This article is part of our larger real estate investing guide available here.
There are many benefit available in real estate investments – among them for many investors is the unique ability to earn returns through both income and appreciation. In some instances, real estate investments can earn income and appreciate in value simultaneously. The ways in which real estate investments can earn these returns – and how investors can receive the returns – can vary by investment. In this article, we’ll explore the fundamentals of how real estate investments can earn money from different investment structures.
- Debt and Equity
- How Real Estate Investments Earn Income
- How Real Estate Investments Earn Appreciation
- Evaluating Your Options
Real estate investments break down into two broad categories: debt and equity. Let’s first look at the differences between these two types of investments to begin to understand how returns are structured in the form of income or appreciation.
- Debt: Under a real estate loan, an investor lends money to a borrower (typically a buyer or real estate developer). The investor earns income for the duration of the loan usually at a fixed rate following a schedule of regular interest payments on the loan principal. A debt investment is typically less risky than an equity investment, but there are several factors that impact how risky each individual investment can be, as discussed below.
- Equity: An equity investment gives an investor ownership of a physical property. An equity investment entitles the investor to a claim on money earned from any appreciation earned by the asset when it’s sold. Appreciation returns are usually realized in a one-time payment, in the form of capital gains. An equity investment also gives an investor the ability to earn regular income from rental payments for the lifetime of the investment typically on a monthly basis. While equity investments enable investors to earn both income and appreciation, they’re often riskier than debt investments as we discuss below.
With this understanding, let’s now explore how real estate investments can earn income through both debt and equity investments.
How Real Estate Investments Earn Income
As we’ve established, both debt and equity investments are capable of earning consistent income. Income can only be earned while an investor owns their investment. Unlike appreciation, there’s no need to sell an investment to earn income from it. In fact, ownership is what entitles an investor to collect income earned from their income-producing assets.
Let’s first examine how income generation most commonly works for real estate debt investments.
Income from Loan Interest Payments
A real estate loan investment is an arrangement in which an investor lends money to a buyer or developer who then pays interest on the principal lent. An investor earns a return in the form of income from the interest payment while the loan is repaid. Payments are often made on a monthly basis making them an appealing investment option for those seeking “passive” or “residual” income.
Debt investments can only earn income, but they offer the advantage of lower risk than equity investments do thanks to their base position of within the capital stack.
Debt holds the most senior position within the capital stack as the “base.” This means that it has the highest priority of repayment. Debt investors receive their principal plus interest before an equity investor can realize any returns (apart from rental income potential). For example, if an owner sells their property while there is a loan open for it, they must repay that loan in full to the lender before they are able to keep any returns from the appreciation for themselves.
Within the debt tranche of the capital stack, there’s a further division of seniority among the types of debt which determines loan repayment priority. Senior debt is unsurprisingly the most senior and therefore has the highest repayment priority. It’s followed by junior debt and mezzanine debt, and then the equity portion of the capital stack.
In addition to seniority, debt real estate investments can be secured or unsecured. An investor with a secured debt investment has the right to foreclose on a property in the event of loan default to recoup the value of their loan. Senior debt investments are typically secured positions, and other debt investments may be secured, but the terms can vary by investment.
Investing in Real Estate Loans
Real estate loans are usually made in substantially large amounts, which often limits them to funds and institutional investors who are capable of lending large sums of money for long periods of time. Accredited investors can access real estate debt investments through a private equity fund, but most individual investors are only able to access debt real estate investments through a fund such as a real estate mutual fund, real estate investment trust (REIT), or investment platform, such as Fundrise. Some investment options focus mostly or exclusively on debt investments. For example, the Fundrise Supplemental Income Plan is allocated primarily to debt investments, selected for their ability to earn consistent income.
Some investment methods offer tax benefits for income-based returns. For example, REIT investors can pay taxes only on the individual level rather than the fund level, removing the potential for double taxation (as long as the fund qualifies as a REIT). Also, as of 2018, income earned and distributed by REITs and real estate mutual funds may qualify for up to a 20% tax deduction thanks to regulation changes governing qualifying business income under the Tax Cuts and Jobs Acts.
Income from Rental Payments
Equity investments can also generate their own income stream using rental payments. Traditional, or common, equity ownership gives investors the right to lease the property to tenants to earn income through rental payments. There are a few key differences between debt and equity investment that affect income potential for each one.
Unlike a debt investment, which generally has a fixed rate of return over a defined lifetime, an equity investment generates rental income that can change over time, growing or shrinking in relation to market demand. Income potential is also based on occupancy rates, which can also vary for any given property. This means that equity investors may incur more risk to earn income, but they also have the potential to earn a higher rate of return.
Also, common equity investments don’t usually have pre-defined periods of ownership and can last indefinitely, giving an investor the ability to earn income until the property is sold. Real estate is a long-term investment, especially for equity investments, which gives investors the ability to earn significant income over time on a monthly basis.
Common equity ownership offers rental income potential, while preferred equity investments offer cash flow in a way that’s more similar to debt investments. Like a loan interest payment, preferred equity investments offer a fixed rate of return commonly referred to as “preferred return.” Due to its middle position in the capital stack, preferred equity investments receive payments until they’ve reached the agreed rate of preferred return after all debt investments have been repaid and before common equity investors receive their return.
Investing in Real Estate Equity Investments for Income
Common equity investments are easier to access than debt investments. Individual investors can buy an investment property and manage it on their own. However, due to the high sums of money, knowledge, and time commitment required for direct investment, individual investors are often limited in the number and types of properties that they can buy — and manage — on their own.
As with debt investments, pooled-fund investment options, such as mutual funds, REITs, and investment platforms, offer a way to invest smaller sums of money across several assets and asset types. Private equity funds are also available to accredited investors. While it’s more feasible for an individual investor to invest in a single-family home or duplex, a fund can give an investor access to investments across a wide range of commercial real estate in multiple locations at a fraction of the dollar investment size.
How Real Estate Investments Earn Appreciation
Real estate has the distinctive ability to earn income and appreciation. An equity investor can earn a consistent income from rent payments while the property itself appreciates. When the property is sold, an investor can sell their investment and capture any property value appreciation in the form of capital gains in addition to any income already earned throughout the holding period of the investment.
Like rental income, property value can change with demand. While a debt investment can be structured to guarantee a certain rate of return, an equity investment’s reliance on the market makes it riskier. But, by the same token, it also means that an equity investment offers higher return potential. Appreciation potential can be substantial or meager depending on many factors, which makes it crucial for the investor to have the acumen necessary to choose investments wisely.
Real estate is a long-term investment typically lasting at least five years. Unlike stocks, appreciation for many properties is maximized over the course of several years, with value gains generally occurring at a slower rate. Although real estate may appreciate more slowly, property values are also less volatile with lower and fewer daily fluctuations in value in comparison to most, if not all stocks.
Investing in Real Estate Equity Investments for Appreciation
As we’ve already discussed, there are several ways to invest in real estate equity investments, including direct investment, mutual funds, REITs, and investment platforms. The investment vehicle used to invest in an equity investment impacts how an investor receives their return as well as how and when it is taxed.
For example, an investor with a direct investment can collect their capital gains directly from the sale of an investment. On the other hand, an investor with an investment through a fund may realize appreciation from the sale of a property through a fund distribution or through an increase in the value of the shares that they own. Each option brings its own advantages and disadvantages, which can make each option more or less preferable for an investor, depending on their financial goals and resources.
Regardless of how you invest in real estate, at some point, a rigorous underwriting process, which evaluates the aspects of a potential investment property, is key. If you’re investing independently, the onus for that underwriting process will fall on your shoulders, whereas, if you’re investing through a fund or platform like Fundrise, a team of experienced real estate professionals will handle the evaluation on your behalf. No matter who performs the underwriting, this due diligence process plays a vital role in determining whether an investment opportunity is financially sound.
Evaluating Your Options
Because real estate is typically a long-term commitment, it’s important to choose the right option that fits with your financial goals. When chosen well, it can become a useful source of consistent income in your investment portfolio. And with a track record of long-term appreciation, it also offers the opportunity to capture capital gains in addition to income. In fact, those who have invested in real estate have historically outperformed those who haven’t.
Fundrise offers a way to invest in a diversified portfolio of real estate according to your goals. The Supplemental Income Plan is designed to invest primarily income-generating real estate investments, while the Balanced Income Plan aims at investing in a mixture of income-generating and growth-oriented real estate investments, and the Long-Term Growth Plan is intended to invest primarily growth-oriented real estate.