3 Paths to Active Real Estate Investing…and Why I Went Passive!

Passive Investing

I’ve been an active real estate investor for over twenty years. I first got interested in real estate when I was trying to figure out my own retirement plan in my late twenties.

As shown above, the Vanguard website I visited suggested you could spend 4% of your portfolio a year when you retire. If you want a $200,000 retirement income, you’d need a stock and bond portfolio of $5 million. My wife and I both had great jobs, but that seemed like a lot to have to save up in our 401k and IRAs!

We needed to find another way. I started to learn about real estate investing as an alternative. I really liked what I found.

In the mid-1990’s, it was plausible that you could make 20% annualized IRR (internal rate of return) with real estate. The IRR is a metric that captures all four ways in which real estate generates wealth:

–        Cashflow from the tenant each month.

–        Paying down the principal of the loan.

–        Tax benefits, such as writing off depreciation to reduce your current income tax.

–        Appreciation.

By comparison, the stock market over the last 50 years has generated around 10% IRR. The bond market returns quite a bit less than that.

Albert Einstein once said that compounding interest is the eighth wonder of the world. See for yourself:

We saw it too, so my wife and I decided real estate was for us. In 1998 when we moved to Denver, we bought a bungalow in Washington Park, a neighborhood just south of downtown Denver, for $219,000 (it would be worth over $800K today with compounding interest!) We put in a separate entrance and created a basement apartment unit that we rented out. It made a big dent in the mortgage. The key skill here was networking to find different tradespeople to help me with the work. It wasn’t too hard to build out, and it was very easy to rent.

I wish I could still find deals like this on the Multiple Listing Service (MLS)!!! I bought several more rental buildings after that.

Real Estate Fix and Flips

We started doing fix and flips (F&F) in 2000 to generate more cashflow. In the late 1990’s and early 2000’s, the average DOM (days on market) was 80-90 days. There was lots of inventory to look at. It wasn’t too hard to find good projects. The best projects would get 2-3 offers and sell in a week, but most “average” deals were on the market for at least a month, and you were the only buyer. The key skill for F&F is to have a good vision for what a successful remodel will look like, and not do too much. It’s important that the style of your work is consistent with the neighborhood and architecture of the building.

For my F&F, I restored a huge Washington Park Victorian that had been carved into a triplex. Some of my contractors turned out to be crooks. It was a LOT of work, and some of the more modern finishes we picked – at that time – were not desired by buyers in that neighborhood. It took twice as long as I expected and certainly went over budget. I got a decent amount of negative feedback about my finish selections. We eventually sold it for about half of the profit expected. That was sweat equity!

I learned a lot. My next project was much smaller and had a highly focused scope of work. I got a lot more precise in screening contractors. We finished a full remodel in six weeks vs fourteen. Again, a Victorian, but this time we got the finishes the market wanted. Despite the average Days on Market (DOM) being near 90 days, we sold the house the first weekend for asking price. That was a highly profitable project. I was on my way.

Of my first eight F&Fs, I made money on seven and lost around $10K on one. It had a terrible floor plan. It was in a nice Denver area (Congress Park) on a beautiful block. But it had the worst floor plan, and there wasn’t any good way to fix it. I thought a nice renovation in a great area would overcome the limitation of a poor plan. Nope. Couldn’t sell it. Eventually gave it away. Never do a F&F if you can’t figure out how to solve all the problems.

Doing a F&F is a big hobby/job if you want to make money from it. It is NOT passive. If I was running two at a time, it’d easily take me 30 hours a week, which was hard to do with a full-time job. Looking at properties, examining comps to determine what level of renovations to do, getting the loans, buying the homes, interviewing contractors and getting bids, supervising their work, solving lots of problems, then finally selling… geez it’s a lot of work.

Value-Add Renovations

Next, I switched from F&F to buying to buying beat-up rentals. I could take a fourplex in disrepair with low rents (and/or high vacancy), repair the units, and re-lease at higher rents. With better cashflow, I could refinance the property, take out all my cash, and keep the asset.

You don’t need a calculator to know that the IRR on this style of project will be VERY high. That kept me busy from 2002 to 2007. This time I used a property manager and hired a bookkeeper. I was starting to have a set of contractors I could (mostly) trust, so project management was less cumbersome. Since I held the asset for more than a year, when I did sell, it would qualify for capital gains tax vs. ordinary income, cutting my tax bill dramatically. Alternatively, I could do a 1031 exchange and defer my taxes. That was not an option with F&Fs (you need to own the asset for a year to qualify for a 1031 exchange, and most F&F should be completed in 3-6 months). I made less money, but it was so worth it to get my time back.

2008 wasn’t a good year to buy, since the market fell an average of 25% in Denver. In nicer areas like the Highlands, prices didn’t drop, or they only dropped a small amount. In lower priced neighborhoods, the values dropped 60-70%. It became clear by 2009 that we were at/near the bottom. Every homeowner that was foreclosed on became a tenant the next morning, so there was a lot of new demand for rentals.

One of the other members of the investment committee at Ironton Capital is Brent Guyor. He has a background as a CPA at KPMG and a real estate developer at Intrawest. He and I got the financial statements for most of the condo HOAs in Denver. We analyzed which were the strongest and built a priority list.

We started to buy many condos. In 2009, I had a memorably great deal where I bought a package of four 1BR and four 2BR condos in a nice complex for $340,000.

They increased 500%+ in value by 2019.

My 25% down payment increased in value by nearly 15x in ten years. I had great cash flow and easily paid off the mortgages in under ten years.

I wound up buying over eighty condos and townhomes in 2009-2012. Brent bought quite a few and we helped clients buy them by the dozens. I think it’s highly unlikely that we’ll ever see another opportunity THIS good. But there are always other opportunities in the future.

Working on bigger projects

Three or four years after buying all these cats and dogs, it was time to refinance and pull out a lot of equity. I used it to buy projects like a 30-unit apartment complex that had 30% vacancy with rents 25% below market. I did light renovations on the units, re-leased at market with a strong property manager, and fixed the utility issues (e.g., install LED lighting, low flow water fixtures, high efficiency laundry equipment, xeriscaping). The skills for this project were:

–        Developing a good work plan and budget

–        Being able to communicate effectively to a bank to get a loan on favorable terms

–        Solving any problems that came up

2015-17 was about the end of when it was relatively easy to find apartment value-add projects like this. Too many people caught on to it. It became insanely competitive to find such projects.

I even tried building over 25 townhomes and spec homes. I discovered that I was making around a 20% IRR, which is fine. But real estate development doesn’t have the same favorable tax treatment that apartment value-add has. And there is, in my view, a LOT more risk in development. Also, I found development work a lot more time-consuming and stressful. I’m sure there are new construction developers that would disagree with me – and I’m glad for that. It’s a corner of the real estate market that isn’t for me, and I’m glad it works for them!

By 2017 I started selling my properties off. In the past when I did this, I would use a 1031 tax-deferred exchange to find a bigger project. Since I was not able to find suitable projects with high enough returns, I just paid the capital gains tax. By that point, I had been a VERY active investor for twenty years and liked the idea of working less and skiing, golfing, and playing more tennis with my family. I started to research if passive real estate investing could be a viable option. The more I researched it, the more I liked it.

With active investing, I was responsible for (the short list):

1.  Understanding the market trends.

2.  Making intelligent purchase decisions about what sort of asset to buy, and how much (if any) renovation to do.

3.  Finding the deal (which became increasingly difficult).

4.  Running all the appropriate due diligence.

5.  Arranging the financing, and personally being responsible for the loan.

6.  While the property manager did most of the day to day, but I still had to supervise the manager, as well as the bookkeeper.

There are enough problems to solve for everyone! While you own the project, you never really get out of the trenches. Then I had to decide when and how to sell at the right time…and manage the sales and negotiation process. Then be on a tight 1031 exchange close to repeat the process. (See the Appendix for the complete active investing checklists!)

It’s the ultimate first world problem, and I’m sure plenty of readers would love to trade places with me…but it does feel like being on a treadmill, right?

Upgrading to Passive Investing

Therefore, I decided it was time to try life off the active investing treadmill. Instead of ME doing all the work, with passive investing, the project Sponsor does all that work.

The passive investor (the “limited partner” or LP) just sends in a check and cashes a check at the end. The LP usually gets a preferred return (often 5-8% per year), which means that they get paid first. But that was still a lot of work, participating in each project individually, and I had to write a large check for each investment, which was higher risk than I wanted to tolerate.

Then I discovered a third way. Rather than finding and negotiating with each Sponsor individually, there could be a General Partner (GP) who found multiple projects for the LPs and each LP could have a small piece of each project. The risk was mitigated, I could participate in more projects, and the GP could take care of all the due diligence and accounting for the LPs.

The LPs still get a preferred return and after the preferred return, GP and LPs share the profits in a “waterfall.” The GP might get 20% of the profit and the LPs get 80%, up until a total of 20% annualized IRR has been paid. If there is any profit beyond that, the GP cut increases as an incentive to do well. I liked how everyone’s interests are aligned and investing gets easier.

After a year of research into this fund of funds model, we made eight passive investments in 2019 to 2020. By early 2024 (about four years later), five investments had been completed and were paid off. The other three projects needed more time and should be completed in seven years (2026). We’re on track for these initial eight investments to make a 15% IRR.

That’s not quite as good as I could make as a skilled, experienced active investor in yesterday’s market in Denver, but it is close. And it was just my first try, even starting during challenging COVID conditions.

In today’s market, with higher interest rates, and very high real estate prices, we can make more as a passive investor nationwide than we can as an active investor in Denver.

What sort of passive investments are we talking about? Let me share two successes and one mistake.

Two great projects and one flop

Our best project was a build-to-rent (BTR) in a suburb of Dallas, Texas. As home prices and interest rates have gone up, many young families that should be first time buyers (FTB) were renting longer than they did in the past. We suspected many of these would-be FTB will end up becoming renters for life.

Since they are getting old enough to have kids and dogs, they no longer wanted to live in a rental house that feels like an apartment complex. They want a garage attached directly to their living space, with a backyard, ideally without someone making noise above them.

The BTR community was a subdivision of duplexes. Instead of being sold to hundreds of individuals, the GP sold the entire community to one Wall Street fund. It was sold before it was finished, as BTR are highly in demand from institutional investors. The LPs got a 56% IRR on this grand slam project.

The next best project was the development of a new luxury apartment complex between Dallas and Fort Worth TX. In the summer of 2022 – with the economy slowing down, a war in Ukraine, massive inflation, and a looming recession – the GP received an unsolicited offer before finishing construction – for more than our pro-forma selling price. The GP accepted, and when construction was complete, we turned over the keys and achieved a 31% annualized IRR for the LPs.

Now, in full disclosure, we must share the worst passive investment, too. The GP bought a distressed office building in a nice suburb of Houston, right before COVID. The plan was to renovate the common areas and vacant office suites. In theory, with better management, we could raise rents, fill the building, then sell it at a good profit.

Great business plan. However, during COVID, not as many companies were interested in leasing space. Supply chain and contractor issues made renovation more costly and take much longer. Nothing went right on this project, and we’re hoping to just get our money back (0% IRR), a few years after the initially targeted timeline. More realistically, we may lose some of the initial investment. Our current expected return of 15% annual after expenses assumes we lose all the money on the Houston office project. The power of diversification is that you can have a problem project and still do well overall.

But that’s the point; there will always be one investment that doesn’t pan out, so you need others to absorb the break even or loss. It’s no different than investing in the stock market – not all stocks go up every year, so you diversify.

Understanding Market Strategy

As I write this in June 2024, the commercial market has changed a lot. Most buyers are in “flight to quality” mode. High-quality, high-performance assets such as the two examples above are easy to sell and banks love these loans. But if you have an apartment that is dated, has deferred maintenance, below-market rents and/or high vacancy – it’ll be hard to sell, and it’ll sell for less than it did two years ago.

Compared to actively managed stock funds which monitor economic trends, interest rates, and many other factors to constantly adjust their portfolio.

Real estate investments move a bit more slowly. The best strategy changes about every 18-24 months, so you must stay on top of the national economics and market trends.

How do the wealthiest families address this?

They have a “family office” (FO) to handle their financial affairs. A FO is a personal financial team that helps wealthy families manage their money and assets. The FO handles everything from investments and taxes to estate planning and philanthropy. They adjust the investment strategy as often as needed to balance risk and returns. The goal is to grow and protect the family’s wealth for current and future generations. Family Offices provide tailored financial advice and services, ensuring that the family’s financial goals are achieved. A Family Office starts to make sense when you have $50 million or more to manage.

While you definitely need something like that, your assets may not have grown to the size for FO management yet. Most of our readers are in the $1 to $20 million range and instead try to do it on their own. You could go out and find a few passive real estate investments and do the homework for you to determine the optimal strategy, which is always changing. You would also have to write a large check for each individual investment, which puts choice investment-grade properties out of reach for most investors.

But there is a new, little-known option for successful families that do not yet have the assets for a Family Office.

You can have a fund manager that selects and manages a portfolio of real estate investments for you, who finds the deals, makes the site visits, performs the due diligence and communicates with the sponsors for you. (We’ll go in-depth into this option more in a moment.)

For example, take those three projects I described earlier. There were eight projects all together in that particular passive portfolio.

Altogether, the eight projects will have around a 15% IRR. The grand-slam BTR project had more than enough profit to make up for the office building mess and that’s perfectly normal. That’s why we made more investments, to spread out the risk.

Diversification is the key. As a newer active investor, you might have only one or two investments, because that’s all you can afford to invest in at one time. That creates a concentration risk of which most investors are completely unaware.

If you are lucky enough to get two great projects, you are off to an amazing start. If you get one good and one bad, your spouse will be unhappy with you. I really like having more investments to diversify and spread the risk. As you will see, the 4 Pillars of Passive Real Estate Investing will come down to four strategic areas where we diversify to manage risk and then flex with market conditions, and that’s always the key to investing.

Isn’t it time your Financial Freedom comes Passively? We’ll review our investments with you 1on1 at https://irontoncapital.com/myreview

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