Investing in real estate has been a time-tested strategy for building wealth. Particularly, real estate investments can generate passive income. With great passive investment strategies, you can make money in your sleep. Today, we will go over the best investment options to generate real estate passive income in 2020.
What is passive income?
Passive income is a regular cash flow generated from investments that don’t rely on the owner’s active participation and work. Passive income is attractive because it requires little effort from you. After investing, you can leave the investment alone and it will make money for you. This gives you more time for other projects and things you love. Rent is a great source of passive income. Landlords rent out their houses and the tenants pay them every month.
Normally, passive income can serve as a supplement to your regular income. If your investment is large, you can even live on passive income entirely. Common sources of passive income include rent payments, stock dividends, bond coupons, and passive business partnerships.
Real Estate Passive Income
The real estate market is great for investors looking for passive income. Traditionally, investors purchase houses and rent them out for rental income. With the rising popularity of Real Estate Investment Trusts (REITs), more people can benefit from real estate investments. REITs allow you to own shares of property portfolios and receive regular dividends from them.
Owning properties and investing in REITs are both great options to generate passive income in the real estate market. Each has its own unique advantages. We will go over each option in detail to help you select one that works best for you!
Investment option one: rental property investment
Renting out an investment property is a popular and tested investment strategy. Many professional landlords have accumulated substantial wealth through rental properties, despite the fluctuations in home prices.
As a landlord, you receive rental income from your properties. While you are also responsible for the maintenance, you can hire a property manager to do it for you. This will further reduce your responsibilities as a landlord.
Rental income is attractive but the initial process requires a lot of effort and due diligence. The first step is to choose a good investment property.
Types of investment properties
The key to becoming a successful landlord is to meet your future tenants’ needs. It begins with finding the right property to invest in.
In general, houses, condos, and townhouses are more suitable for rental.
Houses – houses give landlords a lot of freedom to decorate and improve the properties as they like. The downside of buying a house as an investment property is the high maintenance burden. As a landlord, you will be responsible for all the maintenance around the house including landscaping, roofing, heating, and more. For new homeowners, maintaining a house can be overwhelming.
Condos – condos are single apartments within a larger building. Condo owners have less freedom in improving their units because the Homeowners’ Association (HOA) must approve each alteration to the unit. But Condos are easier to maintain. The HOA takes care of all the work outside of your walls such as heating, AC, and utilities. This significantly reduces the amount of work required. In exchange, the HOA charges a monthly management fee.
Townhouses – townhouses are hybrids between condos and houses. They are multi-level units sharing a common wall with one or more units. Townhouses are easier to maintain because the HOA will take care of a lot of the work including landscaping and roofing.
Understanding the local rental market
A deep understanding of the local real estate market is crucial to your investment success. With the rise of websites like Trulia and Zillow, it is increasingly easy to gain insight into rent pricing and inventory in your area.
Finding your target market
Before buying a property it is important to consider the target market for your property. If you are renting out an apartment, you can expect young professionals and couples to live in your unit. On the other hand, houses and townhouses are more suitable for families.
Knowing your target tenants helps you determine if a property is attractive to your prospective renters. For example, families care about the school district they are in, while young professionals care about building amenities. As an investor, you must take these factors into consideration to maximize the appeal of your property.
Location, location, location
Real estate is all about location. Buying a rental property follows the same principle. Put yourself in the tenants’ shoes and see if the property offers them what they need such as a coffee shop, grocery stores, malls, and an easy commute.
Property inventory
As a future landlord, you need to research other available rental properties to understand the competition. For example, if you see many rental listings unanswered for months, it could be a sign that there is low rental demand in your area. Additionally, you can also find out what types of properties are popular by checking the local rental inventory.
Expected rent
As an investor, you care about the expected rent you can charge for your property. Thankfully, real estate pricing is based on the sales comparison approach. Your expected rent is often comparable to that of a similar property in your area. You can predict your potential rental income by checking the rent level of different properties in your area. You can do this online with rental websites or you can work with a leasing agent who will give you advice on how much you can charge for your property.
Calculating your rental yield
Before buying a property, it is important to calculate the expected investment yield from your rental. Unlike bonds, the investment yield for a property is not directly available. To measure your rental investment return, you can calculate the net rental yield with the formula below. A high rental yield means your investment is effective in generating income.
Calculating the rental yield is the best way to understand your expected rental return. It allows you to compare the return of your real estate investment with your other investments. Additionally, you can compare your rental yield to the average yield in your city or state. This will help you decide if you should invest in a property.
Benefits of investing in rental properties
Investing in rental properties has its unique advantages that many professional landlords love.
Leveraged investment
Financial leverage refers to the mechanism that allows you to amplify the investing power of your cash to control larger investment positions. Margin loans provided by your broker use financial leverage. Similarly, buying a house on a mortgage gives you financial leverage.
Mortgage providers generally require a 20% down payment for properties. This allows investors to buy houses five times their capital. The significance of financial leverage is that it can help you build wealth faster. As an illustration, a couple just bought a house for $300k with a $60K down payment and a $240k mortgage. If the house is rented for $2k a month, the couple will receive $24K a year for their $60k investment. That is a 40% yield before expenses. On the other hand, if they had bought the house in cash, their yield would have only been 8% ($60k/$300k). It is important to note that leverage amplifies the gains but also increases your risks.
Mortgages allow savvy investors to gain substantial financial leverage to increases their investment returns. Additionally, unlike margin loans, mortgages have lower interest rates. These factors combined make rental properties attractive investment options for investors looking for financial leverage.
Building home equity
When you rent out a property, the rental income could cover your mortgage expenses. With each rent payment, you reduce your debt to the mortgage provider and gain more ownership of your home. In a way, your renters are buying the house for you.
Use value
Unlike other investments, rental properties have great use value. As your home equity grows, you can stop renting it out and use the property yourself. Some investors buy investment properties in Florida and California which they later use for retirement or as vacation homes.
Drawbacks of investing in rental properties
Rental properties also have some drawbacks that you should consider before committing to buying a house.
High barrier to entry
Buying a property is challenging. Financially, real estate investments require a lot of capital. Even if you take out a mortgage, the down payment is normally at least 20% of the cost. On top of that, getting a mortgage approved is a stressful and lengthy process that gives many people anxieties.
Choosing and purchasing the right property can present other difficulties. Finding a good property requires diligent research and many house visits. The negotiating and closing process on a property can also be emotionally taxing.
Maintenance
Maintaining a house or even a condo can be a challenging task for new homeowners. You are responsible for painting the walls, changing the carpet, yearly inspection, and many other tasks to keep your property clean and safe. As an alternative, you can hire a property manager to take care of the property for you. This can reduce your burdens significantly but you still have to oversee their work and pay them a management fee.
Concentration of risks
Traditional real estate investments have high concentration risk. If you invest in a rental property, you have a portfolio of one. This means if you have trouble finding tenants, your investment return will suffer. It is very difficult to build a diversified portfolio of rental properties that can guarantee uninterrupted income.
Illiquidity
Real estate investment is illiquid. Unlike stocks and bonds, your property takes much longer to sell when you need the money. Selling a house can take months, even years. If you are in a rush, you might need to sell the property at a discount.
Investment option two: Real Estate Investment Trusts (REITs)
What are REITs?
Real Estate Investment Trusts (REITs) are corporations that pool investor funds to invest in residential and commercial properties. In terms of structure, REITs are similar to Exchange-Traded Funds (ETFs). Instead of holding stocks or bonds, REITs invest in real estate. When you own shares of a REIT, you are entitled to your portion of the rental income the REIT receives.
Professional managers oversee the REITs’ property portfolios. They purchase properties and lease them out to generate rental income. Economies of scale allow them to negotiate better deals for their shareholders. By law, REITs must distribute at least 90% of the income back to the investors every quarter. As a result, investors will receive quarterly rental income from their investments. This makes REITs great tools to generate passive income.
Most REITs trade on public exchanges. You can buy and sell shares of REITs just like regular stocks. You can learn more about REITs here.
REITs by property type
REITs invest in commercial and residential properties. Their main goal is to maximize rental income. You can further invest in specific sectors of the real estate market. Each REIT has its own mandate and investment strategy. Some REITs focus on commercial properties such as hospitals and casinos. Based on your view and strategy, REITs can help you invest in properties that are otherwise unavailable to regular investors, as shown below.
| REIT Category | Example Properties |
| Retail REITs | Malls, plazas, and shopping centers |
| Industrial REITs | Warehouses and distribution centers |
| Medical REITs | Hospitals, senior housing, and research facilities |
| Lodging REITs | Hotels and resorts |
| Office REITs | Office buildings and coworking spaces |
| Residential REITs | Residential buildings |
The benefits of investing in REITs
Compared to traditional real estate investments, REITs can be a good alternative with many great advantages.
Easy access
Investing in real estate normally requires a large amount of money. Building a diversified property portfolio would require even more capital. In comparison, REITs are much more accessible. There is no minimum investment. You can buy as few as one share. Even with one share, your investment is still as diversified as the REIT’s portfolio.
Convenience
The properties held by REITs are managed by professionals. REIT investors have no obligation to take care of the properties or worry about finding tenants. This is a great advantage that helps new investors avoid the complexities of managing a property.
Diversification
As a landlord, you have zero income when the property becomes vacant. REITs are diversified property portfolios. The diversification reduces your concentration risk and makes your income more stable. When some units are vacant, you still receive rents from other properties in your REIT’s portfolio.
Wide investment selection
Traditional real estate investment restricts most investors’ options to residential homes. Hospitals, malls, or hotels are properties unavailable to most investors. If you are looking to include some commercial properties in your portfolio, REITs are your best options.
With REITs that focus on commercial properties, you can gain direct exposure to the growth in niche real estate markets.
Liquidity
Real estate investments are illiquid. It often takes months and even years to sell a house. Because REITs trade on exchanges, selling or buying shares of REITs is very easy.
Drawbacks of REIT investment
As appealing as REITs are, they also have some drawbacks that you should take into consideration when investing.
Lack of control
While REITs make investing easy, they also take control away from the investors. The investors rely heavily on REITs managers to make good profits. The managers make all the crucial decisions including which properties to purchase, rent level and more. Your profit can consequently suffer if the managers are inexperienced or make bad decisions.
No use value
While REITs give investors access to the real estate market, the investors are not homeowners. They receive rental income from REITs but don’t actually own any property. This differentiates REITs ownership from homeownership.
Rental properties V.S. REITs
If you are looking to generate passive income from the real estate market, rental properties and REITs can both be good options depending on your objectives and circumstances. REITs are flexible and convenient, while rental properties have financial leverage and use value.
The following table compares these two investment options in detail to help you choose one that works best for you.
| Rental Properties | REITs | |
| Source of profit | Rental income | REIT dividends (rental income) |
| Home appreciation | REIT appreciation | |
| Pros | Financial leverage | Easy access |
| Building home equity | Convenience | |
| Use value | Diversification | |
| Wide investment selection | ||
| Liquidity | ||
| Cons | High barrier to entry | Lack of use value |
| Maintenance responsibilities | Lack of direct control over investment | |
| Concentrated risks | Management fees | |
| Lack of liquidity | No financial leverage |
Conclusion
The real estate market has helped many investors boost their income and diversify their portfolios. Real estate investments offer competitive passive income that will come in regularly requiring little effort from you.
Fortunately, real estate investing is no longer an exclusive club. Although buying rental properties remains out of reach to some investors, anyone can purchase REITs shares and enjoy passive income. As 2020 is just around the corner, we hope this guide will help you build your own real estate portfolio in the new year.
