This will be a 4 part series of articles and this is the third part.
In part 1 of this series, we talked about defining your investment strategy and in part 2, we talked about investing in stocks and bonds. If you have not read those, I encourage you to read at the minimum part 1 before you get to this article. Having defined your investment strategy and assuming you are interested in investing in real-estate, this article will focus on real estate and different ways to invest in real estate.
Most people who consider investing in real-estate want to do so simply because they wish to diversify their asset allocation from stocks and bonds into another asset class. Personally, that’s what drove me into real-estate investing too. What I realized quickly was that there is an entire gamut of types of real-estate investing out there. There are extremely passive forms of real-estate investing to extremely active forms of real estate investing. The below picture is my own view of the different forms of real-estate investing. This is not an exhaustive list (there are other variants of real estate investing) and certainly arguments can be made as to whether something is more passive vs active contrary to what I have listed below. But this is to just give you a general lay of the land and understand real-estate investing is an entire spectrum. If you are looking for pure diversification of your passive sources of income, you will (like most average investors) want to stay on the left side of this picture. If you move to the right, you are likely creating a full-time job for yourself. In this article, I am going to talk about some items on the left that I am familiar with.
REITs
What are they? REITs stand for Real Estate Investment Trusts. These are companies that own and operate different forms of income producing real estate across different sectors. For a company to qualify as a REIT, they have to meet a bunch of criteria including investing at least 75% of its assets into real estate. When we talk about REITs, we generally talk about publicly traded REITs. We also have public, non-traded REITs which are different and we will talk about that later. We also have private REITs which I won’t talk about and are generally available only to accredited investors.
How do I invest in a REIT? You can invest in a REIT like buying a stock and they trade on most stock exchanges. You can buy individual REITs like buying an individual stock or buy them as REIT funds or ETFs through any of the trading platforms you buy stocks in.
How do I earn money from REITs? You earn money from REITs just like you earn money from regular stocks. You have 2 sources of income – a) dividends b) capital appreciation or reduction. REITs are required by law to pay 90% of their taxable income back to shareholders. Note that this income for REIT holders is taxed as ordinary income. For this reason, it’s a great idea to invest in REITs inside your tax advantaged accounts like your 401K or Roth IRAs. I do have a small exposure (Around 3.5%) to REITs in my 401K.
Who should invest in REITs? If you are looking for exposure to the real estate sector and want something 100% passive, REITs are a good option. But investing in REITs is basically investing in a stock of a company that is in the real-estate sector. That is different from actually investing in real estate because you are not directly investing in a piece of property but in the company that does the investment. As a result, the belief is that there is more correlation between REITs and stocks compared to regular real estate and stocks. Also, REITs are the most liquid form of real estate investment – meaning you can buy and sell them anytime like stocks.So if you like that, then REITs are definitely for you. If you are in a high tax bracket, I would encourage you to consider REITs primarily in your tax advantaged accounts.
If you are looking for exposure to the real estate sector and want something 100% passive, REITs are a good option. But investing in REITs is basically investing in a stock of a company that is in the real-estate sector.
Crowdfunded Real Estate
What are they? At the heart of it, crowdfunded real estate is basically a group of investors pooling money together to make real estate investments. This concept has existed forever. But historically this was available to only ‘accredited’ investors (investors with net worth of at least $1M) and there were some other barriers that made this option available only to people with a lot of money.
Crowdfunding really took off for the average ‘non accredited’ investor only since 2012 with a new law that allowed any average investor for any small amount of money to be able to invest. That led to a new crop of innovative tech focused platforms that allowed easier investments. Examples of these new platforms include Fundrise, Realty Mogul, Diversy Fund. In general, most of these crowdsourced funds invest the money through a public, non-traded REIT – what that means is that the public can invest in it, but they are not traded publicly on a trading platform. These tend to have lesser liquidity and have holding periods.
How do I invest in crowdsourced real estate? As I mentioned, there are sophisticated ways to invest large amounts of money. But for the average investor, you can now use any of the new crowdfunded real estate trading platforms to invest. Most of them have a nominal minimum investment like $500.
How do I earn money from Crowdfunded real estate? The crowdfunding company earns income through rents and in turns pays it to the investors as dividends. The other form of income is by selling them after the holding period. If the value of the underlying assets have increased in value, you will make a gain.
Who should invest in crowdfunded real estate? When you invest in crowdfunded real estate, you are actually investing in a select group of properties directly unlike in a publicly traded REIT. If you want to get more of a direct exposure to real estate in a passive manner, this is a good option. However, this is not for you if you need to access this money on a regular, liquid manner. Also, I am personally not a big fan of this because I don’t have any control over the actual investment decision and am dependent on the company to make that. I personally have a smaller token amount invested in fundrise just because I wanted to see how it worked.
Turnkey residential real estate and single family home investing
What are they? I lumped these together because the underlying asset investment is the same. This is basically one of the most traditional forms of real estate investment. Properties of these types can include condos, townhomes and also standard single family houses. There are variants of this like house hacking, investing in duplexes, triplexes and fourplexes but I am not going to go into those. I will dedicate a separate article on this.
In turnkey investing, you work with a company to identify a property to invest in and most often, they also find tenants and manage it. So it’s pretty passive. Direct single family investment involves you actually finding an investment property, doing the analysis, finding tenants and managing it. However, you can outsource most of the management of the property including finding a tenant to a property management company.
How do I invest in turnkey or directly owned single family real estate? In turnkey investments, once you work with the turnkey company, they will identify a property and if you are comfortable with the numbers, you will have to invest in it by securing a conventional mortgage (For eg 30 year, 15 year fixed mortgages). When you are directly investing in a single family property, you will have to find the property yourself either from the MLS or other sources, and secure the typical conventional mortgage. This process is not very different from getting a mortgage for your personal residence, except expect to pay a higher interest rate for mortgages for rental properties.
How do I earn money from turnkey or directly owned single family real estate? You earn money in 2 different ways here – one, through monthly rents and hopefully if you have done your analysis well, the returns are positive (measured through metrics called CAP rate or Cash on Cash returns). And of course, if the value of your property appreciates over time, when you do sell it, you can earn the growth in the value of the property.
Who should invest in turnkey or directly owned single family real estate? This form of real estate investment is for those who want to directly own assets in the form of property. This is a fairly illiquid investment so this is not for people who want to access this money easily. However, there are ways to tap into the equity of the properties through cash out refinances. But there is a cost to converting all this into cash in the form of closing costs and it takes time to find a buyer. So this type of investment is appropriate for long term buy and hold investors. I am a big fan of this kind of investment and personally invested in a few rental properties. Turnkey investing is ideal for people who like all of the above but don’t want the hassle of finding and managing properties but it comes at a higher cost. In general, people fear this kind of investment because they don’t want to be a landlord and manage tenant issues. You can use a property manager to take care of all that for you. I currently manage all our rental properties myself but I intend to hand them over to a property manager eventually.
Who should invest in turnkey or directly owned single family real estate? This form of real estate investment is for those who want to directly own assets in the form of property. This is a fairly illiquid investment so this is not for people who want to access this money easily.
This concludes my high level framework on all the more passive forms of real-estate investment. As I mentioned, there are other forms of investing but I am not covering them primarily because I don’t have knowledge and experience in them but also because they are typically not for the average investor. Thank you for reading and I wish you success in your financial journey.
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
