How to create residual income in real estate?

residual income in real estate
residual income in real estate

Most people rely on their salaried income for their living. However, savvy investors aim for creating additional streams of residual income through real estate investments. In this blog, we will discuss how investors can create residual income in real estate besides their linear income.

What is Residual Income?

Residual income is the amount of net income generated in excess of the minimum rate of return. So, it is the level of income that an individual has after deducting all personal debts and expenses.

Residual income is also a number that banks calculate when determining whether applicants can afford a mortgage. For calculating residual income the bank determines the applicant’s income and then subtracts the anticipated mortgage, property insurance, and taxes. But, residual income does not take into consideration food and utility expenses.

The remaining amount after the subtractions is considered the residual income. In an equity valuation, residual income is an economic earnings stream and valuation method for estimating the value of a stock. 

How can you earn Residual Income in real estate?

There are various ways for investors to create residual income streams. The most well-known way of generating residual income is through ownership of stock in a publicly-traded company. Residual income streams can also include things like royalties from the sale of a book. 

A lucrative asset class, real estate – both residential and commercial – has become the most popular way to produce residual income. Generally, through real estate investing you can build a residual income stream with a large upfront investment of both time and money. But nowadays new investment vehicles help in earning passive income with several options.

Read Lilypads’ blog on how to generate passive income in real estate here.

Different ways to create Residual Income in Real Estate

The various ways to create Residual Income in real estate are as follows:

1. Investment Properties

An investment property is an asset purchased with the purpose of earning revenue. Income is obtained from investment property through leasing space within an asset or an eventual sale of the asset. For example, this consists of a commercial rental property where businesses lease office space or an apartment building where tenants rent it for living purposes. 

Having an investment property results in both potential appreciation value over the long-term and direct tax benefits of depreciation. However, acquiring an investment property often requires large capital and lots of hands-on work. An investment property carries the risk of large, unexpected, and costly liabilities, which many investors do not experience or handle effectively. An investment property is illiquid, it means you can sell it at any time. 

2. Private Equity Funds: 

A private equity fund is a collective investment fund that pools the money of investors for investing in real estate. Private equity funds consist of several investment options which help in diversifying the portfolio. Private equity fund managers are experts in employing rigorous due diligence and underwriting standards.

Generally, private equity fund investments are illiquid and require high investments. These are often formed by institutional investors and high-net-worth individuals and carry a “two and twenty” fee structure, which means a 2% annual investment management fee, and 20% of any profits earned by the fund.

3. Real Estate Investment Trusts (REITs): 

 In 1960, Congress passed a law creating Real Estate Investment Trusts (REITs), having a large portfolio of income-producing real estate investments. A REIT distributes 90% of its earnings to investors each year. Today approximately 70 million Americans invest in REITs.

Due to its special tax features, REITs follow strict compliance standards and thus carry a certain quality standard for both the real estate and the vehicle’s investment strategy of the managing team.

REITs are of two types: traded and non-traded.

Publicly-traded REITs offer the benefits of liquidity because it is openly traded on a stock exchange. This liquidity is likely to be priced into the value of the shares, which results in a “liquidity premium”, or a cost that all investors pay while buying or selling the asset. The liquidity premium results in lower relative returns for all investors, regardless of whether or not they choose to sell their shares.

Also, traded REITs tend to be in relation to broader market volatility, which means the share value fluctuates depending on the ups and downs of the stock market regardless of whether or not anything has changed with the underlying properties owned by the REIT. 

On the other hand, non-traded REITs are more popular due to their double-digit dividends. Also, non-traded REITs have recently come under heavy scrutiny because of the large fees often charged to investors and dubious practices around the disclosure of those fees.

Regardless of which investment strategy you decide to pursue to earn residual income, an essential part of the investment process is the careful due diligence of each opportunity as it arises and working hard to remove any pre-existing biases. So, before moving forward take your time and find out the correct approach, and carefully calculate your residual income goals. 

While using different asset classes diversification is one of the most effective processes to build stable and viable streams of residual income and a profitable portfolio.

Be smart while choosing residual income

While choosing the program and types of investments you have to be smart enough. Before purchasing investment property be sure to research and use state and local incentive programs. Always go through HUD and pre-closure options, which allow you to purchase your first property at a considerable discount. 

You must consult with your accountant to ensure you are up-to-speed on tax benefits. This is because tax advantages are one of the positive benefits that come with investing in real estate. 

Identify the manager of your property

The premise of residual income is that you have little to no work to put in after the initial investment. If you choose REITs or PE funds, then you are all set. But if you choose investment properties then you have to be concerned about a few things. These include questions about rent collection and tenant issue management.

So from the initial stages itself, you have to sort property management. Will you do it by yourself or will you hire a property manager? Before evaluating your investment options you have to calculate the costs of every necessary issue. 

The Lilypads Bottomline

So the most important aspect of investing in real estate to pursue earning residual income is the calculation and evaluation of every opportunity that comes your way. You have to figure out the appropriate approach which makes the most sense for your situation and come up with residual income goals that are attainable. Diversification into different types of assets is one of the most efficient ways to build a portfolio that will bring in the residual income you desire.