To be Passive or Active? That is the Question
This guest blog comes from Eric Siragusa, Ph.D. Eric is a vice president with MHP Funds, LLC, an operator of mobile home parks that from time to time has offered investment opportunities to RealtyMogul investors. Below, Eric touches on the important role that passive investing can play in a properly designed portfolio.
Which type of portfolio is better – passive or active?
In reality, there is no universal correct answer, and often it is some combination of the two types. The makeup of your portfolio should depend on your particular situation and desired lifestyle. It should be the result of an honest assessment of the time, talent and capital that you have available. Also, answers to the following questions are needed:
- How much time do you have available and want to dedicate to investing?
- What is your investment knowledge and skill level?
- How much money do you have available to invest?
Based on the answers to these questions, you may decide that including passive real estate investments in your portfolio makes sense. Let’s look at some common situations:
- For some real estate investors it is an “end game” goal. They want or need to be hands-on and involved in every detail now (perhaps to build up capital), but “later” they want to stop and live off the income from passive investments.
- For other real estate investors it is about diversification. Perhaps they are heavily involved in single-family home flipping but want to diversify into another asset class (mobile home parks for a not-so-random example).
- Someone in a different profession may want to further increase their income and wealth with real estate in a way that does not interfere with the career they love.
- Others may not like their current job or career path, and want to start creating income to replace their salary.
- For many it may be that they have a retirement account and are looking for an alternative to the stock market.
Or maybe it is some other situation entirely.
If you do not know where you are going...
Knowing where you want to go financially is equally important. No two people or their situations are exactly alike, and you must determine what your goals and needs are now and what you think they will be in the future:
- What are your short-term & long-term cash flow needs?
- What are your short-term & long-term equity goals?
- What is your tolerance for risk?
- What are your liquidity needs?
… and so on.
Why is all of this important? Because in the immortal words of former Beatle George Harrison:
Many people choose to include passive investments in their portfolio to take them down the road they want to meet their needs and goals. In a lot of cases, it ultimately boils down to a desire for true financial freedom, where you have sufficient income from your passive investments to live the lifestyle you choose.
My Three Financial Pillars
For me personally, I decided I wanted the foundation of my portfolio to be based on three main financial principles: high cash flow, value creation, and low risk. Notice that I do not believe in the risk vs. reward myth – I want to be more of an “and” person than an “or” person – I want both low risk and high reward. I want good short-term cash flow that will grow over time, and strong long-term wealth creation. Why did I boil my financial principles down to the three above? Let’s look at each of them quickly:
1. High Cash Flow
The obvious reason for including this is the desire for high income and ultimately the financial freedom that comes from it. However, there is a second important reason that many overlook. In any investment most people would agree on the importance of having multiple exit strategies so you do not get stuck if your desired strategy does not work. High cash flow is extremely important to me because one of the most important exit strategies is the ability to not be forced to exit. With high cash flow, you can sit back and enjoy the cash flow while you determine the right time to take another exit (if you want to exit at all).
2. Value Creation
I want investments where value (i.e. equity) is actively being created through proven strategies, not “hoped for” from a rising market. I definitely want to be in the right market, and prefer that the market is rising – but I want value to be created regardless. Basically I want to be investing, not speculating.
3. Low Risk
Ultimately, all investing has risk. It cannot be totally avoided, but it definitely can be mitigated. This principle is tied to the other two, both of which reduce risk, but also includes risks specific to the asset involved. Make sure you, or whomever you are investing with, understand the potential risks now and in the future, and have plans in place to mitigate the effects of those risks.
These principles led me directly to investing in mobile home parks (MHPs). They have amongst the highest cash flow (if not the highest), have the lowest default rate, are in the ever-growing affordable housing niche with high demand and low supply, and value is created through proven strategies that all increase the cash flow. MHPs are a perfect fit for my goals and needs and are leading me down the road I want.
One last thing to point out here is that these are the principles for the foundation of my portfolio. With a strong foundation, I can always choose to deviate for a particular investment if desired.
Group Investments
There are many different types of passive investments out there, but one structure worth mentioning is the “group investment”. It is getting more and more popular, especially due to recent changes in the law. With group investments, capital from many investors is brought together to purchase a single property or multiple properties. Often a private placement (non-public offering) is used to legally structure the investment. These are also commonly referred to as syndications, or funds. All details are handled by the investment managers, and it is passive (“no hassle”) for the investor. Investors often receive both a cash flow and equity splits. These types of investments have potential advantages including:
- Lower minimum investment amounts since they are being combined with other investors funds
- Bigger overall investment resulting in a more efficient and streamlined operation
- Increased diversification and lower risk if the offering contains multiple properties
Final Thoughts
Once you find a potential passive investment, always educate yourself and do your own due diligence on the investment and the people behind it. There is often confusion over what it means to be “passive”. I think some people imagine just blindly handing over their money to someone. Honestly, I do not think you should ever be truly “passive”, just “active” in a different sense. You should be actively seeking out, evaluating, and monitoring your investment, but without dealing with the day-to-day hassles of managing. It is still much less time and effort than doing it on your own.
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