How to invest

Building passive income through real estate investing

What is passive income?

Passive income is earnings derived from enterprises or investments in which a person is not actively involved. Unlike active income, passive income allows participants to see wealth generation benefits long after implementing the foundational "work". For many, the ultimate goal is to create sustainable passive income streams that eventually surpass their earned income leading to financial freedom.

Is Commercial Real Estate a good option for building passive income?

Commercial Real Estate (CRE) investment is an excellent way to earn a passive income from a real asset driven by a few key factors:

  • The necessity of commercial real estate in the global economy makes it an enduring investment option regardless of the business cycle. This is evident throughout the economy, office spaces house professional workers; industrial warehouses are required to manufacture goods, and retail premises provide entertainment options for patrons.
  • The lease agreements for commercial property are long term in nature, typically, a lease spans for a minimum of three years, which provides a consistent stream of future rental cash flows.
  • CRE is an income-driven investment which isn't materially impacted by emotional drivers, unlike other asset classes such as residential property.
  • The lease agreements can include clauses for fixed annual increases, which allows for growth and certainty of income over the lease term.

4 Ways to Build Passive Income through Commercial Real Estate

1. Direct ownership

Traditionally direct ownership of individual assets has been the main way investors earn passive income in CRE. This method involves an investor sourcing and evaluating an opportunity, liaising with an agent, carrying out significant due diligence, engaging lawyers on property conveyancing, and then either assuming ongoing asset management or outsourcing this to a third party. This method is suited to investors able to dedicate large amounts of time and capital to CRE investing. While asset level control and low fees are benefits to this strategy there are significant disadvantages including; large capital entry requirements, lack of diversification, potential lack of transparency, liquidity issues, and potentially lack of investment expertise to produce sustainable asset performance.

2. Proportionate ownership schemes

Investors can participate in real estate pooled-investment vehicles as a way to build passive income portfolios. Several investors pool their capital together to purchase real estate, which is managed by a third-party, in exchange for ongoing cash and capital returns. Property syndications, and crowdfunding platforms all embody this way of investing by allowing investors to hold a fractional interest in the underlying asset/s. Benefits of this method include the flexibility of allocation size and the ability to leverage investment and management expertise. Downsides can include high fees or misalignment of incentives between the Investor and the manager. This avenue of earning passive income has proliferated in recent years due to the high returns many investments offer compared to bank deposits.

3. Public REITs

A real estate investment trust (REIT) is a publicly-traded company that owns, and in most cases operates, income-producing real estate. REITs give investors the ability to realise the passive income associated with real estate ownership without the trouble of being a landlord in the traditional sense. REITs main benefit is the liquidity the public markets provide along with a certain level of diversification. Disadvantages of publicly listed REITs are that they display a strong correlation with stock market volatility, offer no asset level control, and often offer lower yields compared to direct ownership opportunities.

4. Private CRE funds

REITs give investors the ability to experience the economic benefits associated with real estate ownership without the trouble of being a landlord in the traditional sense. They can be thought of as a mutual fund, and offer individuals an opportunity to invest in the real estate sector while remaining completely passive.

Many regulations govern REITs, the most important being that they must distribute at least 90% of their taxable income to shareholders each year as dividends; the REIT is permitted to deduct dividends paid to shareholders from its taxable income. The unique tax advantages offered by REITs can translate into superior yields for investors seeking higher returns with relative stability. Publicly listed REITs are often correlated with stock market volatility and high management fees, which is why some investors choose to stay away from this method of investing.

Key Takeaways

Commercial real estate offers several different ways to build your passive income. There is work that goes into reviewing an investment opportunity, finding a qualified investment opportunity, or getting an investment to perform as intended. An understanding of critical revenue and cost drivers of an investment opportunity, asset management strategies and the tax implications of that strategy is key to building a sustainable and enduring passive income portfolio.

Here at Jasper, we offer investors the best attributes of direct ownership, proportionate ownership schemes, and REITs. It’s a better, smarter way to invest in real estate.

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Vernon Sequeira
Investment Analyst
Published 6 May 2020