the operator to do more deals, it may be worth it to the operator to give up some of the GP.

 “Capital raiser” is a broad term and can range from solo investor with an investment group to an established and organized private equity firm. The function can also range from being quite passive, if one is only organizing several other investors, to a full-time job marketing and networking for new investor partners.

Advantages of being a Capital Raiser:

• Potential for accelerated returns
• Possibility to negotiate better terms for investor group
• More leverage as investor

Disadvantage of being a Capital Raiser:

• Raising money from others comes with additional responsibility and liability
• Being part of the GP can invite additional liability
• More administrative tasks depending on structure.

11 – Owner Operator / Land Lording (SFR, small multifamily, NNN)

When most people think of real estate investing, they either think of flipping houses or owning and operating single family rentals. While having direct ownership of real estate certainly can be passive, especially with the right systems in place, it can also be a full-time job.

Traditionally, SFRs and small multifamily properties are the most popular form of direct real estate investments.  Another strategy can be to own larger commercial properties, which require larger down payments and tend to attract higher net worth individuals or companies as investors.  Commercial properties include industrial, medical, multifamily (5 units or more), office, and retail.  All of these strategies can range from relatively hands off with third part management or relatively active if you are performing all management tasks yourself.

At the minimum being a direct and independent owner/operator first involves finding and buying deals – ideally knowing what to buy, at the what price, and what not to buy. After closing comes any rehabilitation of the property required followed by the ongoing maintenance. If the property is currently vacant it is up to the landlord to market and eventually lease the vacancy to a quality tenant. If the investment is a SFR, be ready to fix any minor or major maintenance issues ranging from fixing toilets, replacing A/C units, appliances and roofs.

Some forms of direct ownership can be less time consuming, such as triple net leases or NNNs. In a NNN lease a landlord and owner leases a space, usually industrial or commercial, and the tenant is responsible for most, but rarely all, expenses and maintenance related to the property in addition to paying the rent. NNN investments can also be syndicated as single asset deals, inside of funds, or in a REITs portfolio. These pooled investment strategies allow investors who don’t have the time or the large down payment to invest in these types of properties, while giving up almost all control of the investment to the operator.

For some investors who need to be in as much control of their investments as possible, there may be no other alternative to direct ownership.

In theory, regardless of the asset class, land lording can be a relatively passive activity that requires some occasional side work. Typically, this involves coordinating with a contractor or maintenance person and even this communication can be automated or delegated to an assistant or VA. For others who need to be fully hands on, being an owner, handy man and leasing agent across several properties can easily turn into a full time job.

Advantages of Direct Ownership and land lording:

• Full control over investment
• Tax benefits – more in commercial than smaller properties
• 100% of profits, no sharing with promoter/operator
• Pride in ownership

Disadvantages of Direct Ownership and land lording:

• Non-professional operational risk
• Single asset risk
• Third party management fees can be high

“Semi-Active “

The following activities all require a more significant time commitment in order to be successful and therefore are not at all considered passive. While many functions can be automated or outsourced, or one can be a silent partner who funds these activities, the underlying task consumes significant time.

12. Flipping – Buying a property, usually renovating it, to sell within a short period of time

13. Tax Liens – Where one can literally buy a property on the courthouse steps. By paying the unpaid tax bill you can take possession of a property at an incredible discount.

14. Wholesaling – Tying up a property by placing it under contract and selling an assignment to a permanent buyer.

“Full Time Active”

The below are all full-time real estate oriented enterprises and careers that are either directly related to real estate or compliment real estate investing in some way. While some of the tasks, like in any business, can be automated and delegated, the underlying nature of the endeavor requires a full-time commitment. For those who are not ready, or do not want to work for themselves, and/or need a W-2 job, these can be great careers or types of firms to work for in order to continue ones real estate education. It’s not uncommon to be working full time in the real estate industry and a passive investor in the above strategies on the side. These are in no particular order.

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Conclusion

Real estate is one of the most tried and true methods to create, preserve, and grow wealth. For every personality and style there is a strategy to fit. There is no one size fits all method, and while some strategies carry more risk or time requirements than others, that may be what one seeks. Many may cringe at the idea of figuring out a major issue or getting their hands dirty while others enjoy the challenge.

At the end of the day one must examine their goals, objectives, skill set, and time available to commit to their real estate investing. Regardless of the strategy one chooses, by educating and consuming as much quality information as possible and surrounding oneself with as many experienced investors as they can, many of the risks can be minimized. Chances are there are dozens, if not hundreds or thousands of successful investors who have created systems that maximize chance of success in a strategy that resonates with you. It is a highly valuable practice to benchmark what the best have done, and do, and adjust for your own situation. It’s not necessary to reinvent the wheel.

Good luck and happy investing!