The most common way for the average investor to invest through real estate is to purchase stock interests in a real estate investment trusts (REITs). This comes with three advantages: (1) You get diversification across hundreds if not thousands of properties; (2) You get professional management of the properties; and (3) you get liquid marketability of your investment because you can sell it instantaneously online as easily as a stock.
However, among households with net worths in excess of $2.5 million excluding the value of their primary residence, approximately 34% own real estate outright without any REIT investments, 18% own REITs exclusively, and 15% own both real estate outright as well as REITs. The advantage of owning real estate outright is that you get to benefit from the tangibility, control, and passive activity loss rules that buyers of REITs do not receive.
You might wonder then: How do the affluent structure their real estate investments?
Usually, it’s a five-step process.
First, if they seek to take advantage of leverage and the tax code, they will approach a bank and secure a first mortgage for the real estate that they seek to acquire.
Second, if there is a landlord-tenant type of relationship involved, they will approach a property management company to be in charge of collecting rent and performing maintenance on the property.
Third, they will create an LLC for their business that receives the rent as well as an LLC for the property itself. You stick the property inside of an LLC so that your personal assets cannot be touched if, say, a tenant slips and falls and injures himself in snowy conditions while walking on the premises. You create an LLC for yourself so that if a contract dispute arises between yourself and the property management company, then your personal assets cannot be touched.
Fourth, you visit a lawyer and structure a tenant in common ownership of the real estate and contract agreement with the property management company. The contract will include a provision that says something like: “So long as The Smith Property Management Company LLC manages the Westwood Property at 123 Main Street, they shall be granted a 10% interest in the property and be entitled to 10% of the monthly income from the property.” Typical arrangements give management companies 10% of the sale price of the property unless they are fired for cause at least 180 days before the owners actively solicit bids on the property, but this is negotiable and varies significantly throughout the United States. The contract also usually includes a fixed price at which the property management company must sell their 10% interest back to the 90% owner if they terminate the arrangement first. Usually, this price is highly favorable to the 90% owner. An additional benefit of the tenancy in common ownership structure is that it may permit considerable tax savings through a Section 1031 exchange.
Fifth, they set up a bank account that will aggregate all the rental income, deduct the monthly expenses associated with the maintenance of the property, and on a recurring date will deduct a payment to the management company. For instance, if the LLC receives $25,000 in rental income during a month, and then has to deduct $2,500 for electric and plumbing repairs across its units, an automated formula will recognize that $22,500 was contributed to the account during the month and will know to have $2,250 transferred to the bank account of the property management company.
This may sound like a lot of work, but it is almost entirely on the front end. Once you complete the process, you get to see $22,500 show up in your bank account each month with only modest time requirements on your part thereafter. A sixth step would include the insurance for the property, but this can be purchased through the property management company and aggregated with their rate (i.e. the tenant in common agreement might grant the property management company 15% ownership if they secure the insurance. Some states only permit majority owners to secure insurance. No state permits property management companies to secure insurance without any ownership interest in the property.)
Another benefit is that outright property ownership can result in higher monthly property income. REITs have to pay out 90% of their taxable income each year to keep its tax benefits, but real estate properties can often generate much higher actual income due to the effects of depreciation. This can give outright property ownership a percentage or two of additional yield (e.g. you get to collect $7,000 for every $100,000 you invest in physical real estate outright instead of $5,500 through a REIT).
The real estate component of a portfolio can be great at generating monthly income. Essentially, you are trying to build a three-legged stool. You rely on business interests/stock ownership to give you growth. You rely on bonds to give you liquidity and a touch of income. And you rely on the real estate investments to give you income with a touch of growth. They can all blend in harmony to turn your family into a walking hedge fund.