Passive income has become a big buzzword. The appeal of collecting a steady paycheck 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.
The process goes something like this: You borrow money from a bank, buy a home, and the tenant pays off your mortgage and then some. Once you’ve accumulated more equity, repeat the process, buy more properties, scale up… and boom! You are a real estate magnate.
But the reality is different.
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What about a property manager?
To be a landlord, you need to find reliable tenants, collect rent, and handle maintenance and repair requests (out of pocket).
A good property manager can make life easier, but personal finance expert Dave Ramsey points out that income is still not as passive as it seems.
“Even if you run the management company, they still have to call you and approve the new $8,400 heating and air system that blew up, or the other day I had a $26,000 go out in one of our commercial buildings,” he says in an episode from The Ramsey Show. “Didn’t feel passive at all.”
Ramsey still likes real estate as an asset class, but cautions that investors need to know what they’re getting into.
“I like real estate. It does give you better returns than other investments, but if 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.
REITs stands for Real Estate Investment Trusts, which are companies that own income-producing real estate such as apartment buildings, shopping malls 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 on to shareholders in the form of regular dividend payments.
To qualify as a REIT, a company must annually distribute at least 90% of its taxable income to shareholders as dividends. In return, REITs pay little to no corporate-level income tax.
Of course, REITs can still go through tough times. During the pandemic-induced recession in early 2020, several REITs cut their dividends. Their share prices also plummeted during the market sell-off.
In contrast, some REITs manage to pay reliable dividends through thick and thin. For example, Realty Income (O) pays monthly dividends and has made 118 dividend increases since going public in 1994.
It is easy to invest in REITs because they are publicly traded.
Unlike buying a home – where transactions can take weeks and even months – you can buy or sell shares in a REIT whenever you want during the trading day. That makes REITs one of the most liquid real estate investment options available.
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Real estate ETFs
Choosing the right REIT or crowdfunded deal requires due diligence on your part. If you’re looking for an easier, more diversified way to invest in real estate, consider exchange-traded funds.
You can think of an ETF as a stock portfolio. And as the name suggests, ETFs are traded on major exchanges, making them easy to buy and sell.
Investors use ETFs to access a diversified portfolio. You don’t have 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 – known as the management expense ratio – in exchange for managing the fund.
For example, the Vanguard Real Estate ETF (VNQ) offers investors broad exposure to US REITs. The fund holds 167 stocks with total net assets of $63.2 billion. Over the past 10 years, VNQ has achieved an average annual return of 6.41%. The 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 30 holdings and an expense ratio of 0.10%. Since the fund’s inception in October 2015, it has generated an average annual return of 6.56% before tax.
Both ETFs pay quarterly distributions.
Crowdfunding refers to the practice of funding a project by raising small amounts of money from a large number of people.
Today, many crowdfunding investment platforms allow you to own a percentage of physical real estate – from rental properties to commercial buildings to lots.
Some options target accredited investors, sometimes with higher minimum investments that can reach tens of thousands of dollars.
To be an accredited investor, you must have a net worth of more than $1 million or earned income of more than $200,000 (or $300,000 with a partner) in the past two years.
If you are not an accredited investor, many platforms will allow you to invest small amounts if you wish – 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 investor money to fund development projects. These deals typically require longer commitments from investors and offer a different set of risk-return profiles compared to buying equity in established rental properties that generate income.
For example, development may be delayed and you will not earn rental income in your expected time frame.
Sponsors of crowdfunded real estate deals typically charge investors a fee — typically between 0.5% and 2.5% of whatever you’ve invested.
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This article provides information only and should not be taken as advice. It comes without any kind of warranty.