Oct 11, 2022
Passive income has become a big buzzword. The allure of collecting steady paychecks without “actively” working for it is stronger than ever.
One of the most popular ways to create a passive income stream is through real estate — at least in theory.
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The process goes something like this: You borrow money from a bank, buy a property, and the tenant pays off your mortgage and then some. Once you accumulate more equity, you repeat the process, buy more properties, scale up … and boom! You are a real estate mogul.
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But the reality is different.
If you want to be a landlord, you need to find reliable tenants, collect rent, and handle maintenance and repair requests (out of your own pocket).
What about a property manager?
A good property manager can make life easier, but personal finance expert Dave Ramsey points out that the income is still not as passive as it seems.
“Even if you are managing the managing company, they’ve still got to call you and approve the $8,400 new heating and air system that blew up, or the other day I had a $26,000 one go out on one of our commercial buildings,” he says on a recent episode of The Ramsey Show. “Didn’t feel passive to me at all.”
Ramsey still likes real estate as an asset class but warns that investors should know what they are getting into.
“I love real estate. It does give you a better rate of return that other investments don’t have, but when I hear someone say passive income and real estate in the same sentence, it means they’ve been on get-rich-quick websites.”
So how can you invest in real estate and make it as hassle-free as possible?
Here are three ways to consider.
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REITs
REITs stands for real estate investment trusts, which are companies that own income-producing real estate like apartment buildings, shopping centers, and office towers.
You can think of a REIT as a giant landlord: It owns a large number of properties, collects rent from tenants, and passes that rent to shareholders in the form of regular dividend payments.
To qualify as a REIT, a company must pay out at least 90% of its taxable income to shareholders as dividends each year. In exchange, REITs pay little to no income tax at the corporate level.
Of course, REITs can still experience rough times. During the pandemic-induced recession in early 2020, several REITs cut back on their dividends. Their share prices also tumbled in the market sell-off.
Some REITs, on the other hand, manage to dish out reliable dividends through thick and thin. Realty Income (O), for instance, pays monthly dividends and has delivered 117 dividend increases since it went public in 1994.
It’s easy to invest in REITs because they’re publicly traded.
Unlike buying a house — where transactions can take weeks and even months to close — you can buy or sell shares in a REIT anytime you want throughout the trading day. That makes REITs one of the most liquid real estate investment options available.
Invest in an online crowdfunding platform
Crowdfunding refers to the practice of funding a project by raising small amounts of money from a large number of people.
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These days, many crowdfunding investing platforms allow you to own a percentage of physical real estate — from rental properties to commercial buildings to parcels of land.
Some options are targeted at accredited investors, sometimes with higher minimum investments that can reach tens of thousands of dollars.
To be an accredited investor, you need to have a net worth of over $1 million or an earned income exceeding $200,000 (or $300,000 together with a spouse) in the past two years.
If you are not an accredited investor, many platforms let you invest small sums if you like — even $100.
Such platforms make real estate investing more accessible to the general public by simplifying the process and lowering the barrier to entry.
Some crowdfunding platforms also pool money from investors to fund development projects. These deals typically require longer commitments from investors and offer a different set of risk-reward profiles compared to buying shares in established income-producing rental properties.
For instance, the development could get delayed and you won’t earn rental income in your expected time frame.
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Sponsors of crowdfunded real estate deals usually charge fees to investors — typically in the range of 0.5% to 2.5% of whatever you’ve invested.
ETFs
Picking the right REIT or crowdfunded deal requires due diligence on your part. If you are looking for an easier, more diversified way to invest in real estate, consider exchange-traded funds.
You can think of an ETF as a portfolio of stocks. And as the name suggests, ETFs trade on major exchanges, making them convenient to buy and sell.
Investors use ETFs to gain access to a diversified portfolio. You don’t need to worry about which stocks to buy and sell. Some ETFs passively track an index, while others are actively managed. They all charge a fee — referred to as the management expense ratio — in exchange for managing the fund.
The Vanguard Real Estate ETF (VNQ), for example, provides investors with broad exposure to U.S. REITs. The fund holds 167 stocks with total net assets of $72.0 billion. Over the past 10 years, VNQ has delivered an average annual return of 6.2%. Its management expense ratio is 0.12%.
You can also check out the Real Estate Select Sector SPDR Fund (XLRE), which aims to replicate the real estate sector of the S&P 500 Index. It currently has 31 holdings and an expense ratio of 0.10%. Since the fund’s inception in October 2015, it has delivered an average annual return of 8.5% before tax.
Both of these ETFs pay quarterly distributions.
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Jing is an investment reporter for Moneywise. He is an avid advocate of investing for passive income. Despite the ups and downs he’s been through with the markets, Jing believes that you can generate a steadily increasing income stream by investing in high quality companies.
