It takes time and money to earn high returns in real estate when investors buy and manage properties themselves. But passive real estate investing takes the work off of investor’s hands—and can generate a steady and reliable income stream. Yet getting started can be confusing, even for experienced investors, because the options are seemingly endless and require varying levels of due diligence.
Here are the pros and cons of five of the best real estate investment options that can generate passive income. All of them free real estate investors from the burdens of property acquisition, making improvements (if necessary), maintenance and management — but require due diligence and ongoing oversight to monitor performance.
1. Publicly traded REITs
Real estate investment trusts are traded on national securities exchanges, and pool capital from many investors to buy a portfolio of income-producing commercial properties that would be out of an individual investor’s reach. Real estate REITs focus on many different types of properties, ranging from those that make equity investments by acquiring properties across a wide spectrum of commercial real estate (from multifamily and office buildings to hospitals, shopping centers, hotels and more) to those that lend money to real estate buyers through debt instruments such as mortgages, mezzanine loans, preferred equity structures and more. While equity REITs generate their revenues from rents and the potential price appreciation of the properties they own, debt REITs do not own properties and generate revenues from the interest they earn on debt instruments. Equity REITs are much more common than debt REITs, accounting for a majority of the U.S. REIT market.
Biggest Plus: Public REITs are traded directly or on major stock exchanges, so they’re a liquid investment. They must also distribute at least 90 percent of taxable income to shareholders annually as dividends, which create yields that typically range between 3 percent and 10 percent. The distributions also reduce their corporate taxable income and maximize passive income.
Biggest Minuses: REIT share prices aren’t as stable as their underlying properties. As shares are bought and sold, prices can move up and down the same way stocks do, which minimizes their potential to reduce volatility in a portfolio. Also, distributions are taxable for investors.
Ask This: What’s the investment strategy? REITs typically specialize in specific asset types such as apartments, shopping malls, hotels or warehouses. Some REITs hold only mortgages and mortgage-backed securities.
2. Public non-traded REITs (PNLRs)
REITs can be publicly registered — listed with the U.S. Securities and Exchange Commission — without being publicly traded on stock exchanges. They have been so profitable for managers, and in so much demand by investors, that private equity giants such as Blackstone and Starwood now offer them to individual investors.
Biggest Plus: Because non-listed REITs are not traded on an exchange, they are shielded from the market volatility of traded REITs.
Biggest Minuses: PNLRs are illiquid and intended to be held for long periods — often eight years or more, according to the Financial Industry Regulatory Authority (FINRA). They can also have high upfront fees; a share price that is not readily available, as they are not traded; and distributions aren’t necessarily from just rents. Asset managers can heavily subsidize them by borrowing or returning principal, notes the U.S. Securities and Exchange Commission. Finra has a tip sheet to help investors avoid common pitfalls in non-traded REIT investing
Ask This: What’s the track record for return of capital? Liquidations can be less than the original investment.
3. Real Estate ETFs and Mutual Funds
Real estate exchange traded funds and mutual funds are registered on a national securities exchange and invest in REITs or stocks. They enable investors to pursue a number of real estate strategies that include investing in REITs that specialize in lending or owning properties. VNQ is considered the leader in real estate ETFs because of its low fee structure and broad array of underlying stocks. Well-known real estate mutual funds include the Delaware REIT fund (DPREX) for REITs; Baron Real Estate Fund (BREFX) for stocks; PIMCO Real Estate Return Strategy (PETAX) for bonds; and Fidelity Series Real Estate Income Fund (FSREX) for a mix of securities.
Biggest Plus: Index ETF fees tend to offer lower fees than mutual funds, and it’s easy to follow the ups and downs of the index. Mutual funds have low- or no-load fee structures compared to non-traded REITs, which generally have high upfront fees.
Biggest Minuses: Real estate ETFs are highly correlated to stock market fluctuations. They are also subject to brokerage fees. So they’re not ideal for a retirement account making frequent income-averaging purchases. In addition to the potential for market volatility, real estate mutual funds are more costly to manage, according to the Investment Company Institute. Investors pay fees both for the REIT’s property management and the fund’s portfolio management resulting in higher expense ratios.
Ask This: For ETFs, ask if they aim to beat the index? Real estate ETF names with 2X, Bull or Ultra in the name – for instance, UBS ETRACS Monthly Pay 2xLeveraged Mortgage REIT (MORL,) or ProShares Ultra Real Estate (URE) – are using leverage, which only increases the risk. For mutual funds, ask if you are paying sales charges and advisory fees as well. An online cost calculator can show how these charges add up.
4. Private Equity Real Estate Funds
Pension funds, endowments, and other institutional investors buy properties directly for their portfolios. Legislative reforms allow Origin and other asset managers to assemble institutional-quality private investment portfolios that are within reach of an individual investor.
Biggest Plus: Private equity funds produce income or appreciation without the volatility of public equities. The best private equity funds explain their investment plans in detail and give regular updates on the fund’s performance and prospects.
Biggest Minus: Not all private equity funds are created equal. Regulators have put private funds under scrutiny for not disclosing conflicts of interest.
5. Hard Money Loans and Debt Funds
Investors take the banker’s role, providing short-term financing with the real estate as collateral.
Biggest Plus: Real estate debt carries less risk, because if anything goes wrong, hard money lenders get their money back by taking the collateral and selling it
Biggest Minus: Underwriting mistakes can be costly. If borrowers default, the investor takes control of a troubled asset.
Ask This: What’s the property worth now? Hard-money lenders keep loan-to-value ratios low so they can sell a property quickly to get their money back if a borrower defaults.
Sophisticated investors combine passive income streams in a diversified portfolio. With so many choices, they have many options to find the right fit.