Passive real estate investments
Passive investments provide income called cash flow, typically paid in the form of rental income or dividends. Passive income is taxed differently from ordinary income and, for many, is the ideal income source because it requires little ongoing participation.
It's not uncommon for those who start investing to want to branch outside of the stock market and diversify their portfolio to hold real estate investments. But there are still ways to invest in real estate with individual stocks through real estate investment trusts (REITs) and exchange-traded funds (ETFs).
A REIT is a company with a specific designation that buys commercial real estate by pooling investors' money, paying at least 75% of all income to their investors in the form of a dividend. REITs can be publicly or privately traded and, historically, have a strong performance.
You can purchase shares of a REIT for just a few hundred dollars through a brokerage account. While there are two primary categories for REITs -- equity REITs and mortgage REITs -- there are companies that specialize in every type of commercial real estate (CRE) possible. Investing in REITs is relatively easy and a great way for those who have a limited amount of funds to begin investing in real estate.
Real estate ETFs
A real estate exchange-traded fund is similar to a mutual fund but focuses on buying real-estate-related commodities such as REITs. The fund manager chooses specific REITs to invest in, enabling the investors who are buying shares in the real estate ETF to diversify their holdings across a number of different CRE sectors and with a variety of REITs.
You can purchase a real estate ETF through a brokerage account, typically for a few hundred dollars, making this a great entry investment option.
Real estate crowdfunding is a relatively new investment opportunity that allows accredited investors to pool money to fund a real estate venture. Investors can join a crowdfunding platform that connects a sponsor -- the active partner in the real estate venture -- with funding from multiple investors. The investment opportunity is professionally managed by the sponsor and the sponsor's team, paying the investor a specified return over a set period of time.
Funds invested in a crowdfunding opportunity are often illiquid for a set period of time, meaning the investor cannot pull the funds without paying a penalty. Crowdfunding can be a lucrative passive investment option for qualifying investors, but it does come with risk.
Rental real estate
In rental real estate, income is earned by collecting monthly rent. Unlike a traditional job, wherein you trade your hours for money, a landlord earns cash flow each month, without having to work a required number of hours for it. Rental income is ongoing. As long as the property is rented and the tenant is paying, you earn cash flow for the long term, potentially making it a reliable income source in retirement.
You can rent a residential property, such as a single-family home, condo, or triplex; or you can rent a commercial property such as an office, industrial building, retail center, or apartment complex.
While the IRS considers rental income to be passive, the investor still actively participates. The investor is responsible for finding the investment opportunity and managing it and is on title holding liability and responsibility for the property, including paying for taxes and insurance and maintaining and improving the property over time.
How a property is managed determines how passive or active a rental property is. You can hire a third-party management company that handles the ongoing management for you for a fee, or you can manage it yourself. While some rentals require more work than others, typically, if you manage a property yourself, your income is no longer passive as you are trading your time for income.
Residential real estate is a common starting point for new investors because of the lower upfront costs that make it an easier entry point. In many cases, getting a mortgage for a $100,000 single-family home is easier than getting a commercial loan for a $1,000,000 property. Additionally, commercial rentals are analyzed differently from residential rentals, so it's important to distinguish the types of rental real estate to determine which investment strategy appeals to you most.
Private equity fund
A private equity fund pools money from multiple investors to purchase real estate securities. The fund manager and their team manage the investments, paying investors a preferred return or dividend monthly or quarterly. There are private equity funds for investing in commercial real estate, residential real estate, and even real estate debt such as performing or nonperforming mortgage notes.
Investment funds placed in a private equity fund are illiquid for a specified period of time, meaning the investor is unable to pull their investment out of the fund without penalty. Private equity funds must pool their money according to the rules set forth by the Security Exchange Commission (SEC) and are not publicly available.
Performing mortgage notes
Investing in or creating mortgage notes is often seen as a higher-level real estate investment strategy, but it is accessible even to those just starting out. You don't own real estate when you invest in a mortgage note; instead, you invest in the debt behind the property.
Just as a bank lends money to buy a home, an individual can lend money to buy a home. The property buyer signs a note and mortgage, promising to repay the debt, and makes a monthly principal and interest payment to the lender.
A performing mortgage note does require work, especially in reviewing the borrower's qualifications to buy the property and repay the debt. Once the note is purchased, though, it is a form of passive income.
Unlike with a rental, the lender does not own the home, meaning they are not responsible for taxes, property insurance, or maintaining the property. As long as the borrower pays, the investor receives passive income in the form of cash flow.