The “Risks” of Passive Investing

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We live in a litigious society. We, as Americans are sue happy.

The courts were originally designed to offer justice to a party harmed by another’s actions or make things right. However, over time, because litigation can be expensive when each side lawyers up to settle disputes, unscrupulous parties have abused the court’s powers for financial gain.

Worse than the cost of litigating a case is losing one.

The losing party can be financially wrecked from a judgment they can spend the rest of their lives paying. Unfortunately, some would take advantage of this fact and use just the threat of lawsuits to unjustly extract money from others who would rather pay the settlement than spend the money going to court.

The side effect of our society’s litigiousness is the extraordinary steps individuals and businesses take to avoid liability or to mitigate it.

To see how things have changed, look back to your childhood school days. Remember all the things you used to be able to do during recess as a kid that your kids can’t do anymore.

Tackle football? Nope.

Snowball fights? Nope.

Playing baseball with a hardball? Strike three.

It all stopped because the schools didn’t want to be liable for any injuries.

The risk of liability consumes us. We take out insurance on our cars, homes, and businesses to protect against potential lawsuits. It seems you can’t do anything these days without signing some liability waiver or agreeing to the terms and conditions of a business to use its products or services.

Nobody is safe from the threat of litigation and potential liability – least of all professionals.

Doctors, lawyers, accountants, and other professionals take out malpractice insurance to protect themselves from malpractice lawsuits.

This threat of liability keeps them up at night. Still, it is also a motivating factor for finding alternative sources of income in case they’re forced to walk away from their practice one day – whether voluntarily or involuntarily.

Among the alternative investment options professionals often explore is commercial real estate. It’s high on their list because it offers cash flow, appreciation and is known to act as a buffer during an economic downturn or disaster – all backed by a hard asset.

However, most professionals are intimidated by investing in commercial real estate because they feel they don’t have the time or expertise to delve into it. That’s why many savvy professionals turn to passive investment opportunities to participate in the commercial real estate class without getting their hands dirty.

Once a professional expresses their interest in investing in commercial real estate to their family, friends, and colleagues, it doesn’t take long before the naysayers come out.

“What if someone gets hurt on one of your properties? Won’t you be personally liable?”

“What if the company you invest in defaults on a loan? Won’t you personally be responsible for the debt?”

I am here to put your mind at ease regarding potential personal liability as a passive investor.

Companies have been seeking capital from investors to fund their ventures for centuries. And the only way they’ve been able to attract investors is by assuring them that their liability is limited to the amount of their investment.

In other words, no matter what happens to the investment fund, the most any investor can lose is what they invested. Otherwise, investors would be turned off from potential liability and never invest.

Limited liability is a legal concept and is accomplished through a company’s legal structure in the corporate form or a limited liability company or limited partnership.

The common shareholders of a corporation, the non-managing members of a limited liability company and the limited partners of a limited partnership all, enjoy protection through limited liability.

Without limited liability protection afforded to investors, companies would be hard-pressed to attract capital.

Can you imagine if the shareholders of cigarette maker Phillip Morris were personally liable for the company’s liability to its consumers over cancer deaths from its tobacco products?

The plaintiffs, in that case, were awarded $28 billion in punitive damages. Do you know how much of that judgment Phillip Morris shareholders were responsible for? ZERO. Other than any effect on their share prices directly resulting from the lawsuit, the shareholders were personally accountable for ZERO of that verdict.

Passive investors in a private real estate investment fund can have the same comfort of knowing that no matter what liabilities the fund incurs in the form of debts or lawsuits, because of the business structure affording limited liability, passive investors will never be personally liable for the company’s liabilities beyond their investment capital in the fund.

So if the fund defaults on a $10 million loan requiring the company to liquidate its assets to pay a portion of that loan, your investment capital may be used to pay that loan, but you will not be responsible for any deficiencies.

Potential malpractice liabilities can keep professionals up at night – what with the potential financial and professional costs from litigation, not to mention the insurance premiums to protect against those potential liabilities.

Passive investors, on the other hand, don’t have those same worries. They can rest assured that once they invest in a private real estate fund, the most they can lose is that investment.

The U.S. corporate structure that encompasses corporations, LLCs, and LPs is what makes this possible and limits the liability and, therefore, the risk to passive investors – allowing them to invest, for the most part, worry-free.