The average person tends to only think about the income you earn from your labor.
You exchange time (and probably some blood, sweat, and tears along the way) for your pay.
Then, at the end of the day, you try to enjoy your money, buying things or experiences that make you happy, but never really earning true wealth and financial freedom, even if you have a high income.
You’re back at it the next day to earn back the money you’re spending trying to keep yourself both alive and happy.
Even if you enjoy your job, it’s not exactly what we’d all choose to do, day-in and day-out, if we had total control over our lives.
As if to add insult to injury, the salaried income you earn from your career is taxed to oblivion by the government.
For many reasons, one of the main ones being to stimulate investment in the economy, money made through your investments is taxed more favorably than the money you earn from your main job.
When you put all that out in front of you, it’s kind of crazy to not look for some kind of alternative way to earn income, right?
As you may have guessed, the answer to your prayers is through real estate investments.
Not just any real estate investments, mind you — we’re talking about passive investments today.
I know you aren’t trying to exchange your current job for a new job as a landlord. If you’re good at your job, that would probably be a downgrade.
The key is to partner with a real estate investment group that will allow you to reap all the benefits of real estate investing, without having to do all of the work yourself.
By investing into real estate syndications, you can boost your passive earnings until you are earning the same or more than you are at your job.
How it All Started
You might be thinking, “this is too good to be true.
If this is an option, then why aren’t more people working towards this as their goal?
Why have I never heard about passive real estate investing before?”
The problem lies in our school system.
This is a hotly-debated topic and we are real estate investors, so we won’t go too deep down the rabbit hole, but the problem started way back in 1800’s when education reformer Horace Mann brought the Prussian “factory model” of education to the United States.
The purpose of these schools? To create the ideal factory worker.
Public awareness of the fact that our school system arose from a model to churn out industrial revolution-era workers has risen in the past forty years and it’s certainly not true today that the goal of our schools is to create mindless worker drones.
I think the legacy of that system still lives on in our schools, however.
The assumption is that the average person will work for someone else higher up in the social-financial hierarchy than themselves, exchanging their labor and time for money and being taxed heavily in the process (as we mentioned above).
To put it in real world terms, let’s take a look at a typical high-earning career that people think is the ticket to the good life.
Let’s say you’re a single radiologist making $425,000 a year. You’re firmly nestled in the top 1% earners of society, so your life must be all peaches and cream, right?
The brutal reality, even as someone earning better than 99% of society, is that you’re still burning away the one resource you can never earn back, no matter how hard you work or how talented you are: your time.
You still have decades ahead of you that involve you sacrificing yourself every work day.
Worse still, since it’s actively earned income, you’re going to get hammered over the head by the government through taxation.
Say goodbye to 40% of your income – in this example a painful $170,000.
Well, what can you do, right? It’s taxes — everyone pays them.
You might not even give much thought to how much you’re paying, thinking it’s something that’s out of your control.
Not so fast: it’s even more painful if you put a little thought into the issue. If you had earned $425,000 that year through your passive investments, you would end up paying only $85,000 in taxes.
Let’s break this down here –
We’re looking at a situation where in scenario A, you toil away working each year, sacrificing your time and vitality in the process.
In scenario B, you’re kicking back and earning passive money from your investments, yet paying HALF the taxes of scenario A.
Which one would you choose?
Turn Today’s Active Income into Tomorrow’s Passive Income
Alright, this all sounds great, how do we get started?
Well, don’t quit your job just yet – you still need your active income to serve as the bridge to the promised land of passive income.
You’ll need the initial funds to invest in order to build your earnings up to the point where your passive income matches your active income.
Also, remember that this isn’t about rushing to the finish line and then sitting on the couch for the rest of your life.
Human beings gain fulfillment from work and most of our investors that are knocking it out of the park in passive income still maintain careers of their own.
It’s really all about freedom and doing things that make your life feel worthwhile. It might be that you just want to work less, not quit working entirely.
Perhaps you’re building passive income as a safety cushion for you – when the day comes and you want to retire, you already have that stream in place.
Maybe you just want additional stability so you feel you aren’t reliant on working to earn a living.
Of course, if you are looking for an early retirement, you’re asking all the right questions.
If you’re anything like me…
You grew up hearing that the path to success in life was working hard every day..
Doing well enough in school so you can be hired by a good company..
And then squirreling away little bits of your salary for several decades…
So you have the possibility of maybe not working when you’re a senior citizen?
There never seemed to be much of a lesson regarding investing or how to earn money passively to provide extra stability.
If that school of hard knocks life is what you’re after, by all means enjoy.
I’m going to go out on a limb here and assume that most people reading this are after financial freedom.
You want to break free from the chains of your career by having passive income streams in place that are enough to live off of.
Your choice to work is just that — a choice, rather than a necessity.
Once you have your passive income streams in place through real estate syndications, you’re going to fall in love with your set-it-and-forget-it cash infusions that arrive in your mailbox (or bank account) every month.
It’s what allowed me and my partners to completely change our lives – the power of passive income.
Once you’ve invested in several offerings, you will have several passive income streams, all independently working to push dollars into your wallet.
You could travel the world and live the high life, all the while without any possibility of your income being cut off completely due to losing your job.
You aren’t reliant on that anymore!
Why Real Estate?
The next question likely to be on your mind is: why real estate? Most people invest in the stock market and those guys on Wall Street seem to do pretty well for themselves.
First and foremost, you’re going to be getting better returns through real estate than the stock market.
We’re not done yet, though. Within the asset classes of real estate, our focus is on apartment buildings (also referred to as multifamily properties within the industry).
Multifamily properties are an extremely stable investment, in stark contrast to the volatility in the stock market.
As you can see in the graph, during the dog days of the great recession, delinquencies in single family loans spiked through the roof, but there was barely a blip in the radar for multifamily delinquencies.
Beyond the returns and the stability, you have to also look at this in practical terms.
Stocks can be bought and sold easily due to their liquidity, but you don’t receive regular cash flow from stocks.
It’s a constant game of buy and sell if you want to tap into your earnings.
With real estate, your income stream is constantly flowing due to the regular cash flow.
With a stock, the most you can hope for is that the price goes up.
With real estate, you have the potential for the price to go up through appreciation, while ALSO benefiting from the power of cash flow.
Whatever you’re making in your current career, a wise goal is to surpass that amount in passive income.
That’s the level at which your passive funds are actually doing more for you than the fruits of your active labor.
Everyone has different goals; going on multiple vacations a year, spending more time with your family, or simply working less.
Passive income is what you need to achieve these goals.
Components of Passive Income
Okay, we’ve decided that the money we earn from our careers is not going to get us to where we want to be.
Next, we need to break down the components of the passive income game plan:
- Set a goal of getting involved with passive investments until you have surpassed the income from your career.
- Invest in assets that have a long term trend of appreciating over time, such as physical buildings.
- Invest in assets that have longevity and stability with minimal chance of becoming obsolescent.
One of the reasons real estate is so powerful is because it’s not going anywhere. There’s no new invention that will replace the human need for shelter.
That’s why multifamily investing is a great choice for pretty much everyone.
Housing is one of the oldest byproducts of the human economy and will continue being a vital piece of human society, presumably, for as long as we exist.
Demographic trends make the allure of multifamily housing even more tempting to the investor who is paying attention.
The United States has historically been a majority-renter nation, like many parts of Europe.
This changed, largely due to policy reasons, in the post-war era, but things are beginning to revert to the historical norm.
We’re on the verge of a drastic reduction in home ownership rates over the next thirty years, which will means millions of new renters looking to live in multifamily properties.
This is further reflected in the generational differences in home ownership rate. Millenials are now the largest generation in the United States, even larger than the baby boomer generation.
For a variety of reasons, which range from oversized student loan burdens to simple lifestyle preferences, this generation has far lower rates of home ownership than the generations that preceded it.
New renters have already begun to flood the market due to these forces.
Expect to see more and more interest in the multifamily space in the coming years as more investors catch on.
Current estimates predict that the amount of new rental households entering the United States market will exceed ten million over the next decade.
So How Do I Create Passive Income from Real Estate?
Even if you’ve never put a penny in real estate, stocks, or any other kind of investment vehicle, you’re already an investor in my eyes.
You’re just a time investor rather than a financial investor.
Every week you go to work and collect your paycheck at the week’s end, you’ve already made a pretty hefty investment.
What are we talking here, 40-60 hours a week that you can never get back?
You’ve invested it into your job for the sake of earning some money.
What we want to do is get out of the habit of using time for your investments.
You want to instead use money, which can multiply itself, as opposed to time, which can only be lost in exchange for something else.
It’s funny how many of our first time investors had mounds of cash just collecting dust in their bank account.
It’s great to have reserves, of course, but if your money is just languishing away like that, you’re really doing yourself a disservice.
You need to put that money to work for you, so you can work less!
If you don’t, you’re actually doing something even worse than you think. You’re not letting your money lie dormant – you’re actually losing money due to inflation.
That’s why if you fit this description, it really behooves you to put some thought into how you can invest your money into cash flowing assets like multifamily real estate.
5 Step Game Plan for Passive Real Estate Investing
1. Get Started:
The first step is to actually take that first step.
Have you ever heard of the term “analysis paralysis?”
If you’re anything like me, you’ve experienced this many times over the course of your life.
You get introduced to an exciting new concept or methodology, but never really make any forward movement because all you do is analyze and prepare, but never execute.
I tend to look at it is a good sign when someone likes to be overly prepared. It shows you are a conscientious person who is trying to actually do a good job.
There’s no denying that this personality trait can be a double-edged sword, however. It will often prevent you from ever getting up and doing the thing you’re spending so much time researching and preparing for.
The key is self awareness – if you keep in touch with yourself, you can catch yourself in the act of analysis paralysis and break free.
Remain focused on the fact that you need to commit to real progress, rather than just think about doing so.
2. Erect Your Four Pillars of Real Estate:
Real estate investing provides four channels of wealth production that I like to call the Four Pillars.
Pillar One – Cash Flow:
This is what makes people fall in love with real estate. After paying all expenses and debt service on the property, what’s left is sweet, sweet cash flow.
If a real estate deal isn’t cash flowing, it’s a dead deal.
This is one of the things beginners and old hats alike tune in to, and for good reason.
You’re going to need to be producing enough cash flow from your investments to surpass your annual income to reach true financial freedom.
Pillar Two – Appreciation:
This is when a property’s value goes up as time passes.
Property values can also go down, of course, but the average real estate investment in the United States has historically appreciated over the long term.
You don’t have to rely on market forces in order for your properties to appreciate, however.
The strategy we use for all of our investments is to force appreciation. We purchase what are known as “value-add” properties.
These are properties that are already occupied and cash flowing, but could be improved further by someone with the right experience.
The property will likely need some light work and the rental rates will typically be below the market average.
What this involves is slowly improving the property over the course of your ownership.
What improvements are necessary will vary from property to property, but usually include exterior improvements and renovating the units as they turn over.
That way, by year three of your ownership, you can bring the rents up to the market rate, greatly improving your net operating income.
This allows you to force the property to appreciate because commercial properties are valued based on a combination of the net operating income and the capitalization rate for the market the property is located in.
To see how this works, let’s first define the two terms.
Your net operating income is simply your total rental income for the year minus any expenses involved with running the property. You do not subtract your mortgage payments from this amount.
Net Operating Income = Total Annual Rent – Total Annual Expenses
The capitalization rate, also known as cap rate, is extremely important for valuing commercial real estate.
This is the annual return that the property will produce based on the net operating income.
Cap rates vary by asset type and from market to market and are based on the going rate for a particular region.
A property with a lower cap rate will be more expensive per dollar of NOI, whereas higher cap rate properties are comparatively more affordable per income dollar.
Generally speaking, the lower cap rate markets are viewed as more stable and have more demand.
Cap Rate = Annual NOI / Purchase Price
So why does all this matter? The reason is because, in order to value a property in commercial real estate, you simply invert this equation using the going cap rate for your market.
Price = Annual NOI / Market Cap Rate for Similar Assets
To give you an example, say you purchased a property last year in a market where the going cap rate is 5%.
The previous owner’s net operating income for the year was $180,000, so you purchased the property for $3,600,000.
$180,000 / .05 = $3,600,000
Now let’s say that this was a 50 unit apartment building with all one bedroom units, for simplicity’s sake.
The expenses for operating the building are typically 40% of the rental income, which is called your expense ratio.
The market rent for a one bedroom apartment in the area is $600, but the units in your new building are only rented for $500.
Let’s say that, over the course of three years, you spent $100,000 improving the property in various ways that make it more desirable.
These could be new kitchen and baths in the units, a fresh paint coat, or new carpets. By the end of year 3, you’ve raised the rents for each unit to $600 a month.
This would give you a new total annual rent of $360,000 (50 units x $600/mo x 12 months).
Next, subtract 40% of that amount for operating expenses to get your new net operating income.
$360,000 x .6 = $216,000
Now, watch the magic of forced appreciation play out in front of you here on paper.
$216,000 (NOI) / .05 (cap rate) = $4,320,000 new property value
This is the beauty of forced appreciation and why it is a component of all of our investments.
Pillar Three – Leverage:
Where else but real estate can you make investments where a bank will provide a low-interest loan for up to 75% of the value of the investment?
The thing is, your tenants are paying their rental income based on the full value of the property.
They would be paying you the same rent whether you purchased the property in cash or used a loan.
That’s the power of leverage in real estate.
If you invest wisely, you’re producing income from an asset with far greater value than you could purchase in cash, but paying relatively low mortgage payments in order to obtain that leverage.
That leaves you with all that glorious cash flow from Pillar One.
Pillar Four – Tax Benefits:
One of the coolest things about real estate investing that might go unnoticed by some who are just starting out are the amazing tax benefits you receive.
You can write off most of the expenses associated with owning and running the property, such as:
-Interest payments on the loan
-Payroll associated with running the property
That’s pretty great, but we’re not done yet.
The heaviest tax benefits come through what is known as depreciation. The way it works is as follows:
Say you purchased a multifamily apartment building for $20,000,000.
This purchase price, called the “basis of the property,” includes the cost of the buildings and improvements as well as the land they occupy.
Since you can’t deduct depreciation losses for land, you need to separate the value of the buildings (known as “improvements”) from your cost.
One easy way to do this is to use the assessed value of the property, which will include both a land value and improvements value broken out.
The assessed value will almost always be different than the actual cost of purchasing the property, but for our purposes all we are interested in is the percentage of the assessed value that is allocated to the improvements’ value.
For example, say our property had an assessed value of $18,000,000, with the improvements valued at $15,000,000.
15,000,000/18,000,000 = 83%
20,000,000 x .83 = $16,666,666
In this example, we found that the assessor had allocated 83% of the property’s value to the improvements.
We then used that same ratio on our basis of the property (purchase price) to calculate our basis in the improvements themselves.
TIP: Keep in mind that if you erect your own improvements on the land, your basis of the property will increase and your basis in the improvements will increase proportionally along with it.
Now that we know the basis of the improvements, we can determine our straight line depreciation.
Straight line depreciation is the most commonly used method for calculating depreciation and is calculated simply by dividing your basis of the improvements by the 27.5 year period for residential properties.
$16,666,666 / 27.5 = $606,060.00
This allows us to deduct $606,060 as an annual depreciation expense from the income generated by the property, reducing our tax burden each year.
We call this straight line depreciation because the expense each year will be the same and, when plotted on an x-y axis with the basis of the property being the x axis and points on the y axis representing time as the number of years, the graph will produce a straight line until we reach the end of the period and the asset has been fully depreciated.
The final point on the y axis for our example would be 27.5 years because it is a residential property.
Depreciation is one of the great benefits of owning real estate and is also one of the reason why high net worth individuals like to allocate large amounts of capital into passive real estate investments.
The general partner will do all the work in managing the asset, but the passive investor can still benefit from depreciation deductions.
In and of itself, that’s pretty good news, but what if there was an ever deeper level we could go to maximize our depreciation benefits?
Enter the realm of the cost segregation study.
This is a study performed by a qualified professional that breaks your building/improvements down into their constituent parts in order to parcel out some components that may be eligible to claim depreciation deductions more quickly than the rate of the overall building.
The depreciation term for these components of the building/improvements can be depreciated over 5, 7, and 15 years, depending on what specific component we are referring to.
For example, certain fixtures like electrical outlets can be depreciated over a 5 year period as opposed to the 27.5 for the overall building.
The cost segregation study will then determine how much of the building’s value is in each category.
The majority of the building’s value will still be depreciated over the 27.5 year period, but you might be delighted to find that 20% can be depreciated over a 5 year period.
It’s easy to see why this accelerates tax benefits to the investor(s), but thanks to a concept called bonus depreciation the benefits don’t stop there.
Bonus depreciation allows you to claim extra depreciation “up front” at the year of your purchase.
Personal property or improvements with a useful life of less than 20 years are eligible for bonus depreciation.
This means that any components of your building that were allocated to the 5, 7, and 15 year categories for our cost segregation study can claim bonus depreciation in year one.
In 2018, the Tax Cuts and Jobs act was passed, which increased the amount of bonus depreciation one can claim from 50% to 100%.
What this means is that instead of dividing the value of these items by the 5, 7, or 15 year periods, you can claim all of your depreciation deductions at year one, so long as the useful life of the component is less than 20 years.
As a result, a well-done tax segregation study could leave you with no tax liability for the property at all in year one. You can probably see why the tax pillar stands strong for real estate investors.
3. Active or Passive Real Estate Investing?
The next question you need to answer for yourself is whether you want to be involved in real estate as a passive or active investor.
Active investments in real estate involve you becoming the all too familiar landlord. If you have a small portfolio of real estate investments, it may be possible to do this all on your own part-time while still maintaining your career, but make no mistake, it’s hard work.
Being an active real estate investor is a full time job and requires a deep level of knowledge and experience to perform at a high level, much like any other career.
It is pretty difficult to hone your skills as an active investor while also juggling your main source of income.
If you’re considering buying a duplex, you need to ask yourself if you have the time to give to perform proper asset management.
Otherwise, you’re going to be leaving money on the table.
If your goal is financial freedom and reducing your time commitment, you’re going to have a much easier time as a passive investor.
You can invest into what is known as a real estate syndication.
These are a crowdfunding real estate investments that pool together capital from a group of investors.
The general partners are full-time real estate professionals that source the deals, acquire lender and investor funds, underwrite the properties, and perform asset management.
In other words, they do all of the work involved with running the property for you. You simply collect your income distributions and enjoy!
Don’t get me wrong – some people enjoy being an active investor, I’m one of them.
It’s just that it’s a particular skill set that you have to go all-in on. If you try to do it part time, you’re going to get part-time results.
If your goal is to work less, active investing isn’t going to give you that, but passive investing will.
4. What Type of Real Estate?
There are several different asset classes that fall under the real estate umbrella.
The first group are residential properties and the second group are commercial properties.
These are any properties that are used for the purpose of habitation with four units or less. This includes single family houses as well as small multifamily properties such as duplexes.
Lots of people get started in real estate investing through residential properties.
Depending on where you live in the country (due to different housing stock in different geographic areas), this could be single family rentals or smaller multifamily properties like a triple decker.
As we discussed before, building up a small portfolio on your own is a form of active investment and involves a lot of work.
Even worse, many people try to serve as both the property manager and asset manager for their small portfolios, which is overwhelming and usually leads to bad results.
Why do people do it then?
People know real estate is where their investment dollars should go, but don’t know about the difference between active and passive investing when it comes to real estate.
As a result, people who are looking to reduce the amount of time they have to sacrifice for money actually end up increasing it instead.
If you’ve ever self-managed a 20+ units portfolio before, you’ll know what I’m talking about.
The truth is, prior to the passage of the JOBS act in 2012, not many people knew that there was a way to passively invest in real estate syndications.
That’s because the old rules only allowed people who had a prior relationship with a real estate syndication company’s owners to invest in their offerings.
As you can probably imagine, this created a bit of a good old boys club and regular people were left out in the cold.
Since 2012, more and more people have become aware of the passive investing option through real estate syndications and they have exploded in popularity.
Perhaps we’ll see less reluctant and regretful landlords in the coming decades!
As the name implies, these are properties that have commerce and the expectation of profit as their purpose.
Examples of commercial properties include: multifamily apartments, retail, office, self-storage, hospitality (hotel/motel), and flex space.
We have invested in most forms of commercial real estate, but our bread and butter is in multifamily investments. We think the data speaks for itself on the topic:
The first thing you’ll notice is that apartments have the highest average return, which is great, but I think the Sharpe Ratio is even more compelling.
This is a method for calculating risk-adjusted returns.
What this means is, it gives you a measurement of how much risk there is associated with each dollar you earn through the investment.
The higher the number, the better. As you can see, apartments mop the floor with the other asset classes.
5. Choose the Offering for You:
Once you’ve decided if passive real estate investing is the right choice for you, you need to locate a real estate company that offers opportunities to invest in their syndication offerings.
For example, if you sign up to our Winterspring Capital investor group, we will send you new investment opportunities as they become available.
There are typically a few deals a year that we invest in, as we are very picky with our investments.
We put months of research and networking in every market we invest in and turn down 99% of deals that come across our table.
That means the deals we send out to our investors have already been heavily scrutinized by our team.
You can sit back and choose from some of the finest deals in each market and decide which one makes sense for you.
Perhaps you prefer retail real estate investments as opposed to our focus, which is multifamily.
Don’t worry because there are investment groups that offer syndication opportunities for every type of real estate investment.
You just have to do your homework and figure out which type of investment makes the most sense for your goals.
Once you’ve found a deal that you would like to invest in, you’ll next submit what is called a soft reserve.
As we mentioned previously, syndication offerings have exploded in popularity and most offerings fill up on a first-come, first-served basis.
You’ll want to be ready to invest quickly when you see a deal that you like.
A soft reserve is simply a verbal commitment to invest a particular dollar amount.
The next step would be to sign the legal documents for the deal, including the private placement memorandum, or PPM.
This is a legal disclosure that fully defines the parameters of the opportunity, any risks involved, and defining who is involved as an investor member.
Now you’re on to the final step! You send in your investment amount to the general partners and officially become an investor-owner in the deal.
Now you begin your new role as a passive investor.
You’ll receive monthly updates, quarterly asset management reports, and best of all – monthly passive cash distributions.
I know many of you feel done with sacrificing time in exchange for money.
The only way to do that is transition away from actively earning money through your labor.
You need to fully commit yourself to the concept of passive income in order to acquire the real wealth you’re looking for.
Get educated on the subject of passive income and real estate investing and start saving up money from your active profession for the purposes of passive investments.
When you’re ready, put your hard earned money to work for you, rather than the other way around, by investing passively in real estate.
Like all successful people before you, you need to overcome the fear that’s holding you back.
That’s really all it is that’s tripping most people up, fear, stemming from a lack of confidence.
You can choose to change your mentality. You just need to be intentional about it.
Your first investment will take some bravery, but remember that you’re walking down the same path as we all are in the real estate investing world.
We and our other investors have all been there before.
One thing you’ll be happy to find out about the real estate investing community: there’s plenty of money to go around, and we’re all trying to earn together.
We’re always happy to help if you ever need further guidance.
If you’d like to become a member of our investor community:
Join the Winterspring Investor Group here.