By
Dave Seymour
Earning high returns on real-estate is not an easy job. It requires, time, effort and money especially if the investors are managing the property themselves. However, passive real estate investing is relatively easy and doesn’t require a lot of work. It has the ability to generate a passive stream of income and there are plenty of options you can choose from depending on your strategy. Every option requires a different set of diligence and effort from the investor.
To understand the options better, we've compiled a list of 5 real estate investment options for passive income and we discuss in detail their pros and cons.
Publicly traded REITs
Real estate investment trusts can be either equity or debt based and are traded on a national securities exchange. REITs compound money from a pool of investors in order to buy properties which would not be accessible to an individual otherwise. The properties acquired under publicly traded REITs include different types of buildings from hospitals, office buildings, to multifamily homes and shopping centers. In addition, REITs also offer debt instruments through which they lend money to real restate buyers. These debt instruments can be in the form of a mortgage, equity structure or a mezzanine loan.
The money that equity-based REITs earn is through rent payment revenue and the appreciation of the property itself. Whereas, money generated by debt-based REITs is through the interest earned on debt instruments.
Equity REITs are much more common in the US REIT market than their debt counterparts. Although they are typically composed of assets like apartments, shopping malls, warehouses and hotel accommodation, some are comprised of mortgage and mortgage based securities.
Advantages
The biggest advantage of Public REITs is its liquidity. It is bought and sold at major stock exchanges with a distribution of 90% of taxable income as dividends to its shareholders. This not only creates a yield of 3 to 10% but also increases the passive income generated on it.
Disadvantages
The share prices of this type of investment are usually not stable. When shares are traded, prices can fluctuate in the same way as stocks do. As part of a portfolio, their volatility is less. This also means the share price may not reflect the actual value of the underlying real estate. Also, the distributions are subject to higher taxes for investors.
Public non traded REITs
There is a category of REITs which is publicly registered with the U.S Securities and Exchange Commission but is not traded on it. It has proved to be a lucrative investment tool to the extent that private equity corporations offer it and there is a heavy demand from investors for it. If you’re dealing with non-traded REITs, find out how much return of capital is to be expected. If PNLRs are liquidated, you usually get less than what your original investment was.
Advantages
Since they are not ‘traded’, they are not subject to market volatility as well.
Disadvantages
One of the biggest disadvantages associated with non-traded REITs is that they are not liquid and are held for a long period of time. According to the Financial Industry Regulatory Authority (FINRA), the income is earned from distributions over a period of 8 years or more.
Since they are not traded, the share price is not readily available to you. The upfront fee is also high. They are also heavily subsidized by Asset and Portfolio managers through borrowing or returning principal. These managers are allowed to prop up distributions by funding them with other investors’ money. In order to avoid common mistakes while dealing with this investment tool, FINRA has a tip sheet to help investors make an informed decision
Real Estate ETFs and Mutual Funds
These are similar to publicly traded REITs since that they are listed on the National Securities Stock Exchange and are traded as well. In fact, investors can opt for multiple approaches with Real Estate ETFs and Mutual Funds including choosing REITs that comprise of lending and owning properties.
There are a number of well-known real estate mutual funds in the market including Delaware REIT fund (DPREX) and Baron Real Estate Fund (BREFX). If you’re interested in going for a mix of securities, then Fidelity Series Real Estate Income Fund(FSREX) is a good choice.
In real estate ETFs, VNQ is popular in the industry because of its affordable fee structure and multiple types of stocks offered by them.
Advantages
Mutual funds have a very small or no load fee structure associated with it. Additionally, the ups and downs of the index are easy to follow.
Disadvantages
Their performance is subject to stock market fluctuations and there is brokerage fees involved in its management. In addition, they are also expensive to manage as the investors have to pay fees for both the REIT’s property management and the fund portfolio’s management.
Private Equity Real Estate Funds
Individual investors can access institutional-quality private investments offered by asset management companies. These are the same quality properties that are purchased through pension funds, endowments and institutional investors. Before you opt for a Private Equity Real Estate Fund, it is always a good idea to know how the fees are structured and what the asset manager’s previous performance has been.
Advantages
You become apart owner of the company and effectively a part owner of everything the company owns. This means you get to enjoy all the same benefits of direct property ownership with an added layer of personal liability protection by the LLC legal structure. The LLC structure provides additional tax benefits that a REIT wouldn't have. Also, income is generated from rental income without the fluctuation of public equities.
Disadvantages
Private Equity Funds differ from one another. They are also checked by regulators because of their inability to disclose conflict of interest to the investors. As per the SEC, the managers of the private equity funds should inform the investors fully how much a fee is being charged. Although the required disclosures are less for private fund managers than for registered funds, the compliance procedures need to be identified and followed.
Hard Money Loans and Debt Funds
For developers and investors who don’t want to use traditional mortgage lenders, then hard money loans are a good option especially if you want them to be approved in a short time. For the investors providing these loans, they lend money with the property being used as collateral if the borrower defaults.
Advantages
Since real-estate is being used as collateral, the risk is lower as the hard moneylender can get their money back by selling off the property.
Disadvantages
The underwriting mistakes involved can cause a lot of trouble and in case a borrower defaults, the control of that asset is with the investor.
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