Real estate investing - is it passive income?
You’re scrolling through social media and stumble across your favorite real estate guru, or so the algorithm thinks. You see private jets, luxury cars and numbers bigger than you know how to pronounce. How can you not pay attention?!
Jokes aside, real estate investing is pushed onto us from many directions and it’s hard to ignore. And, you shouldn’t. Just like anything else, there is a time and place for real estate in your portfolio. Though, it’s important to consider the pros/cons as well as accept that in most cases there is no free lunch (also known as passive income).
Passive income, what is it really?
It’s the ultimate goal and core of the real estate argument (at least on social media), so it makes sense to start here. What does this actually mean and can real estate investing be passive? First, let’s get a “textbook” definition. From our friends at Wikipedia…
Passive income is a type of unearned income that is acquired with little to no labor to earn or maintain.
Easy enough. Broken down further - minimal effort for an ongoing stream of income. Who wouldn’t be intrigued by this proposition? It’s a win-win. The real question - is it achievable and does it come at a (hidden) cost?
What is the best way to invest in real estate?
Well, it depends. There are many different ways to gain exposure. Let’s take a look at a few options below - including the pros and cons of each.
Flipping houses - who else remembers the show “Flip or Flop” on HGTV? In this case, you purchase a fixer upper, renovate, and sell a few months later - hopefully, for more than your total investment.
Pros
High profit margins
Cons
A lot can go wrong at any stage of the process
Choosing the wrong location
Buying a home with hidden issues
Long turnaround time to sell
And many more…
You need upfront capital to buy the home(s)
Thoughts - this is the extreme opposite of passive. There is a ton that goes in to renovating/repairing a home. Even if you remove yourself from the actual construction part of the process, you are still very much involved in planning and logistics. Although you can make a lot of money doing this, it is more of a full time job rather than a passive investment.
Rental property (short term, long term, multi family units) - simply buying a property and holding onto it for the long run and renting it out to tenants in the interim.
Pros
Steady stream of income
Steady appreciation in value over time
Great way to diversify your investment portfolio with a tangible (you can touch it) asset
Cons
Vacancy risk
Maintenance and repairs could pop up anytime
If you are not local, may need to hire a property manager and/or real estate agent, which reduces your profit margin
Legislative risks - you’re at the scrutiny of local government entities
Thoughts - this is a great, balanced approach to real estate investing. Though, again - there is no free lunch. Even if you hire a property manager, there is some effort that goes into managing them and ensuring they are staying on top of things.
REIT (Real Estate Investment Trust) - a type of investment vehicle you can access through your Brokerage account.
Pros
Don’t need to manage any part of the process
Diversified approach - not investing in one property
Cons
The pro is also a con in terms of you have no discretion over management of which properties are bought, held or sold in the portfolio
High fees - in most cases, more than 1% of your investment balance per year
Thoughts - probably the closest you get to passive income. BUT, it comes at a price - quite literally, fees (also known as expense ratios) are pulled out of your investment balance each year. Also, there’s an intangible cost associated with the loss of control.
Private Placement - another investment type, which is accessed outside of your Brokerage account.
Pros
Don’t need to manage any part of the process
Cons
Most of the time, there is a specific real estate project and therefore limited diversification
Need to be an accredited investor (income >200k if single, 300k for couples) - not everyone has access
High (sometimes hidden) fees
Very limited liquidity
Thoughts - similar to REITs above, this is a “passive” approach. Though, arguably you are paying an even higher cost due to limited liquidity. In other words, you can’t pull your investment out for a specified period of time (anywhere from 5-10 years or even longer in some cases).
How to know if a particular real estate deal makes sense?
As you can see above, there is no clear winner. There are pros and cons to each approach and they all require some sort of effort (or cost in lieu thereof). In other words, they are not completely passive. Even if there is no ongoing effort, you still need to engage initially and decide whether or not you are making a good investment. A great metric to utilize when assessing this is ROI (Return on Investment). There are advanced calculators available online - though, here is a high level (back of the napkin) breakdown:
Rent - Expenses = Net Income
Net income / Total Investment (equity in property) = Return from Cashflow
Return from Cashflow + Annual Appreciation (in value of property) = Total ROI
Note: expenses can be mortgage interest, insurance, taxes, property manager, repairs, etc.
Taking a practical example, let’s say you purchase a property for 350k and put 20% down. Your Total Investment is 70k plus closing costs on the mortgage - about 80k, all in. You Rent out the property for 2k per month, but your Expenses are 1.5k (between interest on the mortgage, taxes and insurance). This means your Net Income is 500/month or 6k/year. Dividing this by your Total Investment (80k), you get a 7.5% Return from Cashflow. Lastly, you add what you expect the property to increase in value each year. This is highly dependent on location - let’s call it 2% in our example. Total ROI then is 9.5%.
Is that a good return - should you stop what you’re doing and build a real estate empire?
Your question remains - is this a good deal? The answer can only be provided if we compare it to another investment vehicle. For example, the stock market - which, by the way, is probably the most diverse, low cost, liquid and passive way to invest in anything. VTI (Vanguard’s Total Stock Market Index) has returned an average of 12.5% over the past 10 years and closer to 9% over the past 20 years. Comparatively, your 9.5% return above matches up fairly well.
Ultimately, it’s imperative to consider what’s important to you (sound familiar?). Why do you want real estate? Does it embody your core values and beliefs? Do you want to potentially use the property at some point in the future as a second home (short term rental can offer this flexibility)? If yes then you can make a solid case for real estate as part of your comprehensive Financial Plan. If not, tune out the “get rich quick” real estate gurus - there is no free lunch.