Most people have heard the quote “90% of millionaires are made from real estate.” But when people think about getting rich by investing in real estate, they certainly don’t imagine all the hassles that come with being a landlord.
The whole reason why people want to invest in real estate is so they can stop working and rely on the passive income the properties generate. The last thing they want to do is now have a new job that lasts 24 hours a day, 7 days a week, called “being a landlord.”
So how do investors get the benefits of real estate investing – like passive income, tax deductions, and non-correlated returns with the stock market – without the headache of property management and maintenance? This is where passive real estate investing comes in.
In this article, we define passive real estate investing, explore how passive real estate investments are structured, and offer some handy tips on how to get you started on your own passive real estate journey.
Key Takeaways:
- Passive Real Estate Investing: Investing in real estate for passive income without being actively involved in day-to-day property management.
- Passive Real Estate Pros: This includes low investment minimums, no property management and higher liquidity.
- Passive Real Estate Cons: This includes lack of control, lower return potential and higher tax rates.
- Passive real estate investments: These include everything from REITs and crowdfunding platforms to private real estate funds.
What is Passive Income?
When most people think of passive income, they imagine the metaphorical “mailbox money” where they do nothing, and checks arrive each month in the mail.
While this may indeed happen, with regards to the US tax code, “passive income” means something specific.
What is Passive Income:
There are three types of income you can earn: Active Income, Passive Income, and Portfolio Income.
- Active Income comes from what’s called “ordinary income” – things like wages and salaries earned from an employer – and is subject to a 10% – 37% tax
- Passive Income – defined by the IRS as either “net rental income” or income from a “business in which the taxpayer does not materially participate” – is subject to a 0% – 20% tax
- Portfolio Income – which includes dividends, interest, capital gains, and royalties – can be taxed at either short-term or long-term capital gains rates, depending on a variety of factors
To put this in plain English, the most common way to earn passive income is by owning commercial real estate and businesses!
But there’s a catch you need to be aware of: “material participation.”
For the self-employed, or anyone else with an ownership interest in a business, the standards for material participation include:
- 500+ hours toward a business or activity from which you are profiting
- If participation has been “substantially all” of the participation for that tax year
- Up to 100 hours of participation, and at least as much as any other person involved in the activity
- Material participation in at least five of the past 10 tax years
- For personal services businesses, material participation in three previous tax years at any time
Or again, put in plain English, if you are a legitimate “investor” and not a “manager” of the business operation, broadly speaking, any income earned will likely count as “Passive.”
And if you’re playing the Game of Money as the Banker – instead of Consumer or Producer – this adds another exceptionally favorable tax treatment to your business activities.
According to the tax code…
You don’t treat the work you do in your capacity as an investor in an activity as participation, unless you’re directly involved in the day-to-day management or operations of the activity.
Work you do as an investor includes:
- Studying and reviewing financial statements or reports on operations of the activity,
- Preparing or compiling summaries or analyses of the finances or operations of the activity for your own use, and
- Monitoring the finances or operations of the activity in a nonmanagerial capacity
With that said, let’s dive into how passive income works in the real estate sector.
What is Passive Real Estate Investing?
Real estate investing is a tried-and-true way to build generational wealth. For those interested in taking advantage of this asset class, there are multiple ways to invest depending on the returns you’re looking to achieve versus the risk and effort you’re willing to take on.
Broadly speaking, we can view real estate investments across three different categories: active, passive, and hybrid.
Active Real Estate Investing
When most people get into real estate investing, what they actually do is become real estate entrepreneurs. This means they are taking an active role in building, developing, managing, and selling real estate.
For the majority of “mom and pop” landlords – who typically own 1-3 income properties – they are the entire business structure in charge of all aspects of managing that real estate.
At some point, these small landlords might decide to hire a management company to take over the day-to-day operations of property so they can sit back and collect checks.
However, by hiring a management company, this adds fee drag to the investment (as would adding any expense that was normally assumed by the landlord).
Depending on the size of the rental portfolio, this added layer of management fees may make the return profile of the properties less attractive. For this reason, many landlords who are looking to “escape” the day to day, it often requires reaching some level of scale in the portfolio to absorb the costs.
This is where you roll up your sleeves and get involved in the nitty-gritty of property ownership. You might be buying properties to renovate and sell at a profit—commonly known as fix-and-flips. Or you might buy rental properties and choose to manage them yourself. This hands-on approach will require substantial time and effort, from researching and bidding on properties to finding suitable tenants, and managing the property.
Passive Real Estate Investing
Passive investing is all about minimizing work required on the part of the investor. In some cases, this involves handing over your money to a professional and letting them take care of the operational side of things. Real Estate Investment Funds are one such example of this, but we’ll explore many other passive real estate investment vehicles below.
Hybrid real estate investing (active real estate investing with passive management) active and passive investing. The active part entails researching and buying rental properties. But instead of becoming a landlord, you hire a property manager to passively manage your investments—from screening rental applicants to collecting rent and fixing property damages. You’d effectively be playing the role of a fund manager.
Main difference between active and passive real estate investing.
Passive vs Active Real Estate Investor
In real estate investing, you’ll find two distinct types of real estate investors. Active investors not only own properties, but they also manage them directly. Think of a landlord who rents out an apartment complex, handles the day-to-day maintenance, deals with tenants, and so forth.
Passive investors operate differently. They make their investments in real estate but typically don’t engage with the physical property. For instance, they might invest in a real estate investment trust (REIT), where they’re essentially buying shares in a company that manages a portfolio of properties.
What are the Pros and Cons of Passive Real Estate Investing?
Passive real estate investing is an appealing option for many, regardless of their experience level, initial investment capital, or time availability. Here are the benefits:
Low investment minimums:
This option is especially appealing to investors working with a tighter budget. Unlike buying your own property, passive real estate investments don’t typically require a hefty down payment.
For example, retail investors can invest in publicly traded REITs directly from their brokerage accounts for a few hundred (or thousand) dollars. While a steady flow of payments may sound enticing, REIT dividends come with unique tax consequences for investors. These payments can constitute ordinary income, capital gains, or a return of capital—each of which receives different tax treatment.
On the other hand, there are several alternative investment platforms offering private real estate investment opportunities with affordable minimums.
No property management required:
Rather than having to spend hours finding properties or managing the day to day operations, you can simply allocate your funds to a passive real estate investment while you focus on other pursuits.
Portfolio diversification:|
Passive real estate investments offer the opportunity to access markets that might be out of reach for individual investors. For instance, commercial real estate like industrial buildings and shopping centers.
Higher liquidity:
While investing in physical properties can tie up your funds, some passive real estate investments like REITs are traded on major stock exchanges. In other words, a passive real estate investor can buy or sell these shares at any time during market hours.
Passive Real Estate Investing Risks and Downsides
Passive real estate investments, despite their apparent ease and convenience, also have some drawbacks.
Lack of control:
With passive investments, like Real Estate Investment Trusts (REITs) or real estate index funds, investors have little to no say over the specific properties that are bought, sold, or managed. This is in stark contrast to active investing, where investors have full discretion over their properties, from acquisition and tenant selection to the sale.
Lower return potential:
When it comes to active real estate investing, be it buy-and-hold or fix-and-flip, the reward potential is higher for one simple reason – if you don’t have to pay other people fees to generate the same return, you get to keep all of the potential upside.
However, this also assumes that you can produce the same returns a qualified real estate professional or investment manager could (which ideally are in excess of the fees they charge).
Higher tax rates:
Active real estate investments, like rental properties, can offer a range of tax benefits including depreciation and mortgage interest deductions. These advantages may not be as accessible with passive investments, leading to potentially higher tax obligations.
Higher liquidity:
Generally speaking, passive investors tend to own an investment product that may be traded on a public stock exchange. This means there may be better liquidity for passive investors in these types of investments.
However, not all real estate is traded on an exchange. This means any investment in privately held real estate companies (or funds) could be illiquid in nature. Please keep in mind your own personal liquidity needs before investing in real estate.
How Real Estate Investment Vehicles Work
Before we get into the nitty gritty details of generating passive income from real estate, it’s important to understand how the actual investment vehicles you’re putting money into are structured.
As a reminder, when you invest in a real estate company, you don’t own the property directly. You own shares in a real estate company, which in turn manages the property on behalf of the owners (who also may be the same people).
Generally speaking, there are four different types of real estate companies you can invest in:
- Real Estate Investment Trusts: Fully managed, hands off, investment company that is at scale.
- Real Estate Developers: These people buy and develop land + build houses on that land.
- Real Estate Operations and Services: Typically smaller landlords.
- Real Estate Funds: Typically designed to execute more complex real estate investment strategies on behalf of investors.
Performance metrics for various types of real estate companies.
Each of these company types can, in turn, be accessed as either Public Real Estate Investments or Private Real Estate Investments. Public investments allows investors to buy shares through any brokerage account. For example, REITs and Real Estate Developers.
Private investments, on the other hand, are typically only available through personal relationships and local networks. Examples include Privately Traded REITs, Private Real Estate Funds and Private Real Estate Companies. However, there have recently been a number of real estate crowdfunding portals that offer accredited and non-accredited investors access to private real estate investment opportunities. A platform like Equifund might be a good place to start. We offer private real estate deals with low investment minimums and low fees.
The company types mentioned above use various real estate vehicles to generate passive income and capital gains—each with varying levels of passivity. Here are some of the most popular ones.
By Strategy:
- Fix And Flip: Buying under-market-value properties in need of repair, improving them, and selling for a profit.
- Buy And Hold: Purchasing properties and holding them for a long period, capitalizing on price appreciation and rental income.
- Build To Rent: Constructing a building specifically to rent it out, providing a consistent stream of rental income.
By Format:
- Single Family: A standalone residential building intended to house one family.
- Duplex – 4 plex: Residential buildings that contain two to four separate housing units respectively.
- Multi Family: A type of residential housing where multiple separate housing units are contained within one building or several buildings within one complex.
- Low Rise: A building with a small number of floors, often less than three.
- Mid Rise: Buildings that are between four and nine stories tall.
- High Rise: Buildings with a significant number of floors, typically more than ten.
By Risk Profile:
- Core: Low-risk, low-return investments, usually fully leased, high-quality, well-located properties.
- Core Plus: Slightly more risk and higher potential returns than core investments, might need some form of enhancement or value-added element.
- Opportunistic: High-risk, high-return investments, often involving significant development or redevelopment, or being in less proven markets.
5 Ways to Invest Passively in Real Estate
Now let’s explore each real estate vehicle more in-depth.
5 ways to get started with passive real estate investing.
1. Real Estate Investment Trusts (REITS)
Real Estate Investment Trusts, or REITs, are a way to passively invest in the sector without the hassle of managing a property. These are companies that buy and operate a diversified real estate portfolio, which could range from rental properties, offices, warehouses, to shopping malls and hotels.
As with mutual funds, REITs can be both public or private—with the main difference being whether you’re buying shares from a stock exchange or directly from the issuer. And since public REITs are listed on an exchange they are inherently more liquid.
You can expect a steady stream of passive income from your REIT investments. The law mandates that REITs pay out at least 90% of their taxable income to shareholders in the form of dividends. Also, the income source is mostly stable, as it comes from the rents collected by these properties or, in some cases, from mortgage interests.
2. Real Estate Syndicates
You can also invest in real estate passively by partnering with other investors who want to take an active role. Real estate syndicates are usually structured as an LLC that’s jointly owned by you and 2+ other investors. For example, one of my real estate investments is an LLC that I own jointly with two other investors. I’m the only one who is actively involved in the acquisition and operation of properties — the other two don’t have any day-to-day involvement.
How a real estate syndicate is structured.
3. Public Real Estate Companies
Passively investing in real estate can also be achieved through purchasing shares of publicly traded companies in the real estate sector. As of writing this, the largest public real estate companies in the world are Proglosis (PLD), American Tower (AMT) and Equinix (EQIX). By buying shares in companies like this, you are by definition investing in their real estate portfolios.
4. Outsourced Property Management
Passive investment in real estate through a third-party property management company is another way to remove yourself from operational responsibilities.
Here’s how it works: you purchase a rental property, be it a single-family rental or a multi-family home, based on your capital. Instead of taking care of the nitty-gritty yourself, you employ a property management company to handle tasks like finding tenants, renewing leases, and maintenance.
Just remember, this service isn’t free. Typically, property managers charge a one-time setup fee plus an ongoing management fee, usually about 10% of the monthly rent. On top of that, they might charge leasing fees, lease renewal fees, and maintenance fees. It can add up quickly, so understanding your property’s cash flow and profit margin is crucial to assess if you can afford these professional services.
5. Real Estate Funds
A real estate fund is a type of mutual fund that’s designed for long-term appreciation rather than dividends.
As a starting point, it’s important to understand that these types of investments are typically done through a fund structure, managed by General Partners (GPs) on behalf of a group of investors known as Limited Partners (LPs).
Private Real Estate Fund structure.
When you put money into a real estate fund as an LP, your returns will depend on a distribution system called a “waterfall.”
This waterfall includes:
- Return of Capital: Your initial investment is returned before any profits are distributed.
- Preferred Return: This is like a minimum guaranteed rate of return, say between 6% to 10% annually, that you receive before any profits are shared with the GP.
- Catch-up Provision: If included in your fund, it allows the GP to receive a portion or all of the next profits, until they match your preferred return.
- Carried Interest or Performance Fee: This is where the remaining profits are split between you and the GP, often at a ratio like 80% for you and 20% for the GP, but these ratios can vary.
When it comes to real estate funds, there’s also hidden fees to consider, like:
- Transaction Costs: This could be fees of 10-15 percent of the investment for commissions and other up-front costs.
- Management Fees: Typically, 1-2% of the total capital invested in the fund per year is taken as management fees.
- Acquisition Fees: Costs related to the purchase of properties, including due diligence costs, legal fees, and others.
- Asset Management Fees: These are separate fees for managing the individual properties within the portfolio.
- Disposition Fees: Costs related to the sale of a property, like broker commissions, legal fees, and closing costs.
- Financing Fees: Fees related to obtaining financing for property acquisitions.
- Development or Construction Fees: Costs related to property development or significant renovations.
- Operating Expense Mark-ups: Costs of various operating expenses, such as property management, insurance, or maintenance services.
- Organizational Expenses: Costs related to the formation and operation of the fund.
- Incentive Fees: Additional fees based on the fund’s performance, on top of the carried interest.
Getting Started With Passive Real Estate Investing
Passive real estate investing refers to investing in real estate properties without being actively involved in their day-to-day management. It’s a way to let your money work for you without needing to be a landlord.
Common forms of passive real estate investing include Real Estate Investment Trusts (REITs), which are essentially companies that acquire and manage income-producing real estate. Another way is through crowdfunding platforms that allow multiple investors to pool their resources to invest in a property. Additionally, you could own rental units and hire a property management firm to handle daily operations, making your involvement relatively passive.
How Do You Know if Passive Real Estate Investing is Right for You?
To determine if passive investing in real estate is the right investment strategy for you, you’ll need to take into account several factors.
Firstly, your financial position. Passive real estate investing will require some capital upfront, though typically less than buying your own property. So if you’re currently short on cash, your first step should be to build up your savings.
Secondly, consider your investment goals. If you’re looking for a steady, relatively stable income stream with fewer demands on your time, then passive real estate investing could be a good fit.
Thirdly, assess your risk tolerance. Passive real estate investments are still vulnerable to many of the same risks as active real estate investments. This includes everything from vacancies and property damage to market fluctuations that could affect property values and rental income.
Lastly, think about your time availability. Active real estate investments, like house flipping, require a lot of time and energy. If you’d prefer to focus on your main job, hobbies, or leisure time, passive real estate investments could be a suitable option.
The right strategy for you might even be a blend of both passive and active methods. Some investors split their money between REITs and owning physical properties, using a property manager to handle the day-to-day tasks. This combination allows you to diversify your investments and involvement level.
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Frequently Asked Questions About Passive Real Estate Investing
Is it smart to own real estate?
Real estate is considered one of the top-performing asset classes and has consistently proven its potential to provide both regular income from rentals and long-term appreciation. The reasons behind this are rooted in some basic principles.
Firstly, real estate, particularly land, is a finite resource. This scarcity adds value to the asset class.
Secondly, real estate satisfies one of the most fundamental human needs: shelter. This need has an intrinsic value. As the population of cities grows, so too does the demand for places to live, work, eat, and shop. More people equals more demand, and given the scarcity of real estate, this demand can drive up the value.
Moreover, it’s worth mentioning real estate’s tax advantages. Typically, passive income such as rent collected from real estate properties is taxed at a lower percentage than active income.
Do most millionaires own real estate?
According to the Wealth-X 2022 Billionaire Census, 7.4% of the richest people in the world built their fortunes via real estate.
