Why should I be an active real estate investor?

Question

As an individual investor, why would I want to invest in a real estate partnership or LLC when I can take the funds and buy a well-run REIT with dividends and total returns approaching 8%?  I have no management headaches, and I have liquidity, so why would I do that?

Asked by: MH - Mississippi
Answer

Restatement: Why should I be an active real estate investor if I can create reasonable yields as a passive real estate investor?  

The short answer is that these two paths seldom meet.  Whether it's because of a lifestyle choice, expertise, opportunity, or something else, few people are both active and passive investors in real estate.  Most people pick a side and stay there.   

What is real estate ownership? It is the right to the income stream from real estate. Ownership through stocks or bonds buys you a tiny percentage of ownership in a larger platform or ownership structure.  There is nothing wrong with that.  But one thing is for sure; you have no control over the management or outcomes from this ownership position: you forfeit the right to create value directly or have any say over operations, acquisitions, dispositions, or sales.   

 REITs represent many platforms within the real estate asset class; some invest in hard assets, other in mortgages, land, or other partnerships.  Then there is product type, from multifamily to warehouses, office buildings, and marinas.  Selecting a REIT that will meet your baseline assumption of 8% is no small task.  Like any other investment, REITs require your attention to ensure they continue to perform. As Jeff Bezos says, "even Amazon will eventually go bankrupt." 

One of the significant advantages to the direct ownership of individual real estate assets is leverage.  Leverage catapults yield and leverage are reduced over time by paying rents that go towards mortgage liquidation. No other form of investing outside of direct real estate ownership allows for such significant leverage and asset control concurrently. This is the reason for considering direct ownership of real estate assets. 

There is a myriad of options within the world of real estate ownership.  Here are the two most common: owning paper assets and owning hard assets with control.  

A paper asset is when you own a mortgage secured by real property.  When you own a mortgage, you are a lender, not a real estate owner. And while you do not own real estate, there is real estate exposure.  How is that?  Because your asset (the mortgage) is a security instrument secured by a hard asset that, in the case of default, may require you to foreclose to protect your investment, to recover your money.  If this occurs, you have to be willing to become an owner of real estate.  

Owning a hard asset with control means owning the real estate directly and having the authority to act unencumbered.  Granted, you must act within zoning laws.  But outside of that, you can do pretty much what you want.  You are free to let it sit vacant or try and make a dollar.  Most of us attempt to apply a perspective that encompasses the highest and best use to real estate assets; our objective is to create value by generating rental income or performing some action on the land that increases its value.  

These "acts" can be as simple as drawing another line on the parcel and making one parcel into two.  It can be changing the zoning from residential to commercial.  Or tearing down a duplex and building a four-unit building.  We can replace a mini-storage with a retail strip center. Replace a retail strip center with a small office building.  Or remove a gas station and build a high-end multifamily asset with underground parking. 

Passive real estate owners must monitor their investments and likely make changes now and then.  Real estate ownership requires active management.  This active participation is what generates the opportunity for superior yields.  

Many people fail in ownership or active management because they have too much leverage and little management expertise.  Just because a lender will allow an 80% loan-to-value mortgage on an investment property doesn't mean it's a good idea.  And, having breath in your lungs doesn't make you a stellar manager of real estate assets.  As the Texas oil rig operators say, the in suits: "that boy can't spell oil." 

The good news is that leverage is a choice.  So, when you can, choose less leverage and better debt service coverage.  Concerning management, hire professionals.  They are out there in every community – full-time folks that got this game down cold.  You don't have to learn the business on the fly.  Sure, invest, but hire the pros to make it work.  Factor in their fees and learn along the way if it makes sense for you.  

The only people who make a second real estate investment learned something from their first one.  Direct ownership does require active participation.  With this comes the potential for greater yields, greater than 8%.  But at the cost of time, energy, capital, and higher risk.  

Determine your risk profile. Don't let anyone else do that for you.  If direct ownership is right for you, bring some people with that particular real estate business from experience.  If that's too much work…then 8% is good to go.  

Becoming an active investor in real estate assets is really a lifestyle choice. No one has to buy, own, and manage real estate as a necessity in life. It's just one choice among many for investing dollars, energy, and effort to make money.  Some people love it and would never want to do anything else.  For others, it's a chore that was thrust upon them and a task they can't wait to get out. 

Then, there are people eyeing at real estate assets from the outside looking in, just itching to get in 'the game" by any means possible. These are the people that should go slow, learn the game, and approach with care their endeavors in real estate investment. 

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