Before we dive into a discussion of the various ways investors can earn passive income in real estate, it?s worth taking a moment to address a pervasive myth about this topic, one that we at Worcester Investments hear repeatedly, even from experienced investors. Here?s the myth: Real estate ownership in general is an example of passive income investing, because unlike operating a business or other types of active investments, with real estate you simply pay the property?s bills and then collect your rent checks.
The truth is, directly owning a piece of real estate?whether it?s a massive office building or just a single-family home?is active, not passive, investing. Even if you have a management company handling the day-to-day operations, that company will need to consult you on any decisions or actions that could materially affect the property, and those issues will likely come up often.
In fact, owning a piece of real estate yourself is operating a business. Because you are ultimately responsible for the property?s profits or losses, you will always need to keep a watchful eye on the property itself, as well as how trends in the local and national real estate markets, and even the broader economy, might affect your property?s performance and market value.
Having said that, there are several ways to earn passive income through real estate. Here are a few of the more common approaches.
3 ways real estate can deliver passive income
1. Invest in dividend-paying real estate stocks
One way to generate passive income in real estate is to invest in the dividend-paying stocks of companies in the real estate industry.
You can find dozens of these businesses, covering the full spectrum of the real estate industry, listed on the major stock exchanges. This means you can choose your preferred area of the real estate market to invest in: property developers and construction companies, mortgage firms, real estate investment companies, real estate sales organizations, even home-improvement retail chains. Some of these publicly traded firms pay dividends higher than 10%.
Buying shares in a dividend-paying real estate company?s stock (or diversifying your capital across a basket of these companies) is probably the easiest and fastest way to start earning a passive income through real estate. This type of investment is also highly liquid: Under most circumstances, you can sell your shares of these equities almost immediately.
One downside to investing in real estate (or any industry) through publicly traded stocks is that your investment is tied to the broader stock markets?which means you could face increased volatility and losses even if the company you?ve invested in is stable and performing strongly.
Another potential drawback to this approach is you will be limited to finding businesses whose equities pay dividends. If your goal is to grow your wealth over time, of course, you can select any publicly traded real estate stock. But if you are looking specifically for passive income, then you will need to narrow your search of the public markets to those companies whose stock pay out dividends.
2. Invest in public REITs
Publicly traded real estate investment trusts (REITs) are companies that use money raised by investors to buy, manage, and in some case resell a portfolio of real estate properties.
There are roughly 225 REITs registered with the SEC and traded on the major stock exchanges. This means you have a great deal of choice in terms of finding REITs that invest in the type of property that interests you (multifamily, office, retail, etc.) and that have a track record that gives you confidence in their management team?s skills and expertise.
In terms of how you can use a REIT investment to earn passive income, REITs pay out regular distributions to their investors, often quarterly or monthly.
Because they tend to concentrate their portfolios on specific aspects of real estate?such as a certain property subsector, like retail shopping centers?REITs? management teams often develop high levels of expertise in these areas of the market. As a result, they can often (although not always) generate strong returns for investors.
Additionally, because you can buy and sell their shares on the major stock exchanges, public REITs are also liquid, meaning you can cash out of your position very quickly. Also, the IRS rules for REITs state that these organizations must pay out 90% of their taxable income to shareholders. (It is worth noting, however, that this mandatory distribution might not always be in your best interest as an investor, as we?ll explain below.)
Public REITs, like other types of stocks, can swing wildly along with a volatile stock market. When this happens, even if you?ve done your due diligence and selected a REIT with a consistently strong performance history, your investment could still face trouble until the volatility subsides and the market steadies itself again.
In other words, when you invest in a public REIT, you are giving your capital an opportunity to benefit from the potential upside of the real estate market, but you are also subjecting it to the volatility of the stock market.
3. Invest in public, non-traded REITs
In addition to the 225+ REITs traded on one of the stock exchanges, there are nearly 1,000 REITs that are not publicly traded. These non-traded REITs are typically open only to accredited investors.
Non-traded REITs can offer investors several of the same types of advantages as publicly traded REITs: a focused portfolio of properties in which the management team has experience and expertise, diversification across many properties, and regular distributions to investors that amount to 90% of the trust?s taxable income for the year.
Moreover, because they are not traded on the open markets like public REITs, non-traded REITs are not as directly vulnerably to stock-market volatility.
Non-traded REITs differ from their publicly traded counterparts in several important ways, however, some of which might make them less attractive to investors. First, they are often highly illiquid investments?in some cases locking up investors? capital for up to eight years.
Another common complaint about non-traded REITs is that because they are often new REITs and are not yet generating steady income streams from their portfolio of properties, these trusts must often borrow the funds to pay out investors. This means the distributions from a non-traded REIT might not be as frequent or predictable as with a public REIT. If your primary goal is a passive income stream, a non-traded REIT might not be the optimal investment vehicle for you.
Moreover, non-traded REITs often provide far less transparency into their portfolios and operations than public REITs do. A non-traded REIT, for example, might build its initial property portfolio through purchases made using a blind pool, meaning its investors won?t know which properties the trust is acquiring. For these reasons, and given the fact theses trusts do not have up-to-date ?share prices? because they are not on any public market, it can be difficult to determine the underlying value of the REIT at any given time.
Finally, as the SEC points out in its investor alert bulletin on non-traded REITs, these organizations tend to charge high upfront fees that can represent as much as 15% of the offering price. This will lower the value of the investment itself, because it leaves less money for the REIT to invest, and it can also lower your overall return.
4. Invest in a private equity real estate fund
Another way to earn passive income from real estate is to invest in a private real estate equity fund. In this type of fund, a management team deploys capital raised from investors to acquire, rehab, and either manage or resell commercial properties.
As research by Black Creek Capital Markets finds, over the 20 years from 1998 through 2017, private commercial real estate funds have outperformed public REITs, returning a higher average annual income to investors over those decades.
One major advantage of private real estate funds is that, like non-public REITs, they are not traded on the stock exchanges. As a result, they tend to be less volatile and subject to stock-market drops.
Private equity real estate funds also have a significant regulatory advantage over all REITs (both public and private). As we discussed above, REITs are required to distribute 90% of their taxable income to investors. On the surface, this seems like a strong benefit?particularly for people investing in real estate for passive income.
But to meet this government requirement, REIT managers must often pay out dividends to shareholders that could be better spent used in other ways to benefit the fund. To satisfy the 90% distribution threshold, for example, a REIT?s management team might have to distribute capital to investors that the team had set aside to acquire an attractive property; they might even have to liquidate a property to raise the needed funds to meet the IRS requirement. This means that REITs? regulatory demands can often force fund managers to behave in ways that undermine the long-term interests of their own investors.
Private real estate funds do not have this regulatory demand, by contrast, and the managers of these funds are therefore more free to deploy their capital in ways that serve their investors? interests.
Although the best private equity real estate funds pay out distributions to investors regularly, these are generally not liquid investments like public stocks.
Also, the experience levels and track records of private real estate funds can vary wildly, so you will need to do your due diligence here and invest only with funds that have a proven history of strong performance and high returns to investors.
Learn how to earn passive real estate income with the right fund
To learn more about how to leverage the right private fund to earn passive real estate income, take a look at the Worcester Fund: the leading fund for Kansas City multifamily real estate, managed by a team of experts that has delivered an annualized 30% ROI to investors over the past decade.
This does not constitute an offer to purchase securities, and that any purchase may be made only through delivery and receipt of a confidential private placement memorandum from the issuer, pursuant to which any potential investor must complete and provide an investor questionnaire, subscription agreement and other things required by the issuer, and are subject to the issuer?s verification of accredited investor status and issuer?s acceptance of the subscription