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The Truth about Passive Income Real Estate Investing
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The Truth about Passive Income Real Estate Investing

How much can you make on a passive income real estate investing strategy and is it really passive income?

Few investments have made as many wealthy as real estate. Investment in land and property seems to be the only true constant across the history of investing and wealth building but is truly passive income from real estate investing possible?

We’ve seen other passive income myths busted in this series while others held relatively good passive income potential.

This post is the fourth in a series where I will look at the four most popular investments for passive income potential:

Passive income is technically an income you receive on a regular basis that involves little effort on your part. You get paid every month, quarter or year but do not participate in management or contribute work in the investment.

Few investments offer absolutely passive income since you have to work for the money to invest in the first place and you likely will want to keep updated on the investment, but some income is more passive than others.Passive Income Ideas

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There are really two ways to invest in real estate, direct purchase of property and investment through indirect means. Direct purchase involves a larger up-front cost but generally higher potential returns. Indirect investment can be made through real estate investment trusts (REITs) or tax liens but does not involve the immediate or direct ownership of the property.

Is Direct Real Estate Investing Passive Income or Not?

When most people talk about direct real estate investing, they usually mean either buying to remodel and resale at a higher price (flipping) or buying to rent for a monthly income. While house flipping can be extremely profitable, there’s nothing passive about the strategy so we’ll stick with real estate rentals for this post.

Like a lot of passive income strategies we’ve covered, real estate rentals can fall on a pretty wide range of passive income potential depending on your strategy.

Passive Income Real Estate StressI know a few investors that simply act as the “money” and do little more than look over reports brought to them by different contractors and managers. Most of them started in the business by doing more of the work but have now grown their portfolio to cash flow enough that they can hire the work out.

This level of passive income is in stark contrast to what many people try to do when starting out in the real estate investing business. We’ll go through the process of finding, leasing and managing your own properties below but you’ll quickly find that it can be a part-time job at the very least.

As we’ve seen in other passive income myths in the series, there are always parts of the real estate investing business model that you can hire out. It eats into your cash flow but moves you closer to a truly passive income.

As someone that has flipped houses as well as managed a group of rental properties, the best advice I can offer is to know yourself and how much time you are willing to spend on the business. A little more money in your pocket every month isn’t really worth it if you spend every waking moment miserable from overwork. Learn what you can realistically do yourself and what you want to hire out.

In fact, about the only way to make direct ownership real estate investing more passive is to share the responsibilities through a real estate investment group. You still won’t be able to make it truly a passive investment but it can help share around the burden while everyone still enjoys the returns.

The New Opportunity for Real Estate Passive Income in Crowdfunding

We’ll go through the entire process of finding real estate properties, analyzing investments and managing your passive income properties but new laws have been passed that may solve all the problems in passive income real estate.

New laws around crowdfunding have opened the door for websites like RealtyShares which allow investors access to real estate projects. Properties are professionally-managed so you don’t have to worry about a 3am call to fix a leaky faucet and management fees are lower than investing in REITs.

With real estate crowdfunding investments, investors can get access to different property types and locations across the country. That’s critical to diversifying your investments for safety and returns have been excellent. RealtyShares reports a site-wide return of 10.75% on properties since 2001, well over the 5% return on stocks. Returns are paid out on a monthly or quarterly basis depending on the property.

Click for more information about investing on RealtyShares and crowdfunding real estate.

How to get your Passive Income Real Estate Empire off the Ground

There are a lot of moving parts to a passive income real estate business model. Before jumping into your first property, there are a few questions you need to ask yourself.

  • Do you want to rent commercial or residential properties? I started my professional career as a commercial RE agent before starting residential investing. Buying and renting out commercial space like office, industrial and retail will generally yield a lower return but will also involve far fewer headaches. The drawback to commercial space is that it costs much more to buy one property.
  • In which socio-economic neighborhoods do you want to buy? I know real estate investors that have done very well buying and renting in lower-income neighborhoods. For me, it was a huge mistake. I fell into the trap of thinking, “I can buy a house for about half the cost as what I would pay in a better neighborhood. Even if I get slightly lower rent, say 70% as much, I’m still making a higher return.” Wrong! The money you lose on tenant turnover, unpaid rent and repairs far outweighs any benefit to buying property at a discount. Now, I always recommend to investors to never buy a house somewhere they wouldn’t want to live. If the business does poorly, you may end up living in one of your homes.
  • Do you want to buy fixer-uppers and remodel the property or do you want to buy homes ready to rent? Many investors immediately think that buying a home that needs a complete remodel, at a steep price discount, will yield the biggest profit. This might be true if you’re willing and able to do the work yourself or hire it out cheaply. For most, heavy real estate remodeling isn’t their strong suit and the home turns into a money trap. I would recommend that new investors start out with homes in need of just cosmetic repairs like painting and carpet. If you manage the rental property yourself, you’ll eventually learn some of the deeper remodeling tasks and can look to buy worse condition properties.

Your first step into a passive income real estate business, after learning as much as you can about the subject, will be to find your first property and tackling the question of financing. We’ll cover financing options first but in reality the two stages will be fairly intermingled.

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Financing your Passive Income Real Estate Investing Business

Few real estate investors pay all cash for their properties. One of the biggest benefits to the real estate business model is the ability to buy on borrowed money and writing off the interest as a business expense for taxes. Without the leverage of financing, my experience is that the return from real estate investing is not worth the risks or headaches.

Many new real estate investors take out a conventional mortgage on their first property, paying between 10% and 30% as a down payment. While a higher down payment will decrease your payment and increase your immediate cash flow, it will likely reduce your return on the money you put up. Most with good credit scores should be able to get a conventional mortgage though interest rates on rental properties are usually higher than owner-occupied home loans.

Special types of mortgage financing like those sponsored by the Federal Housing Administration (FHA) or the Veterans Administration (VA) may offer lower rates and lower credit standards. These loans are only available on owner-occupied purchases but you can get around that by buying a duplex, triplex or even four-plex.

These small, multi-family properties are usually the best for new investors anyway because they give you multiple properties with the benefit of being more easily managed. Even if you aren’t applying for one of the sponsored-type financing options, I would highly recommend a multi-family property as your first purchase.

passive income real estate investing tipsOther types of sponsored financing to consider:

  • 203K Loans are special FHA loans for the purchase of homes that need remodeling work done. The required down-payment is as low as 3.5% but requires payment of monthly private mortgage insurance for where you put down less than 20% of the cost.
  • HomePath mortgages are available through Fannie Mae for foreclosed homes and can be used for investor, non-owner occupied homes. The financing is only available on foreclosed homes held by Fannie Mae so visit the HomePath site to see if any of the properties are of interest.

Depending on how much equity you have available in your own home, you may be able to refinance or get a home equity line of credit (HELOC) on it to finance your rental real estate purchase. These are usually easier to get because the bank has more confidence that you won’t simply walk away from your primary residence.

If you are not able to get a mortgage on the property, there are still a few options available though rates can be fairly high. You might try approaching the seller for owner financing where they sell the property to you on monthly installments. This might not be possible if there’s a mortgage on the property since many carry a “due on sale” clause. If you do go this route, make absolutely sure you get a notarized contract with all the details.

Lastly, you may consider bringing in a “money” partner to finance the property. This isn’t usually an option for new investors with no experience and no connections but might be something you think about as you build out your real estate empire. Money partners can lend on a rate basis, a portion of the profits or a combination of the two.

Finding Properties for your Passive Income Real Estate Investing Business

There are several places to find properties to build your real estate business. The Multiple Listing Service (MLS), a platform for real estate agents to advertise their listings, is the most popular and widely used. MLS listings are searchable on Realtor.com by looking for properties within the area where you want to buy.

Passive Income Real Estate Search

You may eventually build enough of a relationship with real estate agents to get good leads through that channel. At first, it is going to seem like a waste of time because every agent will have a “steal” to show you. Make sure you are crystal clear about what you want and they will be more selective about what they show you.

The banks’ real estate owned (REO) pages are often the best sources of value. These are foreclosed homes that the bank now owns. You may be able to negotiate a lower price than listed on the bank’s website.

Similar to bank REO are sheriff’s sale properties. These are usually managed by the county treasurer’s office or the sheriff and are properties with some kind of judgement against them, often the foreclosure notice before it goes to bank REO.

While you can get some great deals here, the defaulted owner may still live on the property and could make taking possession difficult. Be sure you know the legal process for eviction and be prepared for clean up and remodeling when you finally take possession.

Loopnet is an online platform for commercial and multi-family property that is worth a look. Most of the listings will be for large commercial space but there are also small, multi-family listings as well.

Your best deals, but the most work, will come from properties not formerly listed as for sale. Contacting the owners of abandoned or run-down properties might uncover a deal without the hassle of competition from other investors. Once you have the address of a property, find your county assessor’s page on the internet for ownership information. The assessor’s page will have other useful information like previous sales and house characteristics.

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Income Real Estate Investment Valuation

Even the worst property could be a good deal for the right price. The problem is, you need to know how much it’s worth to know if the price is right. There are a few ways to value property but the two most widely used are comparable sales and the capitalization rate approaches.

The comparable sales approach values a property against those of similar properties that have sold recently. Write down characteristics of the property including age, square feet living space, number of bedrooms and baths, neighborhood, as well as features like a garage and central air. You then need a list of all the homes that have sold within the last year in the same neighborhood and with the same features.

If your county assessor is on the ball, this could be a fairly easy process. My home county of Polk in Iowa has an excellent assessor’s page with a sales search. These are actual home sales so give a true market value. To get a good idea of an average value for your target property, you will want at least ten sales with which to compare.

To get a big enough list of comparables, you may need to set a range on your search. Instead of searching for the exact age or square footage, search for a range of 15 years around the property age and a few hundred feet around the size. Try to keep your search to properties as similar as possible to the one you’re trying to value.

Passive Income Real Estate Sales Search

Passive Income Real Estate Sales Search

Once you’ve got a list of similar homes sold within the last year, divide the selling price by the size (square footage) of the home for a price-per-sqft value and find the average of all the properties. Arrange the list by most expensive, by price per square foot, to least expensive.

Check out any very high or very low values because they may be throwing off the average. Make sure sales are regular “arms length” transactions and not on a contract basis. Properties with extremely low values may have needed extensive remodeling.

The table below is an example of a comparable sales valuation. Notice all the sales are within the same district and within a year of each other. The properties were all built between 1950 and 1970 and are between 1,000 and 1,500 in square foot to be similar to an example property build in 1960 and of 1,250 square feet.

I took the price divided by the square footage of each sold property to find a value and then the average across all 15 properties. There didn’t seem to be any that were exceptionally higher or lower than the average so I didn’t remove any from the average.

Passive Income Real Estate Valuation

Passive Income Real Estate Valuation

If you are unable to search actual sales through the assessor, you can use properties currently listed for sale. The problem here is that the asking price may not be a true reflection of what the property is really worth. You’ll want to be even more skeptical of high- and low-values in this list and I would discount all prices by at least 5% to find market value.

With the average price per square foot from a good list of properties, you can find the value of your target property by using its square foot living space. Keep in mind that this is an approximate market value of the property in a finished condition without the need for repairs.

The capitalization rate approach to valuation is much more straight-forward but may not give you a true market value. The cap rate is simply the annual net operating income (NOI) of the property divided by the cost or value. Net operating income is the amount left of rents after all expenses are paid but before taxes and interest payments.

Cap Rate = Annual NOI/Property Value

We’ll look more closely at how to find a property’s NOI later in the article. There are two ways to look at the cap rate formula above. If you know what kind of return you want to achieve or the average return on similar properties, published frequently for commercial real estate investment, then you can find an approximate value by dividing the NOI by required return (NOI/return rate).

You can also take the NOI divided by the asking price of the property to see what kind of a return offered on the sale without negotiating a better price.

Knowing the approximate value of a property is only the first step to getting a good deal. Never be afraid to ask for a lower price and be an aggressive negotiator. The worst thing you can do is rush into a purchase or get bullied into one and pay too much. Go into the negotiations with a maximum price, a starting offer and several ideas on what you can offer instead of price.

  • Your offer will be stronger if you already have financing approved
  • If your calculations put the actual value around your offer price, be ready to show your work to prove the point
  • Offer to put more money down as “earnest” money on the purchase offer
  • Ask for some repairs to be made as a negotiating point
  • Ask for the owner to cover more of the closing costs
  • Offering to waive inspection or buy as-is, if you are sure of the property’s condition, can get you a better price

Finding Tenants for your Passive Income Real Estate Investing Business

Advertising your rental property can be as simple as a sign in the window. This is actually one of the most effective methods and the one with which I always had the most success. Beyond a sign, online advertising through Craigslist, Rentals.com or other sites can be relatively cheap.

It is so much better to let your property sit vacant for an extra month or two than to rush into an agreement with a bad tenant. You will be tempted to just go with your gut and not check out applicant tenants – fight the temptation if you want to keep your sanity! A bad tenant will trash your property and cost you thousands in missed rent and eviction costs.

Always run a credit check and a criminal records check on your tenant applicants. You can check an applicant’s credit free through Experian and criminal records checks may cost around $20 through the county court system. Good credit and a clean record is not a guarantee of a good tenant but it’s a good start. Drive by the applicant’s current residence as well and note the car they’re driving. If they don’t take care of their car or where they live now, it’s likely they won’t take care of your property.

Again, I can’t stress enough that you need to check out a tenant before you agree to a lease. This is from personal experience and mistakes made.

Make sure your tenants understand that the rent is due in your PO box by a certain day. I recommend using a post office box to avoid tenants coming to your home. Understand how much you can legally charge for a late payment, usually a trivial amount like $15 after a grace period. Explain to new tenants your policy on the eviction process, i.e. when do you start the process when rent is late.

You absolutely must know the eviction process and have a policy for when you begin proceedings. Where I rented homes, you had to send a notice by certified mail and give the tenant seven days. Then you filed in small claims court for an eviction which meant another notice delivered by the sheriff and a court date usually about three weeks out.

Tenants usually move out before the court date but you may have to pay for a removal by the sheriff. All these fees and time delays add up and you can see why it is important to check tenant applicants in the first place. Having a formal eviction procedure will help avoid procrastinating the process and missing out on several months’ worth of rent trying to get tenants evicted.

Maintenance and Permits for your Real Estate Business

Depending on how many properties you have and your experience with home improvement, you may be able to do a lot of the maintenance yourself. You likely won’t be able to fix everything but it will be worth it to learn a few common repairs to do yourself. Typically, plumbing and electrical maintenance will cost the most since work is generally restricted to licensed members of the trade unions.

If you can do one of these, you’ll save a lot of money. You may find it easier, and very much worth a little extra, to just have a maintenance person handle everything directly with the tenants.

Your city may require that you have a rental permit and an annual inspection for properties. This is really where having good properties and good tenants make all the difference. Good tenants that respect the property can make your city permits relatively costless and an easy experience.

Bad tenants that trash the place means you’ll need to fix everything each year to pass inspection. You’ll be replacing window screens, door jams, and every little thing because of tenant neglect.

How much can passive income real estate investing make?

Real estate rentals provide returns through three ways: equity, cash flow and tax benefits. The amount you make from each may change over the years, providing more passive income.

Equity is the combination of appreciation and the amount of your mortgage paid off each month. Since property is a real asset, it offers good protection against inflation and property prices generally increase by at least the annual rate of inflation.

In developed economies like the United States, annual property appreciation over long periods is generally not much higher than inflation because economic growth and housing demand do not grow at high rates. Beyond appreciation, you will benefit from rents paying off the principal balance of your mortgage each month.

The tax benefit to real estate investing can also be a good source of return. The IRS allows you to take depreciation as an expense every year. There are several different ways to calculate depreciation but I always just used the simple straight-line method that allowed for 27.5 years of depreciation. That means, you divide the property cost (not including land) by 27.5 and add that to your expenses every year. Since depreciation doesn’t actually involve you losing any cash, your taxes go down but you didn’t pay anything.

Saving on taxes can be a huge benefit to income real estate investing but you have to know how to calculate them correctly and take advantage of all the tax breaks. It’s critical that you keep track of all your expenses and cost basis with business accounting software like QuickBooks. Tax programs like TurboTax usually include fairly simple step-by-step instructions on entering annual expenses and income to get the most out of real estate tax benefits.

In the early years when there isn’t much cash flow on the property, you might not owe any taxes at all. The downside to taking the tax break is that capital gains will be higher when you sell the property, since your cost basis on the investment is lowered by the amount of depreciation you booked.

Cash flow is the monthly amount you have left over after all expenses and a set aside of estimated tax liability. A lot of investors like to use the net operating income as cash flow but that’s not really cash in your pocket. NOI does not include interest on loans or taxes and is a poor measure of how much you are actually making in cash.

I’ve put together a table of NOI and cash flow below with some basic assumptions that I used when managing my own rentals.

For the expenses that include a percentage estimate, you deduct that percentage of the gross rent. If you charged $1,000 a month then you would estimate a loss of approximately $100 a month for vacancy, $150 a month in repairs and $100 a month in property management.

You may not have all the expenses listed below, for example if the tenant pays utilities or if you manage the property yourself. This is just a list of common expenses. It is extremely important that you build out an estimate on your own before you purchase a property. Most of the information can be gotten by calling around or researching expenses in the area.

Passive Income Real Estate Rental Cash Flow

Passive Income Real Estate Rental Cash Flow

You won’t see the principal payment deducted on most cash flow calculations. I like to remove it to find the actual cash flow of the property and it’s important since we’re talking about passive income strategies. Your cash flow may be low or even negative on the property but it might still be a good investment if you are earning a good return through an increase in equity.

Returns on real estate investing vary and you don’t want to get into the business based on an estimated return but on your own calculation of what is possible for your local market and for specific properties. I have seen pretty common averages between 8% and 12% a year for single-family residential rentals with cash flow accounting for between 0% and 6% of the return. Your return will also depend on whether you can buy a property at a discount and eventually sell it for market value or above.

Of course, returns can be increased significantly if you manage your properties and do your own maintenance or control vacancy. I have friends that do almost all the work on their portfolio of rentals and make upwards of 18% a year return.

Passive Income Potential: Real Estate Investing

Real estate investing falls somewhere in the middle compared to the other strategies we’ve reviewed in the passive income series. The time commitment involved isn’t as strenuous as blogging but is much more continuous than income investing. Start up costs are much higher than blogging or online stores but the benefit of loans gives it more leverage than investing in stocks or bonds.

Start-up costs can be prohibitive if you do not have the credit score for a loan or other financing options. Loan standards have loosened since the financial crisis and most can get some type of financing. The use of financing eats into cash flow during the early years but the strategy turns into a viable income stream after you start paying off properties.

The time commitment for real estate investing isn’t as continuous as with blogging but it can be a part-time job if you have enough properties and the wrong tenants. Sacrifice a little return for quality tenants and repair problems right the first time. These two simple ideas will save you a ton of time and turn out to be the more profitable solution over the long-run.

Income momentum is good for passive income real estate because you progressively earn more as your mortgages are paid off. Your income will also grow as you become a more efficient manager and acquire more properties.

Continuity of income is also good for real estate investing. Though loss of a tenant or a fire could wipe out your income stream, accidents are insurable and good tenants usually stick around for at least a year.

The scale below presents my passive income potential for real estate investing. Each of four factors is scaled in reverse with 1 being the worst or the most unfavorable to a true passive income investment.

The time commitment to real estate investing (4) is more onerous than that of income investing (8) but not as intense as blogging (1)

Passive Income Real Estate Investing

Passive Income Real Estate Investing

Overall, direct real estate investing can be a good source of passive income but it can also be a lot of work. As with other passive income strategies, it depends on how much you want to manage yourself and how much you will outsource.

Cash flow is fairly weak during the early years of a real estate rental business but can grow significantly with more properties and as mortgages get paid down. Real estate investing offers tax benefits we don’t see in other strategies but it is difficult for smaller investors to diversify risk through multiple properties.

In our next post of the series, we’ll look at the passive income potential of indirect real estate investing in REITs and through tax liens. Both of these strategies can yield strong passive income without a lot of the headache in management of direct real estate holdings. We’ll cover how to analyze REIT investments and how to find and buy tax liens.

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Comments

  1. It’s funny, Peter Lynch says before putting any money in the stock market, make sure you own real estate. It’s a rare investment that allows you to own an asset while borrowing a large portion of the value at an extremely favorable interest rate. However you are right, real estate investing does not offer passive income in the truest sense of the word. Great guide!

  2. Ali Rafatjah says:

    Very well written. As a newbie real estate investor I wanted to see what you had to say about how passive it was – I think you’re right on the money! Thank you and looking forward to hearing more about what you have to say!

  3. So many people are seeking lucrative ways to earn income passively, and default to investment properties to do so. Unfortunately, there is a lot of effort that goes into starting a rental property business, especially if you choose to manage your property on your own rather than employ a property management company. That is, however, not to take away from the positive cash flow that is possible from real estate investment if done properly. Thanks again for sharing the realities behind earning “passive” income through your rental properties.

    • Good point Patrick. I still own a couple of rental properties and it can be an excellent source of income, even passive income. Tough to get started but real estate investing has created more family wealth than just about anything else. Thanks for the comment.

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