Investing in real estate means scouting a property, buying it, fixing it up, renting it and managing it, right? Not always.
Becoming a landlord and hosting a vacation property are two ways to actively invest in real estate that demand attention to business details and maintenance. But another strategy can generate income without requiring you to actively manage your properties.
Passive real estate investing is a strategy where you invest your money in real estate ventures without actively getting involved in the day-to-day management of properties.
Just like the previously mentioned strategies, you’re after the cash flow and potential appreciation in property value; however, you don’t have to give up your time to get them.
How Does Passive Real Estate Investing Work?
Passive real estate investing is an umbrella term for different ways to put money into real estate to earn a passive rental income. You invest your money, but your responsibility ends there.
In most forms of passive real estate investing, someone else does all the work of buying, managing and selling properties while you reap the benefits. You’re not building a real estate portfolio but effectively benefiting from helping someone else build one.
One form of passive real estate investment is buying a property and hiring a property manager to maintain it, deal with the tenants and collect the rent. Other forms of passive investing in real estate include real estate investment trusts (REITs), online real estate crowdfunding platforms and real estate funds.
Passive Real Estate Investments vs. Active Real Estate Investments
There are four main differences between passive versus active real estate investing:
- Amount of work required
- Experience required
- Income earned
- Liquidity
Owning and actively managing a property can be a full-time job. However, owning a property and hiring someone to manage it for you requires almost none of your time; other methods of passive real estate investing take even less effort.
Passive real estate investing might be considered low-risk real estate investing, but you still want to do your homework to avoid suffering a loss of principal. Still, your learning might be a few hours on your computer, whereas active investing requires the expertise to know which properties to buy and sell and when.
As a passive real estate investor, consider your investment to be long-term. Over that period, your small investment can net you thousands — or possibly millions — of dollars. The active investor might make that in a year, but they also take on more risk.
Most real estate investments are considered illiquid. Trying to turn a piece of property into cash is a slow process. Property sales can take months or even as long as a year. However, as a passive real estate investor, you can pull your money out when you want, although you might be charged a fee for taking out your money early in some cases.
How to Invest in Real Estate For Passive Income
If you’re looking to earn passive income from investing in real estate, there are many different methods of passive real estate investing to choose from, including crowdfunding, REITs, hiring property managers, real estate syndication, real estate funds and fractional ownership. Here’s a closer look at each investment method.
Crowdfunding
Online crowdfunding platforms make it easy to get started with passive real estate investing. These sites let investors pool their money to buy commercial or residential properties that generate income. You can earn cash from rental income or appreciation and a subsequent sale.
Crowdfunding sites enable beginners to jump into passive real estate investing. The sites work with their network of property managers to find and manage tenants. Your biggest concern might be the timing of distributions.
You must be an accredited investor on many sites, but several now allow nonaccredited investors. An accredited investor is anyone who has a net worth of $1 million or more (excluding your primary home) or has earned $200,000 or more in the previous two years and expects to continue doing so.
The U.S. Securities and Exchange Commission (SEC) set these criteria to ensure that investors have enough sophisticated knowledge to understand high-risk investments. There’s no certification or designation from the SEC — it’s left to each site to verify that you meet the criteria.
Real Estate Investment Trusts (REITs)
The concept of a REIT isn’t unlike crowdfunding in that REITs are companies that own and operate real estate properties that generate income. However, REITs are mostly traded on the major stock exchanges. You can invest in individual REITs, mutual funds and exchange-traded funds (ETFs).
This option is similar to owning a share of stock and being paid a dividend. The SEC requires REITs to pay 90% of their taxable income to shareholders.
You can invest in residential or commercial REITS and choose between different economic sectors, such as healthcare or hospitality.
Using Property Managers
Buying a property and hiring a property manager to maintain it, interact with tenants and collect rent is a type of passive real estate investing. You may or may not have been involved in selecting and purchasing the property, but now, you can sit back and accumulate income while someone else makes decisions about your rental.
Another benefit to having a property manager or management company run the show is that you can buy properties in other locations because you don’t have to be there to oversee things.
Of course, having someone else manage your property could also be a drawback, so choosing an individual or company with professional experience is important.
What you pay for a property manager will depend on what you want done (being completely hands-off costs more). The average cost of a property manager is between 8% and 12% of the monthly rent, plus other fees, which may include:
- A set-up fee
- Tenant placement fees
- Lease renewal fees
- Maintenance fees
- Eviction and collection fees
- Late payment fees
- Routine inspection fees
- Contract termination fees
Numerous factors impact the cost of a property manager, including the quality, size and condition of the property and your market. As such, the lowest price might not always be the best.
Real Estate Syndication
In a real estate syndication, you can pool your money with a group of investors, forming a partnership to invest in a single property.
There are general and limited partners, and your rights in the partnership and potential returns are relative to your investment and liability. There also can be three other players: the passive individual investor, a managing entity and a joint-venture partner.
General partners (also known as syndicators or sponsors) strategize and bring passive investors on board. Passive investors provide capital; limited partners are less liable counterparts to general partners; managing entities collaborate between partners and joint-venture partners offer resources to help ensure the success of a project.
The SEC doesn’t require a particular legal business structure. However, most syndications form limited liability corporations (LLCs).
Real Estate Funds
There are four general types of real estate funds: real estate mutual funds, REITs, real estate private equity funds and real estate debt funds.
To understand real estate funds, consider the example of a mutual fund, which is a collection of several types of investments. Those investments could be stocks or bonds or track an index. A real estate fund is similar, except you’re investing directly or indirectly in real estate.
Here’s a brief breakdown of the funds:
- Real estate mutual fund: Publicly traded; investment in stocks and bonds of real estate companies or directly in properties
- REIT: Publicly traded; owns and operates income-generating properties and pays dividends
- Real estate private equity fund: Not publicly traded; pools money from individual investors and invests in specific properties
- Real estate debt fund: Not publicly traded; pools money from large institutional investors for the development or redevelopment of large commercial properties
Because real estate private equity funds aren’t on the exchanges, they carry an illiquidity premium that’s attractive to investors. These funds also tend to have less volatility than others because of diverse investment strategies and a low correlation to public equity and bond markets.
The skillful management of real estate private equity funds can generate an excess in returns beyond market movements, which is referred to as “alpha.” Seizing these opportunities is known as “tapping into alpha.”
Fractional Ownership
Fractional ownership offers a way to pool your resources with others to buy a property, such as a vacation home, house or condominium. Each investor owns a share of the property, and the value of these shares changes with the property value.
As a fractional owner, you have a say in what happens with the property. The cost of managing the property is spread across all owners, but you also share any rental income generated.
Fractional ownership can take several forms, including joint tenancy, which gives you equal rights and access to the property, and tenancy in common, which gives you a partial interest in the property.
Benefits of Passive Investing
Some of the many benefits of passive investing include:
- Low entry costs
- Little knowledge needed
- No physical labor
- Liquidity
- Reliance on real estate professionals
These advantages make it a great low-maintenance money-making opportunity.
Risks of Passive Investing
That said, passive investing is not without potential downsides, including:
- Unpredictable real estate values
- Less liquidity than stocks and bonds
- Less control over investments
- Long-term holding
These disadvantages are worth weighing if you’re considering getting involved in passive investing.
Factors to Consider in Passive Real Estate Investing
Passive real estate investing can offer you income without becoming a landlord, but there are many factors to consider before jumping in.
Investment Strategy
A turnkey rental property doesn’t require you to make any renovations or upgrades. Buying a ready-to-rent property is extremely convenient — just sign the paperwork, take the key and start earning cash.
By focusing on long-term rental properties, you can reduce your overall expenses with a lower turnover of tenants. Cutting the fees your property manager would charge you for advertising and acquiring new tenants can also present the potential for higher returns on your investment.
Location
Location has always played a critical role in real estate, and this remains true with passive real estate investing. Some research is required to ensure that you don’t drop your investment dollars in a venture that could lead to a loss.
Here are some location issues to be mindful of:
- Zoning restrictions
- Surrounding infrastructure
- Neighborhood decline
Evaluating these factors can help keep you from sinking money into a bad location.
Property Type
The type of property you choose can also impact your returns. Whether residential or commercial, each has benefits and disadvantages. For instance, residential properties tend to offer a more stable flow of rental income. However, commercial properties come with the potential for higher rates of return because of larger leases.
If you’re leaning toward residential properties, take into account the number of bedrooms and bathrooms and research the area to see how those numbers fit into the overall market.
Market Conditions
While passive real estate investing seems low-effort, you must do some work to ensure that you’re making a good investment. Market research is one critical aspect.
Check to see whether the properties in your area exhibit low demand and high vacancies. If so, you might want to hold off on investing until that trend turns around. It’s also a good idea to look at household incomes, employment rates, income distribution and regional job growth.
Examining these factors requires time and energy, but it can help you find the investment that will deliver the income you’re after.
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Consider Whether Passive Real Estate Investing Is for You
If you’re looking for an investment that promises to generate cash flow with little work on your part, passive real estate investing might be a viable option. Just make sure you explore the contours of this type of venture carefully to avoid putting your money into something that doesn’t perform the way you expected.
Frequently Asked Questions
How risky is passive investing?
Like any investment, passive real estate investing has risks. That said, it’s less risky than other types of investing — and therefore generates lower returns.
Is a rental property a passive investment?
While rental properties typically require hands-on involvement from an investor, the IRS considers them a type of passive investment.
How is passive real estate income taxed?
Taxes on passive real estate income are based on an investor’s tax bracket, and the income is taxed in two ways: recurring income during the year and capital gains when a property is sold.
