Real estate, which includes land, homes, offices, and retail structures, is a popular investment option for those who like to put their money into tangible assets. Many investors pick real estate as a source of income or because it is relatively simple to borrow money to purchase homes. Passive real estate investing is the act of owning rental properties that generate income without you having to be involved in the day-to-day management and operation of the property.

If you’re a passive real estate investor, you don’t want to spend your time running around trying to fix a leaky faucet. You want a team of professionals behind you who can take care of all that stuff for you—and that team generally comes from a professional property manager. Look for a company with a proven track record and good references from other investors.

The first step in analyzing a passive investment is to determine whether it’s an equity or debt offering. From there, you can evaluate the deal using cap rates (for debt) and using cash-on-cash returns (for equity). If you’re considering both types of investment opportunities, keep in mind that each has its pros and cons. Debt deals may provide steady income streams with a guaranteed return of capital at the end of your term; equity deals, on the other hand, can provide larger returns over the long term through appreciation and distributions from operations.

What Is Passive Real Estate Investing?

Passive real estate investing, also known as non-active investing, refers to a type of real estate investment that does not require direct involvement from the investor. In this form of real estate investment, the investor can enjoy cash flow from rent received without becoming involved in the day-to-day management and responsibilities of owning rental properties. Passive real estate investing is sometimes called “hands-off” investing because it requires little or no hands-on work by the investor. Passive real estate investments can take many forms, including real estate investment trusts (REITs), syndications, and crowdfunding platforms.

To analyze a passive real estate investment, you should consider the following factors:

1. Location: Is the property located in a desirable area with strong rental demand?
2. Property condition: Is the property well-maintained, or will it require significant repairs?
3. Potential return on investment (ROI): What is the potential for rental income, and how does it compare to the cost of the investment?
4. Management: Who will be responsible for maintaining the property and finding tenants? Will you be required to be actively involved in the management of the property, or will you be a passive investor?
5. Risks: What are the potential downsides, such as vacancy risk or the risk of natural disasters?
6. Tax implications: How will the investment affect your tax liability?

Analyze Real Estate Investment deals

Let’s walk through it, so you can see what I mean.

Let’s walk through it, so you can see what I mean. To begin, the process, the first step is education. This is the time when you, as a passive investor, get educated on the deal. You learn that the deal sponsor has a deal and that they’re seeking passive investors for it. Then, you learn what the deal itself consists of. Often, this information on the deal will come to you from being on a deal sponsor’s email list and receiving a notice from them of the upcoming deal. In learning about the deal itself, you’ll probably join the deal sponsor for some sort of presentation. As a deal sponsor – and a friend to numerous other deal sponsors – I can tell you that presentations are the norm when sponsors wish to communicate their deals to interested passive investors.

Your commitment – if you chose to make it – would be to “softly” pledge to put money in the deal sponsor’s deal. In this case, “softly” means that you’re not making a rock-solid, binding commitment to invest $__.___ in the deal sponsor’s deal. That kind of commitment could be one you make later. Yet for now, you’re just making a “soft commitment” to keep yourself in the running, to potentially participate in the deal.

Let’s begin the discussion with a look at metrics. Metrics are what you’ll use to measure your potential returns from a deal. They’ll allow you to see whether the deal will produce healthy or unhealthy returns. Metrics will also help you to make the right decision when faced with investment opportunities that all look good.

To start on metrics, here’s an example. For this example, suppose you were presented with the following three opportunities:

• Deal 1: A deal where you’d put in $100,000; receive $8,000 cash flow each year for 5 years; and then in the 5th year, earn returns when the property was sold for $200,000.
• Deal 2: A deal where you’d invest $100,000; receive $3,000 cash flow per year over 5 years, and then get another payday from the sale of the property in year 5 for $250,000.
• Deal 3: A deal that has you invest $100,000; receive NO returns for the first year; watch as the property is refinanced for $50,000 cash out in year 2; receive $2,000 cash flow per annum in Years 3, 4, and 5; and at last receive returns when the property is sold for $200,000 in year 5.

Of those three opportunities, which one is best?

It depends on what metrics you’re looking at. (For the sake of simplicity, look only at those metrics for the time being and ignore any buying or selling costs (i.e. closing costs, broker fees, etc.)).

Now, getting into those metrics, we can start with the cash-on-cash return. It’s the simplest metric to understand when assessing your returns from a deal.

cash on cash return = Annual Cash Flow/Total Investment 

In those three deals, we just examined in Figure 6.1, your cash-on-cash return in Deal 1 would be 8% yearly. This percentage is based on $8,000 cash flow each year (in years 1 through 5), divided by the $100,000 you’d invested.

Similarly, in Deal 2, your cash-on-cash return would be 3% yearly (from $3,000 cash flow divided by $100,000 in-vested).

And in Deal 3? Well, for that one, your cash-on-cash return would be…zero for the first year. Then in year 2, your cash-on-cash return would be 50%, since the property was cash-out refinanced at $50,000. And for Years 3, 4, and 5 – the cash on cash return would be 2% (from $2,000 cash flow divided by $100,000 invested).

Our second metric is the Average Annual Return (AAR). It gives you the average return per year including the capital return activity such as refinance and disposition.

Average annual return = Net overall investment profit/Total Investment*Hold in period of years

Let’s look now at how this works for the three example deals

Deal 1’s net profit from sales is $200,000 (sales price) – $100,000 (initial Investment) = $100,000. On top of sales profit, Deal 1 also had $8000 × 5 = $40,000 total cash flow. The Net Overall Investment profit is $100,000 + $40,000 = $140,000. So, with all that in mind, our Aver-age Annual Return is as follows –

Average Annual Return for Deal 1 = $140,000/$100,000*5 = 28%

In Deal 2, the net profit from sales is $250,000 (sales price) – $100,000 (initial Investment) = $150,000. On top of sales profit, Deal 2 also had $3000 × 5 = $15,000 in total cash flow. The Net Overall Investment profit this time around is $150,000 + $15,000 = $165,000 . So, in this case –

Average Annual Return for Deal 2 = $165,000/$100,000*5 = 33%

For Deal 3, the net profit from sales is $200,000 (sales price) – $100,000 (initial Investment) = $100,000. Deal 3 also has a cash-out refinance of $50,000 and $2000 × 3 cash flow. The Net Overall Investment profit in this third case is $100,000 + $56,000 = $156,000. So AAR works out to be…

Average Annual Return for Deal 3 = $156,000/$100,000*5 = 31%

From these computations and looking at the average annual return (AAR) metric, it looks like Deal 2 is the best.

From Average Annual Returns (our second metric), let’s turn to the third key metric for you, when analyzing potential deals. The third metric is Equity Multiple. It’s the accumulated multiple of your investment at the end of the investment cycle.

Equity Multiple = (Net Overall Investment Profit + Total Investment)/Total Investment

Your equity multiple would be 2.5x for example, if you invested $100,000 and your total profit from sales and cash flow was $250,000 at the end of the investment period. In essence, you’d have made $150,000 more from your original investment. This could be put in words simply as “your money back, plus 150%” or “you get 150% more of your invested money”. If the equity multiple is 2x, then you can simply say “you double your money”.

Here’s a look at the three example deals and how we’d calculate the equity multiple for each –

Deal 1’s net profit from sales is $200,000 (sales price) – $100,000 (initial Investment) = $100,000. In addition, Deal 1 also had $8000 × 5 = $40,000 total cash flow. The Net Overall Investment profit here is $100,000 + $40,000 = $140,000. This means that our Equity Multiple is the following…

Equity Multiple for Deal 1 = ($140,000+100,000)/$100,00 = 2.4x

Deal 2’s net profit from sales is $250,000 (sales price) – $100,000 (initial Investment) = $150,000. On top of sales profit, Deal 2 also had $3000 × 5 = $15,000 in total cash flow. Net Overall Investment profit in this second case is $150,000 + $15,000 = $165,000. Thus,

Equity Multiple for Deal 2 = ($165,000+100,000)/$100,00 = 2.65x

As for Deal 3 – we see the net profit from sales being $200,000 (sales price) – $100,000 (initial Investment) = $100,000. Deal 3 also has a cash-out refinance of $50,000 and $2000 × 3 cash flow. Net Overall Investment profit then works out to $100,000 + $56,000 = $156,000. So here, our Equity Multiple is…

Equity Multiple for Deal 3 = ($156,000+100,000)/$100,00 = 2.56x

The last thing we should say here, in regards to equity multiple – is that when this is our consideration, Deal 2 seems to be the best one.

Here’s another of our metrics, to examine when analyzing a deal. This fourth metric is IRR.

As far as metrics are concerned, IRR is one that I like to describe as “The Mother of All Investment Metrics”. It’s an advanced metric and can be cumbersome to calculate. Knowing that I’m not going to bombard you with numbers and stats. We can stay “high-level” in our discussion right now, on IRR. Just make sure that you understand IRR – really understand it, beyond just what I’m saying here – by the time you start investing in commercial real estate.

Let’s summarize all the investment metrics in the table below

With IRR and the 3 core metrics we’ve covered, you’re probably wondering which one(s) is best.

My “official answer” is that all 4 are important, as they show different aspects of measuring investment returns. Unofficially and “off the record”, though, my own opinion is that IRR seems like the best way to compare deals as each deal has different returns and timeline projections. My opinion is based on IRR showing the time value of money, which pertains to an investor’s goals. This makes IRR our most comprehensive metric.

Different aspects of return metrics

Here are 5 steps for analyzing a passive real estate investment deal:

1) Determine Your Return on Investment (ROI)

2) Determine Your Return on Equity (ROE)

3) Analyze the Market

4) Calculate Expenses and Cash Flow

5) Assess the Quality of Management

All the passive real estate deals I’ve invested in have worked out, but it hasn’t been without some bumps along the way. Here are the best tactics I’ve used to evaluate a deal and ensure that it’s as low-risk as possible:

1. Go through every line item in the underwriting and if you don’t understand something, ask questions. You need to understand everything before you invest!
2. Take a look at the background of the sponsor and review their past deals. Do they have a track record? Have they done similar deals in the past?
3. Do your own underwriting of the deal based on your own research and assumptions (including worst-case scenarios). Did you come up with a similar number to what the sponsor came up with? If not, what were your assumptions? If you’re off significantly, try to find out why.
4. Ask lots of questions about how they plan to operate the property. You want an experienced operator who has good relationships with contractors, vendors, etc., so find out who is running things on a day-to-day basis.

An investor should use this formula to determine whether or not a passive real estate investment is worth it.

The formula is:

return = (Rent/Price) – (Expenses/Price) + (Appreciation/Price)

Where:

Rent: amount of rent per month

Expenses: total annual expenses (maintenance, taxes, utilities, management fees, etc.)

Appreciation: expected annual appreciation rate of the property in % form. For example, if you expect a 5% annual appreciation rate, the number to use would be 0.05.

Conclusion

Passive real estate investments can be an excellent method to earn a consistent income without having to worry about remodeling a property or managing it yourself. 

Join Us For A Daily 60-second Coffee Break Series For Passive Investing In Commercial Real Estate With James Kandasamy, The Best-selling Real Estate Author And Mentor.