One of the primary reasons that people explore real estate investment is to develop an income stream that is not derived from their normal day-to-day career/job. In a society where we often trade our most precious commodity of time for money, many individuals are continuously seeking ways to obtain financial resources without having to sacrifice time. Count us at Birgo Capital among them: if we can utilize more time for the things that bring us the most joy, such as interacting with family and friends, pursuing passion projects, exercising, serving those that are less fortunate, or, in our case, improving lives through real estate, our quality of life will improve and we’ll make a greater impact on the world around us. This realization often leads people down the path of pursuing a compelling yet elusive concept: passive income.
Today we’ll explore several ways that investors can utilize real estate to generate passive income and free up more time to enjoy life.
Direct Ownership
The most obvious way to generate passive income through real estate investing is to purchase rental properties. This is the classic method of generating mailbox money: buy the house down the street, fix it up a little bit, and rent it out. Direct ownership of real estate can be an incredibly effective tool to increase both passive income and net worth. Real estate historically increases in value over time, so investors who purchase rental properties are often able to obtain both an attractive income stream as well as increased value.
This strategy tends to be one that generates the strongest passive income stream, but there can also be very real challenges that come along with owning real estate directly. Property management is not for everyone; taking the 2am phone call about a runny faucet or broken toilet can be a major annoyance. It’s possible to hire a property manager, but good property managers are very hard to find. This also requires significant cash reserves: if the furnace or air conditioner breaks down, it’s going to be the responsibility of the owner to replace it. If an investment is not appropriately capitalized, real estate owners can lose years worth of passive income with one expensive repair. Challenges and risks aside, direct ownership of property has long been one of the most popular and effective methods of generating passive income.
REIT Investing
Another way to utilize real estate to increase earnings is to invest in a real estate income trust (REIT). Some advantages of REIT investing are that these investments are highly liquid, they tend to appreciate over time, and they are truly passive. Whereas direct ownership inevitably requires some level of effort and meaningful engagement, those who invest in REITs can “set it and forget it” once they’ve found the right REIT strategy for their risk appetite. Historically, these investments have done quite well, with most analyses pegging annualized total returns for REITs at or just above 10%, which is modestly superior to the returns generated by the S&P 500. For income-oriented investors, dividend yields on REITs can vary widely based on the particular strategy and holdings of the REIT: conservative funds tend to pay 3-4%, whereas more aggressive ones pay 6-7% or more.
A downside of these products is their volatility. They tend to mirror stock market performance, but often with a lag as property prices don’t move as quickly as equities. Still, the volatility of these investments is not for the faint of heart. This is illustrated by the performance of one of the largest REITs, Equity Residential:
Note Investing
For more risk averse investors who want a predetermined, fixed rate of return, investing into mortgage notes can be a profitable strategy. This investment method is ideal for investors who prefer the simplicity and predictability of earning a straightforward interest rate as opposed to the return on investment being largely variable and dependent upon performance. Note investing is a common way for house flippers to capitalize their projects: they borrow a certain amount of money for a fixed period of time and offer a fixed rate of return to investors, and when the project is complete and sold, the investors are the first to see returns. One attractive component of this type of investment is that the returns tend to be higher, typically starting at 6%, and can reach the teens depending on the risk profile.
Downsides to note investing are complexity and concentration risk. With respect to complexity, note investing should be properly legally documented and the underlying project should be thoroughly understood. There are many online platforms that facilitate these types of investments, but investors should not participate unless and until they have clarity around the parties, terms, and mechanics of the transaction. Additionally, investors should be aware that if they invest capital into one specific project and that project fails to achieve its target, principal loss can occur.
Friends & Family Syndication
Another method of accessing real estate involves pooling capital together with friends and family to purchase properties. This can be an effective method of achieving the returns of direct ownership but diversifying into multiple properties while maintaining the control that is lost when investing in a fund. These types of investments can take all different forms: investing in apartment buildings, single family vacation homes, or even storage facilities. They can also be debt or equity investments -- partners can go in together for co-ownership of properties, or one partner can retain ownership while the others earn a fixed rate of return by lending. One advantage of this type of investment is its flexibility to accommodate creative structures based on the various risk appetites of the participants.
In addition to investment risk if the projects don’t go as planned, relationship risk is a noteworthy consideration for these types of investments. As the saying goes, “it’s all fun and games until someone loses an eye.”
In all seriousness, though, investors should tread lightly before deciding to pool capital together with friends and family into a real estate deal. This can be an incredibly effective way for investors to access the attractive income stream that comes from real estate, but all participants should have eyes wide open and crystal clear expectations before putting capital to work.
Private Equity Real Estate Investing
Last, but not least, is private equity real estate investing. Under this strategy, investors pool capital together under the guidance of an experienced manager to invest in a particular property or group of properties. This is the business of Birgo Capital, and is our preferred method of generating passive income through real estate. Benefits of private equity real estate investing are that, similar to REITs, it is truly passive, but does not have the volatility of a publicly traded investment that mirrors the stock market. Returns in this strategy tend to be superior to those that are achieved in REITs or note investing, but they are largely variable and will be dependent upon the risk profile and strategy of any particular fund or project.
Downsides to private equity real estate investing include illiquidity and lack of control. These investments generally require that participants be willing to part with their capital for a meaningful period of time -- typically 5 years or more. For investors that want to be able to pull their capital out quickly, private equity real estate is not the right avenue. Private equity real estate investments also leave the investor with little to no control: once they have selected a fund or project to invest in, operations and decisions from that point forward are typically entirely handled by the fund manager. As such, it is essential that real estate private equity investors select a manager that they trust who will make prudent decisions on their behalf.
Conclusion
Real estate provides several different avenues for investors to generate passive income. Whether it’s investing in the mortgage of a development project, going in with friends and family to buy a vacation rental, or investing into a real estate private equity fund, there are plenty of opportunities to explore in the world of income-generating property investment. At Birgo Capital, we encourage investors to consider how they can best utilize the buildings and land around them to provide cash flow that betters their lifestyle.
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