Active vs. passive investing, which real estate strategy is right for you?
Being a physician can be extremely rewarding. Not only do you get to improve the health and wellbeing of others, but the work can be highly lucrative. Skilled physicians in the right specialty can make high six-figure incomes. It’s compensation for the 10+ years’ worth of schooling and residency required to practice medicine.
One of the biggest conceptions about physicians, though, is that they’re all wealthy. Sure, you might earn a high income. But a high income does not automatically equal wealth, especially when you factor in high student debt.
This is why so many physicians invest in real estate. Real estate investing has multiple benefits, from monthly cash flow to appreciation, tax benefits and more. Buy real estate, then just sit back and collect passive income, is the message so many would-be physician investors hear.
A well-intentioned physician who follows that advice might think they can just buy a single-family home as a “passive” rental property and collect the income, only to realize it’s a lot more work than expected. And therein lies the difference between active vs. passive real estate investing – a distinction that many people overlook when purchasing their first rental properties.
ACTIVE VS. PASSIVE REAL ESTATE INVESTING
There are two ways to invest in real estate, actively or passively.
Active Real Estate Investing
Active real estate investing is when a person is directly involved in the investment process. It involves YOUR time, YOUR capital, and YOUR risk. An active investor is fully engaged in the process, either entirely from beginning to end, or heavily in parts of the process (such as acquisition or renovation). The level of commitment that’s required by active real estate investors often equates to a full-time job.
Active real estate investing can take different forms, from wholesaling to fix-and-flips, development and buy and hold investing.
Wholesaling is when a person ties up a piece of real estate – through a purchase and sale agreement, option to purchase or otherwise – and then sells the rights to that property to someone else. In this case, you aren’t actually investing in or exchanging real estate. You’re purchasing and selling contracts associated with that piece of real estate, usually for an assignment fee.
Then there is flipping properties. Investors often find an off-market deal, purchase the property at a discount, quickly renovate and then sell immediately for a profit. This can be lucrative, but it also requires a lot of work. Finding properties to flip is the biggest challenge, and is incredibly time-intensive, particularly for someone who doesn’t have much real estate experience or lacks local connections.
On the other end of the spectrum are major development projects. These tend to be the most complicated real estate projects. There are a lot of moving parts, from negotiating land contracts to permitting, design, and construction. Once the project is built or the rehab complete, you still need to lease the space before generating cash flow. These projects tend to have a lot of unknowns. You really have to have an experienced team in place to be successful with this real estate investing approach.
An alternative form of active real estate investing is to “buy and hold” property. Buy and hold investors tend to collect cash flow over time, build equity in their property, and then often pass the portfolio on to a family member or sell through what’s known as a 1031-exchange (a process that involves investing the proceeds of the sale into another real estate asset to defer paying capital gains tax). In the event that a buy-and-hold investor wants to sell their portfolio entirely, they can do so with the benefit of paying long-term capital gains tax instead of the short-term capital gains tax that other active real estate investors typically face.
Many investors will begin by purchasing a single-family home, which they then fix up a bit and rent to a third party. Several physicians have gone on to become wealthy by using this approach, buying one SFH (single-family home) after another, growing their net worth and income one property at a time. But again, this approach is incredibly time-intensive and requires a physician to take on the role and responsibilities of being a landlord.
Moreover, Fannie Mae, one of the federal agencies that insures the mortgages for most single-family homes, has recently capped the number of properties that can be financed by a single individual. Therefore, anyone who is trying to grow their real estate portfolio to more than ten single-family rental properties will now have to utilize commercial loans, which often carry higher interest rates and almost always require more substantial down payments (20-25% minimum, in most cases).
Regardless of which active real estate investing strategy you choose, you face a fundamental challenge: physicians are busy, and often lack the time and experience needed to find high-quality investment opportunities. As a result, those who lack the know-how often end up investing in high-risk deals that ultimately underperform given poor market fundamentals, poor management, or both.
Now let’s look at how this compares to passive real estate investing.
Passive Real Estate Investing
Passive real estate investing, as its name would imply, is a way of generating passive income through real estate. You’ll typically generate income more slowly than an active investor who fixes and flips a property, but the income that is generated is consistent and has multiple tax advantages (more on this to come) with less risk.
There are a few ways to passively invest in real estate:
You can invest in a real estate investment trust (REIT), which is like a mutual fund. Essentially, you’re buying stock in a real estate portfolio that is actively managed by the REIT. According to federal regulations, REITs are required to return 90% of profits to their investors. The benefit of buying into a REIT is that you can buy and sell shares at any time. The asset class is more liquid than traditional real estate.
Another approach is to buy into a syndicated real estate investment fund, a process often referred to as syndication. Don’t let the fancy name throw you off – most people have participated in a syndication at one point or another. As an example, if you’ve ever purchased an airline ticket, you’ve participated in a syndication. You paid for your seat, as do others. In effect, you pool your money to rent a plane. Revenue generated by each ticket sale is used to pay the airline, pilot, government fees, etc.
Real estate syndication is similar to buying a plane ticket. You invest in a real estate deal, such as a multifamily residential project, alongside several others. Each project may have a different minimum requirement, say $25,000 or $100,000 per person. The investors share in the project’s risk and reward, with each being paid out a share of the profits accordingly. Usually, the project sponsor will take a small administrative fee, but that sponsor usually falls at the bottom of the equity waterfall, meaning they are repaid last, only after investors have been repaid their equity stake at the agreed-upon terms. Any profit above that threshold will disproportionately go to the project sponsor.
One of the benefits of real estate syndication is that you, as an individual investor, are considered a “limited partner”. The only responsibility of an LP is to bring the capital. Meanwhile, the “general partner,” or GP, takes responsibility for finding and managing deals. Typically, the GP brings their real estate expertise in exchange for a share of the profits, but is paid out only after the LPs have made their profits. This GP/LP structure incentivizes the GP to manage the project diligently; otherwise, he’ll never make money on the deal since the LPs must be repaid first. This structure ensures that the GP/LP’s interests are always aligned.
Lastly, there’s a HUGE and often overlooked benefit to passive real estate investing via syndications: any cash flow the property generates is typically offset through depreciation. The IRS allows investors to depreciate the value of the building over a 27.5-year period – or sooner if investors utilize what’s known as a cost segregation study, which allows you to accelerate depreciation over a shorter timeline. The income reported to the IRS on a K-1 from a syndication reflects this depreciation, which can lead to a lower tax bill.
After you invest in a REIT or syndicated deal, there’s not much more you need to do. Sit back, relax, and collect income accordingly. This is typically what most physicians have in mind when they decide to invest in real estate, though some mistakenly believe active real estate income will both low-effort and highly profitable.
CASE STUDY: THE PHYSICIAN WHO GOT IN OVER HER HEAD
Let’s use a fictional case study to understand the difference between active vs. passive investing.
Robin is a third-year resident at a prominent Boston hospital. She’s worked hard to pay down most of her student debt and now has $50,000 in extra cash on hand that she’d like to invest. She’s already maxing out her employer-sponsored 401k and has an emergency fund, so she’s looking to diversify her portfolio and start increasing her income outside of medicine. A family friend, who happens to be a CPA, has suggested she look at investing in rental property.
Robin spends the next three months taking the time to learn the Boston-area market for single-family properties to invest in. A single-family rental, she thinks, would at least be manageable for her to personally take on. She can use her free time to respond to tenant needs and frankly, she’s excited to put some sweat equity into property improvements.
The Boston-area market is expensive though, so her $50,000 doesn’t get her very far. Instead, she looks outside of the Boston core a bit, settling on a 3 bed 2 bath single-family property in Worcester, Massachusetts – a city located about an hour west of Boston. Since she won’t be owner-occupying the property, and because she’s a first-time landlord, the bank is encouraging her to put down the full $50,000 toward the down payment. The property she’s buying is $250,000, so if she puts all of her savings into the down payment she’ll be able to avoid paying private mortgage insurance (PMI), which can cost a few hundreds of dollars each month. Her mortgage payment is $1100 a month, before property tax and insurance.
Robin is excited. She starts putting together a marketing plan for the property even before she closes. This way, she’ll be able to get in there and get the home rented as soon as possible. She needs that $1500 rental income coming in so that she can afford the monthly mortgage, taxes and insurance. But once she gets the unit rented, Robin is hoping to bring home an additional $500 per month – equivalent to a 10% cash-on-cash return. Not bad, right?
Yet despite her best efforts, Robin didn’t consider how difficult it would be to rent the property in February, which is when she closed on the home. In an effort to get someone renting the property, she settles on a couple, both of whom only work part-time and have poor credit. They seem like a nice enough couple, though, and have reassured Robin that they’ll treat the home as if it were their own. So Robin signs a year-long lease and at a slightly lower rate than she had anticipated (now netting only $425 per month).
Well, it was only a matter of time before the issues started. The first was not the tenant’s fault. The hot water heater died in the middle of the night, and Robin was left scrambling to find a plumber who could replace it on short notice. This was $1,600 out of pocket that Robin hadn’t budgeted for; as a first-time investor, she didn’t consider the fact that she should have substantial reserves on hand for unexpected problems, like a new hot water heater.
Then, about two months later, the police called Robin. Apparently, the young couple had gotten in the habit of having late-night parties at the home. The police had received several complaints and wanted to alert Robin, hoping she could take some sort of corrective action.
Robin wanted to get out to Worcester to meet with the tenants, but scheduling proved difficult. Worcester is an hour from her job with no traffic—figuring in traffic and now she’s looking at about 1.5 to two hours just to have a face-to-face conversation with the tenants. She’s ultimately forced to take a day off from work to go deal with it.
The stress of these tenants is wearing on Robin and becoming evident at work. Her boss notices that she’s had a decline in productivity and comments that she always seems distracted. Her boss isn’t wrong. Robin was overwhelmed by active investing. Later that year, she decides to sell the property. She had bitten off more than she could chew. She needed to turn her focus back to medicine if she was going to have a successful career.
Now, let’s look at what an alternative approach could have been.
Instead of buying a single-family rental, Robin could have invested her $50,000 in a real estate syndication. Sure, the day-to-day responsibilities for the property will be out of her control, but at this point, that’s what Robin wants: to not be in charge.
After selling her single-family rental, Robin only has $30,000 left. She did not own the property for long enough to have it appreciated, and she had to pay for brokers’ fees and closing costs. But Robin has learned her lesson, and now takes that $30,000 and invests in a syndication. This time around, Robin can rest assured knowing that someone else is doing the hard work of finding the property, property vetting tenants, overseeing all property operations and maintenance. Robin can finally turn her attention back to work while still enjoying the monthly checks she receives from the syndication.
“If only I had invested in a syndication the first-time around,” Robin thinks. At a minimum, she wouldn’t have lost $20,000 the way she did with the single-family rental.
Which Real Estate Investing Strategy Is Right For You?
There are advantages to both active and passive real estate investing. It’s up to each individual investor to consider their specific circumstances. As a rule of thumb, physicians should consider the following:
How much time do you have?
Active real estate investing is incredibly time intensive. This is true whether you’re actively seeking out and vetting real estate deals, or whether you’re managing a major fix-and-flip. The same holds true for individual buy-and-hold real estate investors. You might have time to manage one or two rental units, but as a busy physician, can you realistically manage more than that? If not, passive real estate investing is a better way to create both scale and sustained wealth through real estate.
What level of effort is needed?
With the right team in place, active investing might not require a lot of time. A skilled property manager, for instance, can respond to inquiries and oversee repairs and maintenance without you blinking an eye. That said, when effort IS needed in active real estate investing, the effort that’s needed is usually a heavy lift—like negotiating the terms of an agreement or evicting a tenant. Physicians might not have the capacity to manage those heavy lifts.
What level of risk are you willing to accept?
Active real estate investing tends to carry more substantial risk than passive real estate investing. Unless you’re experienced and knowledgeable about real estate investing, you might want to stick with passive real estate investing where a team of professionals will spearhead all active real estate activities, from acquisition to construction and ongoing property management.
Moreover, with passive real estate investment, any risk is shared across multiple parties. If something goes wrong, you won’t be solely responsible for identifying and funding a resolution.
What are the potential returns? Physicians should evaluate potential returns in a number of ways. For instance, a fix-and-flip might generate a $70,000 lump-sum payment once the property sells – but how much of that do you actually take home after commissions, closing costs and taxes are accounted for?
Before investing in a project, calculate the project’s anticipated cash flow, cap rate, internal rate of return and cash-on-cash return. Not sure what these terms mean? That’s a sign that you might want to start with passive real estate investing.
What are the current market conditions?
It’s important to understand where we are in the real estate cycle. Real estate cycles generally last ten years. That puts us at the top of the current market cycle – some experts have joked that if this were a baseball game, we’d be well into extra innings.
As a real estate investor of any kind, where we are in the real estate cycle matters. Real estate is a highly illiquid asset class. A number of people decided to get into active real estate investing back in 2004 and 2005, only to find themselves with half-complete, underwater projects that they struggled to sell. Many of these projects went into foreclosure. Those that didn’t go to foreclosure were often sold at a loss. Investors never saw a return on their money.
While the market cycle affects both active and passive real estate investors, active real estate investors carry more risk. Active real estate investors tend to have more of their own capital tied up in projects. They are responsible for mortgage payments and taxes. They bear the costs of project over-runs. They still have to pay commissions to brokers upon sale, even if selling at a loss.
When the market contracts, you’re much better off as a passive investor than an active investor. No matter what the market conditions, people will still need somewhere to live – and with passive real estate investing, the cash flow keeps coming in, month after month. You might not be able to raise rents during a down market, but at least the revenue keeps coming.
These questions are intended to be a guide for physicians considering real estate investments. For instance, say a physician DOES have plenty of time, real estate knowledge, and experience in the industry. That doesn’t mean she needs to be an active real estate investor. She may have neither the inclination nor the desire to take on that level of responsibility. He may have other priorities he’d rather focus on, like spending time with his family or focusing on one of his hobbies.
At the end of the day, real estate investing is about generating additional income. People wrongly assume that all real estate investing is passive – that’s simply not the case. Physicians are often encouraged to invest in real estate with the promise that it will help create passive income, only to find out that buying, owning and managing real estate directly is a lot more time-intensive than they had anticipated.
Instead of working hard for your cash, put your cash to work for YOU. That’s the only way to get out of the rat race once and for all. Passive real estate investing is what will help high-earning physicians become wealthy physicians. While active real estate investing can be lucrative, unless you have a passion for real estate, passive real estate investing through syndications will set yourself up for financial freedom so that you can live comfortably well into retirement, with a sizable nest egg to pass on to future generations when the time comes.
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