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What Is Passive Real Estate Investing & How Does It Work?

August 7, 2022
6
min

Passive real estate investing is a hands-off approach that can help diversify a portfolio. There are several ways to invest in this asset class, learn more about it.

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Passive real estate investing offers a hands-off approach to earning money. Instead of flipping a fixer-upper or managing a property full time, a passive real estate investor only contributes money upfront and lets others grow the investment.

What is passive real estate investing?

Passive real estate investing is a strategy in which an investor contributes capital to a real estate investment and another professional manages it. This allows investors to earn extra income without doing physical labor, acting as a landlord, or even buying property in some cases. Some examples of passive real estate investments include purchasing stocks in real estate funds or real estate-related businesses, purchasing shares in real estate investment trusts (REITs), getting involved with real estate crowdfunding, or buying a rental property. 

Active vs. passive investing in real estate 

The key difference between active and passive real estate investing is the level of work involved. Active real estate investments come with more responsibilities, so investors work directly in the construction, development, management, or renovation of commercial and residential properties. 

Passive income typically refers to income that's somewhat automated, so the investor isn't directly managing the investment. Passive real estate investors automate their earnings by contributing capital upfront and letting others make decisions or handle the day-to-day tasks of growing the investment. While passive investors have less control compared to active investors, they may not need much operational experience to get started. 

Take a look at one example to see the difference between the two types of investing. An active investor may, for instance, buy a single-family home and take care of everything from screening tenants to collecting rent, doing repairs, and replacing appliances as needed. The passive investor may also buy a property but would hire a company to manage the daily details. 

4 types of passive real estate investing 

There are several options when it comes to passive real estate investments, and most fall into the following four categories.

1. Real estate investment trust (REIT)

A real estate investment trust, or REIT, is a company that owns income-producing real estate such as shopping malls, office buildings, hotels, and apartments. Each REIT usually focuses on a specific property type, but some hold multiple properties in their portfolios. These companies are traded like stocks, so investors can buy and sell shares of them on major stock exchanges. REITs must pay out at least 90% of their taxable income to their shareholders in the form of dividends. 

REITs make it possible to earn money from real estate without having to buy physical property and pay a mortgage. According to the FTSE NAREIT All Equity REIT Index, REITs outperformed the S&P 500 between 1972 and 2019, with total annual returns of 13.3% and 12.1% respectively. 

2. Real estate fund

A real estate fund is a type of mutual fund that invests in publicly traded securities, such as REITs and real estate operating companies (REOCs). REOCs operate like REITs but have more flexibility in how they invest and distribute earnings. Real estate funds tend to be more diversified than REITs because they invest in many types of properties. (While it’s possible for REITs to invest in multiple types of property, it’s much more common for REOCs to do this.) 

Investors can buy shares of a fund by using a brokerage, and can choose between an actively managed fund, in which a manager chooses the investments, or one that's passively managed, in which the fund tracks the performance of a benchmark index, like the Dow Jones U.S. Real Estate Index. Instead of providing income through dividends, real estate funds aim to gain value through appreciation. 

3. Real estate crowdfunding

With real estate crowdfunding, multiple investors pool their money using an online platform and take on larger projects than they could afford or manage on their own. The lead developer funds ventures such as housing developments and retail space, or they give investors partial ownership in a share of existing holdings. 

These investments may be illiquid unless the platform offers some form of early redemption. However, crowdfunding platforms may provide better returns compared to some publicly traded REITs. One platform, Fundrise, posted an average income return of 5.42% for clients between 2017 and early 2022, while publicly traded REITs returned 4.34%. 

4. Rental property

Passive investors can also buy rental properties and hire on-site management companies to handle the everyday upkeep. Creating lease agreements, collecting rent, paying property-related bills, maintaining the exterior, and fielding tenant requests are some of the tasks a management company handles. 

This method of passive investing offers more control compared to REITs and real estate funds, and tracking the property remotely makes it easier to invest in high-demand rental markets without living in the area. However, the passive investor will still need to do some active work at the outset to source a property to purchase. There’s also a higher barrier to entry in this form of real estate investing: the down payment and closing costs, plus ongoing expenses in the form of maintenance, repairs, and property management fees.

4 Potential benefits of passive real estate investing

  1. You don't need extensive knowledge. Passive real estate investors need to research any type of fund, REIT, or rental property before diving in. But after that point, they'll hand the reins over to another professional and leverage their experience. 
  2. Investment diversification. Diversification is a method of spreading money across different assets to reduce the risk of losing principal. A real estate investment may diversify a portfolio that focuses on other asset classes such as stocks and bonds. 
  3. Potentially short time commitment. Some passive real estate investments, such as REITs and real estate funds, are a way to gain exposure to the real estate asset class without the time commitment required when buying property. They can also be liquidated much more quickly than property.
  4. Potentially low entry costs. Investors can start passively investing in real estate without much money, typically by purchasing a few shares in a REIT or other real estate stock. Crowdfunding investments may also have low buy-ins.

4 Risks of passive real estate investing

  1. Unpredictable. Real estate values tend to rise over time, but they go through peaks and valleys like any other investment. Because these investments are ultimately tied to the value of real estate, investors may lose money if property values depreciate. 
  2. Low liquidity. An investor who buys a rental unit will need several weeks or months to sell the property, making this type of investment less liquid than stocks and bonds. Investors may also lose money if they need to sell when the market is on a downswing. Crowdfunding investments are usually illiquid, too. 
  3. Expenses. A property owner is on the hook for repairs and maintenance costs, which can eat into their earnings. Likewise, trading shares in a REIT or real estate fund may incur management fees. Equity mutual funds typically charge 0.5% of total assets, and they may be higher for funds that specialize in a specific sector, like real estate. REITs charge fees that typically total 0.5% of all trust assets, plus other expense charges.
  4. Less control. Passive investing requires someone else to handle decisions. A fund manager decides which securities to buy, while a property manager takes care of a piece of property. There’s always a chance the professional could do a poor job.

The bottom line

Passive real estate investing is a hands-off approach that can help diversify a portfolio. There are several ways to invest in this asset class, and the major ones include REITs, real estate funds, crowdfunding, and rental properties, each with their own set of pros and cons.

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