What is Passive Investment in Real Estate?

You may have thought about real estate investment to diversify your portfolio and grow your wealth. Compared to stocks, real estate brings stable and predictable income. On top of that, you can enjoy tax benefits that can significantly reduce your tax obligations. Yet, many of us haven’t taken steps to actually invest in real estate because owning property comes with a lot of work as a landlord—from dealing with tenants to negotiating with contractors and handymen on a near daily basis. Even finding a good deal that generates positive cash flow on Day #1 isn’t easy in this competitive market environment and it usually takes time. For those who want to invest in real estate, but don’t have enough time for it, passive investing through syndication is a great option.

Passive investment in real estate means that you, as a passive investor, invest together with active investors who have experience and expertise acquiring and managing properties. This structure is called syndication. The active investors (usually a small group of investors) act as operators of the investment and do all the work—from finding a good deal, conducting due diligence, negotiating and coordinating with the seller, lender, and other parties, and raising equity, to managing the property and executing a business plan until exit of the investment (See below the sample syndication process). Usually once a deal is advanced and ready to accept investment, passive investors are provided with a deal summary (property details, business plan, financial projections, etc.) in order to help them understand the investment opportunity. During the investment period, passive investors receive quarterly (or monthly) distributions as well as project updates on the property and don’t have the hassle of dealing with day-to-day operations. Passive investing is a hands-off investing approach that makes real estate investing easy and simple.

<Sample syndication process >

For the work the operators provide, they take a fee (usually 2% of purchase cost included in the closing cost) and upside profit based on pre-agreed terms (usually 20-50% of excess profits after passive investors have received a pre-agreed preferred return (e.g., 8%)).

At the same time, you, as a passive investor, can enjoy the tax benefits used by many wealthy real estate investors. The operators work with a specialist to conduct a cost segregation study (*) for the acquired property to recognize as much depreciation as possible upfront, which results in a paper loss on your investment despite you actually receiving cash distribution from the investment. This means that you will likely not need to pay any taxes on the income you receive from the investment, except at the time of exit (there will be depreciation recapture and capital gains taxes when the property is sold although there are a few tax strategies widely used to defer those taxes). You won’t get this tax benefit by investing in a REIT. You will actually own a percentage of a property, and the depreciation benefits will be passed through to you.

Moreover, you will participate as a limited partner (**) and thus be protected from any losses beyond your investment amount. The operators are the ones who sign the loan agreement, satisfy loan guarantor requirements (in order to borrow for this type of investment, a guarantor usually needs to have net worth equal to or larger than the loan amount and liquidity of 10% or more of the loan amount). Unless you’re a wealthy individual who is willing to use your own balance sheet and take on more risk, passive investing will enable you to own a large property that you wouldn’t otherwise been able to acquire on your own.

One downside is that passive investing is considered illiquid. This means that if you suddenly need cash and want to sell your shares in the investment, there is no guarantee that someone else will buy it. The usual holding period of this type of investment is 5 to 10 years, although you will receive regular distribution on the investment every quarter or month. Therefore, passive investing is a great way to build long-term tax advantaged wealth, but you should only use funds that you don’t need access to immediately.

With all the aspects above, passive investing can be a great way for you to gain exposure to real estate and build your wealth for the long-term. If you’re interested to know more about what passive investment opportunities that Now West Capital offers, please contact us at info@nowwestcapital.com.

(*) A cost segregation study is used as a tax deferral strategy that front-loads depreciation deductions for real estate assets into early years of ownership. The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) vs. the standard straight-line depreciation (27.5 years for residential property and 39 years for non-residential property).

(**) In a syndicated deal, passive investors are called limited partners and active investors are called general partners. Under this structure, an LLC is formed to acquire a target property and the passive investors invest in the property by purchasing the shares of the LLC. This structure provides passive investors with benefits such as limited liability (no liability beyond the initial investment amount) and tax savings (tax loss due to depreciation will be pass through to the investors).