Factors You Must Consider in a Passive Real Estate Investment
The amount of money you earn from your career or business ultimately comes down to how many hours you can work in a day. This is an extremely limiting system that eventually takes its toll. But by building passive income streams, you get to flip that script.
Real estate investments provide steady passive income through rents, generous tax benefits and a potentially hefty sum once it’s time to sell. As such, real estate offers higher risk-adjusted returns compared to traditional passive income sources like dividend-paying stocks, bonds or annuities.
But passive doesn’t mean inactive, especially in the initial stages of an investment. You still need to actively do your due diligence and understand the extenuating factors that will influence the success of an investment. Passively investing in real estate has proven itself as a smart financial move, but you need to have enough industry knowledge to protect your capital from costly mistakes. The three most critical factors to consider are: the team, the market and the business plan.
The general partner (GP) team is often the maker or breaker of any given real estate opportunity. Before moving forward, you should be able to answer these questions: Has the GP team previously worked together? If so, has this team gone full-cycle on a real estate syndication deal? Most importantly, you want to understand if the end result of the previous deal (or deals) aligned with the initial business plan.
FULL-CYCLE REAL ESTATE SYNDICATION
- Found a deal
- Raised capital from passive investors
- Bought an asset
- Managed an asset
- Sold the asset
Property Management Company
Outside of the GP team, you’ll want clarity around the property management company they work with or are planning to work with. Find out if the property managers have operated in this market before and how many assets they have under management. (Bonus points if they’ve already worked with the GP team on another project.)
While passive investors have virtually nothing to do with the asset’s day-to-day management (see: passive), you still want to feel confident that this team is trustworthy and professional. They are, after all, instrumental to a rental property’s success.
If your GP team is purchasing a value-add investment in need of rehab, investigate the construction team or general contractor that will take on this work. If they’ve done proper due diligence here, your GP team should be willing to hand over the paperwork outlining their own investigation and the full breakdown of renovation costs.
There may be times where an investment team has a preexisting relationship with a general contractor that isn’t local to the investment property’s market. The GP may opt to hire that general contractor to delegate renovations out to subcontractors in the area. While this could be a red flag, it’s not necessarily a deal-breaker. But when there is increased risk to the profit margin (as there is in this case), passive investors should be compensated accordingly.
Market research will give you invaluable insight into how well an investment may or may not perform. You need to know if the market is generally growing, both in population and income. Within your macro-level research, hone in on (1) the job market and (2) any relevant laws that may affect the investment.
First things first: What does the job market look like? Understanding the number of jobs, span of industries and average income level is paramount to understanding the rental market and, therefore, your potential returns.
Is the market beholden to one main employer (e.g., a military base)? Does the market include multiple employers but only one industry (e.g., auto manufacturers in Detriot)? To protect your capital against any major downturns, you’ll ideally invest in growing markets with a high income level and multiple employers across industries.
An often overlooked part of market research is real estate–related laws. Ideally, you should aim to invest in landlord-friendly states that allow for evictions within a reasonable timeframe and don’t have stringent rent-control rules.
Case in point: It can take nine months to evict problem tenants in Illinois, New York and California. Another example is Oregon, which became the first state in the U.S. to implement a statewide rent control policy in 2019. A policy like Seattle’s ”first-in-time rule” (FIT rule), which requires landlords to choose the first applicant who applies, is also worth noting. These tenant-friendly markets may be lucrative, but it’s up to you—the investor—to decide if you’re comfortable with the risks they pose to an investment’s bottom line.
The Business Plan
Last but not least, you should understand the business plan before moving forward with any real estate investment. What you’re essentially looking at here are the capital stack and the overall strategy.
Capital Stack & Debt Payments
The first part of the capital stack is always going to be who owns the debt used to purchase the property. Find out if the GP team is going through a local bank or a national conglomerate like Bank of America or JP Morgan. Or maybe they’re using government-backed debt through an agency like Fannie Mae and Freddie Mac.
Go a level deeper and ask about the interest rates on said debt. Is it a floating rate or a fixed rate? Is it interest-only or fixed payments with an amortization schedule? The goal is to uncover how the GP team strategized this debt and if they’ve worked with the property’s debt owner in the past.
In other words, what’s the GP team doing with the property? On one side of the spectrum would be purchasing a Class A property that’s 97% occupied and raising rent as the market inflates. This is essentially a buy-and-hold strategy. Swing all the way to the other side, and the team could purchase a value-add asset with 85% occupancy that they plan to take down to the studs over a five-year period. Both are valid strategies, and both come with their own set of risks and rewards.
Last, But Not Least…
Building passive income streams through real estate investing is one of the best ways to beat the 9-to-5 system and pave your own way to financial freedom. We hope these guidelines help build your confidence in taking the first step. If you want to hear more from us, check out our weekly podcast, where we sit down with successful investors to uncover their secrets in the real estate investing space.
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