Hi there,

When I speak with new real estate investors, they often default to residential real estate with a desire to buy one or more single-family (SF) or small multifamily (MF) properties. Most have never heard of passively investing in larger apartment complexes.

In my recent newsletter, I displayed two current investments. The first was a ground-up 2-unit development. The second was a passive limited partnership (LP) investment in a 228-unit apartment complex. In this article, I will explain the differences between these two asset classes to assist you in deciphering which one suits your investment goals.

Residential vs. Commercial Real Estate

Residential real estate generally consists of properties with up to 4 units. This includes single-family homes and small multifamily properties such as duplexes, triplexes, and quads. This asset class often has a lower barrier of entry for investors as they are less expensive and can be purchased with mortgages similar to your personal home.

Commercial multifamily buildings have 5 or greater units and require commercial loans to purchase. Larger apartment complexes have a higher barrier of entry as they cost substantially more and need different skill sets and experience to purchase. They are often purchased by groups of investors (syndications) that pool funds and expertise to overcome these barriers.

Valuations

Both residential and commercial real estate investments allow individuals to build wealth in several ways, including cash flow, appreciation, principal paydown by tenants, and depreciation tax benefits. These two asset classes are, however, valued by different appraisal means. Residential real estate is valued by comparing your asset to similar properties nearby. This can be great when the market is hot but can hurt in a down market when your neighbor sells their property at a discount. It makes little difference that your property rents for $500 more per month; your value is based on nearby comparable properties.

Commercial real estate is valued on the net operating income (NOI) that the property produces. This allows investors additional tools to boost revenue or cut expenses of the property, thereby forcing appreciation. Some commonly used tools to foster appreciation include water conservation programs, rent increases on remodeled units, valet trash services, and community Wi-Fi.

I plan to discuss real estate terminology in greater detail in future blogs, but I will leave you with a simple equation for now. $1 = $20. At today’s Houston valuations, for every $1 increase in net operating income, the valuation of an asset increases by $20. Now assume boosting income $100 per unit per month on a 100-unit building. This would deliver forced appreciation of $2,400,000 to the value of the building.*

Control – Is it always the best thing?

Real estate is not a liquid asset. We can’t log into a phone and sell it. Residential real estate assets are easier to dispose of (sell) when you desire. Passive apartment investing is more illiquid. Yes, there are ways to get your investment out early, but these processes can differ between sponsorship teams. I go into passive real estate investments understanding that I will be in the deal until it sells.

With control comes responsibility. Before investing in real estate, investors should ask themselves how involved they want to be? Even with a property manager on board, you must make decisions when personally owning real estate. To start, you’ll have to hire a property manager and check in often to ensure they are performing. You’ll also have to set tenant criteria, shop insurance quotes, pay vendors, and oversee unit turns. You are the captain of the ship.

When investing passively as an LP, your role is entirely passive. The most critical part is vetting the team, market, and deal at the beginning. After that, you will not have to make decisions. The building will be run by a larger, more experienced property management team managed by the general partners (GPs).

Vacancy and Expenses

The larger the unit count, the larger the cushion you have if units go vacant. I set aside a percentage of monthly cash flow to account for vacancies on my personally owned properties. In the instance all the units happened to go vacant simultaneously, I will have to dip into reserves or come out of pocket to cover the mortgage and expenses of each property.

The greater unit counts of large multifamily assets also allow you to decrease the per-unit cost of expenses, allowing you access to higher quality vendors and property managers at a lower price.

Loan Guarantees and Risk

Loans secured to purchase residential and smaller commercial real estate will require personal guarantees. This means that if the deal is negatively impacted, you are personally liable for the loan. When investing as a limited partner, you will not be held responsible for the loan if the deal does not perform as planned.

Returns

I expect my personally held properties to provide better returns than passive real estate investments. This compensates me for the time spent managing the asset and the elevated risk exposures previously mentioned.

Paperwork

Active investing is going to require more paperwork. Closing documents, leases, applications, and yearly changing insurance policies add up. How does protesting and paying taxes on five properties every year sound? Additionally, the income and expenses for each property need to be tracked and given to your CPA at tax time.

Passive investing will require electronic signatures through an investor portal during the initial investment process. Afterward, investors can expect to receive yearly K-1’s for tax reporting and email communications from the sponsorship team.

Diversification

Diversification tends to be easier with passive investing. Imagine owning a single-family home in five cities requiring five different property managers?

When passively investing, you are relying on an experienced team to run the asset. In addition to selecting different markets, you can also choose other asset vintages and classes. Maybe a B class in Houston this year and a new construction deal in Austin, TX next. How about a self-storage deal in year three? Spreading risk is never a bad thing.

Conclusion

In summary, both small active and large passive real estate investments can build tax-advantaged wealth and provide significant diversification of one’s portfolio. Investors should decide how involved they want to be in day-to-day decisions before deciding on an investment strategy. As an investor in both asset classes, I’m always happy to help you find clarity before investing.

* Assumes a 5% cap rate