What do you picture in your head when you think about the term “real estate investor”? Maybe you imagine a buy-and-hold investor who buys properties and rents them out. Some of you might picture a property developer who builds subdivisions or office buildings. The rest of you think back on the hours you spent watching the house flipping shows on HGTV where people buy houses, fix them up, and then sell them for a profit.
These are common forms of investing in real estate, and they share one important characteristic – they are not passive.
Passive income can be defined as earnings derived from an investment where the person (the investor) is not actively involved in the investment activity. It is interesting to note that the IRS treats passive income differently from “material participation” in a business, rental, or other income-producing activity. If you are considering real estate investing, this might be something you want to get advice on from a tax professional.
Three Dimensions of Investing That Affect How Passive or Active an Investment Is
IRS definitions aside, I like to think about three things that determine how passive a particular investment is:
- The work involved
- The knowledge required
- The risk you take
These three dimensions loosely mirror the aspects of “body, mind, and soul.” For some people, investing is a core activity that engages all these aspects. You can imagine an entrepreneur that invests all their savings, works 80 hours a week to build a real estate empire, reads all the books and watches countless YouTube videos, participates in real estate investor networks, and goes all-in. Despite the risks, the hardship, and the relentless hustle.
For other people, investing is something they want to do on the side. They would like to put money into real estate investments and watch their investments grow and deliver consistent returns. This article is intended for this group of people. Once you recognize that each form of investment involves a level of activity, you can better choose investments that have the right amount of passivity for you.
Let’s explore the three dimensions:
#1 The Work Involved
This dimension of real estate most clearly affects how active or passive an investment is. I already mentioned examples of active investment in real estate in the opening paragraph. It is clear that if you pick these kinds of hands-on investments that you will need to put in the hours. I will mention that even if you do choose an active form of real estate investing, there are ways to make them more passive. For example, you can hire a property manager to manage your rental properties, a general contractor to manage your house flips, or use professional construction management companies for larger projects. However, there is a trade-off between spending fewer hours working as an active real estate investor and giving up some of your profits to pay others to do the work.
There are types of real estate investing that are passive and which do not require your labor. Some examples include:
- Stocks that are bought and sold on the stock exchange in listed real estate companies.
- Mutual funds or ETFs (Exchange Traded Funds) with a focus on the real estate industry.
- REITs, or Real Estate Investment Trusts, are corporations that own and manage real estate portfolios and pay a share of the profits from their activities to investors. They are traded similarly to stocks but are subject to specific regulations governing how much of their profits they pay to their investors.
- Property syndications and Crowd Investing are gaining significance as a form of real estate investing. They both involve multiple investors investing in a real estate project. The real estate project is monitored by a sponsor (in the case of property syndication) or a lender (in the case of crowd investing). The minimum amount that an individual invests in a single project is generally higher with property syndications, and investors need to be “accredited investors” that meet requirements related to income, net worth, or professional experience. Generally, crowd investing companies require smaller minimum investments.
So, what did I mean when I said no form of investing in real estate is ever completely passive? That’s where we get to the other two dimensions!
#2 The Knowledge Required
Due diligence is required when you are investing your money. Due diligence should go beyond scanning through a prospectus and thinking to yourself, “this seems legit.” You’ve probably been told more than once that you should know and understand what you are investing your money in. Reading the prospectus of a potential investment is a good start. However, truly understanding an investment will involve reading up on the investment type, the company or fund, and having a good idea of what the objectives and activities of the company or fund are.
Gaining knowledge will require you to actively seek it out. Everyone must decide for themselves how much knowledge they need or want, in order to understand an investment. At the end of the day, knowledge is power.
#3 The Risk You Take
Managing risk isn’t exactly work, but it does eat away at our time by keeping us awake at night. Every investment involves some risk, and you should not underestimate this. It’s probably fair to say, you shouldn’t invest in something that keeps you awake at night, but if you are new to investing or just generally nervous, you might not be able to avoid this. Gaining knowledge can help you understand risk, assess how much risk you want to take, and counteract excessive worrying with rational thought and composure. Consider that avoiding risk and putting your money under the mattress will not be associated with any rewards.
Final thoughts
All this is to say that there is no entirely passive form of investing. You will have to put at least a minimum amount of time and effort into choosing profitable investments that allow you to achieve your financial goals at an acceptable level of risk.
This post was written with Fiverr, I partner with writers on Fiverr who have experience on a variety of topics. Wendy writes about real estate investing and has substantial experience. Subscribe for more business, sales and investing posts. Have a lovely day.
