If an investor has decided that they would like to invest in the multifamily asset class, they have two options for doing so: actively or passively.
In an active investment, investors form a limited liability company (LLC) and find a property on their own. Once identified, they also need to underwrite it, perform due diligence, arrange financing, get the deal closed and manage the asset once the purchase is complete.
This is a tremendous amount of work and requires very “active” participation from investors/property owners. It also requires a significant amount of expertise, time, resources and relationships to do it well. For individual investors, this is likely not the best strategy for investing in multifamily properties. They may be better served by a passive approach.
What is a passive multifamily investment?
In a passive multifamily real estate investment, all of the above work still needs to be done; it is just outsourced to someone else. Often, this takes the form of a multifamily investment firm or individual transaction sponsor who specializes in the acquisition and management of multifamily properties.
For individual investors, there are a number of important benefits to this approach.
What are the benefits of passive multifamily investment?
For students and potential investors, I like to highlight six key benefits to passive multifamily real estate investing.
- Lower Barriers To Entry
The barriers to entry for passive investing are much lower than an active approach. An individual does not need to be a multifamily expert or have detailed knowledge of the tools and systems used to acquire and manage these assets. Instead, they simply need to have a relationship with a transaction sponsor who will bring them investment opportunities and the capital to make an investment. In certain types of transactions, they may also need to qualify as an “accredited investor,” which means they need to meet certain income and/or net worth requirements.
Multifamily investment firms are experts in the space. It is all they do on a daily basis and individual investors who work with them get the benefit of their relationships, software tools, expertise and time. These are extremely valuable assets in commercial real estate investing and can have a positive impact on investment returns.
- Better Properties
One of the major downsides to an active approach is that there is a limit on individual resources, which can also limit the quality and scale of the investment properties that can be purchased. At the other end of the spectrum, multifamily investment firms have the ability to source capital from a large number of real estate investors. This means that they can afford to buy higher quality apartment buildings that are in better locations and have more stable cash flow. For individual investors, it can be more advantageous to own a fractional share of a high quality asset than a 100% share of a lower quality asset.
- Passive Income
As described above, a multifamily investment firm is responsible for the day-to-day management of the property in a passive investment. For individual investors, this means that the manager does all of the hard work of property management and they are entitled to their share of whatever income is left over after all of the property’s operating expenses have been paid (including debt service).
In other words, a passive investment provides investors with the benefits of multifamily ownership without the hassle of actually managing the property. This provides them with passive income so they can use their time to pursue other interests.
- Tax Efficiency
Investments with a multifamily transaction sponsor are structured in a tax efficient manner, which provides two important tax benefits for individual investors.
First, the apartment complex is purchased in a limited liability corporation, which is structured like a corporation and taxed like a partnership. All property income and expenses are run through the LLC and anything left over is “distributed” to individual investors. This sort of structure reduces individual tax liability.
Second, individual investors can defer capital gains taxes on a profitable investment by utilizing a specialized type of transaction known as a 1031 exchange. There is no time limit on these exchanges and they can be repeated over and over, which allows for the tax-free growth of capital while deferring taxes indefinitely.
- Relative Stability
A multifamily real estate investment is often compared to other alternatives available such as those in the stock or bond market. Many passive investments are not publicly traded, which means that they also benefit from a degree of price stability not seen in publicly traded debt and equity markets.
However, I advocate for passive multifamily investments as part of a broadly diversified investment portfolio.
How can you make a passive multifamily investment?
For those who are convinced of the benefits of a passive multifamily investment, there are two common investment vehicles through which this can be accomplished: REITs and individual syndicators.
Real estate investment trusts (REITs) are a specialized type of investment firm that provide investors with exposure to commercial real estate assets. REIT shares can be publicly traded on major stock exchanges or they can be privately offered to accredited investors. REITs can also specialize in certain property types. For example, Camden Property Trust is a large, publicly traded multifamily REIT. As an investment strategy, publicly traded REITs provide liquidity and low minimum investments. But, they aren’t for everyone.
As an alternative, multifamily investors can work with an individual deal syndicator who is raising capital for the purchase of one specific rental property. This scenario provides less liquidity, but it also provides investors with direct knowledge of the property they are investing in so that they can complete their own due diligence.
Regardless of the vehicle chosen, passive investors in multifamily housing have the potential to realize both the benefits described above and a handsome return.