Most people earn a living based on the work that they produce – every day they perform work and then every few weeks or so they get a paycheck. When they stop working the paychecks stop and they are left with whatever money they may have saved during that time. This is called active income.
Some people are fortunate enough to create residual income streams. Residual income (also known as passive or recurring income) refers to income that you continue to earn even after the work required is done.
How can you earn residual income?
When given the option, most of us would much prefer to continue to reap the benefits of our work even after we’re done. Why then do the majority of people support themselves only through active income?
One answer is that most people assume the ability to earn residual income is a luxury that can only be created if you are very wealthy. However, there are many ways to create residual income streams regardless of net worth.
One of the most well known forms of residual income is owning stock in a publicly traded company. Residual income streams can also include things like royalties from the sale of a book or song. Today there are also several online platforms like Lending Club or Prosper that allow you to invest in personal or small business loans.
A notoriously lucrative asset class, real estate—both residential and commercial—has become one of the most popular ways to secure residual income. Traditionally, building a residual income stream through real estate has required a large upfront investment, both of time and money, but thanks to new investment vehicles those interested in earning passive income through real estate have several options to choose from.
Different Ways to Build Residual Income through Real Estate
An investment property is an asset purchased with the sole purpose of earning revenue. Income from an investment property can be generated through leasing space within an asset or an eventual sale.
Owning an investment property can result in both potential appreciation value over the long-term and direct tax benefits of depreciation. However, acquiring an investment property often requires a large upfront investment ($100K to several million dollars depending on the type of asset) and lots of hands on work. Furthermore, as with any investment, investment properties carry the risk of large, unexpected, and costly problems, which many investors do not have the experience or time to effectively handle. An investment property is relatively illiquid—meaning you can sell at any time, but the sale process can often take months and may be unsuccessful.
Private Equity Funds
A private equity (PE) fund is a collective investment fund that pools the money of many investors to invest in real estate. Private equity funds often consist of several different investments, which increases diversification for investors. Additionally, PE funds are often managed by real estate experts with very rigorous underwriting standards.
Traditionally private equity fund investments are illiquid and carry high investment minimums. Private equity funds are often formed by institutional investors and high worth individuals with a “two and twenty” fee structure, meaning a 2% annual asset management fee, and 20% of any profits earned by the fund.
Real Estate Investment Trusts (REITs)
In 1960, Congress passed a law creating Real Estate Investment Trusts (REITs), large portfolios of income-producing real estate. A REIT is required by law to distribute 90% of its earnings to investors each year. Today, an estimated 70 million Americans invest in REITs.
Due to their special tax status, REITs must follow strict compliance standards and thus carry a certain quality standard for both the vehicle’s investment strategy and the real estate experience of the managing team.
There are two primary types of public REITs: traded and non-traded. Traded REITs offer the benefits of being traded openly on an exchange, giving investors liquidity. However this liquidity is likely to be priced into the value of the shares, resulting in a “liquidity premium”, or lower relative returns for all investors, regardless of whether or not they choose to sell their shares. Furthermore, traded REITs tend to be correlated to broader market volatility, meaning that the value may fluctuate depending on how the stock market is doing, regardless of whether or not anything has changed with the underlying properties owned by the REIT.
On the other hand, non-traded REITs have become more popular because of the perceived consistent double-digit dividends. However, non-traded REITs have recently come under heavy scrutiny because of the large upfront fees often charged to investors—and dubious practices around the disclosure of those fees.
New Technology Platforms
In the past few years, new platforms have emerged that use technology to make the process of real estate investment more efficient, resulting in increased transparency, lower fees, and higher returns. As the broader financial technology (FinTech) space grows, more and more investors are moving to online platforms that give them more control over their finances and take advantage of the efficiencies that transacting on the web can offer.
These companies aim to offer the benefits of public market access, but with lower fees that potentially help investors earn better returns. Fundrise, one of the pioneers in the space, has leveraged both technology and new federal regulations to offer investors the first ever low-fee, diversified commercial real estate investment available directly online to anyone in the United States, no matter their net worth.¹
However, it’s important to remember that every platform uses a different set of due diligence criteria to determine what investments it offers its members and, as with any investment, investing in real estate through an online platform carries significant risk.
Regardless of which avenue you decide to pursue to earn residual income, an essential part of the investment process is careful calculation and evaluation of each opportunity as it arises and working hard to remove any preexisting biases. Take your time to figure out which approach makes the most sense for you, and carefully calculate your residual income goals. Remember that diversification into different asset classes is one of the most effective ways to build unique streams of residual income, and a profitable portfolio!