This is a guest contribution from G. Brian Davis, Founder of SparkRental
With enough passive income, working becomes optional. You can retire, regardless of your age. Better known as financial independence, it’s the ability to cover your living expenses with passive income from investments.
Dividends offer an excellent source of passive income. But it’s far from the only one, and savvy investors know the value of diversification to limit their risk exposure.
As you build your portfolio, consider the following sources of passive income from real estate, beyond publicly-traded REITs.
1. Rental Properties
A joint study by several US and German universities and the German central bank analyzed returns on all asset types over the last 145 years. What they found surprised them: rental properties outperformed stocks over the long term, and with less than half the price volatility. That flies in the face of conventional wisdom that risk and reward go hand in hand.
And yes, they took into account both price appreciation and yield/income.
Rental properties come with a slew of advantages for reaching financial independence. First, they generate ongoing income, forever. That income inherently adjusts for inflation as well; in fact, rents are a primary driver of inflation.
Rents rise over time, even as some of your expenses (such as your mortgage payment) remain fixed. That means your cash flow improves, every year that goes by. Eventually, your tenants pay off your mortgage for you, and your cash flow jumps upward even more.
Which raises another advantage: you can leverage other people’s money to build your own portfolio of income-producing assets. With a rental property mortgage, you can borrow money inexpensively, and start earning cash flow from the first money.
This is cash flow that you can predict. You know your purchase price, you know the market rent, and you can accurately estimate all expenses. Experienced investors know to include the long-term average of expenses like repairs and vacancy rate when calculating cash flow.
Finally, real estate comes with inherent tax advantages. You can deduct nearly every conceivable expense, from mortgage interest to repairs to travel to and from your properties. The expenses you can’t deduct, you can depreciate. And when you sell, you have many ways to reduce or avoid your capital gains taxes, such as 1031 exchanges.
2. Seller Financing
When you sell a property — whether a long-term rental property or a flipped house — you can offer to finance it for the buyer. They pay you the up-front lender fees, rather than the bank. And more importantly, they pay you monthly interest for the next 15-30 years.
When you offer seller financing, you sign two documents: a promissory note (the legal commitment to pay the loan back) and a mortgage or deed of trust (that secures a lien against the property for collateral). If the borrower defaults on the monthly mortgage payments, you can foreclose to retake possession of the property.
No one says you only have to offer seller financing on residential properties, either. I also invest in land, and offer seller financing on parcels when I sell. The foreclosure process is far faster, and there’s no risk of the owner damaging the property!
3. Private Notes to Other Investors
I also lend money to other real estate investors who haven’t bought a property from me. In these cases, we sign a promissory note, but I don’t put a lien on a specific property. I simply lend them money as flexible funds to use in their real estate investing.
On the one hand, that adds risk for me. But I charge high interest rates, and on I only lend money to investors with a proven track record of success. And, for that matter, investors who I know and trust personally to always pay their debts.
Only consider lending private notes to real estate investors you know well, and who have demonstrated a long history of profitable deals. Otherwise your money could disappear, and your only recourse would be to sue the investor and then try to collect the money judgment.
4. Real Estate Crowdfunding: Property Funds
Real estate crowdfunding comes in many shapes and sizes. One option includes private REITs that own properties directly, sometimes called equity REITs.
These crowdfunded REITs don’t trade on public stock exchanges. But like their public counterparts, they own a portfolio of income properties, and pay high dividends.
Also like public REITs, different crowdfunded REITs own different types of property. You can invest in funds that own residential properties (usually apartment buildings, but sometimes 1-4 unit residential properties), commercial office buildings, mixed-use properties, mobile home parks, or other types of real estate such as industrial buildings.
However the SEC regulates real estate crowdfunding differently than publicly-traded REITs. Public REITs by law must pay out at least 90% of their profits in the form of dividends. That ensures high yields for public REITs, but it limits their growth potential, because they can’t reinvest their profits to grow their portfolio of properties.
Another important difference is liquidity. You can buy and sell public REITs at a moment’s notice, like any other share on public stock exchanges. But that comes with two major downsides: volatility and correlation with stock movements. Publicly-traded REITs tend to fluctuate right alongside stocks, even though the underlying value of the properties they own don’t swing so capriciously.
I have some personal money invested in Streitwise for commercial properties and Fundrise for residential properties, as both allow non-accredited investors. But accredited investors have plenty of other options for private REITs as well.
5. Crowdfunded Loans
An alternative model for real estate crowdfunding involves putting money toward loans secured by real estate.
These lenders work with real estate investors, usually offering hard money loans: short-term fix-and-flip loans. A real estate investor takes out a hard money loan to buy a fixer-upper, renovate it, and then sell it (or refinance it with a long-term rental property mortgage).
You can fund these loans, either individually or collectively, through crowdfunded lenders. In the collective model, you invest money with the hard money lender, which they use to fund their short-term loans. You don’t actually pick and choose individual loans — you just effectively lend money to the lender.
Alternatively, some crowdfunded lenders let you pick and choose individual loans to fund. The interest rate varies based on the risk inherent in each individual loan.
I particularly like GroundFloor as a crowdfunded lender who offers both options to investors. You can lend them money at a flat interest rate, or you can pick and choose loans at varying interest rates.
As you build passive income and work toward financial independence, diversify your income investments as much as possible. That includes multiple asset classes (e.g. stocks and real estate), different types of investments within each asset class (e.g. rental properties and crowdfunded real estate investments), and diverse geography.
To measure your progress, start tracking your FIRE ratio each month. It may sound complex, but it’s simply the percentage of your living expenses that you can cover with passive income. For example, if you live on $4,000 per month, and you generate $2,000 per month in passive income, you have a FIRE ratio of 50%.
Once you reach 100%, congratulations! You are financially independent and work is now strictly optional. Go travel the world, raise your kids, volunteer full-time, or find a career that brings genuine meaning to your life.