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The difference between Passive and Active investing

How active do you want to be?

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How active or passive you are in a real estate investment will depend on several factors including, your financial strategy, your relationship with the deal provider, and your personal interest in being involved in the mechanics of the deal.

Active Investors

 

Active investors are the ones who find, organize, and manage the deals. These are typically individuals or a small team of individuals who have experience in evaluating opportunities, identifying and managing risks, and coordinating the network of suppliers and contractors needed to execute the deal successfully.

 

They have a fiduciary responsibility to the passive investors.

They also assume the financial and legal risks for the deal. If something goes wrong, they bear responsibility.

 

If bank financing is used in addition to the investment capital, the active investors are often required to provide personal financial statements to the lender and individually guarantee the loan.

 

For the elevated level of risk they assume, they are typically compensated by a combination of management fees and a portion of the profits that are shared with the passive investors.

 

To be a successful active investor, you need three things - knowledge, skill, and time. Time to find and manage deals, knowledge to know what a good deal looks like and how to mitigate the risks, and skill to put that knowledge into practice.

 

Active investors who find themselves lacking in one of these areas will often partner up with one or more active partners to fill these gaps in their team.

 

If you have an interest in dealing directly with real estate or you want to apply more than just your investment capital to a project, being part of an active investment team might be a good fit for you.

Passive Investors

 

There are two types of Passive investors, equity investors and debt investors.

 

An Equity Investor buys a share of ownership in the real estate itself in exchange for an agreed percentage of the profits generated by the deal.

 

A Debt Investor doesn’t invest directly in the asset.

 

Instead, they structure their investment as a fixed interest loan to the active investors, secured by a mortgage on the real estate.

 

Debt investors don’t share in the risks and rewards of profit sharing, but they are guaranteed a predetermined return on their money no matter how well or poorly the deal goes for the active investors.

 

 

Example

 

XYZ Property Investors has an opportunity to buy a single family house to remodel and resell at a profit. An investor has $100K to invest for 6 months in the deal and is considering whether to be an Equity or Debt investor.

 

XYZ offers the investor two options.

 

A. Borrow the investor’s money at 8% annual interest, paid monthly. With the loan being paid off when the house resells. (Debt Investment)

 

B. Offer 50% split of the net profits on the deal when the house sells. (Equity Investment)

 

 

Let’s look at how their investment options might perform.

 

 

Scenario 1

The house sells in 6 months as planned, with a net profit of $40,000

 

The Debt Investor would receive a monthly cash flow of $666.67 per month for the six months of the investment, totaling $4,000 in payments.

 

The Equity Investor would receive a lump sum payout of $20,000 when the house sells, representing a 20% return on their investment.

 

 

 

Scenario 2

The house sells in 8 months due to a slow market. In addition, extra repairs were needed on the house, reducing the net profits to only $5,000.

 

 

The Debt Investor would receive a monthly cash flow of $666.67 per month for the eight months of the investment, totaling $5,333 in payments.

 

The Equity Investor would receive a lump sum payout of $2,500 when the house sells, representing a 2.5% return on their investment.

 

 

 

 

As you can see, the Debt Investor is the more conservative position, offering monthly cash flow that is not tied to the performance of the deal. The full value initial investment is also secured by a mortgage on the property.

 

Meanwhile, the Equity Investor has the potential for much higher returns if the deal goes well. But, they are also exposed to poor performance and a potential loss on their initial investment if the deal does not perform.

 

 

IN SUMMARY

 

Most people can take advantage of passive investing in real estate by connecting with an experienced team who can help them achieve their financial goals.

 

Active investing provides the opportunity for higher rewards but requires a time and labor commitment to the success of the deal.

If you would like to learn more about investing in real estate to build wealth using your savings, HELOC, or 401k/IRA funds, feel free to contact us. We would love to talk about investment  strategies and share our experience to help you leverage your resources to achieve financial success.

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