Real estate is proving to be one of the more reliable asset classes for investment. But in this opportune moment to get into real estate, what’s the best way to get involved so that you generate the highest cash flow possible?
Contrary to what people first think, there are many ways to get involved in real estate. Some of the best options available to investors are passive real estate investments.
Let’s take a look at these specific real estate investment options, what they are, how they work, and how to get into them.
Passive or Active Income?
Let’s establish what active and passive income means. In doing so, you’ll gain a better grasp of the benefits of passive income and how to prepare yourself for these types of real estate investments.
Active income describes earnings that are earned with qualified material participation. Material participation is a qualifier meant to determine what level of involvement an investor is with the income earned.
Material participation is determined by the IRS for tax reasons. The more involvement there is in regard to the income, the more deductions available for the individual earning the income.
In a real estate investment context, it describes the amount of work an investor does to earn an income from their property assets.
The at-risk assessment of an active investor’s stake in the income—how much they have to lose if the investment fails—is a key metric that determines material participation.
Active income, in general, has a broad meaning.
It can refer to wages earned, salaries paid, and revenue generated from a business. Going back to the material participation qualifier, these are clear examples of a high level of participation in order to earn this type of income stream.
Wage-earners are doing the work; salaries are earned in the same way; revenue generated by a business owner is directly connected to their work.
In an investing context, specifically in real estate, active income usually refers to rental properties and house flipping.
Private ownership methods like these require a high amount of material participation from the asset’s owners. Running a rental property to earn rent or flipping a house to generate a profit requires about as much work as running a business, meaning that they’re able to qualify as active income investments.
What is Passive Income?
Passive income describes income earned that does not qualify as being generated by sufficient material participation.
Like active income, passive income can refer to a wide range of income earnings. In its most general sense, passive income describes earnings that did not require the individual collecting them to be actively involved in the process.
For real estate investment purposes, this refers to investors who don’t actively manage properties the way rental owners or house flippers do. Oftentimes, passive investors in this scenario are called silent investors—investors whose investment almost solely consists of their capital invested.
Due to the relative hands-off nature of passive real estate investing, they don’t qualify for the material participation deductions that active income has.
Examples of material participation metrics include:
- Participation for more than 500 hours
- An action that makes up a substantial portion of the income earned
- Five of the past ten taxable years have active participation from the investor
What Are Examples of Passive Real Estate Investing
- Real Estate Investment Trusts (REITs)
- Private Equity Real Estate Funds
The active real estate investments are clear; they’re the ones that necessarily take up a great deal of investors’ time—managing rental properties, flipping houses, and so on.
But what do passive real estate investments look like?
Unbeknownst to many new investors, there are more ways to get into real estate beyond investment property management. In order to get more investors on board with real estate investments, without the burden of active participation, there have been real estate investment opportunities made available that are far easier to access.
Real estate investment trusts and private equity real estate funds are two good examples of passive income earning real estate investments. Both REITs and private equity funds provide great ways to increase the diversification of your real estate portfolio, even if you are primarily an active investor.
Real Estate Investment Trusts (REITs)
Real estate investment trusts were created in the 1960s with the explicit purpose of opening investment opportunities into the lucrative financial world of real estate to a wider audience of investors.
These trusts are not all that different from the companies selling shares of their stock on the exchange. REITs are essentially companies that make their income from the financing or ownership of income-earning properties.
In the same way, Ford makes an income on the cars they sell; REITs make their income by collecting rental payments from the tenants leasing the properties in the trust’s portfolio, in addition to the profit generated by the sale of commercial real estate assets.
The different types of real estate assets in a REIT portfolio mean that there are many different types of REITs investors can choose from. Here are a few different niche real estate marketsREITs can serve:
- Residential properties
- Medical facilities
- Student housing
- Retail storefronts
- Mortgage interest
REITs are publicly traded, like any company on the stock market. This allows investors to buy into a REIT with a much higher degree of accessibility than active income real estate investments.
Instead of acquiring a property, maintaining it, and renting it out, real estate investors can just buy into a REIT to get a compelling return. But there are even more lucrative passive income opportunities investors can choose from.
Private Equity Real Estate Funds
Private equity funds have a few things in common with REITs. They are both funds built from pooled investor capital. They both build a portfolio of high-value income-earning real estate assets that most individuals would not be able to buy on their own.
But private equity funds and REITs have a crucial difference: private equity funds are not publicly traded.
On the contrary, private equity funds can have some degree of exclusivity to them. Due to the fact that they are more hands-on operations for their investors, these funds tend to set accreditation standards for the investors they allow to buy into the fund.
This translates into a few advantages that private equity funds have over REITs.
Private equity funds can get better returns and higher dividends for their investors because they are able to operate by a more relaxed set of standards.
Their more selective investor pool allows these funds to better navigate more competitive and more lucrative markets because they are leaner and can move faster than oversized organizations like REITs.
Why Passive Real Estate Investing Is Better: Less Risk
Passive real estate investing allows investors to get into the real estate market without the significant burden that active income-earning strategies put on their time and finances.
The key benefit of passive income strategies boils down to their significantly lower levels of risk.
Passive income investing insulates investors from the high degree of risk active income strategies foist on the investor.
Private ownership strategies put a significant amount of risk on the owner. More than the hard work that goes into sustaining the earnings generated by the investment, the real stress entangled with this kind of real estate investment is the high stakes involved.
When things go well with rental properties or house flipping, investors stand to make a good deal of money.
However, these strategies can go bad very quickly. With such high levels of capital wrapped into these assets, private ownership can turn into one of the most burdensome financial quagmires imaginable.
Private ownership carries serious risks, whether it’s a bad tenant taking you to a court or getting stuck making unending, costly repairs to take a property to market.
On the other hand, passive income investments are far less risky.
- Fund portfolios have more assets, meaning they can sustain losses if a property asset earns less.
- Passive income strategies provide better exit strategies for investors.
- Funds employ professional money managers whose best interest for both their investors and themselves leads them to identify high-value assets with the least risk.
- The earnings generated by fund assets do not require investors to be actively involved.
- Pooled capital allows funds to acquire more reliable, higher-value assets that are less risky.
How to Get Started In Passive Real Estate Investing
- Assess your finances
- Find the Best Investment for Your
Compared to active income real estate opportunities, passive income options are far easier to get started with.
Depending on how you decide to get involved, you can get started within the span of a few days.
Here’s how you can equip yourself with the best possible start in the world of passive income real estate investments.
Assess Your Finances
As with any investment opportunity, take the time to make a sober assessment of your finances before you commit to putting money down.
Passive income investments are steady investments that can net you high returns. But any financially healthy decision you make should be made after you’ve made a scrutinizing analysis of your financial state.
That way, you can ensure that you’re investing the best possible amount for you, a level of investment that won’t leave you in financial straits if it is not immediately on hand, while large enough to maximize your return.
Find the Best Investment for Your
Make sure that where you decide to put your investment is the right one for you.
When it comes to passive income real estate investment options, real estate investment trusts and private funds are two of the most dominant options to choose from. Which one you select depends on the level of investment you’re committed to making and the longevity you’re willing to stay in.
Over the past 40 years, the total average of REITs gave their investors a return of 13.3% annually. The median annual return for private equity funds is around 14.2%.
There are plenty of different types of REITs and private equity firms to choose from, all with their own performance metrics and niche investment strategies. In order to find the best one for you, all it takes is a little research into a given firm.
Invest With The Best
Christina has found resounding success in one of the country’s most competitive and lucrative real estate markets: Los Angeles’ Westside region. Our investment strategy to navigate this niche market helps us manage some of the highest value assets at the most opportune time.
Get started with Christina if you’re looking for bona fide passive income.
Publication 925 (2021), Passive Activity and At-Risk Rules | IRS
Material Participation Tests | Investopedia
REITs vs. Stocks: What Does The Data Say? | Motley Fool