Today Theo and Travis will be answering their listeners’ questions and sharing their insights on investing in modern real estate development – like how important are entry cap rates versus exit cap rates in underwriting and how important are preferred returns?
Rather than outsmarting the stock market, the best strategy is to mirror it in your portfolio — typically with investments based on market indexes — and afterward, sit back and see what happens.
We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening, and I will talk to you tomorrow.
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TRANSCRIPTION
Theo Hicks: Hello Best Ever listeners and welcome to the Actively Passive Investing Show. As always, I’m your host, Theo Hicks, with Travis Watts. Travis, how are you doing today?
Travis Watts: I’m doing great, Theo. Thanks for asking.
Theo Hicks: Yup, absolutely. Today, we will be answering another question that was submitted by a listener. Thank you for the questions. This week’s question comes from a listener Jay. We’re going to do a little passive investing a 101 course. The question from Jay was asking us about the pros and the cons of passive investing compared to actively investing, so we’re going to go over a list of pros and cons today. But as always, first, Travis is going to mention why we’re talking about this topic in addition to it being a question from the listeners, about why is this relevant to listeners of the Actively Passive Investing Show… And then he is going to start off by defining what passive investing actually is. Take it away Travis.
Travis Watts: Sure. I’m so glad that we got this question. Thank you, Jay, for submitting it… Because I often forget sometimes. After 12 years of self-study, reading all the books, podcasts, and networking with thousands of people– that there’s a ton of folks just getting started in the space. They’re hearing about the word syndication for the very first time, they’re hearing about passive income, perhaps from the wrong sources… So I kind of want to give our take on it and kind of make a passive investing 101 show.
And quite frankly, this isn’t even about multifamily. You could relate it that way, but I really wanted to dive into specifically passive investing, to Jay’s point, versus active investing. We talk a lot about multifamily syndication, market trends, vetting deals, vetting sponsors, but what about the concept, or the strategy, or the philosophy of just passive investing, multifamily aside? So with that, I want to give you guys some practical math, some practical examples, and I want to go through a few definitions with you just to get started. Before I jump in, Theo, did you have anything else to add before we get going?
Theo Hicks: No, I don’t.
Travis Watts: Got you. All right, cool. So with passive investing, the way I look at it is this is the type of investing that doesn’t require your active participation in the business itself. Hopefully, that makes sense. I’ll give you some examples. Investing in stocks, for example – you’re not the CEO of the company, you’re not an engineer at the company, if we’re using an example like buying Apple stock; so in this case, you’re a passive investor. You’re just going to own a fractional portion of that company, and you’re going to let the team handle the business itself. That’s being a passive investor. You could invest in REITs, real estate investment trusts, you could invest like I invest, in real estate private placements, or real estate syndications as some people call them… It’s anything that doesn’t require active participation in the business.
So what is it not? It’s not fix and flipping properties. So many people think of it that way. Or “I’m going to go buy a turnkey property, a single-family home.” These are not passive strategies, because you’re still having to manage some elements of the business. If it’s not putting a tenant in, maybe eventually you’re doing that, or it’s managing the property manager, or it’s out there seeking and driving to find these properties… There are active components. It’s not wholesaling houses, it’s not day trading stocks, it’s not syndicating your own deals and being a general partner… Those are all active strategies that require your personal time, effort, commitment, inside the actual business of generating the income and the returns.
So with that, why passive investing? I would say this generally falls into two categories for people. You’re either in it for what I call time freedom, which is freeing up your time and having flexibility over your time –I’ll explain that a little bit more in a minute– or you’re in it for just general wealth creation. You’re either more money-focused, or more time-focused, or simultaneously the combination of the two.
Think about this – when your passive income, be it dividends, interest, cash flow, etc., from your assets, when that exceeds your lifestyle expenses (your mortgage, rent, insurance, food, etc.) then you become financially free. This is really the sweet spot of why passive investing and why passive income. I like to think of it this way – we all end up, if we’re ever going to “retire”, with passive income. That could be Social Security payments. That’s pretty passive. You’re not actually working for that money as it’s coming to you in retirement; it’s just being sent to you. Same with a pension, if you’re lucky enough to have a pension, or old enough to have a pension, I guess I should say, these days. Or a lot of people park money in things like annuities, which is another form of converting your nest egg into passive income.
My whole message here is, why not start focusing on that cash flow and passive income generation now, instead of later? There’s not a lot of cons to that. At least you’ll be educated, you’ll have the know-how, you’ll have, hopefully, some diversification built-in, you’ll know different strategies… It’s unfortunate that so many folks either never learn it, or they wait till their 60s or 70s to start trying to figure it out. In some cases, that’s really not a good thing. You may be taking an abnormally high amount of risk at that point, etc. So that’s what passive investing is in a nutshell – you’re trying to diversify, get multiple income streams rolling in to offset your lifestyle expenses, so you either have flexibility over your lifestyle and what you want to do with your time, or just to generate wealth and perhaps pass that on to someone else. It’s just building income streams, instead of the buy low/sell high mentality that so many folks have. With that, that’s kind of passive investing in a nutshell. Theo, I’ll turn it over to you on whatever topic you want to cover on that.
Theo Hicks: Yeah, a lot of the things that you just said are going over the main benefits of passive investing. I really liked how you positioned it that, look, you’re going to have some sort of passive income, most likely eventually, or at least the baby boomers and older generations today; maybe not us, but most people are going to have social security pension, some sort of passive income coming in. So why not just do it now instead of later; why just rely on getting Social Security or pension? Why don’t you just also passively invest now so you can kind of have both of those? Just in case one of those happens to go away, especially our younger generation.
So I want to go back over to what Travis just said a little bit and extract a list of the benefits of passive investing. Then I also have a list of cons or drawbacks, but all these are going to be compared to actively investing. Before I even go into that, I’m going to call these potential pros and potential cons, because it’s not like every single passive investment is going to have all these cons or all these pros to the same degree, same with active investing. So it’s going to depend on the three things that Travis talked about all the way at the beginning, which is going to be the market, the deal, and then also the team you’re investing with.
So assuming that you’ve got a passive investor with a team who’s got a level 100 skillset, a level 100 market, a level 100 deal, as opposed to that person who’s actually investing having a level 100 experience, a level 100 deal, a level 100 market, all things being equal – what are the pros and cons of being a passive investor in that amazing active investment or actually being the active investor? I’ve got four categories for the pros and the cons. It’s going to be control, time commitment, risk, and return. So I’ve got benefits for each of those four points, as well as potential drawbacks for each of those four points.
Let’s start with the pros first. This is what Travis talked about, and that’s going to be the time commitment. When you’re passively investing, you have a lot more flexibility over your time. Of course, this is the Actively Passive Investing Show, so passive investing isn’t completely passive, so to speak. It’s not like you do nothing. You still have to look at deals and understand what’s going on, but it’s not going to be as large of an ongoing time commitment as being that active investor who needs to actually work in the business, as Travis said. That’s probably one of the major benefits of passive investing over active.
Also, from a time commitment perspective, you can also look at it from a lower upfront time commitment. Because when you’re actively investing and you’re managing your business, that takes a lot of time; it’s like a full-time job. But it also takes a lot of time to get to that point in the first place where you actually buy your first deal; because you need to have the money, the team, you need to find a lender, you need to raise capital, or have enough money to actually do the deal before you even actually have a deal in the first place, that you have to manage. So the upfront time commitment for you as a passive investor is going to be a lot less, because you’re just finding someone who’s already done all that upfront work and then you are just investing. So you don’t need to have an insane amount of experience or expertise in whatever asset class you’re investing in, because you’re relying on an experienced team member.
Also, from a risk perspective, passive investing, again, all things being equal, has a lower risk than actively investing. Same reason, because you’re plugging into a proven system, a proven business plan, a competent team, in addition to your ability to diversify more easily across multiple asset classes, multiple markets. When you’re actively investing, you’re usually focused on one asset class in one particular market, so you’re not very diversified.
The fourth point would be return. So from a passive investor perspective compared to actively investing, you’re going to most likely see more consistent returns. Passively invest – I’m going to get my monthly distribution or my quarterly distribution. Whereas if I’m an active investor, I might not get paid off at first; I might have to wait until the sale happens actually make money. Also, if you look at it from a time perspective, passive investing has a lot higher return on your time too, because you’re making money without having to actually put forth a lot of time. So before I go into the cons, I want to pause there. Travis, any thoughts on those?
Travis Watts: No, I think that was an excellent job. Thank you for covering those.
Theo Hicks: So the cons – again, they’re gonna be related to the same four points. We’ll start with the point of control. Sure, you have a lower upfront time commitment, a lower ongoing time commitment, don’t need expertise, don’t experience… But the flip side of that is that you have no control over the actual business plan of what you’re investing in.
Using stocks, as an example, you have no control over whether or not the CEO gets fired, or how much money gets invested in R&D; all you can do is just select what you invest in and then let the team do all the work. Same with real estate – you can pick what you want to invest in, what team, what market, but once you invested, you have no say over the business plan. So really no control once you’ve actually invested; your control is exclusive to picking what you invest in.
And then from a time commitment perspective, sure, there’s a lower upfront time limit compared to active investing, as well as a lower ongoing time commitment compared to active investing, but it is possible that you need to have more of a financial foundation before passive investing. For example, if you need to be an accredited investor, you need to meet the liquidity of the net worth requirements. Whereas if I want to actually invest in say, a house hack, I can just bring five grand down, get a 3.5% down loan and get into actually investing. Or you can do creative financing, 0% down, or you can be a syndicator where you’re not bringing that much money to the deal. Whereas if you’re a passive investor, you may need to be accredited. It is possible to be sophisticated, but you still need to have some level of knowledge of investing before you can passively invest; whereas active, technically you don’t need any experience or money to do a deal.
And the last one would be a return perspective. So you’re going to get more consistent returns, as well as a higher return on your time. But by being an active investor, you’re going to have a higher upside potential by being the active investor, compared to passively investing. When you’re passively investing, you might just get a preferred return, you might participate in some of the upsides, but the return on investment, the ROI percentage is going to be much higher when you’re actually investing, compared to when you are passively investing.
And then I really couldn’t think of any downsides from a risk perspective in passive investing; maybe that can be related to the lack of control. But as long as you’re investing with a competent team that’s implementing a proven business plan in a valid market, then again, all things being equal, a lot less risk when passively investing compared to actively investing. Those are my lists of pros and cons.
Travis Watts: Excellent list. On that last point, I was just thinking out loud here… Yes, to your point, there are really three areas of risk. You have the sponsorship team, the market you’re in, and the deal itself – those are all risk points. So I don’t want to make it sound like there’s no risk in passive investing; absolutely not true. And it has so much to do with the team. It’s just simply their ability to execute the business plan. But then also thinking, there’s a lot of things out of all of our control. What is the Fed going to do? What’s the government going to do? What tornadoes or hurricanes are going to come through? We don’t have a say over this stuff. We can do things to insulate that risk, like have insurance or buy an interest rate cap, etc. But at the end of the day, there are always unforeseen things that can happen. But it’s a lack of control, I would say, when you’re an LP like me. I’m doing my best due diligence ahead of time; that’s my active portion. I’m making that commitment, I’m sending funds, and from there, it’s really not in my hands. So that can be a risk for sure. Great points.
What I want to cover quickly here is just some practical math. Again, this is kind of a passive investing 101 episode, so I want to depict the differences between someone who’s got $10 to start and someone that’s got $100,000 to start. We’ve got people listening from all different types here; someone that may be very young, that wants to start their journey. My nephews are starting their passive journey now, around 18 years old, which is fantastic. I didn’t get started until 20, so they’ve got a little bit of upper hand if they commit to it.
Then you’ve got folks who — maybe they never really intended to be an investor. They started a business, they were successful at what they did, they sold their company, and now they’re sitting on a few million dollars… They don’t know what to do with it. So there could be someone definitely with 100k plus to invest at this point.
So I kind of want to cover both of those really quick – how do you get started with $10? Well, again, we’re talking about passive investing, not necessarily multifamily. So for my nephews, they’re starting with a little bit more than that, but still, they’re buying shares of publicly-traded REITs, real estate investment trusts. You could potentially find a REIT out there that’s publicly traded, that has a $10 per share price attached to it. Let’s run those numbers. So if you bought a $10 share, and it had a seven-cent dividend per month, that’s 84 cents per year, that equates to an 8.4% yield, or cash flow, or dividend, whatever term you want to use. That’s an example; you could literally get started with that. It’s usually free to open a brokerage account these days; it’s no commission trades, etc. So that could be your starting point.
I got started with house hacking. Theo, you mentioned that. I just bought a house that I was going to live in myself at a depressed price in 2009, and I rented out a spare bedroom, and I had a roommate basically paying my mortgage.
So you can start in different ways. I would deem that pretty passive. I didn’t have to work or do any labor there. I just had a spare bedroom, I collected a check every month, and I had to deal with just someone living there. So I would say that still falls under passive.
There’s a lot of barrier of entry sometimes to private placement investing, which is mostly what we talked about on the show. You may have to be an accredited investor and perhaps you’re not, you may have to come up with 50,000 or $100,000 to get started; maybe you don’t have that right now, you’re not a millionaire, etc. So the concept here is that you have to graduate, –you don’t have to, but– I graduated to the level of investing in private placements. I didn’t start there. Everyone’s going to have a different starting point. But to your point earlier, Theo, you have to have a way to earn some income, then perhaps save some money, and then build up that nest egg so that you have more options and more things you can invest in, that may have these higher barriers of entry.
But here’s what I want to compare and contrast. I just used that $10 per share REIT example. It’s the same philosophy and the same concept for private placements. Let’s say you have $100,000 to invest, and you invest in multifamily syndication, you’re getting $700 per month; that’s $8,400 per year, that’s an 8.4% return annualized. So all you’re doing there is you’re adding some zeros, but it’s the same game, it’s the same concept.
So if you’re interested in the passive journey and the passive concept of time, freedom, wealth creation, financial freedom etc, just know, you could start with that 84 cents a year, work it up to 8,400 a year, work it up to 84,000 per year, so on and so forth. You just accumulate, it’s a snowball effect that takes time and commitment. As I often say, it’s simple, it’s not easy. Simple on paper.
So I’ll leave you with this thought… Most people have the investing mentality, as I mentioned earlier, of buy low sell high. Nothing wrong with that, but note that that builds net worth; that builds equity, that builds your nest egg. And that’s important, but that’s what that is focused around. Now, if you invest for cash flow, you build wealth, you build income streams. So it’s vastly different; it’s not highly marketed, it’s not highly talked about, because most stocks aren’t paying a dividend, and if they are, it’s 1%or 2%, it’s very low, so it’s very hard for most people to ever retire on yields like that. It’s kind of how our system is created.
We’ve talked about the 4% rule, I’ll just touch on that – the stocks, bonds, and mutual funds world that we’re all used to suggest to a lot of folks that you live off the 4% rule. So you have a million bucks in your retirement account, you withdraw 4% a year, and you live on it. That’s 40k. And then you’re pulling out of your nest egg every year, and the theory or the logic is that the stock market historically goes up more than 4%, so you’ve got a margin built into that. Not a big fan of that myself, but that’s how our system is built and I think that’s why so many of us think “nest egg.” Save, save, save, or max out your 401k and put it all in under the mattress or whatever, and then one day you have enough money. But really consider passive income in exchange for that philosophy. I think it can be very life-changing. I know it has for me, and it has for so many people. Thank you for listening to this, as we tune into that alternative message, perhaps. Theo, any closing thoughts?
Theo Hicks: Yeah, just to kind of go back to what you just mentioned… I like how you focus on that barrier of entry, because again, one of the pros and the cons would be the upfront time commitment or the upfront investment of needing –at least for my real estate syndication perspective– to have that liquidity, that net worth. Something I didn’t mention that you mentioned, which is that the actual money to invest, that $50,000 or $100,000 minimum investment. But then you said, well, that’s one way you can passively invest. But you can also get started for as little as say $10 by passively investing in a stock or in a REIT.
Of course, there are different pros and cons of passive investing in different types of things. Maybe one day, we’ll do a show on the pros and cons of the various types of passive investments. I know we’ve kind of hit on that before, with talking about REITs and stocks versus syndication. The whole point is that it is kind of a myth that I need to be a millionaire and have $100,000 in order to passively invest. So I need to be an active investor first, become a millionaire, have $100,000 in cash before I can passively invest. Not necessarily the case. You can get into other types of passive investments for a lot less, while you continue to work at your full-time job to save that money. So if you’re young and only have $5,000, you might not be able to invest in a syndication. You may be able to invest in a crowdfunded real estate deal, but there’s other options out there besides the $50,000, $100,000, $500,000 syndication investment.
I don’t have anything else on this topic to mention. Do you want to say anything else, Travis, before we sign off?
Travis Watts: Yeah. And to your point, Theo, there are so many ways that you can be a passive investor. We’ve only really hit on private placements, and stocks, and REITs. But one of the places that my wife and I live, we have our car there that we leave for us, but then we also signed up for this platform where we rent our car out to other residents and we get passive income off of that. That rental income is essentially paying all the expenses for that vehicle being there, and that’s just a creative outlet that you can do. You can invest in ATM machines, you can loan out money at a high-interest rate to people for various purposes, whether that’s a business, whether that’s real estate, note lending, tax liens… There’s so many different things out there. I just wanted to paint the picture of being passive versus active and why you might consider that.
The only thing I’ll end with is a quote from me. A famous, famous Travis quote – “The most important asset that we have is our time. Passive Income can help free up your time so that you can pursue the things that you love.” That’s my philosophy in a nutshell, my mission, and my message to the world.
Theo Hicks: I’m going to start doing that. “A famous man once said…” “Who’s this famous man?” “Me.” Travis, thank you so much for joining us today and providing us with your famous quote and breaking down the pros and cons of passive investing versus active investing, and at the end giving us examples of very creative ways to create passive income, like renting the car out.
So that’s all we have for today, thanks for tuning in. If you want us to answer one of your questions on the show or in our 60-second question segment, you can email me at theo@joefairless.com, and we will add that to the calendar. Again, Travis, thanks for joining me. Best Ever listeners, as always, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.
Travis Watts: Thanks, Theo. Thanks, everybody.
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