I recently told you all about I started building passive income with real estate, but I have not discussed how I funded the purchase. Since I don’t have several hundreds of thousands of dollars just sitting around to purchase a house, I have to fund my real estate purchases in other ways.
Below, I’ll walk you through different ways to fund a real estate property, along with why I used the specific method I chose.
Cash or Mortgage?
There are really two ways to fund a real estate purchase.
Buyers literally pay the entire purchase price in cash. Now, there are some people who have a lot of money and can buy a property in cash. In fact, data estimates say cash buyers make up 40 to 57 percent of all home sales.
Financing / Mortgage
This is the method that I used. The cash portion used for a down payment can come from savings, a windfall like a gift from a family member, a loan or by other means. Financing involves using a loan to buy the remainder of the property and typically comes from a bank, but may also come from private investors.
In order to get the cash for the initial down payment, I sold stock from my portfolio. Now you may ask, why on earth would I sell shares from my portfolio?
Why Sell Stocks to Start Building Passive Income With Real Estate?
That is the million dollar question.
If I had the perfect answer, I would probably be selling it. I don’t know if there is a “right” answer to this question, to be honest, but I truly believe it comes down to an individual’s objectives. If you were to ask me five to seven years ago if I would sell stocks to buy real estate, I would have laughed in your face.
However, my mindset has shifted since then. Now, I would sell stocks for real estate primarily because I would simply be exchanging future potential appreciation in stocks for current (and future) cash flow. t Other reasons why I chose to sell stocks to buy real estate are:
1. I wanted to take money out of the stock market.
Over the past year, my personal portfolio gained 21.2%, outpacing the S&P 500 index (a broad mix of stocks that is viewed as the average return of the US market).
While I am thankful for my high returns, I don’t believe that the performance can be sustained forever. I wanted to lock in some of those gains and use them for a different asset class, which leads to my next reason ….
2. I wanted to diversify.
My wife and I have nearly 90% of our assets invested in the stock market. While that has been beneficial thus far, we wanted to have a broader mix of assets and not rely on the stock market as our sole wealth building tool (you may remember the Great Recession, where the stock market lost ~50% of its value).
3. I wanted to experience both tangible and intangible benefits of asset ownership.
Stocks don’t provide much tangible benefit (aside from seeing your account grow!). There is something personally appealing about having tangible benefits from owning an asset like real estate.
For example, I know the real estate I purchase will be someone’s home, and I can provide quality service and lodging for an individual, which may be something they haven’t experienced before. I find value in both the ability to provide a service to someone and seeing my portfolio grow.
In addition,my wife and I want to be FIRE (financially independent, retire early). There are two ways to achieve FIRE: (1) capital appreciation, which focuses on rising value in an asset, or (2) income investing, where an individual receives dividends, rents or interest payments from an asset.
Investing in stocks (excluding dividend stocks and income investing) focuses on capital appreciation (e.g., I want to turn my $100 into $1000). This is a way to live better in the FUTURE.
Now, if my wife and I had $10 million, we would totally go and buy a dividend stock fund and live off the approximately four percent dividend yield forever.
When I say dividend fund, I mean a stock-based fund that can be purchased through a brokerage and has a strong dividend yield (regular payments to shareholders). If I assume a yield of four percent, that would mean that every year, I would receive $400,000 annually in dividends.
But we don’t have $10 million (yet), so that option isn’t feasible for us today. Since we want to generate income TODAY and earn higher amounts on invested capital, investing in rental properties makes perfect sense for us.
Why Care So Much About Capital Appreciation?
For some, capital appreciation matters more, and in that case, funding real estate through stock sales may not make sense.
There are potential downsides to using stocks to buy real estate, including missing out on potential appreciation of the stocks you own (selling out of the stock market today may mean you miss out on potential future gains).
There are also tax implications when you sell stocks. Depending on how long you have held the stock, you may have short-term capital gains (if held for less than one year) or long-term capital gains (stocks owned for more than one year), each with a different tax rate.
To handle these additional taxes, I set aside a portion of the sale to cover the expense. My brokerage provided me with estimated gains and losses when I sold.
For example (assuming you have no other income), if you needed $25,000 for a real estate deal and have a long-term capital gains tax of 15%, you could sell $29,500 worth of stock and set aside $4,425 to cover the taxes. That would leave you with approximately $25,000 for your real estate deal. To be safe, you should always consult a tax professional for advice on your tax situation.
What This Means For My Portfolio
Right now, I want to further diversify my portfolio into additional asset classes. My goal is to build passive income streams and not rely solely on capital appreciation.
I envision a mix that is 30% stocks/bonds that generate income, 40-50% income-generating real estate and 15-20% in alternative investments (like venture capital/private equity). The remainder would go into interest-bearing savings accounts.
As I mentioned before, my current portfolio is heavily weighted toward equities. This first rental property purchase allowed me to reduce exposure to the stock market and take my family one step closer towards creating ongoing passive income.
Through selling shares, I effectively increased the percentage of income-generating real estate to seven percent of my portfolio (I don’t include our primary residence as income-producing since we don’t earn money off the property).
I still have a large portion of my assets in the stock market, but will continue to liquidate over time to fund real estate purchases. While I may be forgoing future appreciation, I am building passive income today.
This is my personal preference – each situation is different! However, I believe that building passive income with real estate investing – over the long term – will do a better job of generating passive income compared to the stock market.
As a result, I will continue working towards an asset mix of approximately 30% stocks and 40-50% income-producing real estate.
How are you thinking about funding your real estate purchase? Feel free to leave comments below to let us know your thought process for investing in real estate!
Derrick Deese got started investing when he was 18, buying Starbucks stock. He is still kicking himself for not holding it, but has learned a lot since then. He’s passionate about investing, financial freedom, and photography. He works in marketing and lives with his wife Natalie in Seattle.