This post is from Joseph Hogue, CFA, who is an investment analyst and author of The Passive Income Myth: How to Create a Stream of Income from Real Estate, Blogging, Stocks and Bonds. (Join the community on PeerFinance101 for more tips on investing, managing debt and reaching your financial goals.)

Real estate rentals can be great investments

Of all the passive income strategies in which I’ve invested, my favorite has got to be real estate. Ever since Will Rogers made his famous quote about real estate in the 1930s (“Buy land. They ain’t making any more of the stuff.”), people have lined up to get in on the action.

It’s spawned libraries of books and countless strategies promising six-figure incomes on little more effort than picking up rent checks.

The only problem…it’s a passive income myth!

A passive income myth

Sure, real estate is a great investment and the returns can be amazing but it is far from a source of passive income.

Case in point, check out the process Jackie went through to rent one of her properties out on a Section 8 certificate. It all worked out but it’s a lot of uncertainty and a lot of work.

My own experience with real estate investing began in 2002 when I started buying single-family homes. I spent my first few years out of the Marine Corps rehabbing houses to rent out, owning as many as six properties before selling most in 2006. I made good money and still own a few rentals but it isn’t the passive income source most people believe.

Fortunately, there is one investment that offers the upside return of real estate investing without all the tenant headaches and bookkeeping. You can buy into the investment without taking out massive loans and you get professional management for your properties.

It might just be the landlord’s dream investment.

Getting diversification and passive income from one investment

As I said, I still own a few rentals and love the idea of real estate investing but now complement my direct real estate holdings with an investment in real estate investment trusts (REITs).

REITs are a special type of corporation, established by law in 1960, and they do not have to pay federal income taxes as long as they pay out at least 90% of their income to shareholders. This creates a huge tax advantage for holding real estate and even non-real estate businesses like McDonald’s have considered selling their land holdings to a REIT.

REITs issue shares just like any other company in the stock market. You can buy shares for less than $10 and as much as hundreds of dollars each for some companies. On the mandate that they pay out most of their income, the cash flow from a REIT investment is very good. According to the National Association of REITs (NAREIT), the average dividend yield of 4.1% is nearly double the 2.1% yield on stocks in the S&P 500.

Most REITs invest in commercial properties and specialize in a specific segment of the market, i.e. industrial, retail, storage or office space. While some REITs might own most of their property in one region of the country, most hold hundreds of properties across the nation. This provides great geographic diversification, something single-family landlords sorely need in their portfolio. With REITs, you no longer have to worry about a drop in the local economy destroying your wealth.

Potential advantages of REITs

Besides the return from dividends, REIT investments provide upside from price appreciation. The NAREIT index increased at an average annual rate of 13.5% over the 41 years to 2013.

Owning shares of a REIT will not provide the tax benefit from depreciation and I still like the pride of ownership I get from directly owning real estate rentals. Managed effectively and doing the work yourself, real estate rentals can provide a slightly higher return versus the REIT investing alternative.

But putting a portion of your money in REITs is about as easy as it comes in real estate investing. As a landlord, I love the instant diversification and the relatively stress-free opportunity I get in REITs.

Examples

(Jackie’s note: the companies mentioned below are examples, not specific stock recommendations.)

There are hundreds of individual REIT companies in which to invest. You can actually make it even easier by just buying the Vanguard REIT ETF (NYSE: VNQ) which is a fund that invests in individual REITs. With a single investment, you get exposure to 145 REITs investing across all the sectors including health care, retail, office properties and even residential homes.

Just recently, several REITs have been formed that invest in single-family residences. American Homes4Rent (NYSE: AMH) was founded by billionaire Wayne Hughes, after becoming rich in public storage real estate, and holds more than 37,000 homes in 22 states. The company uses its massive size to cut management costs and is able to keep more than 90% of its properties leased. It doesn’t pay much of a dividend yet since it’s still a growing company, but it might be one to watch for any landlord.

Balancing your real estate portfolio

While few investments will provide an income as high as real estate rentals, investing in REITs can complement a landlord’s portfolio in all the right ways. Professional management and nationwide diversification make REITs a great way to take advantage of the benefits in real estate investing without having to buy more properties. Consider balancing out your wealth by putting some of your cash flow to investing in these special types of companies.