Real estate can be an excellent way to build wealth and generate income, but the reality is that being a landlord isn’t a good fit for everyone. Even if you choose to hire a property manager to deal with the day-to-day operations of running your rental properties, there is still a substantial amount of time, risk, and capital involved with buying and holding individual rental properties.
Fortunately, there are several ways you could passively invest in real estate that can be rather lucrative ways to put your money to work. You can invest in real estate through the stock market thanks to real estate investment trusts (REITs) and other real estate companies. You can participate in a crowdfunded real estate investment and invest in a single-property opportunity that an experienced real estate developer has identified. Or you could choose to partner with an active real estate investor to buy investment properties and take a passive role in the business.
However, there are some important things to know before you get started, particularly how to avoid excessively risky passive real estate investments, how to spread your money out the right way, and how to monitor your investments over time.
With that in mind, here’s what to consider when you are looking for and managing your passive real estate investments.
1. Avoid falling into traps
As the old saying goes, if something looks too good to be true, it probably is. However, you need to be able to spot what "too good to be true" looks like when it comes to passive real estate investments.
Let’s start with real estate investment trusts. One of the first red flags you should look for is a dividend yield that’s significantly higher than its peers. For example, if the average hotel REIT pays a 6% dividend yield and you find one that pays 10%, it could be a sign that something is wrong with the business. Stock investors often refer to this as a yield trap.
In addition to a too-good-to-be-true dividend yield, there are some other potential red flags to look for when evaluating REITs. To be clear, none of these are a perfect indicator of trouble all by themselves. However, the presence of any of these factors should be a reason to dig a little deeper into the company’s business before you keep it on your watch list.
- A dividend payout ratio that’s more than 100% of a REIT’s funds from operation (FFO). Funds from operations is the REIT version of earnings. While REITs typically pay out more of their earnings than the average dividend stock, a dividend that is more than a company’s FFO isn’t sustainable over the long run.
- Declining occupancy in the company’s property portfolio. You’ll see this quite a bit in the retail sector, although a declining occupancy rate can be a troubling sign for any REIT.
- Slowing, stagnant, or declining same-store revenue growth. Healthy commercial properties are able to increase their rent slightly each year, and many have rent increases built right into multi-year leases. If same-store rent growth turns negative, it can be a serious sign of trouble.
- Excessive debt. There’s no set-in-stone rule about how much debt is too much for a REIT to carry, but if I see a debt-to-capitalization ratio of more than 50%, I start to get suspicious.
The same "too good to be true" principle applies when considering crowdfunded real estate deals or individual investment properties. For example, a crowdfunded real estate investment that is targeting a 25% annualized return for investors might be an indication that there’s a lot of execution risk involved in the deal. A duplex that’s selling for $100,000 while similar properties are listed for $150,000 or more could be a sign that something is seriously wrong with the property and that if you choose to buy it, you should take your due diligence period very seriously.
2. Diversify your portfolio
If you had a bundle of money to invest in the stock market, would you put it all in just one company? Probably not. The same concept applies to real estate investing.
To be clear, real estate itself can certainly be used to diversify your assets. For example, if you have a $1 million net worth and 95% of it is in stocks and bonds, putting some of your money in real estate can help protect you from stock market crashes.
However, it’s important to spread out your real estate allocation as well. This is especially true if you choose to invest in crowdfunded real estate deals, as these tend to be higher-risk investments and spreading your money around is vital to ensure that if a deal goes sour, you won’t end up financially devastated.
Additionally, different types of commercial real estate don’t react in the same way to economic conditions. For example, hotels, self-storage facilities, and entertainment properties tend to be highly cyclical -- that is, their business tends to get adversely affected by recessions more than the average company. On the other hand, healthcare properties, office buildings, and apartments tend to be much less economically sensitive. By diversifying the nature of your passive real estate investments, you can set yourself up for relatively strong investment performance no matter what the economy is doing.
3. Do your homework
As a final point, it’s important to discuss what passive real estate investing is, and what it isn’t. Passive investing means that you don’t take any active role in the underlying business. In other words, when you invest in a stock, you don’t have any involvement with the company’s day-to-day business operations.
However, passive investing does not imply that you simply put your money in and then forget all about it. If you’re investing in REITs or other real estate stocks, it’s important to keep up with how the company is doing to ensure that your reasons for buying the stock in the first place still apply. At a minimum, I suggest you read the quarterly reports for each company whose stock you own and sign up to receive email alerts whenever the company has a major news release (most REITs have an easy way to do this on their investor relations webpage). Listening to the company’s quarterly conference calls can give you an extra layer of insight into the business.
All of the REIT stocks in my portfolio were bought with the hope that I’ll own them forever, but that doesn’t necessarily mean that I will. If my original thesis for buying a REIT changes, I’m usually pretty quick to move on.
Ongoing homework is less critical in crowdfunded real estate investing, simply because you can’t just cash out of your investment whenever you want. However, it’s still important to keep up with the updates you receive from the deal’s sponsor. After all, if a particular crowdfunded investment isn’t going well, even though you can’t sell the investment, it could affect how much risk you want to carry elsewhere in your portfolio.
The bottom line is that passive, buy-and-hold real estate investing is certainly less of a time commitment when compared to active strategies like owning and managing rental properties or fixing and flipping houses. Just be aware that this doesn’t mean that there’s no ongoing time commitment after you invest.