Most real estate can produce income. Combined with an increase in value, this income helps you earn a profit on your investment.
There are several ways to earn investment income in real estate. But the terminology used for different methods can be confusing. Here are four common terms for investment income depending on the type of investment:
|Type of Real Estate Investment Income||What It Means|
|Dividends||Payments from a real estate investment trust (REIT), stocks, bonds, or property owned by a corporation or partnership.|
|Net operating income (NOI)||The amount of money you make after expenses, vacancy, and other costs, but before the mortgage is paid, on an income-producing property.|
|Passive income||Income paid by a REIT or tangible asset, which pays you in the form of dividends or rent, even when you're not working on it or maintaining it.|
|Cash flow||The difference between the rent paid to you and your expenses or costs for maintaining and owning an asset. This is after the mortgage is paid and what you actually get in your pocket.|
What’s the difference between investment income and a capital gain?
Investment income is cash flow or profits produced on a recurring basis during the time you own the property.
A capital gain is calculated when you sell an asset. You start with the sale price and subtract your cost basis in the property. Your cost basis is the purchase price plus expenses and costs during the ownership period.
How to create investment income
There are many ways that you can create investment income from real estate. But these are three of the most popular.
Buy into a real estate investment trust (REIT)
There are different REITs for different asset classes. There are also mortgage REITs, which buy mortgages secured by real estate. REITs are required to pay at least 90% of their net investment income as dividends. There are other special conditions for REITs, too.
These dividends can add up to a pretty penny. When you factor in dividends, the average annual return for REITs over the past 20 years is 10.3%. That trumps the return you could expect if you bought and leveraged an individual property in most regions.
Dividends are usually paid on a quarterly basis, providing income throughout the year. Unlike other investment returns, REIT dividends are taxed as ordinary income. Some also charge high management and administration fees that eat into overall profits and return on investment.
Purchase a rental property
You can create regular investment income through the purchase of an income-producing property. It might be a single-family detached home, apartment building, industrial warehouse, or even a storefront.
Whether you buy this property with a mortgage or cash, do your due diligence and conduct a financial evaluation. Rents need to be high enough to cover vacancies and expenses and still provide you with income.
To be successful, you’ll need to know what you’re getting into. That means buying the rental property at the right price, with the right financing, and understanding your rental market so you don’t lose money.
Along the way, keep account of all your costs and expenses and add them to your cost basis when you sell. This keeps your tax liability on capital gains as low as possible.
Buy into a crowdfunded real estate deal
Title III of the JOBS Act lets companies raise capital through online crowdfunding. That includes real estate developers. And, importantly, non-accredited investors can buy into some of those deals.
Crowdfunding has a few stipulations, including limitations on how much you can invest in a 12-month span. If your income or net worth is below $107,000, the limit is:
- the greater of $2,200 or
- 5% of the lesser of the annual income or net worth.
If both your income and net worth are at least $107,000, the limit is 10% of your annual income or net worth, whichever is less, up to $107,000.
Before you sign on, do some research to understand how you’ll make money. Is it an annualized return, a single cash-out, or through dividends? Fees charged by crowdfunding platforms can reduce your income and profits, so make sure to examine the offering documents carefully and understand the fees you'll pay.
There are many real estate crowdfunding sites to choose from with varying barriers to entry and niches. Some offer direct investment into individual deals, while others offer public non-traded REITs -- also known as eREITs -- that allow you to invest in a portfolio of properties.
Real estate crowdfunding sites backed by venture capital are under pressure to quickly show viability, progress, and income. Given that they're still new, you need to be cautious and choosy with your investments.
Just because your crowdfunded deal is publicly available doesn’t mean it's been properly or thoroughly vetted by the platform. It’s still on the individual investor to conduct his or her own due diligence. Make sure you understand the deal’s opportunities and potential downsides.
If the project requires an extensive fix-and-flip, it could go south if repairs go over budget or the developer over-leverages it with debt.
Just like with any other investment, it’s a good idea to diversify your crowdfunded holdings and expect to keep them a while.