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Active Investing Vs. Passive Investing: Understanding The Pros And Cons

June 19, 2024

chrisseveney

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Creating Wealth Simplified | Active Vs Passive Investing

 

Tired of the toil and trouble of active real estate investing? But are you also wary of the lack of control in passive options? This episode is your one-stop shop for the debate! Chris Seveney breaks down the pros and cons of both approaches, helping you decide whether you crave the lazy river of passive investing or the white-water rapids of active deals. This episode is packed with real-life examples and insider tips to help you find the perfect fit for your goals and lifestyle.

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Active Investing Vs. Passive Investing: Understanding The Pros And Cons

I am going to tackle the debate of passive investing in real estate versus active investing in real estate. Before we get started diving into passive versus active, I want to set the ground rules and define my definition of active versus passive. For me, passive investing means after you invest, you have no decision-making to be made. Active investing is when you have to make decisions.

Passive Investing Pros

I know some people think I bought a rental and I have a property manager, so it’s passive. No, it isn’t. That’s not passive, that is active. Passive is essentially investing in a third party to manage the asset and provide you with a hopefully targeted income stream. I’m going to talk about five pros and five cons of each. I’ll start by saying there’s no right or wrong answer to either one. I’ll talk more about that in my conclusion, but we will start first with passive investing.

For me, passive investing is investing in some type of offering, for example, our regulation, a plus offering, invests $5,000 to $25,000, and you rely on a third party to manage that asset and provide you, hopefully, like we do at this point, monthly distributions. What are some pros of passive investing? Number one, typically lower costs, lower barrier entry. You can get in.

Now there might be fees that get paid, management fees, or other types of fees, but it’s usually pooled and it’s a lower cost, meaning you can get in with a lower amount. It’s very difficult to buy a piece of real estate for $5,000 to $10,000 where you can invest in real estate passively for $5,000 to $10,000. That’s a pro.

Secondly is simplicity. Now, begging people that they need to go out and do due diligence on the offering, and the sponsor, understand what they’re investing in, and know the capital stack. Once you understand that, now it’s easier to manage. Am I getting paid or am I not getting paid? You’re not again, going through, “Was the rent paid?” “What were my expenses?” “Why do I only get this much money?” Sometimes it can be more suitable for people who do not have time or experience.

Another is performance. I don’t like to say consistent performance with passive investing, but again, it’s pooled so I view it as lower risk. If they’re investing, it’s a fund investing in multiple assets. Now, if it’s one asset that’s a different story, but it allows for a performance to be diversified. Another pro to talk about is say tax efficiency.

You typically both provide tax benefits. Now, it depends on your active side, whether you’re fixing or flipping or whether you’re buying long-term rentals. Passively, you’re not an active member, so hopefully, it contributes to long-term capital gains and you get some of those tax benefits. Lastly, it’s less time-consuming.

After you get your due diligence done, passive investing takes really minimal ongoing research and monitoring. Click To Tweet

After you get your due diligence done it’s minimal ongoing research and monitoring. It’s, “Did I get my distribution or not?” Now, this is where I get into a debate with people where if I’m investing passively, I would rather invest in something for five or seven years. I said it and forgot it and I’ll have to find a new investment.

Some people are just such control freaks over their money that they just want to go chase opportunity and be able to get their money in and out of deals or have that liquidity, which reality is, I think I showed research, people who jump investments more frequently typically perform less. Now, on the real estate side. That was the case when I was moving a lot from 2001 to 2005.

You buy a house, make some equity in it, and sell it to move up to another house because A), I was making more money, but I also was making more income. When you look at every selling transaction as 5% or 6%, all of that gains typically go away. Again, the five pros are typically lower cost, easier to manage, diversification, tax efficiency, and less time consuming.

Creating Wealth Simplified | Active Vs Passive Investing

Active Vs Passive Investing: The five pros of passive investing: typically lower cost, easier to manage, diversification, tax efficiencies, and less time consuming.

 

Passive Investing Cons

Of course, there are cons. Limited flexibility. You are locked in. That sponsor is based on the terms that you signed up for. That can be a con. Things aren’t going well. Not much you can do. You can’t cut your losses. You can’t do a sell order typically on the asset, especially if it’s an alternative. Something to realize why it’s so important to understand your sponsor.

Another con is, whether you’re passive or active, there is just that market risk that you’re exposed to that downturn, but doesn’t give you that flexibility to get out and you’re just tied. Another is the lack of customization. What I mean by that is you can customize which funds you invest in, but you really can’t adjust the offering.

You can’t negotiate with a sponsor. I find when you’re active, which I’m of course, active and I invest passively, I can control things better or move their chess pieces a little bit better and customize things and adjust risk, I think a little bit better than you can do on investing passively, but it takes a ton of time. It was not an overwhelming con compared to active.

Next is significant reliance on the sponsor. Now you are relying 100% on that sponsor. If there’s underperformance, you could miss out on higher returns through other opportunities because you’re locked in, as I mentioned a minute ago, I would much rather be tied to a 5, 6, or 7-year investment. Of course, that’s if it’s going well. If it’s going bad, then it just feels death by a thousand cuts.

That is the risk that people take. Understanding risk is so important in real estate and making sure you understand every aspect. The fifth con, and this is the one I think I see the most, honestly, we don’t seek these types of investors for our fund because they’re not a right fit and it’s boring.

Understanding risk is so important in real estate. Click To Tweet

I’m at a point in my life, in my late 40s, where we go to a water park, and I’ll do the Lazy River. I want slow and boring. That’s how I want my investments. The Lazy River. I don’t need the Wave Pool. I don’t need the water slide or the River Rapids that you get flipped over in. It’s cool. It’s fun. It’s exciting. It’s thrilling. Is that how you want your investments? No.

I call myself a goat. No, it’s not the greatest of all time. Getting Old And Tired from some of these active investments. Now, I run an active company. I love that, but for my portfolio, which is how also I manage our fund, I want it to be boring. We look at our loan-to-value, the assets we buy and now where we structure our fund. I to say we’re a boring fund.

Now we target hitting singles and doubles. People don’t go to the baseball stadium typically to hit singles and doubles. People who do, those are the investors that we want. People who are chasing returns, typically they can go chase returns in other offerings. That is a con. Spend some time, pros, cons, passive. If you have questions, reach out to us.

Active Investing Pros

Now, happy to answer them, happy to debate this even further in another podcast. Now let’s flip. Active, pro, higher returns. Of course, you’re managing, you’re spending time. What’s the cost of your time? Something to understand. Of course, it should be because you’re paying somebody to manage that time, you’re paying somebody to perform a skill.

Now, if you don’t have that skill set, maybe you shouldn’t be active, but if you have that skill set, of course, you should have higher returns when you’re active. The second pro is more flexible. You can adjust your portfolio quickly. If you’re doing fixes and flips, one’s taking you longer, you can pause or shift things around because it’s more dynamic.

It is liquid, it’s more dynamic, so you can respond quicker to things. It gives a little bit more flexibility. If you’re in one fund that’s not going as well and you invest in others, not much you can do unless you’re using new funds to invest. Active does give you a little bit more flexibility. Also gives you a little bit more customization in regards to how you structure things and how you go after different assets.

The last pro, but its con is the risk management side of things. Managers can use exit various strategies to hedge risk. Many don’t honestly, when it comes to being active, most people are chasing money all the time but if you’re good at being an active investor, then you are managing the risk versus somebody else. Again, it’s a con.

Active Investing Cons

Last is that engagement. The thrill, the seek, it’s more engaging for investors to enjoy the challenge. They want to go down the river rapids because it’s more thrilling, provides a higher return, more engaging. It’s more exciting. It depends on where you want to be. Those are the pros. Quickly run through those. Talk about some cons. It could be a higher cost.

What do I mean by that? It’s tough to get into real estate actively with 5,000 to 10,000. People can do it, even note investing. I was looking at a loan the other day. I was just scrubbing some old funds I had. I had a loan of about $3,000. I had $20,000 doing taxes. The payoff at the time was $70,000. I knew I’d have to pay the taxes.

I paid the taxes, I had to continue to pay the taxes, and spent about $20,000 on legal. I was into this loan that started at $3,000 for $51,000. The same thing can happen if you’re in active real estate because you can go into a fix and flip thinking you’re going to spend $25,000. Next thing, you’re $50,000 into it. It was going to cost more.

Next, it’s time-consuming to be an active real estate investor. I love being active in running our fund. It’s time-consuming. Even before I ran my funds, when I was just doing real estate notes and working a W2 and then at night had to respond to emails and the worst is owning property, without a property manager.

You’ll get that Sunday phone call where you’re out with your family and the toilet overflows or your tenant threw potatoes down the garbage disposal and jammed it full of potatoes. Yes, that has happened or your tenant threatens a lawsuit because your lead paint certification expired on Saturday and they don’t have the renewal. They’re threatening to sue you because they want to opt out of their lease.

Yes, these are all things that have happened. It is time-consuming. It’s sometimes a little more stressful. Can be more inconsistent on the performance side. No returns can fluctuate. If you’re a fix and flipper you can make a pause, tenants are not paying, and you have expenses for some months. If you’re in a decent fund that pays a distribution, that’s usually going to be more consistent.

Creating Wealth Simplified | Active Vs Passive Investing

Active Vs Passive Investing: Active investing is time consuming. Sometimes, a little more stressful. It can be more inconsistent on the performance side.

 

Again, we talk about how taxes could go either way. Either way on taxes, if you’re active, typically if you’re getting into the ordinary income, that’s a crusher. When I was doing notes, now I remember I made some good money one year. I’m just going to use an example. Let’s say it was 100,000 and I was still working on my W2 and then all of a sudden, “Great. 37% for Uncle Sam and 5% for estate tax.

Every time, I just walked away with $50,000 something out of the $100,000 I earned. That’s annoying. It could be taxes or long-term capital gains, $100,000 would only be 80, but would you have made that much money? Who knows? There are those tax implications. Last is vendor management and the stress along with that. You have to pick your property manager. You have to pick your team.

If you’re going with a sponsor, they have to do that. This reminds me of the time when I went from being a general contracting side to the developer side. The joke internally, if people are in that space, they go to the dark side. After fifteen years on the GC side, yes, I got burnt out. When I went to the development side, I was running a call at a $100 million project, about 300 apartment units and very large contractor guys were pretty skilled, talented, superintendent, old school, basically hard knocks guy, loved him.

He said, “Why’d you get out? Do you miss the thrill?” I looked at him, his name’s Larry. I said, “Larry, the benefit I have right now is instead of having to yell at 50 to 60 subs like you have to, I just got to yell at one person, which is you, and you got to figure it out. My job’s a lot easier now and it’s similar when you go from active to passive.

When you’re active, you have vendors and everyone you have to manage. When you’re passive, it’s that one, that sponsor that you got to chase and make sure they’re sticking to their word. They’re doing what they’re saying. People go through life and as I mentioned when I started, there’s no right or wrong. You could do both. I do both right now to do one or the other.

As I said, there’s no right or wrong answer to any of this. If somebody’s going to try and convince you otherwise, it is based on what fits their needs. I have coworkers, we have two young kids at home. Now, after they work on their W2, do you think they want to continue to be active or do they want to spend time with your kids?

Of course, they want to spend time with their kids and be active and passive. I think a lot of people, especially millennials who are starting to raise a family understand as much as Gen Zers and boomers. Time is the one asset that you can’t make more of. You can make more money, you can do a lot more. I was brought up in you work your butt off that nine to five and just try and work your way up.

Somebody finally told me the 40 40 40 rule, which is to work 40 hours a week for 40 years to get 40% of your income. People would work nights, and weekends, and do whatever it takes. That’s how I started. Now, do I look back and wish I did things differently? A few? I don’t have any regrets but I think times have changed and people are realizing the value of time.

For example, in notes, someone invests with us and can get 8% to 10% or do it on their own and get 12% on a $100,000 investment. Let’s say pick a number 10% versus 12% is $2,000 worth all that time and effort, which is most likely less when you look at the net because if you’re doing it yourself, you’re probably paying ordinary income. In our fund, you’re paying long-term capital gains, not tax advisor, but we issue 1099 dividends.

Something to think about is when you’re active, what is the cost to be active, not only monetarily but time? How much time are you taking away from your family? Something to consider. I do want to thank everyone for reading this episode of Creating Wealth Simplified podcast. As always, if you have questions or comments, go to our website, 7EInvestments.com. We look forward to hearing from you. Take care. Catch on to the next one.

 

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