Co-produced with PendragonY and Beyond Saving
One of the most common investment strategies is passive investing. Done correctly, once the initial due diligence is done, an investor will not have to devote large amounts of valuable time to tend to their portfolio positions. Others do the day-to-day work while the passive investor collects the proceeds as their reward for providing capital.
When investing in the stock market, it is a passive investment. You don’t buy a handful of shares and then strut into the home office and start bossing people around!
At HDO, we aim to generate a substantial passive income stream from a diverse array of investments. Once you do your due diligence and invest, your income starts coming in. You can go on vacation, work your regular job, and even sleep while the income flow continues unabated. This income stream can then be used to increase your savings, achieve financial independence or provide income throughout retirement.
One sector that we hold is real estate. Real estate has long been recognized as a great source of passive income. If you have done any research on investing, you have likely come across numerous real-estate-related opportunities that promise to generate in and out of the stock market.
High Capital, High Income
Real estate is a business that can have significant and repeatable cash flows but also requires significant capital. Investors have many options to collect passive income with real estate. One avenue (several popular radio shows cover how to do this) is to buy rental homes, both single-family and small multi-unit homes. Other investors may opt for various commercial properties which comes with several benefits over residential tenants but tends to require a lot more capital.
When real estate prices are climbing, there is always a surge of people looking to “flip” houses. Buying cheap, fixing them up, and selling for a profit – potentially profitable venture, though many amateur flippers find they bit off more than they can chew.
Many of you might have been approached by cold callers, colleagues, friends, or even family for capital. Some groups make a business out of raising money from retirees and high-net-worth individuals. They will offer you free dinners in exchange for just listening to them pitch their real estate investments. Numerous websites promise direct investments in real estate, persuading investors with passive income.
It is true. Real estate is a business that lends itself to passive income opportunities. This is why real-estate-related stocks like REITs and mortgage REITs pay out dividends that are well above average.
For those who wish to take the risk of direct investment in real estate, either individually or with a group, the rewards can be substantial. However, you might find out that the income isn’t so passive, as owning real estate can become a job. If you are relying on others to manage your investments, be cautious.
While there are many legitimate real estate management companies, this sector has plenty of scammers as well. With the stock market, you enjoy some protections from the SEC. However, even that failed to protect investors in American Realty Capital Partners (ARCP). Fraud in a publicly traded company gets more headlines, but similar frauds occur every day around the world.
With any real estate investment, make sure you do your due diligence and properly diversify.
Types of Real Estate Passive Income
There are many different options when considering passive income real estate investments. The one you should choose will depend on your level of experience, your available cash flow, and the time you can afford to dedicate to your investment. Here are a few real estate investment options to consider.
Residential properties vary in size from residences for a single family to large apartment buildings. The common factor is that people live in them.
A single-family home is an individual stand-alone property. This doesn’t mean that it is free-standing, as condo units are included. You can purchase these properties and then rent them out with a single lease. Properly structured, the rent will cover the ownership costs and even provide a small monthly income. Over time you should also see significant capital gains. While this is the most common real estate investment, it also has its risks. Vacancy and turnovers can reduce the amount of rent collected. Problem tenants can also impact rent collections and even damage the property.
Multi-family units are another option for a rental property. These buildings typically have 2 to 4 units. Not only does this increase the cash flow, but it also reduces the impact of an empty unit. Now a single vacancy won’t stop the flow of rent entirely. And by having all the units in a single building, they are easier to manage than a group of physically separate single-family units.
Generally speaking, a multi-family property is easier to manage than a group of single-family units. You will only have one mortgage and tax bill, for instance. And while it will require more than one lease and possibly have multiple vacancies to manage, so would a similar-sized group of single-family residences.
If you are looking for an even larger scale investment, apartment buildings might meet your needs. These are residential buildings with five or more units. These types of buildings have even more of the scale advantages of smaller multi-unit buildings but are even more complex to manage. Often hiring a property manager for such assets make sense because of the increased time such a large holding will require. For instance, the HVAC system for such a building is likely to be a lot more complex than those used in smaller residential buildings.
The main advantage of residential investment is that it is easily accessible. Many people might start with a single home they choose to rent rather than sell when they buy a new home for themselves. Or they see a home in their neighborhood at a good price and buy it up. I’ve met many people who started with one rental home and then expanded over time and end up owning numerous rentals.
How much work is it? Well, renting one property can range anywhere from super easy to an absolute nightmare. One property rented to a single good tenant is a piece of cake. One property with tenants who cause damage and disturbances, and are too familiar with local eviction laws can quickly lead to large losses and significant time. Being a residential landlord can be a good and rewarding business, but it is a business.
- Easily accessible. Direct investments can be in the low hundreds or even tens of thousands in some localities.
- Residential properties are more liquid than commercial real estate.
- Residential property loans are relatively easy to obtain, and high LTVs (loan-to-value) are available to individual borrowers with good credit.
- Demand is local – regardless of macro conditions, some localities will always enjoy stability in housing prices and rent.
- Owning a property in a popular vacation destination can provide passive income with temporary rentals while also offering a location you might enjoy using.
- Landlord/tenant laws in residential real estate tend to strongly favor the tenant.
- A high-quality tenant can be a dream, a low-quality tenant can be a nightmare. Many landlords have been surprised at how difficult it is to determine which type a tenant is before signing the lease.
- Residential leases are short and can experience high turnover.
- Development is not pre-leased. Residential tenants generally expect to move in shortly after signing the lease, which means that new development is speculative.
The REIT Options
Some REITs invest in residential buildings. The advantage of a REIT is that no management input is required of the investor, so once you have done your due diligence, your work is pretty much done (other than cashing dividend payments). You buy shares on the open market, and if you need liquidity, you can sell them. This is far easier than buying or selling individual properties.
As an investor, you get significant diversification as REITs own many buildings in multiple cities. They deal with day-to-day management headaches. True, the yield is likely lower than you could achieve in an “ideal” scenario of owning real estate directly, but it requires a fraction of the effort on your part.
BRT Apartments Corp. (BRT) is an example of a REIT that invests in apartment buildings. Greystone Housing Impact Investors, LP (GHI) (fka ATAX) is a higher-yielding option that includes a mix of residential development and investments in mortgage bonds secured by apartment buildings.
Depending on your available capital, you could consider purchasing a commercial building, industrial complex, or a mixed-use property that blends various commercial and residential properties (think of an apartment building with retail space on the ground floor).
The drawback here is that such investments generally require a much higher initial investment than residential properties. It is very easy to get into the millions with a single investment, putting it out of reach for most individual investors and making a single investment high stakes for many others. The management complexities are also much larger and often will require the services of a property manager.
While having the potential to bring in stable passive income with long-term tenants, be sure to account for lengthier vacancies and higher remodeling costs.
- Commercial leases tend to be 3+ years. In some sectors, 15+ year leases are normal.
- Tenant quality is easier to estimate, especially if you invest in properties with national tenants.
- “Sale leasebacks” with high-quality and even “investment grade” tenants are available.
- “Triple-net” leases, which make tenants responsible for property costs, are becoming increasingly popular and common. These leases remove the day-to-day property-level obligations and expenses from the landlord.
- Development can be pre-leased. Commercial tenants frequently sign leases years before they move to a location.
- The barriers to entry can be significant. Commercial leases should not be entered into without lawyers and sophisticated due diligence. The cost is prohibitive for many individuals.
- Be especially cautious buying commercial real estate with “groups”. Development/redevelopment stories always sound attractive, and reality is usually a lot uglier.
- While defaults are rare, vacancies are much harder to fill for commercial properties than residential properties. The costs of maintaining the property and fixing it up to attract new tenants are high.
- Commercial properties become obsolete. Everything about commercial property is larger, more specialized, and more expensive to replace.
Given the barriers to entry and the high costs, this sector lends itself even more to using REITs.
Examples of REITs that invest in commercial property are quite numerous. They include diversified REITs like Realty Income (O) and W.P. Carey (WPC). Some opportunities specialize in certain types of properties, like Medical Properties Trust (MPW) buying hospitals or EPR Properties (EPR) buying experience-based properties. You can easily tailor your public REIT investments to gain exposure to specific sectors.
Investing in vacant land for future development can be very profitable. It all comes down to location, location, location. If you live in or know an area that is likely to expand in the future, buying up vacant land to sell down the road can be very profitable. Many states offer lower property tax on land that is farmed, so if the land can be farmed, renting it to a farmer can be a great way to reduce property taxes and defray the costs of ownership.
Though, if you intend to develop the land, make sure you understand local zoning ordinances. Not all vacant land can be developed.
- Vacant land is inexpensive and tends to hold value.
- You can buy property without a specific intention. Maybe you will sell it for development, develop it yourself, or maybe you want to build something for yourself. Vacant land is very flexible.
- Vacant property can be used for your own enjoyment, even if it never becomes valuable. Camping, hunting, ATV trails, etc. If you are into outdoors, you’ll find plenty of uses. If you live in a rural area, maybe you just want to “own your view” so that development can’t happen without your blessing (and getting paid).
- The carrying costs of vacant land are typically low. Your only direct expense is property taxes.
- It can take a long time for vacant land to appreciate in value. Unless you get lucky, this is not a “get rich quick” strategy.
- Cash flow is minimal to non-existent. If the property is attractive for farming, you can lease it to a farmer. But farm leases are typically low. It will cover your property taxes, but your investment yield probably will not be high.
- Borrowing on vacant land can be difficult. Even with good credit, vacant land is seen by most lenders as only a small step better than being unsecured.
This is one sector where public REITs are not better. In our opinion, you are better off buying a piece of land you might enjoy personally, and if, at some point in the future, it can be developed into something profitable great!
We are familiar with two farming REITs. Farmland Partners (FPI) and Gladstone Land (LAND). If we had to choose, we would go with LAND. However, both have very low yields, and the recent high prices have more to do with the market speculating on inflation. As long-term investments, we don’t see a bright future for either and believe they are very expensive right now.
In the HDO Model Portfolio, we also carry three CEFs with exposure to REITs. Right now, this is the highest-yielding method of investing in REITs. Cohen & Steers Quality Income Realty Fund (RQI), Cohen & Steers REIT and Preferred and Income Fund (RNP), and Aberdeen Global Premier Properties Fund (AWP) provide diversified exposure to U.S. REITs and Global REITs, including many of the highest-quality REITs, which often have lower yields.
Passive income streams allow an investor to build a sustainable financial plan to support the investor into retirement and beyond. HDO’s Income Method is all about obtaining passive income streams and is very compatible with passive income investing.
Real estate investments can be tailored to almost anyone’s situation, which makes them a great choice for passive income investors. Regardless of how much time or capital you have to invest, you can find a real estate passive income option to fit. Passive income streams from real estate investments can boost your savings and pay down personal debt. And, for many investors, it can ensure that your life after retirement is as financially secure as possible.
We prefer the liquidity of owning REITs in the stock market. This creates the flexibility to develop an income stream and to shift your portfolio between sectors. It also allows you to diversify because investments in any one REIT can be very small, whereas even a “small” real estate investment is tens of thousands in capital and more in debt.
If you choose to get more “hands-on” with direct real estate investments or invest with a group, make sure you do your due diligence and diversify. Real estate investing can come with a lot of rewards but also some risks.