On today’s episode of the impatient investor, we’re going to talk about which passive investment camp you fall under.
As many of us know, there are many kinds of investors out there in the marketplace. There are some that choose to be what’s called an active investor and that’s someone that becomes an operator or a sponsor. Some good examples are someone buying their own apartment complex or maybe building a single- family house or maybe ground up construction on an apartment building. Arguably this is much more difficult of a path to go down and certainly very, very time consuming. And also, I would argue there’s a pretty complex learning curve to being an operator or a sponsor.
As a passive investor, you typically partner with the sponsor or operator. Many passive investors spend most of their time on the front end of a
deal. They’re checking or vetting out the sponsor or operator before they move forward. Maybe they’re learning about the asset class or the team associated with that deal or the risk profile and specifics of that deal, returns and hold time period, et cetera. But maybe you didn’t know. There are two different kinds of passive investments and we’re going to group these into two camps. The first is those seeking passive income to increase their retirement savings with stable, consistent returns or seeking to build wealth through a compounding passive income stream. I think the major differences between these two camps is where you fall in age and risk tolerance. Someone in their late fifties might be a little bit more conservative and look for a lower rate of return on a stabilized asset, but no matter which camp you fall under, I’m sure you’ve considered both stocks and real estate as passive investment options. The other reason you’ve sought out passive income opportunities is because you either don’t have the time or feel like you don’t possess the expertise to actively trade stocks or actively invest in real estate. For passive income, the most common vehicle in the stock market is through mutual funds and for real estate, although many passive income options are available, most of these options like REITs are tied to the stock market and correlated with wall street. So, for the purposes of this discussion, we’re going to stick to the non-stock market. Passive investment options.
Among the most popular of these options is the investment in a private real estate investment fund or syndication, a real estate syndication is a way for investors to pull their financial resources, invest in properties and projects much bigger than they could afford or manage on their own. Or perhaps it’s a portfolio of real estate where investors are diversified over multiple markets and multiple assets.
So when faced with a passive investment options between mutual funds and a private real estate fund, what are the most important factors to consider? I would say returns are the most obvious consideration in choosing between the two. But there are other factors you should consider that you may not have thought about. So let’s talk through and summarize some of these options. We’ll start with returns and let me give you a few more statistics.
The performance of the average mutual fund is likely to mirror the S&P 500. The S&P 500 index is average annual return over the past 20 years has been approximately 8.6%. Average annual returns from commercial real estate during the same time period averaged about nine and a half percent. Residential and diversified real estate and vet investments averaged about 10.6%. Assuming fees are equal between a mutual fund and a private real estate fund. The presumption is the average returns from passive real estate investments exceed those of mutual funds. In addition to the advantage in average annual return, passive real estate investments also have other benefits. One of the greatest benefits depending on the asset class of course, is passive income generated from productive assets should continue to produce even in bad times or that’s what we like to call a recession hedge. In a recession, stocks will correlate with the broader economy as the economy goes down, so does the value of stocks and logically the value of mutual funds. Real estate investments as a class of alternative investments are by nature, uncorrelated to the broader market.
Passive income generated from productive assets should continue to produce even in bad times. Income generating real estate won’t suddenly cease providing income and some real estate has even proven to thrive in a recession, mostly due to do the constrained supply of affordable housing that exists in the greater market. Mutual funds and stocks in general are not tangible assets. So when the value of stocks plunge, there are no tangible assets backing up the stocks to salvage value from. With passive real estate investments like debt or equity investments in a private real estate fund, your investment is often secured by a physical asset, so when all is lost, there’s always the underlying value of the real that can be liquidated to salvage your investment. With stocks, there is no underlying tangible asset, so when all is lost, there’s usually nothing left. With stocks, there is no added benefit from appreciation, like an investment in a tangible asset like real estate. When you combine the security aspects along with the appreciation benefits of a tangible asset like real estate, there’s no comparison for the passive investor between real estate and stocks.
Let’s switch gears and talk about control. With mutual funds you are at the mercy of faceless fund managers whose investment strategies are at their sole discretion and typically not aligned with you as the investor. With private real estate funds, you maintain control of how your funds are invested in by choosing who you want to invest with. If you prefer to invest in commercial real estate, then you choose to invest in a commercial real estate fund. Oftentimes with special purpose funds, you can invest in properties like retail center or an apartment complex. With some funds you can also maintain control over the rate of return. As many private real estate funds will offer a preferred annual return somewhere ranging from 6% to 8% and with private real estate funds, you are not at the mercy of faceless managers. And with private real estate funds, you are not at the mercy of faceless managers. Most of the time the fund sponsors are accessible from the introduction to the life of the investment.
For the investor looking to build wealth through passive investments. The choice between passive real estate investments and stock investments is clear. For above average returns, security, control as a hedge against bad times there is no comparison. However, with any investment, it’s important to do your due diligence.
Just as there are poorly managed mutual funds. There are also poorly managed real estate funds, but all things being equal, the choice is clear.