Passive Income from Real Estate: Syndications, REITs, and Real Estate ETFs
Like many investors, you’re considering adding real estate to your portfolio. It’s almost a given if you’re looking to diversify your portfolio and grow your wealth through passive income. Real estate is one of the best passive options to build wealth. That thing that’s holding you back, though? Constant accountability. A call about a leaky roof or clogged sink as you’re finishing a long shift doesn’t appeal to you. Active investing through direct ownership in real estate has its perks, but it’s hard work and never believe anyone that tells you otherwise. Fortunately, earning passive income with real estate investing has never been easier.
How do I generate passive income with real estate?
While there are many ways to create a passive income stream from real estate, we’ll focus on the three best-known ways to generate the income you’re craving and move you one step closer to financial freedom. Enter real estate syndications, real estate investment trusts and real estate ETFs – all the freedom of passive income with none of the responsibility. Many people confuse these passive real estate investments, but there are significant differences between them. It’s worth the effort to master the pros and cons of all three passive income strategies. After all, you work hard, so let’s get your money working as hard as you.
What is a real estate syndication?
Simply put, it’s a way for you and other investors to pool your money to invest in real estate together to generate passive income. Think of it as crowdfunding for real estate, but on a much larger scale than the typical online crowdfunding deals. It is a group investment in a property that is too large for any one of the investors to purchase alone. You’ll know exactly what you’re buying with your money, you can ask questions about the property, and discover the details upfront before committing capital. As an investor, you have the rights to receive a portion of the profit from the entity that owns the property. A sponsor, also known as a general partner (GP), invests a smaller amount (typically 5-20%) than the limited partners (LPs or investors) but the GP provides the expertise: scouting for deals, acquiring a property, and managing the day-to-day operations, both financial and physical. You invest in a real estate syndication on the private market by contacting the sponsor.
What’s a Real Estate Investment Trust (REIT)?
A REIT is a company that creates income by investing in commercial real estate or mortgages. Equity REITs usually specialize in one asset type, such as multi-family residential, office buildings, timberland or shopping malls. Mortgage REITs lend directly to real estate investors or purchase mortgage-backed securities. Hybrid REITs earn income from both direct investment in buildings and interest earned from mortgages. When you buy a share of a REIT, you’re buying a share of a company that owns properties or makes mortgage loans, but you do not own those properties or loans yourself. Buying a share of a REIT is similar to buying a share of a mutual fund. An equity mutual fund pools investors’ money to invest in a basket of stocks. You can purchase shares of the mutual fund, giving you exposure to many different equities. A REIT invests in real estate and mortgages and you purchase shares in the REIT, giving you passive dividend income from that basket of investments. By law, REITs must invest 75% of assets under management in either real estate, cash or US Treasuries and return 90% of more of its taxable income to shareholders in the form of dividends. Most REITs are publicly traded while some are private investments purchased through the REIT or a third party salesperson.
What’s a Real Estate ETF?
A Real Estate ETF (exchange-traded fund) is also similar to a mutual fund, but in this case, it’s a mutual fund that buys REITs. While a REIT invests directly in real estate, a Real Estate ETF invests in multiple REITS. Think of it as another version of a fund of funds, like target-date mutual funds. With one single investment, you can participate in REITS that own multi-family, senior living facilities, shopping malls and mortgages, rather than focusing on just one type of asset. You buy and sell real estate ETFs on the open market.
How do you earn passive income by owning real estate syndications, REIT or real estate ETFsy?
In a real estate syndication, rental income is paid to investors monthly or quarterly. As the rents increase, so does your passive income. More profits come later from the eventual sale or refinancing of the property. With REITs and ETFs, you’re making money the same way you would with a stock or mutual fund. You receive dividends from the profits of the company and take a profit (or loss) when you sell.
How are real estate syndications, REITs and real estate ETFs similar?
Syndicated deals, REITs and exchange-traded funds have two key similarities: passive investing and managing risk. All three of these options are passive investments. After you make the decision on which one is best for your portfolio, your work is done. You have no influence over the decision making with REITs, real estate ETFs, or real estate syndications. All three of them expose you to the risk that the person running the show makes a mistake. In the case of a real estate syndication, that would be the sponsor, and with a REIT or exchange-traded fund, it would be the portfolio manager. The success of your investment in all three depends largely on excellent management.
What are the major differences between syndications, REITs, and ETFs?
While all three options are forms of passive investing in real estate, there are 7 key differences: taxation, transparency, diversification, liquidity, minimum investment, returns, and fee structures/management compensation.
Standard disclaimer: every investor has a unique tax situation. Ask a professional about your taxes. But for arguments sake, let’s assume you hold your passive real estate investment in your own name, outside of any retirement or tax-advantaged vehicle. When you invest passively in real estate, you enjoy certain tax benefits, although not as dramatically as with active real estate investing, such as turnkey rentals. Tax deductions, especially depreciation (writing off the value of an asset over time) are available to you if you are participating in a real estate syndication, as the income reported on your K-1 to the IRS reflects depreciation. Although the monthly passive income check you receive may be significant, the amount of income reported to the IRS will have depreciation subtracted from it. The benefit of depreciation alone is a substantial reason to consider investing passively via a syndicated deal. At the completion of the syndication, the gain is sale would likely be taxed as a long term capital gain.
With a REIT however, you’re investing in a company that owns properties, not a property itself, so you don’t receive as much of the tax benefits of owning real estate. Of course, the REIT itself does benefit from depreciation, but that happens before you earn your dividends, meaning you can’t use that depreciation to decrease your reported earned income. The same is true for an exchange-traded fund – the underlying REITs record depreciation on their books and shareholders received the benefits secondhand. Any dividends you receive with a REIT or real estate ETF are usually taxed as ordinary income, not dividend income.
Knowing Your Asset
In syndication, you learn what you are investing in before committing capital. You are privy to all the details before you invest your money. You have the opportunity to take an active role in educating yourself by interacting with to the sponsors and getting all your questions answered prior to investing. With a typical publicly traded real estate investment trust or real estate ETF, you may not get details on the exact properties held in the portfolio, beyond what types of property they hold and the percentage of each type owned. You won’t have the opportunity to see the detailed business plan of each of the underlying investments.
REITs and real estate ETFs are liquid investments (assuming they are the publicly traded variety). You’re able to buy and sell them quickly on the open market. That means any time you want you to buy or sell shares, you can. You are not locked in for a specific amount of time and can quit at any time. A real estate syndication is illiquid, and you’re unable to buy or sell them on the open market. There are a range of hold periods with syndication, and during that time your money is locked up. For most passive income investors, this is a positive thing, as it prevents irresponsible trading. However, if you do need fast cash, you may not be able to sell a syndication at all. While syndication are a great source of passive income from real estate, they are not liquid.
A REIT or ETF has a much lower cost of entry than syndications. You could potentially invest for as little in for $50 in an ETF, giving you an easily achievable way to build wealth. REIT minimum initial investments run a bit higher but range from under $100 to several thousand dollars. The minimum investment amount in syndications is the highest, and ranges from $50,000 to $100,000 or more, although occasionally a syndication may allow smaller investments. Often (but not always), you need to be an accredited investor to invest in syndication, although most people able to afford the outlay for a real estate syndication have a good chance of meeting the criteria.
Building a diversified passive income portfolio is possible with all three options. Real estate ETFs require the smallest amount of money to create a highly diversified portfolio. If you pick an ETF with a broad investment mandate, you earn income from all types of real estate, with geographical diversification, with just one investment. Of course, this depends on which ETF you choose. Most REITs focus on one strategy, leading to the necessity for multiple REITs to achieve diversification. Syndications are typically investing in one property, so building a passive income portfolio solely with real estate syndications will require the highest number of investments.
Returns today will be different than historical returns. But since we can’t predict the future, let’s review how investing in all three options has panned out in the past. For comparison purposes, the S&P 500 has earned 10% on average annually since 1977. REITs earned 12%. Real estate ETFs are relatively new compared to REITs, but given that they invest in REITs, their returns should be comparable, albeit lower owing to fees (more on that below). Compare that with a good return for syndication, which is about 10-15%. Of course, historical performance never fully guarantees future performance, something to consider when crunching the numbers, but the significantly higher payout is an attractive part of syndication.
Syndications have complex fee structures than can overwhelm the beginner. However, a well run real estate syndications should have a fee structure that aligns the interest of the sponsors and the investors. The general partners (or sponsors) collect fees for management, an acquisition fee and a disposition fee on sale, along with other fees that vary with each deal. For example, with a 70/30 split, once a syndicated property earns enough to start paying out rental income, the investors earn 70% of rental income and the sponsor would earn 30%. This generates an incentive for the GP to perform well without risking the principal. If you look at REITs and real estate ETFs, managers are usually paid a base salary corresponding to on assets under management, not based on performance. Although assets under management rises with success, the portfolio managers don’t have the same incentive to knock it out of the park, unless there is also a bonus structure in place to reward performance. REITs also charge an asset management fee to investors, sometimes up to several percent of funds invested. The real estate ETFs charge and asset management fee and they have to pay the asset management fee to the REITs they hold, essentially causing you to pay management fees twice.
Which passive income strategy is right for you?
It depends on your financial goals. There are many ways to earn income passively with real estate and the right path is different for everyone. Chatting with your financial advisor about how much passive income you need to meet your financial targets is the first step. Then figure out your liquidity requirements and how much volatility you can handle. Then you can choose the best strategy to help you quit your day job!
You’re here because you like real estate… (at least that’s my guess), but do you have any questions? Feel free to reach out to me at firstname.lastname@example.org. I’d love to hear from you.