[Editor’s Note: The following is a guest post by Ben Miller, CEO & Co-Founder, Fundrise.]
Most of us earn a living based on the work we do five days a week and then every few weeks or so we receive a paycheck. When we quit working, the paychecks stop and we’re left with whatever money we may have saved. This is called active income.
However, some people (likely including the visitors to Lazy Man and Money) are fortunate and smart enough to strive to build what are known as residual or passive income streams, payment 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 so many people support themselves only through active income? One answer is that most assume the ability to earn residual income is a luxury that can only be created if you’re already wealthy. However, there are many ways to create residual income streams that don’t require huge upfront investments.
One of the most well known forms of residual income is owning stock in a publicly traded company. Residual income streams can also include royalties from the sale of a book or song. Additionally, real estate — both residential and commercial — has become one of the most popular ways to build residual income. Historically, building a residual income stream through real estate has required a large upfront investment, both of time and money, but thanks to new investment vehicles those wanting to earn passive income through real estate have many options to choose from.
Ways to Build Residual Income through Real Estate
Real Estate Investment Trusts (REITs)
In the 60’s, Congress passed a law creating Real Estate Investment Trusts, large portfolios of income-producing real estate. A REIT is required by law to distribute 90% of its earnings to investors each year. 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.
Today, an estimated 70 million Americans invest in REITs.
There are two primary types of public REITs: traded and non-traded. Traded REITs offer the benefits of being traded openly on an exchange, giving investors liquidity. However this liquidity is likely to be priced into the value of the shares, resulting in a “liquidity premium”, or lower relative returns for all investors, regardless of whether or not they choose to sell their shares. Furthermore, traded REITs tend to be correlated to broader market volatility, meaning that the 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, non-traded REITs have become more popular because of the perceived consistent double-digit dividends. However, 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.
New Technology Platforms
In the past few years, new platforms have emerged that use technology to make the process of real estate investment more efficient, resulting in increased transparency, lower fees, and higher returns. As the broader financial technology space grows, more and more investors are moving to online platforms that give them more control over their finances and take advantage of the efficiencies that transacting on the web can offer.
These companies aim to offer the benefits of public market access, but with lower fees that potentially help investors earn better returns. Fundrise, one of the pioneers in the space, has leveraged both technology and new federal regulations to offer investors the first ever low-fee, diversified commercial real estate investment available directly online to anyone in the United States, no matter their net worth.¹ Fundrise is working to do to real estate what Vanguard did to stocks – create a low-cost way for individuals to invest a diversified pool of assets. The savings they generate through more efficient technology are passed on to investors in the form of potentially better risk-adjusted returns.
Over the past six months, the company has launched the first ever eREITTM investments – two different $50 million real estate investment trusts both with direct online distribution models. You can learn more about Fundrise here.
However, it’s important to remember that every platform uses a different set of due diligence criteria to determine what investments it offers its members and, as with any investment, investing in real estate through an online platform carries significant risk.
An investment property is an asset purchased with the sole purpose of earning revenue, through leasing space within an asset or an eventual sale. 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 a large upfront investment ($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 problems, which many investors do not have the experience or time to effectively handle. An investment property is relatively illiquid — meaning you can sell at any time, but the sale process can often take months and may be unsuccessful.
Private Equity Funds
Conversely, a private equity (PE) 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, PE funds are often managed by real estate experts with very rigorous underwriting standards.
Traditionally private equity fund investments are illiquid and carry high investment minimums. Private equity funds are often formed by institutional investors and high worth individuals with a “two and twenty” fee structure, meaning a 2% annual asset management fee, and 20% of any profits earned by the fund.
Regardless of which avenue you decide to pursue to earn residual income, an essential part of the investment process is objectively evaluating each opportunity as it arises and working hard to remove any preexisting biases. Take your time to figure out which approach makes the most sense for you and your investment goals and remember that diversification into different asset classes is one of the most effective ways to build unique streams of residual income, and a profitable portfolio!
This information does not constitute an offer to sell nor a solicitation of an offer to buy securities, nor does it contain any individualized tax advice. The information contained herein is not investment advice and does not constitute a recommendation to buy or sell any security or that any transaction is suitable for any specific purposes or any specific person and is provided for information purposes only. Each investor should always carefully consider investments in any security and be comfortable with his/her understanding of the investment, including through consultation with investment and tax professionals.
1. However, under the Regulation A+ rules, each investor is limited to investing no more than the greater of 10% of such investor’s net assets or gross annual income.