Disclaimer: This article is not intended to be financial or legal advice.
In this article I want to dispel two myths I hear a lot when talking about investing in real estate:
- You need hundreds of thousands of dollars to get started
- You have to deal with tenants and toilets if you own rental property
The truth is that you DON’T need a ton of money to get started and you DON’T have to be actively involved in the property to make money!
Allow me to explain:
Passive Investing vs Active Investing
In the real estate world, active investors are responsible for actively managing the property. These people find the deal, secure the loan, evict bad tenants, turn units, manage the property manager and so much more. The larger the asset the more people are likely involved in these activities, forming a team to manage all of the various aspects of the deal. On the other hand, passive investors provide the capital required to purchase the property and then they collect monthly or quarterly distributions as the active investors execute the business plan.
Passive investors are not involved in the day to day operations of the property. They are kept informed of the progress the active team is making, but they don’t make any decisions. Passive investors enjoy the benefits of passive income and all the tax advantages associated with real estate without having to lift a finger.
How it works
Before we go any further it’s helpful to understand the structure of these arrangements. These types of real estate deals are called syndications. A syndication is simply where a number of investors pool their resources together to purchase an asset that they individually, on their own, would not be able to afford. Purchasing a real estate asset through a syndication is typically done through an LLC where there are Active members and Passive members. In this legal structure, the active members are referred to as General Partners (GPs) or Sponsoring members and the passive members or investors are referred to Limited Partners (LPs).
General Partners (GPs)/Sponsors: The general partners, sometimes called sponsors, in the deal are the individuals who will be responsible for:
- Acquiring the property
- Performing due diligence
- Securing financing and signing the loan
- Raising capital
- Closing the deal
- Executing the business plan (performing renovations, evicting bad tenants, managing contractors etc.)
- Managing the day to day operations of the property, including managing the property manager
There may be several GPs who divide these activities among themselves. Ultimately these individuals bear the responsibility ensuring that the property performs well to generate a return for investors.
Limited Partners (LPs): These individuals provide the additional capital to the deal and enjoy a healthy return on their investment without having to assume any additional liability or actively participate in the management of the asset. Yep! That’s all they have to do!
Limited partners are called “limited” because their liability is legally limited under this structure. They are not signing members on the loan and they are legally protected from any legal or financial recourse. Their risk is limited to the amount of their original investment.
Depending on the structure of the deal, LPs may receive a preferred return and preferential equity splits. Each deal is unique, so LPs should evaluate the merits of each deal and understand their projected return structure. We will cover how to do that in the following sections.
As a Limited Partner, a syndication is a great option for individuals who want to take advantage of the benefits of real estate, such as passive income and tax advantages like depreciation, without having to deal with “tenants and toilets.” Limited partners generally receive a regular cash return, or distribution, as well as a share of the proceeds from the sale after the hold period, typically 5-7 years.
Why haven’t I heard of this kind of investment before?
A syndication is the equivalent of issuing a security in the investment world and it is therefore governed by the SEC which sets forth laws to protect investors. These laws are covered under the Securities and Exchange Commission’s Securities Act of 1933 Regulation D, Rule 506 to be specific. Created in 1982, Regulation D covers securities that are issued by private parties.
Initially there was only one kind of offering allowed under this rule, known as 506(b).
506(b): This is commonly referred to as a “friends and family” offering, which means that investors must have a pre-existing relationship with the deal sponsors or GPs. These types of deals cannot be advertised, which means that you likely haven’t heard of this kind of investment opportunity unless you know someone who is involved in a deal.
In 2012, as part of the JOBS act, Regulation 506© was created to provide businesses and real estate investors more opportunities to raise capital and stimulate the economy.
506(c): This investment offering is for accredited investors only. An accredited investor is a person with an annual income exceeding $200,000 (or $300,000 jointly for married couples) for the last two years with the expectation of earning the same or a higher income in the current year or with a personal net worth exceeding $1,000,000. These investors will also need to provide proof of their accredited status. The benefit of this type of investment offering is that it can be advertised, however unless you’re an accredited investor you cannot participate.
Unless you know someone who is actively participating in a syndication, you likely haven’t heard of them because they are relatively new and the ones that can be advertised are only available to accredited investors.
Benefits of being a Passive Investor
Passive investors receive regular cash flow from their investment as well as all of the tax benefits associated with real estate. Passive investors get to take their share of depreciation expense to offset their income from the property.
Getting Started
The best way to get started is to develop a relationship with a sponsor team you trust. Get added to their list so they can contact you when deals come up. Educate yourself on these types of investments and define your investment criteria and goals. We have seen most deals require a minimum investment between $25K and $75K.
Are you ready to get started investing in multi family or commercial real estate? Schedule a call with us today!