If you don't find a way to make money while you sleep, you will work until you die.
This quote from Warren Buffett clearly lays out why investing is so important: passive income is the key to an early retirement and living life on your terms. The more passive income you generate, the more freedom you have.
Real estate is a popular path to financial independence and early retirement as it offers the advantages of always being in demand, being relatively disruption-proof, being inflation-resistant, and easily leveraged (thereby juicing the cash flow yields).
For investors wanting to pursue financial independence and early retirement through real estate, there are three main options:
This is a popular strategy and certainly has its perks. After all, investing in something tangible that you can see and touch and call fully your own has a certain allure to it. Furthermore, for highly entrepreneurial investors who have a passion for real estate and want to put time and energy into it, investing in individual properties like this could lead to the most upside.
However, it also has its drawbacks. First and foremost, mortgage rates are soaring and residential real estate prices are sky high. As a result, buying rental properties in the current environment offers a less-than-ideal risk-reward proposition. Second, it's very difficult to get sufficient diversification investing in this manner unless you already have millions of dollars because real estate is expensive.
Third, real estate ownership is more akin to operating a business than a truly passive investment as landlords have to deal with the infamous triple Ts:
If you want to make it more passive, you will need to hire a property manager, which will typically cost you ~8% of monthly rents. This can seriously eat into profit margins - especially if the property is heavily leveraged - while also not fully mitigating the time and hassle of rental property investing as it still will require a degree of active management on your part.
Another popular option is to simply invest savings into real estate investment trust (i.e., "REIT") funds like ETFs and CEFS. The most popular REIT fund is the Vanguard Real Estate ETF (NYSEARCA:VNQ).
VNQ has a lot going for it:
Performance comes and goes, but fees are forever.
By investing in a broadly diversified fund with minimal fees like VNQ, passive investors who can invest consistently and hold for the long-term set themselves up to achieve very solid long-term total returns and see their passive income compound at a solid clip with minimal risk of suffering long-term underperformance.
While investing in REIT funds like VNQ is also a proven technique for compounding wealth over the long term and is truly passive, it also faces two key challenges in today's environment:
1. The VNQ - similar to rental real estate - is trading near all-time highs today. As a result, the risk-reward at current levels is less than ideal and could lead to disappointing total returns over the next five to 10 years, especially with interest rates (and mortgage rates in particular) rising.
2. Its trailing twelve month dividend yield is a meager 2.76%. While that income stream is likely much safer than that offered by a small rental property portfolio given its immense diversification benefits and is also entirely passive, generating enough passive income to live off of from such a low yield is likely going to be a bit challenging.
As a result, a third option - which we ourselves pursue - is to invest in individual REITs. While this does require a bit more work and involves a little bit more risk than merely investing in a broadly diversified passive index, it's still far easier and lower risk than buying individual rental properties.
Additionally, it provides us with the following advantages that - to us - make it the most attractive risk-adjusted option for investing in real estate for passive income:
While real estate in general is a proven and popular method for achieving financial independence and retiring early, the most commonly beaten paths - buying rental properties and investing in passive index funds like VNQ - are not nearly as opportunistic today due to elevated valuations and lower yields.
However, opportunity still exists for those willing to venture into the world of picking individual REITs. By building a portfolio of ~20-30 high-yield stocks - including REITs - investors position themselves to not only achieve their passive income goals faster, but even outperform the market in terms of total returns:
... and currently offer dividend yields that are nearly twice what's offered by VNQ. Meanwhile, they have broadly diversified portfolios of quality real estate, are led by world-class management teams, have investment grade balance sheets, and enjoy very conservative recession-resistant long-term lease structures on their properties. By building an intelligently diversified portfolio of individuals high yield stocks that include the likes of these two REITs, we're able to generate a weighted average dividend yield north of 5% while more than doubling the total return performance of VNQ since inception.
This means that we will get to our passive income target twice as fast as we would if we were investing in VNQ and also enjoy greater total returns along the way without taking on meaningfully greater downside risk.
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This article was written by
Samuel Smith is Vice President at Leonberg Capital and manages the High Yield Investor Seeking Alpha Marketplace Service.
Samuel is a Professional Engineer and Project Management Professional by training and holds a B.S. in Civil Engineering and Mathematics from the United States Military Academy at West Point. He is a former Army officer, land development project engineer, and lead investment analyst at Sure Dividend.
Disclosure: I/we have a beneficial long position in the shares of STOR, WPC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.