Most people have a single source of income, which they generate from their job. This is their active income which they earn in exchange for their services. However, investors can generate a stable source of passive income in real estate. Through passive investing in commercial real estate, financial-minded investors can have multiple streams of income. Therefore, this steady cash flow can lead to long-term wealth creation and financial freedom.
What is passive income real estate investing?
Passive income investing is an automated strategy through which an investor can create an income stream without their active involvement in investment.
The term “passive income” is used in passive investments because the investor makes an upfront capital investment into a real estate venture. However, they do not have any direct role in its management.
Hence, the investor only receives a regular income from the investment in the form of dividends, rents, and so on.
So, real estate investors are keen on identifying multiple avenues of generating passive income in real estate.
The advent of real estate crowdfunding platforms, typically equity or debt-based investments, enables investors to invest in individual real estate deals along with a pool of investors. Besides, it is the most popular mode of passive income real estate investments.
In addition to this, Real Estate Investment Trusts (REITs), rental income from commercial real estate, and capital appreciation are also beneficial modes of generating passive income in real estate.
What is residual income?
Residual income refers to the income usually calculated monthly, that remains after the investor has paid all the debts and expenses.
People can create monthly cash flow from commercial real estate investments that will grow their residual income over time.
How to create passive income in real estate?
There are several ways for turning in passive income in real estate. Commercial real estate assets may include anything from multifamily assets, industrial warehouses, and office spaces to retail properties. These assets can build wealth and also appreciate income through favorable market situations, capital improvements made to the property, and efficient property management by the ownership.
Additionally, several investors may also appreciate their investment fully when they sell or refinance their assets.
Investors can also generate passive income when they rent out their commercial real estate assets and get monthly rental income. Also, if the investors want to ensure immediate stable cash flow, they can buy properties with quality tenants.
On the other hand, properties that require renovations can reduce the owner’s earnings. Therefore it can affect the investor’s monthly distributions.
There are different ways to generate passive income in real estate including:
1. Single-family units lead to a stable stream of passive income in real estate:
The most common way of creating passive income is to purchase a single home or condo and lease it out to a single tenant.
Read Lilypads’ blog on single-family rentals here.
2. Apartment buildings:
Apartment buildings are properties with five or more units. After taking a commercial mortgage, real estate investors Investors can purchase such assets. These properties are more profitable than single-family rentals since they have multiple tenants. Therefore, apartment buildings spread the risk of potential vacancies across various units and also provide better cash flow prospects.
3. Commercial real estate:
Investors can purchase commercial real estate assets and lease the commercial space to office, retail or industrial tenants. These properties are most profitable for earning higher rental income. So, the investor can use the rental income to make monthly payments on the mortgage.
Therefore, they can repay the loan and still retain residual income from commercial real estate assets. However, commercial tenants tend to highly customize the property to their business objectives. Hence, investors should plan for longer vacancies, as they have to remodel their spaces extensively between tenants.
4. Mixed-use developments:
Demands for mixed-use development projects have increased rapidly as they cater to residential, office, retail, industrial, and institutional tenants. So, investors can enjoy real estate income streams and lease lengths from a wide variety of tenants within a single property.
5. Self-storage facilities:
Self-storage facilities are experiencing high demand across the US with their relatively low per-unit cost. However, self-storage facilities typically require a management team. And, the owners of such spaces must bear security and insurance expenses.
6. Real estate investment trusts (REITs):
REITs offer individuals an opportunity to invest in the real estate sector while remaining completely passive. And, investors can earn a stable stream of passive income through the distribution of steady dividends by the Real Estate Investment Trusts.
Read Lilypads’ detailed blog on Real Estate Investment Trusts here.
7. Tax liens and deeds:
Investors have the opportunity to buy up tax lien properties, that the local Governments seize after the property owner fails to pay its taxes.
Read Lilypads’ blog on whether tax lien investing is profitable here.
8. Value add properties/ Property rehabs:
Fixing and flipping properties is a lucrative way of passive income real estate investing. When an investor buys distressed properties in high-demand locations and renovates them extensively, they add value to the asset.
So, they increase the value of the property which they can then lease out to quality tenants for market price rents.
Read Lilypads’ blog on the value-adding strategies for multifamily properties here.
Alternate investments that ensure a stable stream of passive income in real estate:
In addition to the aforementioned ways, real estate investors can opt for alternative investments for generating passive income in real estate. These include:
Real estate syndication: a group of investors who pool their funds to purchase a property.
Real estate investment trusts (REITs): REITs offer individuals an opportunity to invest in the real estate sector while remaining completely passive. And, investors can earn a stable stream of passive income through the distribution of steady dividends by the Real Estate Investment Trusts.
Read Lilypads’ blog on Real estate syndication here.
Targeted metrics to evaluate passive income in real estate
There are few available metrics for evaluating the potentiality of a real estate asset to generate passive income, that include:
1. Debt service coverage ratio (DSCR)
Credit Partners and Lenders use this metric to evaluate the borrowing investor’s ability to repay the loan. DSCR measures the net profits and cash flow an investment asset generates for paying its debt obligations.
2. Net operating income (NOI)
Net operating income is the annual income an investment property generates minus any expenditure related to operations, fees, or costs (this excludes depreciation, amortization, and interest).
3. Targeted Average cash-on-cash Return:
This metric is a popular rate of return in real estate transactions. Average cash on cash return calculates the cash income an investor earns in a year on the initial cash that they had invested for acquiring the asset.
So, while some investors target the same returns each year, some investors aim to predict more returns with increased net operating income.
4. Targeted Investor IRR:
IRR is the rate at which a real estate investment grows. This annualized return metric spreads your cash flow and equity return over the entire holding period. and incorporates a concept called the time value of money.
But, commercial real estate investments are illiquid. So, the investors can’t sell off your investment before the hold period is over.
However, IRR may not accurately reflect how much income the property generates each year.
5. Targeted Investor Equity Multiple:
Equity multiple measures the total cash distributions that an investor receives divided by the total initial equity investment.
However, it is noteworthy that riskier investments provide higher returns as opposed to safer, less risky investments that target low returns.
The Lilypads Bottomline: Real estate investors must focus to earn and re-invest passive income in real estate
In a nutshell, the investors seeking a future-proof and reliable method must focus on creating multiple avenues of passive income in real estate. Traditional methods like leasing of commercial real estate, single-family rentals, and others to alternative investments like crowdfunding and REITs, real estate offers several opportunities to an investor to utilize for generating passive income and building long-term wealth.