When evaluating investing in alternative investments, one of the first questions you should ask yourself is whether you want to be an active or passive investor—or perhaps a combination of both. The decision often depends on your investment goals, available time, industry knowledge, and financial flexibility. Each approach offers unique advantages and challenges, so it’s essential to determine what aligns with your lifestyle and strategy before diving in.
Active Investing: Hands-On, High Risk, High Reward
Active investing appeals to those who want more control over their investments. It involves directly managing properties, making decisions on acquisitions, and handling the day-to-day operations. While this hands-on approach can lead to higher returns, it also demands more time, effort, and risk.
Advantages of Active Investing
- More Control: You get to make all the decisions—from which assets to buy to how to manage them and when to sell.
- Tax Benefits: Active investors often benefit from additional tax write-offs, such as depreciation and operating expenses.
- Potential for Higher Returns: Because you’re managing the assets yourself, the upside can be substantial, especially if market conditions are favorable.
Challenges of Active Investing
- Significant Time Commitment: Active investing requires a hands-on approach, meaning you’ll need to dedicate time to sourcing deals, performing due diligence, and managing the properties.
- Higher Financial Barriers: Active investors often need substantial capital to acquire properties, limiting access for those with smaller budgets.
- Limited Diversification: Typically, active investors focus on fewer assets, concentrating their capital in one or two properties. This lack of diversification can increase exposure to risk if those assets don’t perform as expected.
Passive Investing: Letting Others Do the Work
For those who prefer less involvement, passive investing offers a way to earn returns without the responsibilities of managing properties. This approach involves investing in funds, such as real estate funds or Real Estate Investment Trusts (REITs), where a sponsor or fund manager handles the operations. It’s ideal for investors who want to generate passive income without the hassle of day-to-day management.
Advantages of Passive Investing
- Minimal Time Commitment: Once you’ve chosen your investment, you can relax as the fund manager takes care of operations, leaving you to collect passive income.
- Diversification: By investing in a fund, you can diversify across multiple assets, which helps mitigate risk.
- Lower Entry Barriers: Passive investing often requires less capital upfront, making it accessible to a broader range of investors.
Challenges of Passive Investing
- Lack of Control: Passive investors must trust the sponsor or fund manager to make decisions. You won’t have direct influence over the investment’s operations or management.
- Potentially Lower Returns: While passive investments tend to be more stable, they may offer lower returns compared to active investing, especially if the fund or investment underperforms.
Passive Income vs Active Management
Deciding between active investing vs passive investing depends largely on your lifestyle, available time, and financial goals. For example, if you have a full-time job or other responsibilities, the time commitment required for active investing might be overwhelming. Conversely, if you want to be more hands-on and have the flexibility to manage properties, active investing may be a more rewarding option.
Many investors overestimate their available time and industry-specific knowledge when starting out. For instance, owning rental properties with a property manager may feel passive, but when tenant issues escalate, you might still need to get involved. On the other hand, truly passive investments, like real estate funds, require less oversight once due diligence is complete.
There’s no one-size-fits-all solution. Your decision to be an active investor or passive investor should reflect your specific financial situation and goals. Active investing offers higher potential returns at the cost of time and involvement, while passive investing trades control for convenience and diversification.
Active vs Passive Tax Considerations
Taxes play a crucial role in choosing between active and passive investing. Active investors often benefit from tax advantages like depreciation and deductions for operating expenses, potentially reducing their taxable income. However, they may also face self-employment taxes on rental income.
Passive investors, particularly those investing in REITs or real estate funds, can take advantage of long-term capital gains tax rates if they hold investments for more than a year. Additionally, using strategies like 1031 exchanges can defer taxes on property sales, further enhancing tax efficiency.
Long-Term Considerations
Your investment strategy may evolve over time. Active investing can be highly rewarding but demands continuous involvement. As you age or your priorities shift, managing properties may become less appealing. Exiting from actively managed assets can also be time-consuming and complicated.
On the other hand, passive investing is more sustainable in the long term, especially for those planning for retirement. It allows for steady passive income without the day-to-day management responsibilities. This approach is ideal for investors looking to simplify their portfolio while continuing to grow wealth.
The Hybrid Approach: Best of Both Worlds
For many, a hybrid strategy offers the best of both worlds. You might start with active investing to build capital and experience, then transition to more passive investments as your portfolio grows. A combination of active property management and passive real estate fund investments allows you to balance control with convenience.
Diversification in Real Estate
A well-diversified real estate investment strategy can provide more stable income by spreading risk across different assets and markets. By diversifying, investors are less reliant on a single property or investment, which can lead to more consistent returns and reduced volatility in their portfolio.
Finding Your Fit in Passive Investing
Ultimately, the choice between active and passive investing should align with your long-term financial goals, lifestyle, and risk tolerance. For those who prefer flexibility and scalability without the burden of daily management, passive investing is often a more sustainable option. Investing in real estate funds or REITs allows you to leverage the expertise of professionals while enjoying the benefits of real estate investing—without the time commitment.
By carefully assessing your financial situation and future objectives, you can make the right choice to build a successful, well-balanced portfolio.
More From 7e Investments on Passive Investing
Are you interested in learning more about this topic?
Explore more on active vs. passive investing in our webinar titled, How to Evaluate Deals & Sponsors.
Watch our Creating Wealth Simplified podcast episode to discover the mistakes to avoid when passively investing in real estate funds.
