Investors have been buying stocks in the U.S. since 1792 when the New York Stock Exchange began. And, as you might expect, the market was dominated by large investors and corporations. But with the advent of mutual funds in 1924, ordinary investors gained the ability to participate. And when John Bogle, founder of the Vanguard Group, introduced the first index mutual fund in 1976, passive investing was invented.
Passive investing is a basic strategy in which investors buy shares in a fund whose investments mimic a specific index (such as the S&P 500 or the Russell 1000) and hold them for the long term. The intent is to maximize returns by minimizing buying and selling, thereby reducing the costs of trading. According to Statista, as of 2022, there were 517 index funds.
Compare that to the 6,585 active mutual funds in the U.S. as of the same period. In contrast to passive funds, with active funds, the fund managers’ goal is to outperform their benchmarks by selecting individual investments.
Since then, funds and exchange-traded funds (introduced in 1990) have offered everyday investors an entrée into the stock markets—using both active and passive funds. Today, active ETFs number 1,136 and passive, a little over 300.
Passive investing is growing, and according to BofA Global Research, “only 47% of assets under management in the U.S. are now overseen by active funds, down from 80% in 2009.” That growth is due to a couple of factors:
- Index funds have much lower fees than active investments, around 0.2%, compared to 0.5-2.5% for active funds.
- Excellent transparency. Since the passive fund is a mirror of the underlying index, investors always know what stocks or bonds the portfolio holds.
- Tax efficiency, due to less trading than an active fund, so the funds accrue fewer capital gains.
By investing in passive funds, investors can participate not only in the broad market indexes I mentioned above but also in almost any sector, including financials, technology, consumer cyclical, utilities, healthcare, precious metals and real estate—the sector I want to bring to your attention today.
How to Invest in Real Estate Without Breaking the Bank
Do you feel that you missed out on the real estate boom that has happened since the recession of 2007-2009? The graph below shows just how far and fast home prices in the U.S. have moved since that time.
According to the National Association of Realtors, the median price for an existing home is $387,600 today. If you bought a home at that price, with a 10% down payment ($38,760), and an average 30-year mortgage rate of 7.55%, your monthly outlay (not counting taxes, HOA, etc.) would be $2,448.
But all hope is not lost! By utilizing passive real estate investing, you can participate in the real estate market for much less money.
As you know, I own a real estate company and I’m always interested in reading about the latest developments in the industry. What prompted this piece was an article I read about Arrived, a real estate investment platform backed by Jeff Bezos, the founder of Amazon, who put in $37 million to get the company started.
Arrived created the Single Family Residential Fund which has acquired $124 million of single-family rental properties (about 400 homes) located in up-and-coming neighborhoods. It’s already attracted more than 500,000 investors who can participate in the rental income and potential share appreciation by investing as little as $100 (although in reality, Arrived says the average amount its customers invest per property is closer to $3,195).
The properties are discovered by using data analytics to determine the best investments in 27 markets across the country that are ripe for the highest appreciation. Then they work with real estate agents with local knowledge to fine-tune their purchases of single-family homes. The houses are then shown online to nonaccredited (net worth less than $1 million) potential investors.
Investors can choose between single-family homes with regular passive income or vacation rentals such as those listed on Airbnb, which may offer more lucrative income opportunities.
As you saw in the above graph, prices for real estate have been appreciating—between 5% and 12% annually for quite some time. So I’m not surprised that Bezos—who is the king of innovative ideas to make money—is involved in such a project. Plus, he is joined by other deep-pocket investors, like Uber Technologies Inc. CEO Dara Khosrowshahi and Salesforce Inc. Co-CEO Marc Benioff, who also seeded the company with serious money.
For the investors, the advantages are attractive:
- An opportunity to own real estate without a huge investment
- No need to worry about taxes, HOA fees, maintenance, and renters
- A steady income stream (from rents)
- Diversification of income streams.
But investors will pay a 1% annual management fee, and some investors have complained that they haven’t been able to participate as the properties are sold out quickly.
Bezos Isn’t the Only Passive Real Estate Opportunity
But don’t worry, there are plenty of other passive real estate investing opportunities—most of which have been around for years, and so are market-tested.
Let’s look at a few.
Real estate investment trusts (REITs) were created in 1960 by an act of Congress to allow individual investors to participate in the ownership (and profits) of large-scale, income-producing real estate properties, such as single-family homes, apartments, retail locations, hotels, offices, warehouses, or shopping malls.
Like mutual funds, they allow individual investors to “pool” their monies to invest, while sharing the risk of the investments. They are also excellent tools when used to diversify your portfolio as well as to allocate your assets. And, as with mutual funds, they are professionally managed. But REITs have one tremendous selling point not shared by most mutual funds—high dividend yields.
By law, REITs must return at least 90% of their taxable income to their shareholders, annually, which generally translates into very nice yields (4.46% on average, compared to 1.40% for the S&P 500 Index) for the REIT investor, making these investment vehicles very attractive. The New York Stock Exchange currently lists 158 REITs, including equity, mortgage, and hybrid models.
I’ve long been an investor in REITs—for their income, as well as their appreciation. REITs gained an average of 11.4% last year, which negates the oft-believed (but incorrect) idea that REITs suffer in a rising rate environment. Most industry experts believe the sector will continue to improve this year.
However, with the commercial real estate business being roiled by decreasing occupancy rates, I would probably steer clear of that sector.
Here are a few suggestions for investing in REITs:
- Revenues and earnings should be growing at a sustainable level.
Debt should be reasonable, and the leverage should be used to grow the REIT’s top and bottom lines. - Compare four quarters of funds from operations (FFO) to the REIT’s annual dividend payments. That is the dividend coverage ratio, which should be more than 1:1, meaning the REIT is earning more than it pays out in dividends.
- Dividend track record—is it stable? Has the dividend been cut? One important note: If the yield looks outrageously high compared to the industry, it may be an indication of too much risk.
- Review the portfolio, including the vacancy rate history, credit ratings of its holdings, and diversification. Find out the geographic regions in which the REIT invests. Check out housing prices, condominium conversion rates and the current apartment rental market.
- Valuation of REITs is every bit as important as with any other stock. It’s best not to overpay; that way, you get the benefit of appreciation plus a handsome and steady cash flow.
REIT exchange-traded funds are traded just like stocks but include investments in multiple REITs or real estate companies. There are currently 62 real estate ETFs traded on the U.S. markets, with total assets under management of $70.59 billion.
REIT ETFs are a great way to diversify your portfolio with real assets without the headaches of real estate ownership.
The average expense ratio for these ETFs is 0.43%.
There are more than 300 real estate mutual funds, which pool investors’ funds to invest in portfolios of properties owned by REITs and real estate operating companies.
The average expense ratio for mutual funds is between 0.5% and 1.0%.
Non-traded REITs don’t trade on stock exchanges but are purchased on online portals such as Fundrise or RealtyMogul or through a financial advisor. They usually offer a higher yield than publicly traded REITs, but may also require a higher minimum investment. They also tend to be less liquid than their public alternatives, as many only redeem shares quarterly and may also limit the amount of redemptions.
Private real estate funds are also available. These are large funds that are created by sponsors to invest in real estate. The investor receives an equity partnership in exchange for a fairly high minimum investment, anywhere from $25,000 to $250,000, so are more suited to well-heeled investors.
Crowdfunding involves a management company that pools funds from investors to raise large sums of money to finance real estate projects that would be too expensive for many individual investors to buy. Examples of investments include farmland, large apartment buildings, office complexes, retail locations, storage facilities, and hotels. Some crowdfunding platforms allow you to own a percentage of physical real estate—from rental properties to commercial buildings to parcels of land.
A main advantage of crowdfunding for real estate is that investors can invest in amounts as low as $500 or $1,000. But be aware that some platforms require that you be an accredited investor.
Investors pay a management fee (an average of 0.15% to 4.25% per deal) to the management company. In return, they receive dividends or interest payments. The downside is that because each investment has a stated strategy, target return, and investing timeline, investors may not be able to cash in and sell their investment until the management company closes down the investment, potentially preventing them from quick access to their money.
Remote ownership offers rental income and/or property appreciation for investors who buy properties in different geographical locations via online platforms or property management companies that help operate the investment.
You can, of course, manage your properties yourself (become an active investor), or delegate a property management company that will charge you 4%-15% of the monthly rent.
I’ve owned rental properties locally and out of state, and I’m telling you if you can hire a good management company, it is worth its weight in gold. My remote property was a ski condo in New Hampshire, which was rented pretty much all year, more than paying for the manager. And my participation in the operation was limited to occasional phone calls and sending checks for items that had to be repaired or replaced.
Turnkey rental properties are those properties that you can rent out immediately. They don’t need repairs, renovations, or updates. You just buy them and rent them out right away. And to be truly passive, you can hire a property management company to vet renters, collect the rents, and manage any repairs.
Fractional ownership is the strategy that Arrived offers. But it’s not the only one in this space. Investors can also participate in fractional ownership with luxury providers Ember and Equity Estates.
Ember has a couple of options that allow you to stay in the property for up to 44 nights per year for a 1/8 ownership, which will cost you $100,000 to $500,000 to buy into luxury homes. You must put 30% down on the properties you purchase, and Ember offers financing to buyers.
Equity Estates offers ownership in homes valued at $2-$5 million in 60 destinations in 25 countries and offers up to 45 days a year for owners to stay at their properties.
I tried to find out about operating fees for both companies but came up empty. I expect they are pretty lofty.
There are many companies now operating in the fractional real estate ownership field, including several that are not luxury providers, so the buy-in fee is much smaller than the two I cited above.
I found this guide to fractional ownership at a site that offers a number of questions to answer before committing to such a large purchase, such as the cost-per-night-per-square-foot, the fractional pricing multiplier (the relationship between the price of a fractional ownership interest and the price of whole ownership of a similar property), owner control and non-owner use (including rental use), developer experience, resale and exit options, and more.
In some cases, you will receive a deed and equity in the property, so make sure you understand the legalities of ownership before you sign on the dotted line. Additionally, I would recommend that you conduct a detailed analysis of all the fees, as well as expected returns prior to investing.
Real estate syndications allow accredited investors to buy commercial real estate as a limited partner in a single real estate asset, such as an office building, self-storage operation, or multifamily property. As a partner, you will share in the passive income, which will typically be higher than a publicly traded REIT. Portals such as CrowdStreet and EquityMultiple, as well as deal sponsors, provide these types of partnerships.
Note that the minimum investment is steep, more than $10,000, and these deals come with holding periods of five to 10 years.
Hard money lending—unlike a bank loan—is focused on the value of the property (the collateral) itself, with much less emphasis on figuring out if the buyer is creditworthy. These loans are generally only for six months to a few years, unlike the typical 30-year mortgage loan that is commonplace for home financing.
Hard money loans include bridge loans, temporary financing until a long-term loan or the next phase of financing is obtained; construction loans for real estate developers; and fix-and-flip loans, customized for properties that need renovation before they can be sold.
They are typically used by folks who need funds to purchase or renovate homes with the goal of flipping them for profit. Interest rates for hard money loans are priced according to risk and they tend to be higher than traditional mortgage loans, ranging from 8% to 15%. Additionally, you can expect to pay points, or upfront fees of 2% to 4% to the lender.
Real estate-backed debt investments require you to lend money for financing, purchasing, renovating, redeveloping, or constructing of a property. This would typically include buying mortgage notes, being a hard money lender or investing in mezzanine debt or preferred equity on a single asset syndication deal.
These investments usually are low risk, short term, and provide steady income. On the other hand, returns are limited, there’s a risk of prepayment, and inflation may affect your returns.
Pros and Cons of Passive Real Estate Investing
Just as with active real estate investing, passive investing has advantages and disadvantages:
Pros of passive real estate investing:
- Little effort to earn income
- Your investment is backed by a physical asset
- Diversification of your portfolio
- A great way to learn about real estate investing before committing to active investing
- Allows you to invest small sums, so if mistakes are made, they shouldn’t be life-altering
- Access to high-value properties
- Potential tax benefits, such as deductions for depreciation, mortgage interest, and other property-related expenses
- Professional management.
Cons of passive real estate investing:
- Limited control over your investment
- May have to hold the investment longer than you’d like
- Vulnerable to market conditions (Whether active or passive, you will always be at the mercy of the real estate market, where timing is important. Just know that the value of your real estate will fluctuate, and you won’t have much control over it.)
- Fees and expenses will cut into your profits
- Returns will also fluctuate, according to the market as well as the location of your properties
- Higher taxes (as in the case of REITs) compared to other investments that qualify for long-term capital gains or dividends
- Interest rate risk, depending on the type of financing
- Tenant problems.
The 10 Rules of Passive Investing
Now that you know how to begin passive real estate investing—as well as the pros and cons—here are some strategies to make sure you are maximizing your investments:
- Evaluate your finances, including your income, expenses, assets and liabilities to determine how much you can invest and how much risk you can tolerate.
- Create a budget for your initial investment costs and ongoing expenses such as maintenance costs, property taxes and management fees.
- Diversify investments across different types of real estate and geographic locations.
- Choose investments managed by reputable and experienced firms. Analyze their past performance and know their goals.
- Consider the impact of potential interest rate changes on your investment. Look for fixed-rate financing options if you can.
- Thoroughly investigate the investment prospects and managers. Make sure they align with your goals and risk tolerance.
- Analyze the different real estate property types—residential, commercial, industrial or retail—and make sure you understand their risks and benefits, and how their markets might change in various economic cycles.
- Consult with a tax professional to understand your investments’ tax implications and strategize for better tax efficiency.
- Focus on properties or investments with a strong tenant base or in areas with high rental demand.
- Don’t forget the age-old real estate rule—location, location, location!
Evaluating the Performance of Passive Real Estate Investments
Look at the total (potential) returns over time, including rental income, appreciation, and costs and compare them to other investments to see how they perform in good and bad markets. Make sure you are calculating risk-adjusted returns, which will take the volatility of the investment into consideration.
Research occupancy rates, rent growth, and capitalization rates (a comparison of net operating income to property values) in the region in which the properties are located.
Review the growth of funds from operations (FFO) for any REITs. This figure illustrates a REIT’s core operating cash flow from properties, similar to earnings for stocks.
Consider risk-adjusted returns, not just headline returns. An investment with 10% returns but high volatility may not be as good as 7% returns and low risk. Review risk factors like tenant concentration and management practices.
Compare fees—management fees, acquisition costs, profit splits, and other expenses—between potential investments.
Go over projected improvements, rents, occupancy, and operating efficiency to determine if the forecasted returns are realistic.
The IRS Treats Rental Income as Passive (Mostly)
In most cases, rental income is treated as passive income, even when an investor spends time overseeing a rental property business.
According to IRS Publication 925, “a rental activity is passive even if an investor materially participates in the activity,” if “real estate is used by tenants and rental income (or expected rental income) is received mainly for the use of the property.”
There are some exceptions:
- If the rental property owner is classified as a real estate professional.
- If the property is rented to a company, such as an LLC or S-corporation, in which the investor holds an interest.
- Rental income from short-term rentals (STRs) may be considered active if the average period of a tenant’s stay is seven days or fewer.
- Rental income from a personal residence may be active if the home is occupied as a personal residence for more than 14 days or 10% of the days the home is rented out.
Lastly, the good news is that the IRS allows you to use losses to offset your passive income in the same tax year. Additionally, losses can be carried forward to offset future income.
Are You More Suited to Active Real Estate Investing?
If you are more hands-on and have additional funds to actually buy real estate, you may consider several ideas for becoming an owner, including:
Buying long-term rental properties. This requires calculating acquisition costs such as down payment and interest as well as ongoing expenses, compared to the income potential.
Buying short-term vacation rentals and running a hospitality business. You should include the amount of time you have to manage the property yourself or the costs of a good property manager, as well as all the expenses cited above.
Flipping houses. You will need to buy low, keep renovation costs reasonable, and sell at a higher price, reaping the difference as your gain. This is simple math, but, of course, if you need to get a loan to purchase and/or renovate the property, you will have to consider those costs. And don’t forget the selling costs—marketing and real estate commissions.
Flipping land. See above.
Buying and operating mobile home parks. This is a complex investment, and I would recommend finding a good real estate professional, accountant, and attorney to help you with such a transaction.
Buying and operating self-storage facilities. See above. As an aside, I just can’t believe the amount of storage facilities being built in my area. Like the gas stations of old, it seems like there is one on every corner!
Ground leases. These are generally agreements by commercial landlords to lease land for 50 to 99 years to tenants who construct buildings on the property. The father of one of my friends owned three such leases that he leased to Burger King for a 99-year term. Very lucrative!
While active real estate investing may mean higher returns over time than passive investing, it does have its disadvantages, including:
- High minimum investments in time and money for the purchase, financing, repairs and maintenance, advertising, screening tenants, collecting rents, etc.
- Complex research is required to find the right properties for the niche you have defined as your target, such as pre-foreclosures, or buying properties through probate, or massive direct mail campaigns to owners of abandoned properties.
- If you are an owner for the long term, you may collect rents, but your big payoff is when you sell the property, which could be a long way away and will also cost you time and money.
- Prepare to spend a lot of time on accounting, keeping track of every expense and every cent of income, and making sure you keep good tax records.
Passive or Active—Which Strategy Has the Best Returns?
Actively managed investments usually cost more, as the investor is paying for research and analysis and teams of analysts that are needed to beat index returns.
Consequently, you would assume that active investments had greater returns than passive investments.
But not so fast. According to a study by Wharton Business School, over a 10-year period, on an after-tax basis, “managers of stock funds for large- and mid-sized companies produced lower returns than their index-style competitors 97% of the time, while managers of small-cap stocks trailed 77% of the time.”
The report also noted, “In case you are curious, those very few investment managers that outperformed the passive index were still likely to underperform in the future. In fact, outperformers had only a 20% chance of repeating the following year, and … just a 10% chance of outperforming three years in a row.”
Yet, there are some advantages to active management, including:
- Flexibility as to the types of investments, since the manager doesn’t have to mirror an index.
- Hedging your portfolio is an oft-used strategy, using short sales, put options, and other strategies to insure against losses.
- Risk management—changing your portfolio makeup to accommodate economic and market changes.
- Tax management customized to your personal needs, including selling money-losing investments to offset taxes on winners (tax-loss harvesting).
The Wharton study noted that “Passive management generally works best for easily traded, well-known holdings like stocks in large U.S. corporations, because so much is known about those firms that active managers are unlikely to gain any special insight, but in certain niche markets, like emerging-market and small-company stocks, where assets are less liquid and fewer people are watching, it is possible for an active manager to spot diamonds in the rough.”
Ultimately, it’s up to you, your available assets, and the time you want to devote to real estate investing as to whether you choose passive or active investing, or a combination of the two. I have clients who buy to flip, buy to renovate and flip, and buy for rental income, and do very well.
3 Ideas for Passive Real Estate Investing
As I mentioned earlier, I’ve always been a fan of real estate investment trusts. And I prefer ETFs over mutual funds due to liquidity, ease of trading, and generally lower expenses.
I searched my databases and ran these ideas through my rating and analysis parameters, and found three possible passive investments for you.
Prologis Inc (PLD) is a REIT that leases modern logistics facilities to a diverse base of approximately 6,700 customers principally across two major categories: business-to-business and retail/online fulfillment.
Target Price: $144.15
Dividend Yield: 2.64%
GX Green Building ETF (GRNR) is a non-diversified fund designed to provide exposure to companies that are positioned to benefit from increased demand for buildings that reduce or eliminate negative impacts, and/or create positive impacts, on the natural environment.
Target Price: $32.80
Dividend Yield: 2.82%
Pebblebrook Hotel Trust (PEB) is a REIT that is the largest owner of urban and resort lifestyle hotels and resorts in the United States. It owns 47 hotels and resorts, totaling approximately 12,200 guest rooms across 13 urban and resort markets.
Target Price: $22.00
Dividend Yield: 0.25%
As always, please make sure that these investments suit your personal investing strategy and risk profile before buying.