Real estate can be a lucrative form of investment. Not only will it diversify your investment portfolio, but the chances of substantial returns are high. There are three main categories of real estate investing: residential, commercial, and industrial, and they each have ways of generating revenue.
If you've previously read our first real estate investing installment, feel free to skip down to "Passive Real Estate Investing."
Types of Real Estate
Residential Real Estate:
Residential real estate encompasses any property that a person or group of people will live in. Examples of residential real estate include single-family homes, multi-family homes, townhomes, and condos. However, if you purchase a home with more than four units, it is considered commercial property.
Commercial Real Estate:
Commercial real estate includes any land or building used for business purposes. Common examples of commercial real estate include:
Industrial Real Estate:
- apartment buildings
Industrial real estate consists of any buildings or land used for industrial business. Examples of industrial real estate include warehouses, storage buildings, and power plants.
Ways to Generate Income with Real Estate Investing
Just like there are three main real estate property types, there are three main ways to make money from real estate
Interest from Loans
Real estate developers don't typically have all the money they will need to develop their projects —that's where investors come in. A real estate loan is an arrangement where investors lend money to the developer and earn money from interest payments. Interest from loans is also called "debt." There are a few different types of debt: senior debt, junior debt, and mezzanine debt. Real estate debt can also be classified as secure or insecure, with the secure version protecting the investors in case of property foreclosure.
When someone purchases a home, and it gains value over the years, they can then sell it at a profit. This is known as appreciation. Similar to the ownership of any equity, real estate ownership gives the owner the potential to make a sizeable lump-sum profit when they sell the house. Unfortunately, you can't just purchase a property and leave it. You need to invest in maintaining the property, which can cut into your bottom line.
Rent is a hugely popular type of real estate investing
because of the monthly returns it provides. Rent can provide a regular income stream, but it's not without its faults. When you own a rental property, you frequently have to act as a landlord, repairing the home when needed and dealing with the tenants themselves. To avoid acting as a landlord, you can hire a property management company, but you will have to share the monthly rent payments with them for their services.
What is Passive Real Estate Investing?
Now that you have an understanding of real estate types you can invest in and ways you can generate money from your investments, we will dive into the hands-off approach to real estate investing: passive investments. If you're looking for more information on DIY real estate investing, take a look at our Active Real Estate Investing Guide
Passive real estate
investing allows you to invest in real estate without the need to physically do anything. Both novices and experienced investors alike can passively invest in real estate. With this form of investment, investors only provide the capital. Investing professionals then take the money and invest it on their behalf (similar to a portfolio manager with stocks).
The most substantial downside of passive real estate investing is that it usually involves large sums of money that are tied up for long periods, so it's not always accessible for the general public. There are four main types of passive real estate investments: private equity funds, Opportunity Funds, REITs, and online real estate investment platforms.
Private Equity Fund
A private equity fund is an investment model where investors pool their money into a single fund to make investments. Almost every private equity fund has a manager in charge of directly managing the equity fund's investments. Because of the active role of the fund's manager, investors are not required to be directly involved.
However, just like with any real estate investment, it helps to have a financial and real estate background to understand the risks and potential returns of each investment.
The downside of private equity funds is they're difficult to join. The minimum investment to join a private equity fund is typically around $100,000, but it can be much higher. Private equity funds use a "two and twenty" model, meaning they charge a 2% annual management fee, and an additional 20% fee on any profits that the fund earns.
An Opportunity Fund is an investment model where investors pool their money to invest in Qualified Opportunity Zones. Opportunity Zones are tracts of low-income communities where the government encourages private investments to improve the neighborhood.
By law, the government requires 90% of an Opportunity Fund
to go toward improving the impoverished areas with new buildings and the redevelopment of previously unused properties.
Those who invest in Opportunity Funds can receive substantial capital gains tax incentives for their investments. An Opportunity Fund allows an investor to defer taxes on their capital gains until 2026. This typically translates into a 10-15% reduction in tax liability on their deferred gains, depending on how long they hold the investment.
If the investment is held longer than ten years, any capital gains earned from Opportunity Funds investments will be excluded from any capital gains taxes.
Real Estate Investment Trust (REITs)
A REIT is a company that makes equity investments in commercial real estate. Investors purchase shares of this company and earn an income from the equity it gains in the form of dividends.
Unlike a Private Equity or Opportunity Fund, some REITs allow ordinary investors to take advantage of passive real estate investing. Legally, a REIT must earn 75% of its gross income from real estate and invest 75% of its assets in real estate. They also have to distribute at least 90% of their taxable income to their investors each year.
There are three main types of REITs
: private, publicly-traded, and public non-traded.
: Similar to Private Equity Funds, private REITs are limited to investors with a high net worth, as they have high minimums and high fees (usually around 15%). They also require that the investor be able to invest large sums of money for long periods.
: REITs, on the other hand, publicly-traded REITs have no investment minimum other than the price of the share; they're also registered with the SEC and traded in the stock market. Although publicly-traded REITs are easily accessible to the public, they're also one of the more volatile real estate investments since they're correlated to the public markets.
Public non-traded REIT
: Considered the middle ground between a private REIT and a publicly-traded one, non-traded REITs are registered with the SEC like publicly-traded REITs, but they're not traded on the stock market. Public non-traded REITs can be either open or restricted, and their investment minimums can vary.
Online Real Estate Platforms
Online real estate platforms are the easiest way for individual investors to take advantage of real estate investing. With online real estate platforms, you can either choose to invest in a single investment or a diversified portfolio of real estate. Some investment platforms only offer debt investments, while some offer both debt and equity investments. Make sure to research the right platform for your situation, as they each have their own requirements and capabilities.
Take Your Knowledge Further
Now that you understand the basics of passive real estate investing, are you ready to take your knowledge to the next level? Take our Real Estate Pre-License course
to learn advanced real estate knowledge and prepare you (if you'd like) to become a licensed real estate agent. Start your training today!