The real estate passive income myth pulls many unsuspecting investors into direct investing when there is a more passive real estate opportunity.
We covered the potential for passive income from real estate rentals in our prior post in the series and found that, like many of the passive income strategies, direct real estate investing takes more work than most people suspect.
What most investors do not realize is that there are two investments available that offer indirect exposure to real estate passive income with returns that are comparable to direct investing and with much less work.
This post is the fifth in a series where I will look at the four most popular investments for passive income potential:
- Online Stores
- Income Investing
- Real Estate
Passive income is technically an income you receive on a regular basis that involves little effort on your part. You get paid every month, quarter or year but do not participate in management or contribute work in the investment. Few investments offer absolutely passive income since you have to work for the money to invest in the first place and you likely will want to keep updated on the investment, but some income is more passive than others.
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The popularity of real estate passive income have given rise to countless strategies to make money on property. While directly owning and managing real estate for income is probably one of the oldest investments, that doesn't necessarily mean it's the best.
As we've seen across this series on passive income myths, it really comes down to your preferences as an investor and how much time you want to spend working on an investment. For those that want the benefits of real estate investing without the time commitment, start-up costs and risks of direct ownership, there are two popular indirect strategies that offer good returns and a truer form of passive income and a new opportunity in real estate crowdfunding that few know about.
Real Estate Passive Income through Tax Liens
Property tax liens have been a popular real estate passive income strategy for decades. If an owner fails to pay taxes on their property, a debt is placed on the property and eventually sold to an investor. A tax lien usually wipes out a mortgage or other debt so investors have the potential to get a property for just the amount owed on property taxes.
Twenty-eight states, the District of Columbia and Puerto Rico allow tax liens to be bought by private investors with more than $6 billion in liens sold every year. The liens work like any other kind of debt. You are entitled to an interest rate on the value of the investment until the debt is paid off. If the debt is not paid off, you have the right to take possession of assets the debt is on, which in this case is the real estate.
The interest rates on tax liens usually start very high, so high that the strategy becomes the stuff of late-night infomercials and get-rich-quick schemes. In most areas, rates on tax liens are between 1% and 3% a month. The prospect of a passive income investment that pays 36% a year with the potential to get the property draws a lot of people in every year.
Unfortunately, as we’ve seen in other passive income strategies, the actual returns and effort involved is usually an entirely different story.
The real story of tax lien investing
I tried tax lien investing in 2003 and can tell you that it is anything but easy money. Different local governments set different rules and procedures for lien sales so I will run through how it is done in Polk County, Iowa and touch on some of the other methods.
Almost all jurisdictions hold their tax lien sales through a bidding process, the only difference is how that auction is conducted. In Polk County, I paid $50 (2003) to register for the tax sale. There were hundreds of other investors registered for the sale and upwards of a thousand properties with liens. I researched a lot of the properties through the assessor’s page though the bidding process (below) makes research mostly a waste of time. Many of the properties were undeveloped land that really weren’t worth much anyway.
You are assigned a number for your registration. The auction administrators go down the list of available liens and a registration number is randomly selected. If the investor with that number wants the lien, they can buy it. If not, another registration number is selected. If that second investor doesn’t want the lien then anyone in the room can bid on the lien.
- While you’re guaranteed that your number will be called sometime during the day, you don’t know when or for which property.
- If two investors have already passed on a lien and it goes to auction, what are the odds that it is a good investment?
- A lot of larger investors actually pay people to attend the auction, paying for their seat, and then just tell them to buy any property they are offered when their number is called. Most of these are property developers that can work with just about anything they get.
So my experience with the tax lien process in Polk County was a bust. The property that came up when my number was called was a small vacant lot with more than $4,000 in taxes owed. Not only would I have to pay the $4k for the tax lien and any subsequent taxes but then I’d have to do something with a vacant lot if I ended up with the property.
Other areas conduct their auctions in a more traditional bidding process where investors bid on a lien at the lowest rate they will accept. This is a pretty sweat deal for property owners because rates are often bid down extremely low and they don’t have to worry about paying much in interest. I went to a tax lien auction in Illinois that was like this and the interest rate you usually ended up with just wasn’t worth it.
Yet another auction type is where investors bid up the price they pay for the lien but receive a fixed interest rate. This has the same effect, a lower interest rate on the investment, but the county wins because it gets the extra money.
If you do get a tax lien then it is usually your responsibility to check with the county treasurer to see if the lien has been paid. Some areas will mail you out a check but in others it’s a matter of constantly logging into a website and waiting. It is also your responsibility to notify the property owner and pay any foreclosure expenses if it comes to that.
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If you do go to a tax lien auction, it is a good idea to only bid about half or less of the money you plan on investing over the next year. You will need to continue paying taxes on the properties when they are due or another tax lien might be sold on the property, wiping out your investment. This can get expensive if you get a lien on a large property with high taxes.
The National Tax Lien Association reports that average returns for tax liens are between 4% and 7% with 99% of liens eventually redeemed by the property owner. While you might forget to pay your property taxes for a month or two after the deadline, receiving a letter saying the tax lien has been sold to an investor usually results in a check being sent out pretty quickly. Often, the creditor on any other liens or mortgages will make arrangements to pay off the tax lien. The bank doesn’t want to be wiped out on a $100,000 property because the owner didn’t pay a couple of grand in taxes.
One of the reasons returns are actually pretty low for tax lien investing is because of this quick payment of liens. If the lien is paid off in a month then you’ve earned a percent or two but now have to find another investment for your money. Tax liens are usually only held once a year so you’ll have to sit on the cash or be content with short-term rates in other investments to have the cash available next year.
Property tax liens are not really a good way to invest in property because of the costs to foreclosure and the time it will take to actually get the property. If you do end up foreclosing, the property isn’t likely to be in good shape and you’re probably looking at a complete tear down and remodel.
While you can look at assessed property value to get an idea of how much it's worth before you invest in a tax lien, you never have the right to actually inspect the property until you foreclose. I’ve been involved in real estate as a commercial property agent, as a flipper and as a landlord. Buying a property which you’ve never seen the inside does not strike me as a good way to invest.
Still, there is a return available in tax lien investing and it doesn’t involve the kind of work that goes into a real estate rental business.
- Research the counties within reasonable driving distance to find out about auction processes.
- Do your research on the properties through the county assessor page, at least finding how much the property is valued for taxes and how much taxes are each year.
- Understand what kind of a return you are getting depending on how much you bid for the lien (if it is a bid-price auction). Set a minimum return you will accept to avoid getting carried away and overbidding.
- If you invest in tax liens long enough, you are going to end up getting a property. Have a plan for what you’ll do with the real estate before that happens.
- While the average return on tax liens of 4% to 7% seems low, it is not an annual return. You’ll likely earn that return in less than a year to the point where the lien is paid off. This is a respectable return, especially for a limited amount of work, but you need to have a plan for what to do with the money for the rest of the year.
Crowdfunding Real Estate Investing: The New Opportunity for Passive Income
While tax lien investing was disappointing, a new opportunity for passive income real estate investing has just opened up. New laws around crowdfunding mean you can invest directly in real estate projects on crowdfunding portals like RealtyShares.
Unlike real estate income trusts, discussed below, these crowdfunding real estate investments are for direct ownership in the properties. You can invest in different property types and across the country for greater safety and diversification. Because it is a direct ownership, returns will tend to be higher than investments in REITs and other hybrid real estate investment.
The best part about real estate crowdfunding is that properties are professionally-managed so you don't have to worry about 2am calls to fix a water heater. You get the return of direct real estate investment without the hassles.
Click for more information about investing on RealtyShares and real estate crowdfunding.
Real Estate Passive Income through REITs
Investing in real estate investment trusts (REITs) is the more popular indirect way to get real estate passive income. The concept is pretty simple. REITs are companies that own or finance real estate and issue shares in the stock market. These companies remove a lot of the barriers that investors face with real estate passive income.
- Low start-up cost – Direct investment in real estate means tens of thousands of dollars or more even with smaller properties. Shares of REITs can be bought like regular stocks for less than one hundred dollars.
- Diversification – It’s extremely difficult for most investors to buy enough properties, differentiated by location and type, to get safety through diversification. REITs hold hundreds of properties with varying levels of geographic and investment-type diversification.
- Management – Hiring someone to manage a few properties is extremely expensive and you may not have the time to manage your own properties. REITs are managed by experts in real estate with efficiency through hundreds or thousands of properties.
The biggest advantage to REITs is their tax advantages. REITs are structured under a special law that protects them from corporate taxes. If they pay out at least 90% of their annual income to shareholders, they don’t have to pay taxes like other companies. That means an extremely efficient way to manage real estate and more money in your pocket as a shareholder. The tax advantage is so powerful that regular companies like McDonald’s and Sears have considered selling their locations into a REIT and then renting the space.
There are primarily two types of REITs, an equity-type and a mortgage-type. Equity REITs own and operate real estate. Mortgage REITs lend money for the purchase of real estate and make money off the interest on the loans.
Because of the advantages of REITs and the popularity of real estate as an investment, shares of REITs are widely held by pension funds, insurance companies, bank portfolios and by individual investors. With the exception of the recent housing bubble, real estate has historically been an extremely stable investment. Commercial property benefits from the stability of long-term leases and property value that rises slightly faster than the rate of inflation.
The graph below shows the annual returns to equity REITs over more than four decades to 2013. Over the period, investors earned 8.0% each year in dividends and 5.5% from share price increase. For reference, that 13.5% total return is nearly twice the 7.2% annual return on stocks in the S&P 500 over the same period.
Just like other stock investing, you can buy shares of individual REIT companies or shares of funds that hold REIT shares themselves. Even though many REITs offer diversification through properties of varying location and property-type, funds offer one more layer of diversification.
Some good REIT funds to check out include:
Vanguard REIT ETF (NYSE: VNQ) holds shares of 140 REITs in every property type, almost exclusively invested in the United States. The shares pay an annual dividend of 3.76% and have returned 14.8% annually over the last five years.
SPDR Dow Jones Global Real Estate ETF (NYSE: RWO) holds shares of 226 REITs across property types and countries, though U.S. companies still account for 56% of the holdings. The shares pay an annual dividend of 3.0% and have returned 13.6% annually over the last five years. Even against slightly lower returns and higher expenses on the fund, it’s important for investors to have some diversification outside of U.S. real estate.
Investing in individual REIT companies for real estate passive income is also an option if you understand that investors are often their own worst enemies. You always need an investing strategy and a long-term outlook to avoid panic-selling in any stock investment.
Understand that REITs are different that other companies so they are not valued the same. Since depreciation is a very important part of a real estate business, but is removed from accounting income, the earnings per share (EPS) reported by REITs is not a valid measure. Instead of EPS, investors look at the company’s Funds from Operations (FFO) or adjusted FFO. The FFO is a more accurate measure of how the REIT is generating cash for shareholders.
The table below shows basic calculations for FFO and AFFO. While it can be overwhelming for new investors, it can be intuitive if you think about it. A REIT’s true operational performance is the money it makes including the benefit from depreciation but not including one-time things like selling its own properties. A word of warning, you’ll see the calculation for FFO stay pretty consistent though companies and analysts differ on how to calculate AFFO. When you’re comparing different companies, just make sure all the calculations methods are the same.
Once you’ve got a REIT’s FFO or AFFO, you can use it to value the company much like earnings are used for other companies. Dividing the price by FFO will tell you how “expensive” the shares are compared to other REITs. You can also compare the REIT’s growth in FFO over the years to make sure they are progressively growing funds.
Analyzing individual REITs can get just as complicated as with other stocks. If you are going to analyze and invest in individual companies, I would suggest putting some money in the ETF funds above as well. That will help diversify your investments while still giving you the chance for higher returns on your own analysis.
Risks in Real Estate Passive Income REITs
There are two primary risks with REIT investing, interest rates and property cycles. Both of these are not a problem for long-term investors who will see their investments grow and return cash over many rate- and property-cycles.
Since REITs pay out most of their cash to shareholders every year, they constantly have to take out loans for growth and operations. If interest rates are rising, that means higher interest expense that might eat into the amount of cash the company can generate. This effect is partially offset by a strengthening economy, usually happening at the same time as rate increases, which means stronger rental payments on real estate.
While real estate prices generally go up over time, it’s not always a steady upward climb. Prices for commercial real estate, the majority of REIT holdings, are going to rise and fall with the business cycle and the prospect for rent. On a long-term investment, the effect of falling prices in a downturn is going to be offset by rising prices in the recovery.
REITs are a great investment choice for real estate passive income but no single type of investment should be more than 25% of your total wealth. How much you have invested in REITs will depend on your age and need for current income as well as your investment risk tolerance.
Passive Income Potential: Real Estate Indirect Investing
Indirect investing in real estate results in slightly better passive income potential than direct investment. Investing in REITs is similar to income investing in dividend stocks for passive income while tax lien investing can take quite a bit more work.
Start-up costs are very low for REIT investment with some shares trading for less than $10 each. Costs for tax liens vary quite a bit. You’ll have to pay any liens you win immediately and will need to pay subsequent taxes due to keep your right to the property.
The time commitment for investing in REITs can be next to nothing if you just pick one of the diversified funds. Even a little more analysis of individual REITs can be done fairly quickly. The time you spend investing in tax liens could add up depending on how many properties you research and how far the foreclosure process goes for a lien you buy.
Income momentum is good for REIT investing because you can reinvest the dividends into more shares, earning money on your earnings. For tax lien investing, income momentum is not as good because the rate you earn is fixed when you buy the lien. You can reinvest the money you earn but it might be at a lower rate.
Continuity of income is generally good for REIT investing. Most of these companies are very large and cash flows are stable. There is always the possibility of bankruptcy, meaning stock investors would be wiped out. With REITs, there’s also the possibility that tax law changes will remove the advantages they enjoy which would cause stock prices to crash. This isn’t likely to happen because of the affect it would have on real estate prices.
Income continuity is poor for tax lien investing because you really don’t know when the lien will be paid off. Since most tax lien sales are held just once a year, you could be stuck holding the cash if your liens are paid quickly.
The scale below presents my passive income potential for indirect real estate investing. Each of four factors is scaled in reverse with 1 being the worst or the most unfavorable to a true passive income investment.
Overall, indirect real estate investing through REITs can be a great source of passive income though returns may not be as high as with direct real estate investing. Investing through tax liens offers better passive income potential than direct management of real estate but not as good as with REITs. Both indirect real estate strategies offer decent returns, though you need to pair the tax lien strategy with another to earn something on your money after the liens are paid.
My experience with tax liens is more than ten years old. I would love to get feedback from others that have tried the real estate passive income strategy more recently, especially in the low-rate environment. What kind of returns have you made and what tips would you give new investors?