How to Earn Residual Income by Investing in Real Estate
How to Earn Residual Income by Investing in Real Estate
- Most people earn a living based on the work that they produce – every day they perform work and then usually every few weeks or so they get a paycheck. When they stop working they stop receiving paychecks and are left with whatever money they may have saved during that time. This is called active income.
- Some people are fortunate enough to create residual income streams. Residual income (also known as passive or recurring income) refers to income that you continue to earn even after the work required is done.
How can you earn residual income?
When given the option, most of us would much prefer to continue to reap the benefits of our work even after we’re done. Why then do the majority of people support themselves only through one stream of active income?
One answer is that most people assume that the ability to earn residual income is a luxury that is attainable only by the very wealthy. However, there are many ways for everyday investors to create residual income streams regardless of net worth.
One of the most well known ways of generating residual income is through ownership of stock in a publicly-traded company. Residual income streams can also include things like royalties from the sale of a book or song.
A renowned lucrative asset class, real estate—both residential and commercial—has become one of the most popular ways to produce residual income. Traditionally, building a residual income stream through real estate investing has required a large upfront investment of both of time and money. But thanks to new investment vehicles, those interested in earning passive income through real estate investments have several options.
Investment Properties
An investment property is an asset purchased with the sole purpose of earning revenue. Income from an investment property can be earned through leasing space within an asset or an eventual sale of the asset. Examples of this include a commercial rental property where business lease office space or an apartment building where tenants rent a home to live in.
Owning an investment property can result in both potential appreciation value over the long-term and direct tax benefits of depreciation. However, acquiring an investment property often requires large upfront capital ($100K to several million dollars depending on the type of asset), and lots of hands-on work. Furthermore, as with any investment, investment properties carry the risk of large, unexpected, and costly liabilities, which many investors do not have the experience or time to effectively handle. An investment property also is relatively illiquid—meaning you can sell at any time, but the sale process can often take months and may be unsuccessful.
A private equity fund is a collective investment fund that pools the money of many investors to invest in real estate. Private equity funds often consist of several different investments, which increases diversification for investors. Additionally, Private equity fund managers are often real estate experts who employ very rigorous due diligence and underwriting standards.
Traditionally, private equity fund investments are illiquid and require high investment minimums. Private equity funds are often formed by institutional investors and high net worth individuals and carry a “two and twenty” fee structure, meaning a 2% annual investment management fee, and 20% of any profits earned by the fund.
In 1960, Congress passed a law creating Real Estate Investment Trusts (REITs), large portfolios of income-producing real estate investments. A REIT is required by law to distribute 90% of its earnings to investors each year. Today, an estimated 70 million Americans invest in REITs.
Due to their special tax status, REITs must follow strict compliance standards and thus carry a certain quality standard for both the vehicle’s investment strategy and the real estate experience of the managing team.
There are two primary types of public REITs: traded and non-traded. Publicly-traded REITs offer the benefits of liquidity, because it is traded openly on a stock exchange. However, this liquidity is likely to be priced into the value of the shares, resulting in a “liquidity premium”, or a cost that all investors pay for the ability to buy and sell the asset whenever they wish. The liquidity premium results in lower relative returns for all investors, regardless of whether or not they choose to sell their shares. Furthermore, publicly-traded REITs tend to be correlated to broader market volatility, meaning that the share value may fluctuate depending on how the stock market is doing, regardless of whether or not anything has changed with the underlying properties owned by the REIT.
On the other hand, public non-traded REITs have become more popular, because of their possible double-digit dividends. However, public non-traded REITs have recently come under heavy scrutiny because of the large upfront fees often charged to investors—and dubious practices around the disclosure of those fees.
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