Investing in real estate can be a great long-term investment strategy. It adds diversification to any portfolio and provides an opportunity to own a tangible asset. But if you are going to invest in real estate, is there a suitable way?
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
There are two general paths to investing in real estate — passive and active. Which one you choose is a personal preference. You’re probably wondering, though, how do I actually get to that decision point? In this article, we’ll cover both paths in detail and outline who each path is may be suited for.
Direct Real Estate
Direct real estate investing is an active investment strategy. As an investor, you’ll be more hands-on with property management. That includes taking out a loan, repairing the property, improving it, and addressing various tenant issues. If there are any legal problems, you are also involved in that.
Direct real estate means that you’ve bought a property and hold direct title to it. This might be a rental house, residential duplex, self-storage facility, or office building. You’ll have to find the tenants, ensure monthly cash flow, and handle any evictions.
If hands-on is your style, direct real estate may be appropriate for you. A potential benefit of active real estate investing is that you have total control — you make all of the decisions. If you slant towards micromanaging, direct real estate might be right up your alley.
Tenant-In-Common (TIC) is a direct real estate investment structure where several owners acquire and manage a property. It splits the responsibility across all owners. This route may suit you if you are okay with splitting ownership and decision-making with other people. If you know everyone involved in the TIC, it may work well. But otherwise, given all of the decision-makers, it can be a frustrating experience.
Leverage
When you invest directly into real estate, you can buy the property outright or make use of leverage. Some investors prefer to use leverage because it can amplify potential returns. Using leverage typically equates to taking on a mortgage. No matter how the deal is structured, if you are only putting up part of the property’s purchase value for acquisition, you are using leverage. Using leverage frees up cash for other investments since that cash is not locked up in the property.
Semi-Passive Investing
For some people that want to own a property but be a little more hands-off, hiring a property manager can be a good middle road. You’ll have to give up some control but how much can be decided on between you and the manager. Hiring a manager will also decrease your potential returns since you’ll need to pay an ongoing management fee. That is the trade-off between passive vs. active investing. The more passive your investment, the more control you must give up, and in some cases, the less your potential return may be.
Passive Investing
Passive real estate investing means giving up control to a sponsor or company that manages the investment or fund. However, that doesn’t mean you’re going into the investment blind. Doing your research on the sponsor ahead of time is a necessity of passive investing. You want to be sure the sponsor has a good track record and will be aligned with your objectives.
There are several ways to passively invest in real estate. They include funds, REITs, and Delaware Statutory Trusts (DSTs). These methods work by pooling together investor funds and using them to purchase properties, which typically allows for smaller investment minimums. A sponsor makes all of the decisions and investors have little to no say in the process.
In a passive investment, generally, you sit back and collect a periodic (monthly or quarterly) distribution from the investment. There may be a liquidation event in some cases, which can provide the opportunity to capture additional gains.
For many passive investments, such as a Delaware Statutory Trust (DST), the investor must be accredited.
There is no guarantee that the investment objectives of any particular program will be achieved.
The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.
Delaware Statutory Trust (DST): A Passive Investment Option
Which passive investment structure is suitable? While that is also a personal decision, DSTs have many potential advantages. A DST is similar to a fund in that investors pool their money together to purchase properties through a sponsor. The DST sponsor makes all of the decisions, but follows an investment strategy that is always disclosed to the investor.
DSTs typically invest in commercial-grade properties, with asset values that range anywhere from $5 million to $100+ million. Oftentimes, DSTs invest in more than one property. This creates a built-in diversification for investors. Instead of investing in multiple DSTs, an investor can invest in one DST that distributes those funds across multiple properties. Unlike an investment in a REIT, DSTs are considered a real property investment, which makes it 1031 exchange eligible…
1031 Exchange
A 1031 exchange applies to both active and passive real estate investments. It’s a type of investment transaction that provides tax benefits. When you sell your real estate investment and use the proceeds to acquire another property, you’ll incur capital gains taxes — a 1031 exchange positions itself in the middle of that transaction. The result is a deferment of capital gains taxes. There are specific deadlines and restrictions to follow when executing a 1031 exchange. By working with a qualified intermediary, successfully executing a 1031 exchange is something almost anyone can do.
Once your first 1031 exchange has been executed, you can continue executing 1031 exchanges. Want to acquire a third investment property? Consider a 1031 exchange to do it. You’ll just keep deferring your capital gains taxes. By deferring capital gains taxes, you free up capital for more investments.
Active and passive real estate investing are the two main paths for getting involved in real estate. Active or direct real estate investing is suited for those who want the most control. Passive investing is for the investor who wants a hands-off experience and is ok with giving up control to a sponsor. Both types of investing allow you to utilize a 1031 exchange, providing long-term tax benefits in the process. Note that investing passively into a REIT is generally not 1031 exchange eligible, unless a Section 721 exchange is executed.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
