In our previous article we broke down the differences between active investing and passive investing. If you didn’t catch that primer be sure to read it here.
Passive investing may seem to be the new rage that has been around for years but maybe you are just finding out about it now. As you may have realized or learned in our previous article, many people have the wrong idea about what passive investing truly is. This mistake is costing them time and money and may even lead to feelings of burn out and disillusionment. If you know of anyone that has that feeling or if you are experiencing it yourself then you probably aren’t truly passive investing.
As you may now have a better understanding of what the true definition of passive and active investing is and what the differences are between the two, you may be wonder “what are the pros and cons of passive investing vs active investing?”
The reality is that you will be most fulfilled when you choose the strategy that works the best for you.
“And what strategy is that?” you ask.
Look at some of advantages and disadvantages we have listed down below to help you make your decision.
If you are reading this article you probably know the benefits of investing in real estate as an asset class. Given that understanding we will focus our review of negatives and positives more directly on the differences between active vs passive investing.
Benefits and advantages of passive investing in real estate
Your money is working when you are not: When you are investing passively in a real estate investment, you are not responsible for the work necessary to make the investment successful. This means that your investment is growing whether you are burning the midnight oil at your W2 job to meet your latest deadline or if you are vacationing in Bora Bora for the week or even if you decide to live a nomadic life and move from city to city on a whim. Whatever you are doing, sleeping, eating, traveling, even when you are working your money is working for you 24/7. You can earn returns without worrying about the responsibility that comes with owning real estate.
Tenants, Toilets, Termites, Trash etc: if you have told anyone about investing in rental properties or even thought about it yourself its very likely that you’ve heard the horror stories of what could go wrong. You know all the issues that pop up in your house or apartment that you barely want to deal with, much less in someone else’s apartment. When you are passive investing you can bypass the late-night calls and ruined weekend plans and rest easy as none of these problems are yours to resolve. You have a group of active investors who are ready and excited to take on those problems so you can enjoy your free time.
Bypass the learning curve and connect with seasoned investors: Investing in general is not easy. You will have to learn a lot, perhaps make a few mistakes before you are successful. Especially if you want to invest in larger more institutional type of assets. When you invest passively you get the ability to skip the line on those years of pain that it takes to become exceptional at something and invest with experienced operators that already have proven success.
You can learn, earn money and have less overall risk: Since you are investing with seasoned operators you are able to take a lower risk learning approach (compared to trying to go out and do your own active investing deal on your own). Not only are you getting a return on your investment, but you are also learning about real estate as well. It’s like getting paid to go to college. As a passive investor you will get to see some of the behind the scenes of what it takes to make a real estate investment successful and what the expectations are from passive investors. This is all useful insight that you can act upon if you one day decide you want to transition to be an active investor.
Potentially easier to diversify: As an active investor you may be limited to the amount of deals you can be involved in at any one time. Passive investors however can invest with several deal operators, in several different cities as their funds allow them to do. This is easy for passive investors as they could potentially deploy capital to make several investments in one day, while active investors may search months or even over a year to find a deal they can invest in.
Lower barrier to entry: To be a successful active investor you will need capital and knowledge to be able to do a real estate deal. As a passive investor you only need your capital and it most likely will be a lot less than what is needed by an active investor. If you are investing in REITs it could be as little as a hundred dollars or as low as $10,000 if you are investing in a larger syndication. Even with higher minimums of $25,000- 50,000, passive investors are putting up a lot less capital to do a deal compared to their active investor counterparts that may spend hundreds of thousands just to get a chance to review a deal during due diligence.
Benefits and advantages of active investing in real estate
Control: one of the main reasons people become active investors is because they want more control. They are not comfortable with being a passive investor and giving up control to someone else. If this is you then you probably should not be a passive investor.
Entrepreneurship opportunities: If you are someone that has the entrepreneur bug, then investing actively would be a great opportunity where you can start and grow an investment business. Owning a business can be a great way to earn wealth as the value of the company grows and you are also building wealth via real estate investing.
Hands on experience: One of the best ways to learn is by doing. Being an active investor, you will learn exactly what it takes to make real estate investment successful and you will know the right questions to ask deal operators if you decide to make a passive investment.
Potential tax benefits: As we all know real estate provides incredible tax benefits. If you are an active investor you may be able to claim your real estate earnings as active income and your losses as active losses. The ability to recognize these income and expenses as active will allow you to offset other earned income that you have, lowering your overall tax bill. Be careful however, as the bar to qualify for active income tax treatment is high. Just getting a real estate license alone does not qualify, you would effectively need to be doing real estate in a full-time capacity to get this tax treatment.
Negatives and disadvantages of passive investing in real estate
Risk: Like with all investments you can lose the money that you invest. However, as a passive investor that loss is limited to the amount that you invested.
Lack of control: To be a passive investor you must give up control over the success of the deal. You effectively operate in a passive capacity in the deal. This may be a disadvantage if you disagree with a decision that is made by the operating team.
Negatives and disadvantages of active investing
Difficulty in getting preferential tax treatment: As described previously, the bar to recognize real estate income as active income (and thus benefit from additional deductions) is very high and you may be doing a lot of work without the incremental benefit (on taxes) compared to a passive investor.
Your earnings are tied to how much you work: Active investing is very much a job although you may not receive a W2 at the end of the year. As an active investor you need to be constantly on the hunt to identify, acquire, manage and sell real estate assets. If you are not working, then there will be a cap on how much you earn.
Significantly higher time commitment compared to passive investing: Active investing can seem like a 24-hour job sometimes as whenever something goes wrong you are the point person to fix it. Since you are always on call there is inherently more of a time commitment in the deal life-cycle.
Risk and responsibility: As an active investor the success and failure of the investment lies on your shoulders. If you cannot handle the stress of that responsibility, then you may not have the temperament to be an active investor.
Why is active real estate investing better than passive real estate investing?
Active investing is better than passive investing if you are built to be a hands-on person. If you have the time and energy to commit to growing your real estate empire this maybe a very profitable avenue to explore as you will have con