What is Passive Investing in Real Estate?
Updated: May 27, 2019
My original intent with multifamily was to save up my capital to go straight into syndicating my own deal, because there are a lot of up-front costs in taking down a 100+ unit property. These costs commonly exceed six figures. However, before I put my first apartment deal under contract I passively invested in my colleague's 114-unit multifamily property in Atlanta, GA. That deal was so attractive that I just had to do it.
While not strictly necessary, it has been a helpful step for me to get where I am. That deal projects a 10% cash-on-cash return and 20% average annual return including sale following a 5 year hold. It needed very little rehab and is located in the path of progress close to public transportation.
So what does it mean to passively invest in something like this?
Apartment syndicators buy multi-million dollar cash flowing assets. But if the property costs that much, the downpayment would also be seven figures. Supposing I had seven figures in the bank (I don't), it wouldn't be a great strategy to put all of that into one property as I would be failing to diversify my investments. Furthermore if I put so much money into each deal it would limit the number of deals I could do.
However, what if I decided to find people who are interested in real estate investing and willing to contribute funds towards the property acquisition? Such a person would receive a share of the proceeds in proportion to their investment. That includes operational profits which are commonly distributed every quarter, proceeds from a refinance (if there is one) and proceeds from the sale of the property. If the property is operated through a pass-through entity such as an LLC, the investors would also receive proportional tax benefits such as bonus depreciation and accelerated depreciation through cost segregation. There's also the matter of being taxed at the capital gains rate as opposed to the ordinary income rate which could be yet another tax savings.
OK that sounds great, but what if you don't want to have anything to do with managing an apartment? What about evictions, insurance claims, repairs, renovations, leasing etc? Passive investors (also referred to as limited partners) don't do any of that. The general partners (aka "leads", "sponsors", "syndicators") are the ones who actively manage the property.
1. You put up the money via cash or a qualified retirement account to help purchase the asset.
2. You receive profits in proportion to your investment.
3. You do not have any management responsibilities.
In turn, you must:
1. Vet the deal sponsors to confirm their character and track record.
2. Do your up-front due diligence on the market and the property.
3. Confirm that the deal structure ensures the sponsors' interests are aligned with yours.
3. Be willing to invest in real estate, which is relatively illiquid - you must expect to be in the deal until it sells. It is sometimes possible to transfer one's ownership shares to another investor but it is typically not an advantage to the transferor. However the plus side of illiquidity is that asset prices are usually less volatile than in highly liquid markets such as stocks or currency exchange.
Chihiro Kurokawa is founder of BlackRiver Equity Partners, a real estate private equity firm providing private offerings to investors seeking tax-advantaged cash flowing investments in real estate.