7 Steps to Become a Successful Passive Investor
People are usually surprised when they learn that I am a passive apartment investor. Most acquaintances assume I only take lead roles in apartment syndications. I’m a strong believer in apartment investing and being involved in different aspects of this business.
My position of passively investing in over 1,000 apartment units has only made me a more confident and knowledgeable lead syndicator. Many times, when I’m talking to others who are interested in becoming Passives, I suggest the same crucial steps. Today, I share them with you.
Here is an overview of the process we suggest for anyone considering becoming a passive real estate investor.
Step 1: Decide on Passive Investing
Step 2: Find Money to Invest
Step 3: Decide on a Passive Investment Vehicle
Step 4: Decide Who Manages Your Money
Step 5: Understand Your Investment
Step 6: Just Do It
Step 7: Make Money While You Sleep
Step 1: Decide on Passive Investing
I have always believed that being intentional with our lives is key. Therefore, the choices you make with investments need to serve your life goals. What do you picture your ideal life to look like? How will your goals get you closer to this ideal life? What is the overall goal of investing?
Compelling reasons why people invest are as diverse as the people investing. These reasons could include independence from a W2 job, financial security for self and family, getting out of the rat race, time freedom, increase in passive annual income, making money while you sleep, retiring faster than you ever thought possible, growing wealth and moving money out of the stock market and into a less volatile investment vehicle. These are just a sampling of reasons our students and investors have become Passives.
There is risk in every investment, large or small.
For a passive investor, certain risks could include transferring sums of money that are over $50K and have it tied up in an asset for 5-7 years.
For some, having other people (the syndication team) in control of the asset (the apartment building) is a risk.
So give yourself some time to figure out what you want out of life and decide why you are investing. Map these life goals and your risk tolerance with your investment style and see if passive investing directly into a project is more suitable to your needs.
Step 2: Find Money to Invest
Where will your investment money originate? The most common source of money that I see my investors leverage in passive deals are retirement funds and lazy cash that they aren’t putting to work. We find this money laying around in our under-utilized retirement funds and basic savings accounts.
To invest with retirement funds, you need to free them up from the grasp of your employer’s retirement plan. You will need to spend time setting up an alternative retirement plan such as a Self-Directed IRA or Solo 401k Account. See an interview I did with John Park, CEO of PGI Self Directed, to dive deep into these accounts.
For more ways to find or create money to invest, check out my previous articles:
9 Side Gigs that Create Cash talks more about small things you can do to make more money.
7 Ways to Finance MultiFamily Deals, expands on the different strategies for buying your first investment property actively.
Step 3: Decide on a Passive Investment Vehicle
This is where you start researching the different forms of passive investments. We are partial to apartment investing because this is our area of expertise. However, we love learning more about different ways to invest passively and make money while we sleep. Some examples are mobile home parks, storage buildings, senior living facilities, coin-operated laundry facilities, note investing, hard money lending etc.
This step is crucial and it is very fluid. A passive investor has to be active in the beginning of their journey to be equipped with knowledge. It would take more work to become well-versed in that type of investment vehicle before handing over the money.
However, knowing what you are investing in falls in line with best practices of Passive Investing. Due diligence is required for Passives to understand exactly the type of investment vehicle is being chosen much like due diligence is required of the Lead Syndicator in regards to acquiring an apartment building. After all, instead of paying some hotshot hedge fund manager to invest for you, you are taking control of your own investments.
This leads us to the next step - knowing who is managing your money.
Step 4: Decide Who Manages Your Money
Some people start by investing with a person they know and some start by choosing an asset type. Some syndicators are well-versed in evaluating multiple investment types, thus bringing diverse profitability for their investors.
There are many factors that make or break a deal. The most important factor is who is running the deal. A great sponsor can make an average deal perform well. A great deal could turn into a bad one if the sponsors are not good at what they are doing. Here are the questions I ask when I am choosing a sponsor for a passive investment:
Do I know this person and agree with his/her investment strategy?
Have they sold a deal yet?
What is their track record on current deals and past deals?
What is their track record on turning around a challenging deal? If they did not have a challenging deal, then run. They likely don’t have enough experience yet. All seasoned syndicators can tell you one or two challenging deals.
Did they have any deals that didn’t perform? How did they recover or manage the consequences? All investments have risks, you know if they are the right person for you based on their priority when they are under stress. Did they put investors first in these situations?
Are they great at communication and being transparent?
Are they good at project management?
Have they passively invested?
Are they focused? A single focus should be very obvious to spot with a good asset manager. For example, the sponsor can have a property management company if its sole purpose is to serve their own properties and generate acquisition leads. They may also happen to have a construction arm of the company that focuses on cutting the cost of renovation. This is good, because this means they are very deeply invested in one single area - residential rentals. If they also own commercial office buildings and hotels, then one might need to take a second look at why they own these and how it fits into the overall company strategy. Good company has a single focus.
How do you find these sponsors? You will need to get out there and network. Going to local or national conferences, asking for a referral, joining a mentorship program that has networking elements, being a real estate related community online are all part of the networking to find the right person for you to invest with.
After you find them, you would want to set up a couple calls with them to get to know them better. You would also ask for a few referrals to their existing investors that would like to talk with you about them and their investment experience. Do not contact the syndicator to ask for their investor information unless you are serious in passive investing with them.
By law, depending on the offering type (506b), a potential passive investor may have to have a substantive relationship with a potential deal sponsor or lead syndicator before any money is exchanged. At EZ Real Estate, we follow this rule regardless of the type of offering (506b or 506c). We are very proud of the personal relationships we have established and have nurtured within our investor database. When we build connections, we build mutual trust. When we have mutual trust, we work together as a team for a better investing experience for all. We’d love to start this conversation with you. Schedule your call with Elisa.
Ideally, phone calls and email communications between lead sponsors and passives are a regular occurrence during the life of the investment. If a lead sponsor makes time to talk to their passive investor teammates before closing, this is a good sign of their commitment to building strong relationships and, in turn, a stronger team. That being said, seasoned sponsors are usually extremely busy working on multiple deals, so be respectful of their time. Do not expect to use passive investment to get in on free coaching from lead syndicators. That is another sure way to land yourself on the do not contact list.
Step 5: Understand your Investment
Once you’ve selected the type of investment and with whom you want to invest, it is time to evaluate each opportunity separately.
Here are common metrics to look for:
What is the return?
You should be expecting cash flow and/or equity gains when investing in apartment buildings. Different classes of assets have different types of return. Some are heavier on cash flow and some are heavier on equity. In apartment building investing, 7-8% cash flow yearly and a total return of 70% - 80% is common in projection if someone projected conservatively.
What is the business plan?
Does the plan make sense considering the current market trend? Investing with market trends is a good way to profit. Investing against the market trend such as forcing value when the market is volatile is playing with fire.
Who gets paid first, passives or sponsors?
There are priorities regarding the payout on cash flow as well as equity. A preferred rate is often used to provide investors a more predictable cash flow. It basically means that investors will get paid before sponsors do on cash flow up to a certain percentage.
Are you limited on sharing the upside?
Often with preferred rate structure, the sponsor does not get paid in the first couple of years when the property is going through renovation. They will put in a bonus structure in the back end. When they reach a certain equity return when property is refinanced or sold, their profit share increases. For example, a deal could be structured with a 70/30 split in favor of the passive investors. If a 14% IRR is reached, then the bonus portion of the deal (and ONLY this portion) is split 50/50. I like this structure combined with preferred rates because it provides me, the Passive, with a stable income as well as incentivizing my sponsor to work harder and faster.
How are the sponsors incentivized?
I will look at all different fees, splits and deal structures to see if my sponsors are getting paid for the right things in the right way. I have seen refinancing fees, disposition fees, acquisition fees, asset management fees (different from property management fees). Personally, I think acquisition fees and asset management fees make sense as they are tied with what the sponsor brings to the table. Smaller deals usually have a higher percentage of acquisition fees. Each deal takes months to find and acquire and sponsors should be compensated accordingly.
Asset management fees should be tied with performance of the asset. This serves as a good incentive for the sponsor to perform better. The preferred rate and structure I mentioned above is a good combination to make sure the sponsor is not starving but is putting performance of the project first. A 10/90 equity split on the surface looks great, but I will never invest in it because this means the margin is too thin.
Do you like the asset in terms of location, age, unit mix and tenant demographics?
This is an important factor since we are buying real estate. This should be adjusted with the economic trend and migration pattern. For example, in the recovery cycle, you may want to buy higher risk properties in not so great locations as this presents the most discount. In a cooling market, you may want to focus on good location assets due to a potential economic downturn that will have more impact on neighborhoods with less income.
What is the projected total income growth?
Total income growth is the rate of growth for the total income of the property. I see a lot of deals advertise 0% rent income growth or 0% market rent growth but they had other aggressive growth such as utility charges and pet charges. At the end of the day, the tenants care about their total monthly payment. During an uncertain market cycle, I like to see a <2% total income growth in the first 1 or 2 years.
Can the property service the loan?
Large reserves and good cash flow will carry you through any down markets. When you evaluate a deal, make sure you are looking at stabilized cash flow. You should look at if the property does not have any total income increase in the first year, with your expenses, can you service the debt comfortably. You should be able to service your loan with an extra 30% buffer.
Are there healthy reserves?
When COVID-19 first hit, most of my passive projects stopped distributing payouts to Passives. These sponsors wanted to build up their reserves to weather the storm. A few of our properties continued passive distributions because we had healthy reserves.
What is the reversion cap rate?
Reversion cap rate is the cap rate you use to calculate your exit price. Cap rate is the annual rate of return on a real estate property if you would pay cash for the property. Think about this as your business multiplier. The purchase price can be calculated by using the net operating income divided by cap rate.
In a typical growth market that is more cyclical, the cap rate can vary as much as 4-5%. Even a 1% cap rate swing is significant. For a property that is generating 100K cash flow before paying the debt and capital improvements, that 1% cap rate swing can mean a $1M difference in purchase price. It is a metric impacted by the market. You want to make sure you buffer for not being able to sell at optimal market conditions if you are buying at a hot market cycle.
Step 6: Just Do It
Now it’s time to put your money to work. Stay connected and keep forming new relationships. The steps described above will get easier with practice. You may want to invest in one deal and wait for a few months before you invest another deal. Its entirely up to you and your unique situation.
To invest in a deal, you should follow these steps:
Go over the deal very carefully and ask questions during and after the investor webinar.
Move quickly to avoid missing out on a good deal. Sign up for a soft commitment, if applicable, to reserve a spot.
Read all legal documents carefully. Pay attention to how sponsors say they will handle situations when the deal does not go well.
Sign documents quickly to secure your spot.
Wire money promptly and make sure to have at least two ways to verify wire information to avoid wire fraud.
Step 7: Make Money While You Sleep
You should be expecting monthly reports and quarterly or monthly ACH payments. Annually, you should receive a partnership K1 return. Give that to your CPA for tax purposes. Your first year K1 is likely negative due to bonus depreciation. This can be used to offset your taxes, depending on your tax situation. If you invested with your retirement account, you may need to file Form 5498 annually. For that, you will need to request for an annual evaluation of fair market value of your share. Have a conversation with your CPA about your passive investing activities to make sure you are covering all of your bases.
Invest with someone with a solid track record, who values and nurtures relationships and understands the unique needs of passive investors.