Real estate has historically been a significant driver of wealth, but not all real estate investments are the same.
Real estate assets come in all shapes and sizes. Some require active management from a hands-on investor, whereas others are perfect for a passive partner.
Allocating some of your assets to real estate investing can help diversify your portfolio, and we’ll share some insights into why passive real estate investments can be an important part of an investment portfolio.
Difference Between Passive and Active Real Estate Investing?
People often equate owning a rental house, an apartment, or some commercial property with passive income. This leads to them misclassifying these investments as “passive.”
However, anyone who has dipped their toes into real estate investing can tell you that owning properties is anything but passive.
Even with a professional property manager, the owner bears a lot of responsibility, including:
- Selecting the property.
- Securing financing.
- Approving major repairs.
- Worrying about tenants not paying rent or damaging the property.
Ultimately the owner is responsible for managing and fixing anything that can go wrong.
Conversely, passive real estate investing is different since it means not taking an active role in running the business or investment. This can include stocks or ETFs as well as certain types of real estate investing.
Here Are a Few Ways to Obtain Passive Real Estate Income:
- REITs (real estate investment trusts) are usually publicly traded companies that manage or finance a wide range of income-generating properties. Some can be private, meaning that they may be exempt from registering with the SEC.
- Becoming a silent partner by providing capital to a property manager.
- Joining with a syndicate of investors who pool their capital to purchase investment properties.
- Real estate crowdfunding is one of the newest ways to generate passive real estate income. It’s a modern version of syndicate investing, often on a larger scale.
Why Diversification Matters
Diversification is an important strategy for reducing risk in your investment portfolio. It’s achieved by buying different types of assets or investments. Some investors equate diversification to simply buying a basket of stocks or ETFs. Unfortunately, the trouble with this type of diversification is that in our global economy, many markets are interconnected. A range of ETFs can all be built on the same underlying assets. This “sharing” makes it challenging to build a truly diversified portfolio using only stocks (i.e equities). Recessions like the current one caused by COVID-19 can devastate your 401k and it can take years to recover from these events.
Fortunately, real estate and other types of private investments aren’t directly correlated to changes in the stock and bond markets. Per Zacks, there is little direct relationship between the stock market and real estate values. Thus, a well-diversified portfolio needs some allocation to real assets via physical property or paper assets like REITs. Essentially, investing for passive real estate income can have the added benefit of helping you de-risk your portfolio.
6 Benefits of Passive Real Estate Investing
Investment properties generate cash flow from the tenants’ monthly rent payments. After all loans, fees, and expenses are paid; the investors keep the remainder as profit. REITs pay out this profit as monthly dividends, which could be higher than the average dividend-paying stock’s yield of 2%. Investing in professionally managed properties and REITs offers truly passive cash flow since you aren’t actively managing them.
Appreciating real estate can be a great way to build wealth, especially over long time horizons. Property values can increase due to a number of reasons including, but not limited to:
- Increasing demand for real estate in the area.
- Changing local industries.
- Improving school districts.
- Strong community investment by private companies or governments.
Although inflation causes buying power to decrease over time, real estate investments are often a good hedge against inflation. Property values can increase over time and rents tend to increase as inflation increases.
Real estate investing can come with a number of tax benefits. Any gain generated from the sale of real estate held for longer than one year is taxed at a lower long-term capital gains rate. In addition, a number of expenses are tax-deductible including but not limited to:
- Management expenses.
- Mortgage interest and property taxes up to certain thresholds.
There are also investment strategies that defer the payment of capital gains upon sale. Investors, for example, can roll capital gains from one sale into the purchase of a new property with a 1031 exchange, without paying capital gains taxes on the proceeds of the sale.
Potential Leverage (i.e Debt)
One of the most attractive advantages of passive real estate investing is the potential of leveraging your investment with debt. Investors can often buy a property for 25% down or less, leveraging a small amount of equity secured by the property to make an investment in a larger asset than they would be able to buy outright. It’s important to note that, while leverage can increase the potential return on an investment, it also increases an investor’s risk.
Experienced property managers can be hired to oversee and manage real estate properties. This can help you feel more confident knowing that your investment is in experienced hands.
It can also help you acquire more physical real estate without sacrificing more of your time.
How to Find Passive Real Estate Income Opportunities?
You can use online platforms like NextSeed to find passive income investments on crowdfunding platforms. While some investments and platforms only allow accredited investors to participate, it’s no longer a requirement to be an accredited investor to access some new opportunities.
Real estate can be a powerful tool to diversify your portfolio and build wealth opportunities. It offers many benefits like lowering your taxable income, protection against inflation, and being able to create passive income.
However, be sure to work with experienced real estate professionals, financial planners, and tax consultants before investing in real estate. Adding this new asset class to diversify your portfolio comes with its own risks and rewards.
About the Author
Dave Seeburger launched and grew a multi-award winning residential real estate development company. Started his career in oil and gas, analyzing and structuring global projects. Recently served as Executive Director of Business Battle, a nonprofit highlighting veteran-owned businesses. Earned a BS from Missouri University of Science and Technology and an MBA from Rice University.