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"Passive" Income: A Real Estate Fallacy

Updated: May 6




I see articles and LinkedIn posts from time to time about so called “passive income” and the term is frequently used in the context of real estate.  Investopedia describes “passive income” as “revenue that takes negligible effort to acquire. It includes earnings from rental properties, limited partnerships, and other projects where you're not involved in the continued generation of earnings.”   In part I think the IRS does no favors by having a concept of “passive activity losses".


Personally, I believe that the term is frequently used as a dog whistle (to use a harsh term) for a “get rich quick” scheme and for a means to “early retirement.”  I love and invest in commercial real estate. However, I fear that this maxim is disconnected from math, attendant risks and amount of work truly involved.


The Math:  First, let me supply some math around “retiring early.”   Let’s say you want to make $100,000 per year without touching your principal.  If you believe your expected return is 5%, then you would need $2M in investable assets.  Furthermore, say you have $100,000 now and want to know how long it will take you to get to $2M.  Assuming an 8% return and saving $10,000 per year that would be 28 years.  I believe the allure to real estate is the possible returns.  That same $100,000 at even a 15% return that is still 17 years of growth with significant illiquidity along the way.  That hardly seems like “negligible effort” to acquire.


Returns & Risks:  The reason commercial real estate returns tend to be higher is due to leverage.  If you buy a multifamily asset at a 5% cap rate and income grows at 3% per year, that’s an 8% return.  That’s not an earth shattering return for the illiquidity.  However, if you lever the asset with debt to a 65% LTV at a 7% interest rate that return becomes 16%.  Banks are willing to lend far more to CRE than they are to other businesses because of the residual value collateral. 


However, that debt comes with risks.  Obtaining true non-recourse debt is very hard to do.  Even then if you are not careful then bad boy provisions can result in exposure.  The personal guarantees associated with that debt end up making the investment fully recourse to your entire wealth and that fact is often “mispriced” in people’s minds in terms of risks.  That is a big reason why being a limited partner investor can be key as the sponsor takes that risk on the limited partners’ behalf. 


Finally, real estate is illiquid and it requires massive amounts of capital (equity and debt) to do well at scale.  Furthermore, there is a reason the SEC has rules and income levels on raising money from investors and that many minimum investments are $250,000....because there are risks.


The Work: “Buy real estate and you won’t have to work” they say.  I have worked for a long time in commercial real estate and real estate is anything but a “passive” endeavor.  If commercial real estate requires so little work, then why are there so many fees ranging from leasing, property management, asset management, financing, acquisition, disposition, development, general contractor, architectural and engineering and so on.  This is even before you pay for legal, accounting and tax advice for the significantly more complicated than normal taxes.   I assure you that someone is working hard and getting paid. 


I also fear that inexperienced investors do not appropriately “value” or “charge” their time to the real estate.  You can invest in real estate and also work.  So what is the opportunity cost of your time?  It is very rare that you can just buy a piece of real estate and have no one do anything at all.  Someone has to operate that asset.


Summary:

The overconfidence bias is strong in real estate. Real estate is about leverage, the resulting returns and requires professional management and oversight.   Earlier this year my network colleague Shlomo Chopp summarized it best:



Do I think you should consider professionally managed real estate as part of your portfolio?  Of course!  I recommend it so long as you have sufficient liquidity, can find great sponsors, know what you are investing in and why the returns are the way they are.   


I caution on believing that real estate is "passive" and does not require work.  If you treat real estate passively, then you will end up with no income.

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