Disclaimer: This article has been submitted by our sponsor, Aloha Capital
In this article, we will explore the basics of building passive income through notes (or debt) on real estate.
- What is passive income?
- What is passive real estate investing?
- What is real estate debt investing?
- Ways to passively invest in real estate debt
Let’s get started.
What is Passive Income?
By definition, passive income is money earned with little to no effort or direct involvement after the initial setup. Essentially, passive income allows you to generate earnings without actively trading your time for money. “The way I see it, if I am managing people, making ongoing decisions, or thinking about how to make the investment cashflow on a month-by-month basis, it is not passive” – Kevin Hill, CEO of Aloha Capital.
What is Passive Real Estate Investing?
Active real estate investing requires direct involvement in tasks such as locating, purchasing, renovating, leasing, and managing rental properties. If you’re investing in real estate this way, you’re really just generating passive income for someone else who is benefiting from your efforts while you guarantee their return on investment. Wait, what?
That’s right, behind every residential investment property that is financed, a private credit participant (or bank) is providing capital into the transaction. Then either directly or through an investment entity or financial institution, there are ordinary people earning truly passive from the active investors hard work and protected by the equity in the property and the personal guarantee of the borrower(s) if the collateral is not sufficient.
In general, to become a passive participant you are giving up the active role of investing and finding the team that you trust and has a track record of success.
“Becoming a passive real estate investor is more about “who” you’re partnering with than “how” you’re generating passive income. Medical
professionals have dedicated years to mastering their field, and similarly, they have the chance to connect with and trust real estate experts who can handle the complexities and effort of real estate investing for them. It’s just like when I trust medical professionals for their expertise when I’m sick or injured—they’re the experts, and I rely on them to deliver the best care.” Nate Agnini – Business Development at Aloha Capital.
What is Real Estate Debt Investing?
Investing in real estate through debt, rather than equity, involves providing loans to active real estate investors like developers, redevelopers or
investment property owners. Instead of owning a property directly, as in equity investing, real estate debt investors lend money that is secured by the property and typically a personal guarantee of repayment. In return, they earn interest payments over the life of the loan and eventually get the principal back when the loan is repaid.
Banks and other financial institutions underserve and ignore segments of residential real estate such as redevelopment, as they don’t allow their loans to be collateralized by a property with deferred maintenance. In 2023, approximately 300,000 single-family homes and condos were flipped in the United States, which accounted for about 8.1% of all home sales. That’s down from prior years, where over 10% of home sales were recently renovated by an investor. It’s a massive marketplace that is supported through private credit participants. They typical interest rate on short-term loans to redevelop residential properties ranges from 8% to 15% or more depending on the terms of the transaction.
Real estate debt investing does take consistent effort in the form of finding the borrower(s), underwriting the borrower, the property and the exit plan, creating legal contracts and collecting interest payments. This is not exactly passive as defined above, so let’s explore a few ways to passively invest in real estate debt.
Ways to Passively Invest in Real Estate Debt
Just like passive equity investments in real estate, you are finding a trusted partner that takes care of the day-to-day activities. You should be asking questions such as:
- How long they have been acting as a lender?
- How many transactions have they underwritten & how many have they funded?
- What is the loan underwriting criteria?
- What percent were successful vs defaulted?
- Would they have personal capital at risk along with you?
You will also need to consider how you will invest into real estate debt as there are several paths to explore:
- Real Estate Debt Fund or mREIT. Through an investment entity, you are investing in a portfolio of loans that can provide diversification
across many borrowers, markets, and/or project types. You would need to understand the makeup of the portfolio, the fees and expenses
charged along with the liquidity provision. You may need to be an Accredited Investor to access this type of investment vehicle. Investing
in a Fund or mREIT allows you to invest capital for a longer period of time without the need to make investment decisions. - Whole Loans. Investing or buying a whole loan that is originated, managed and serviced by a trusted 3rd party lender allows you to select
the specific borrower, property and project profile that you are comfortable with. It can be difficult to find the perfect fit at the perfect
loan size that aligns with the capital you are ready to invest. Your investment is typically for the life of the loan, so you would want to
understand the loan maturity date and extension provisions. - Partial Loans (Participation). Similar to whole loans, you can select the specific borrower, property and project profile that you are
comfortable with, but you invest in a portion of the loan or percentage of the income stream from the loan. This removes the barrier of the right loan size to match your investment allocation. You may even be able to create a custom, diversified portfolio of partial loan investments.
The team at Aloha Capital, a PIMD community supporter, is happy to share further knowledge on real estate debt investing and provides access to all three paths of passive debt investing. To learn more visit their investment platform –Swell.
