If you are looking to start making real estate passive income, or make more than you already are, investing in rental properties is an excellent method for that. With an average return on investment (ROI) of 10.6% for residential real estate and a 9.5% average ROI on commercial real estate, there is serious potential to earn large amounts of passive income. So much so, that some people retire in their 30’s living off their rental property passive income alone!
How do you make passive income on rental properties?
The way to make passive income on rental properties is to rent out rental properties to tenants who would pay you each month to live in or use that space.
Unfortunately, though, if it were that simple, there wouldn’t be a wealth of information on the topic. In reality, there is a lot more to think about when it comes to securing the most amount of passive income from rental properties. You need to choose the right type of property, the right location, the right financial backing, and even the right tenants! Rental properties teeter the line between active income and passive income.
If you approach the process improperly, what is supposed to be a way to make passive income can quickly turn into a massive headache at best, and a lawsuit and loss of money at worst. Read on for more details on how to increase your chances of success at making passive income through rental properties.
Making Passive Income On Rental Properties: Starting Off
When it comes to real estate, you have the option of residential and commercial properties. You also have multiple different investment types to choose from: a single-family rental, apartment complex, industrial building, office space, and more. However, for someone first starting with making passive income on rental properties, it would be best to start with a single-family rental.
The reason for this is because it’s simpler to manage. It’s also a way to dip your toes into the real estate world before jumping all-in. Dealing with fewer tenants will make your life easier.
Additionally, you’ll get an opportunity to learn and improve your rental management skills before buying more complex properties. There is also substantially less risk with a single-family rental.
When securing a rental property, you don’t have to purchase the entire home yourself. Instead, you can get a mortgage. You can even get private or government loans making interest-only payments with $0 down. Either way, how you finance the home is essential. You need to consider all of your financing options.
Different lenders of mortgages have different terms, rates, and repayment policies. You need to research who the best lender is with conditions that would give you the highest return on investment. The way to determine if you are getting a good deal is by figuring out what your expenses would be and basing your ROI calculation on the terms you would be getting (aka your monthly payments).
While some mortgage lenders will let you put as low as a 3% down payment on a home, most will want at least a 20% down payment. If you choose to go with a lower down payment, the lender will require that you get private mortgage insurance (PMI). This insurance protects your lender if you stop making payments on your loan. The insurance has no benefit to you, so it’s in your best interest to save up enough money to put the 20% down payment instead.
On the other hand, you could also get a loan that doesn’t require any down payment. These types of loans typically come with significantly higher interest rates. Some would say that taking out this kind of loan is risky. You can make it work; if you are financially smart about it. For one, don’t purchase an expensive home. If the home is only $100,000 and you’re paying 7% interest every year, that’s $7000 a year. If you’re making $10,000 a year from rent (after subtracting expenses), that’s $3,000 a year in passive income.
However, lenders who give out these types of loans are going to want to make sure you have adequate income to make the interest payments yourself. Or they will look to see if you have any collateral (like a previous home you purchased). They are also going to make sure you have a high credit score.
If you want more information about whether or not you would be the right candidate for an interest-only loan, and to have a better understanding of the risks involved, click here.
Figuring Out The Cap Rate And ROI
Before figuring out what property to buy, you need to calculate your capitalization rate and return on investment. Both will help you determine how much passive income you can make.
Both are important to calculate. The cap rate will show you what a property should be worth based on the rental income generated. It doesn’t take into account leverage, though, which is why you’ll also want to calculate your ROI.
Leverage is how you use your debt to increase your potential return on investment.
Capitalization rates are useful for comparing similar properties in the same market area. Generally, you should shoot for a cap rate of 4% to 10% per year. Yet, because fair market rents, market values, property taxes, and operating expenses vary by location, so does what is considered a “good cap rate.” Ultimately, an excellent cap rate for one market could mean a lousy cap rate for another.
On the other hand, your ROI does factor in the power of leverage. You will see that, depending on your loan terms, your ROI can vary dramatically. That is why it is vital to consider the terms of your loan before taking one out, as stated previously. In terms of ROI, many investors are happy with a 10% ROI. Yet, some investors won’t buy a property without an ROI of 20% or more.
Click here to figure out how to calculate your cap rate and ROI.
Choosing A Rental Property
There’s a lot to take into consideration when it comes to choosing a rental property. This decision is not one to be taken lightly. Investing in real estate property is a substantial financial commitment, and you can’t afford to make any seriously bad decisions. Doing your research and knowing when to buy a house and what kind of property to buy is crucial. Details on how to choose the best property will be detailed below.
When it comes to wisely choosing a rental property investment, you need to do research. Research is crucial for making sure you are going to be investing in a property that is going to bring in revenue. If you don’t know how to do the research yourself, you can always hire a professional to help you instead.
The research you need to do includes the following:
- Physically visiting the investment property that you want to buy as well as checking the condition of it.
- Conducting a real estate market analysis to determine the potential ROI.
Again, if you don’t know how to conduct the market analysis yourself, it is imperative that you hire an expert that can help guide you in making the best decisions.
Types of Rental Properties
Most landlords begin with your standard single-family home. In most markets, they’re the simplest to rent and the easiest to purchase.
A condo is basically an apartment that you own just like a house and is part of a condo association. They can make great rentals, especially in some markets. There are, however, important factors to consider when it comes to condos.
Some condo associations place severe restrictions on renting the property. Also, basically all condo associations impose a monthly homeowner’s association (HOA) fee. You’ll need to consider the HOA fee when you crunch the numbers for your profit margin.
A multi-family house has several segregated units. These can also make great rentals, but usually add a certain complexity into the mix.
Rent for each unit could be difficult for you to calculate based on the uniqueness of each unit. You’ll also be dealing with multiple tenants living in the same building, which can sometimes spell disaster based on the specific mix of characters.
A benefit of multi-family units though is that if one tenant leaves, you still have monthly cash flow from the remaining tenants while you market the available unit.
Who hasn’t browsed some of the most expensive homes on the internet and dreamt of owning one? If you find yourself in the position to enter the luxury rental market, you’ll be playing a game of high risks and high rewards.
Luxury properties have a much smaller pool of potential tenants and it’s possible the property may sit empty for a while. Renters of high-end homes though tend to be more stable in their careers and it’s much less likely they’ll have difficulty coming up with the rent check each month.
Lakefront cabins and ski chalets are an entirely different animal compared to other rentals.
For one thing, most renters won’t lease the property for a lengthy time period. Additionally, monthly rent can drastically fluctuate with the seasons depending on your specific property.
A strong pro, however, of vacation properties is that you can occasionally find the property available for your own personal use. You could, for example, set aside Memorial Day weekend for yourself at your lake cabin and then rent it out for the rest of the summer.
Turnkey VS. Fixer-Uppers
When it comes to choosing a property, some people are strong advocates of turnkey properties while others prefer to flip homes (where you buy a fixer-upper, fix it up, then sell it for a profit). Turnkey properties are fully renovated properties that can be purchased and immediately rented out. Fixer-Uppers require you to do renovations.
No matter what kind of property you plan to buy, you still need to do research. You still need to weigh out the potential income versus expenses. Both can bring you in passive income, and both can also be costly. There is no definite right answer. Again, this is why research is so important.
With that said, though, there are some key pros and cons to consider for both.
Turnkey Property Pros:
- You don’t have to wait months for repairs and construction to be complete. You can buy the house and immediately rent it out afterward.
- You don’t have to stress about doing repairs and meeting building codes.
Fixer Upper Property Pros:
- You can sometimes negotiate these down and get a terrific deal. If you can fix the house up quickly and cheaply, you can end up charging a lot more for rent, and they can be very profitable.
- Price is lower than other homes in the area.
- You get to decide what improvements you want to make and contract the labor.
- You have more control over the layout, appearance, and style of the home.
Turnkey Property Cons:
- Turnkey homes tend to generate a lower ROI than houses you would flip.
- Expensive property investment.
- Less control over the layout, appearance, and style of the home.
- There are turnkey companies that will spruce up the home aesthetically but won’t work out issues, such as foundational and electrical ones. If you don’t do research, you could end up with a terrible home in a terrible location.
Fixer Upper Property Cons:
- There can be substantial responsibility involved in remodeling them, so they can end up being expensive.
- The more time you spend on remodeling, the more revenue you are losing each month.
- Due to the cost of extra labor, upgraded materials, and other projects that will drive your expenses up, budgeting for a fixer-upper can be tough.
- Although there is potential for higher returns, there is also a higher risk involved. Insurance companies view fixer-uppers as high risk as well, especially if they’ve been foreclosed on or abandoned in the past.
Once again, always do research on any home you plan to buy. Make sure you weigh out the costs and benefits. If you go with a turnkey property, you need to know how to protect yourself against potentially dangerous turnkey property companies. On the flip side, you can find more information on how to pick a fixer-upper here.
With choosing the location of the property, you don’t have to choose a property in your state. For instance, if you live in California, you might want to look into investing in nearby states with cheaper housing. It’s worth checking out property in other states. You may be able to invest in a better real estate property than merely buying a home in your town, city, or state.
When it comes to choosing a location, you want to look for the following:
- Vibrant local economies
- Low unemployment rates
- High occupancy rental opportunities
- High per-capita incomes
- Good neighborhoods with a low crime rate
The reason you are looking for these factors is that you 1) want to reduce the chance of tenant vacancy; 2) you want a property that people want to live in. It doesn’t matter how cheap a house is: if people don’t feel safe living in it, they won’t. That’s why the second point is so important.
You may find the perfect house in a lacking neighborhood. Or you may pull a complete 180 and see a stellar neighborhood with a not-so-impressive home. Resist the urge to pull the trigger on either house.
Also, another tip for looking for a high-quality location is to search for properties near universities, especially private ones. Having a house near a university gives you a higher chance of always having tenants because there will be students every year looking for nearby housing. Additionally, if you put the house near a private school where there tends to be a lot of affluent students attending, you can charge higher rent. After all, affluent people have the money to pay for it. Plus, if it’s within walking distance from the college, there are people willing to pay a pretty penny for that.
Buy at a Good Value
When you find a property you like, it may be tempting to overpay in order to tie it up. Don’t. Overpaying shrinks your profit margin.
Instead, wait it out until a reasonable deal comes along. Check out what comparable properties go for in the area. While it will cost you time, your wallet will thank you later.
Pay Attention to the Construction of the Home
While your jaw may drop at the site of an ostentatious house, simpler is almost always better when it comes to rentals. Houses with standard construction will be less expensive to repair and maintain in the long run. Ornate houses also shrink the pool of potential renters for your property.
Also pay attention to important factors, like the roof or whether the house sits at the bottom of a slope. A roof without a steep slope may have problems in areas with heavy snowfall. Homes at the bottom of a slope may be more prone to flooding and have expensive foundation repairs due later on.
Know Your Local Laws and Regulations
Did you know that in San Francisco, if you advertise a rental property as having a view and new construction later blocks that view, your tenant can force you to reduce the rent?
Most first-time landlords wouldn’t be aware of the lengthy list of rules and regulations that bind landlords. Make sure that you don’t get bit by one of these rules or regulations down the road because you didn’t do your homework beforehand.
Avail offers a great state-by-state resource for landlords to research applicable laws.
If you’re still concerned about landlord laws, check out your state, county, and city housing websites for more info, or consult an experienced real estate attorney.
Consider Your Own Commute to the Property
If you’re going to be a hands-on landlord, think about the time you’ll spend traveling to the property. That hour long drive back and forth could become an absolute headache for you, especially if your tenant calls you in the AM with an emergency.
Bigger Isn’t Always Better
You’ll certainly pay more for a five-bedroom home, but you may find that you don’t collect that much more in rent than if you had purchased a four-bedroom home. Larger homes also have more components, which will add to your list of repairs and maintenance.
Don’t neglect lot size either. A home on a two-acre lot may not collect much more rent than the same home on a half-acre lot, but you’ll certainly end up paying more in property taxes for the two-acre lot home.
Inspecting The Property
This aspect of buying a home is crucial. Whether you buy a turnkey or a fixer-upper, you need to inspect the home. A house can look good at first glance, but if it comes with a bunch of issues you didn’t check before buying, that will end up costing you. If you don’t inspect, you could end up purchasing a home that isn’t worth the money.
Getting an independent and professional home inspector can help you discover issues such as a deteriorating roof, faulty foundation, or a damaged plumbing system.
When inspecting the home, the inspector should be checking these aspects:
- Plumbing fixtures, faucets, and water heater
- Thermostats and heating, cooling, and ventilation (HVAC) system
- Electrical panel, light switches, and power outlets
- Exterior stucco or paint
- Rain gutters and downspouts
- Attic space
Once you’ve inspected the property and know it doesn’t have any significant issues, you can go ahead with purchasing the home.
Finding The Right Tenants For Your Rental Property
Finding the right tenants can make a big difference in how “passive” your income truly is. If you have tenants that don’t pay their rent on time, end up needing to be vacated, or are calling you at all hours of the night, you’re going to have to do a lot more work than required for typical passive income.
You want tenants who will pay on time, who will take care of the property, and plan to rent long-term. This kind of tenant is most likely to be found in high-income areas. On the other hand, tenants in low-income areas generally tend to cause negligent property damage, fail to pay their rent on time, and rent short-term.
However, there is always some wiggle room when it comes to choosing where to purchase a home. Just make sure that, no matter what, you screen your tenants. Always check their level of income and credit rating. You also need to do a check on rental, criminal, and employment background.
So, how do you go about finding a tenant? Below are some tips that could help you snag a tenant.
Use a “For Rent” Sign
Pop into your local supermarket or hardware store and chances are they’ll have several “For Rent” signs for you to choose from.
It’s the oldest and simplest way to capture a tenant, but it will market your rental to anyone passing by. What’s even better is that you’ll only spend a few dollars using this marketing tool.
Many potential renters begin their search on Craigslist. You can have your property posted in under 10 minutes and in most US cities, Craigslist doesn’t charge you anything for rental postings.
Make sure to use high-quality photos to capture attention. Also list any important details (e.g. pet policy, who pays utilities, etc.) so that you won’t be contacted by people who won’t be a good fit for your property.
Real estate websites, such as Zillow and Trulia, have become popular tools for browsing properties for rent. They give your listing a more professional appearance and make it easy for would-be renters to check out your property on their smartphone using apps.
A lot of these sites used to make rental listings available for free, however many have begun to charge a fee.
Similar to posting on Craigslist, your listing should include eye-catching photos and relevant information.
Think of all the friends you have on Facebook. Now think of all the friends those friends have.
Creating a Facebook post showcasing your rental spreads your listing through a limitless network. The cost for you to do this? Zero dollars.
Believe it or not, about 30 million Americans still subscribe to their local daily newspaper. While this route will cost you some bucks, anyone reading a newspaper these days will probably be less likely to be a low-quality tenant.
Keep in mind that you’ll have to learn the specific abbreviated lingo associated with these types of listings. For example, “W/D” indicates the property comes with washer and dryer.
Word of Mouth
Chances are someone you know knows someone in the market for a rental. The next time you attend a friend’s barbecue or your kid’s soccer game, bring up the fact you have a home ready to rent. Talk is cheap and this method won’t set you back a penny.
Real Estate Agent
By far the most expensive way to obtain a tenant will be using the services of a real estate agent. It’s not uncommon for an agent to charge anywhere from 50 to 100% of one month’s rent for their work.
But with that cost comes some added benefits to you. An experienced agent has most likely mastered the art of marketing and will know what kind of rent you can get for your house. Their list of duties often includes showing the property to potential renters, answering inquiry calls, and screening applicants. This allows you to mostly sit back and wait until it’s time to sign the lease.
Getting A Property Manager
Last but not least is getting a property manager. While yes, you could technically manage the property yourself, it would take away a lot of the “passive” part of the income. If you don’t want to be taking calls from your tenants at 2 AM or managing the property 24/7, it would be wise to hire a professional to do these things for you.
Even with a property manager, there is still work you may have to do, but at least they would lessen the load on you. In addition to being more available to your tenants than you probably want to be, they can also help you with:
- Advertising a vacant rental property
- Screening potential tenants
- Evicting tenants
- Making sure you are following federal, state, and local landlord-tenant laws
Even though it may not be a necessity to get a property manager (which we’ll take a closer look at below), the point of buying a passive income rental property is to do as little as possible while still having money coming in. With that said, if you decide to hire a property manager, make sure you are checking their client portfolio, experience and training, client retention ratio, tenant lease-renewal rate, and their average eviction rates before making a hiring decision.
When to Use a Property Manager
You Possess a Large Inventory of Rental Properties
If you keep at it and grow your portfolio of rentals, you’ll reach a point where managing everything will become more than a full-time job. Once you reach this point, you should seriously consider utilizing a property manager to alleviate the stress.
You Don’t Live in the Area or Travel Frequently
While the internet allows all sorts of tasks to be done remotely, with rentals there will come a time when someone needs to pay a visit to the property. Whether it be a repair, inspection, or showing, if you’re permanently or frequently out of the area, a property manager can take care of those in-person tasks.
You Don’t Want to Deal with the Hassle
Toilets will break. Sprinklers need to be blown out. Any homeowner knows the list goes on and on for the maintenance of a house. If you find yourself balking at the idea of handling all of this or taking complaint calls from your tenant, a property manager will deal with these stresses for you.
When to Pass on a Property Manager
You Can’t Afford It
Most likely you’ll use a mortgage to purchase your house. Add the mortgage payment to the list of everything else you’ll be writing a check for, like property taxes and insurance, and you may find that the cost of a property manager isn’t feasible.
You’re a Full-Time Landlord
Don’t have a full-time career? Then you may consider yourself a full-time landlord. If the idea of communicating with tenants and handling maintenance and repairs doesn’t turn you off, then you may consider saving yourself the cost of a property manager and keeping the extra money in your pocket.
Setting Up an LLC for Your Rental
A majority of serious landlords don’t keep the title to their property in their name personally. They setup a limited liability company (LLC) for this purpose. When you start to list off the benefits of setting up an LLC for your rental, it becomes clear that it’s something you should strongly consider.
Limits Your Personal Liability
It’s all in the name. Many landlords find themselves in the unfortunate position of being sued at some point. As long as you have your ducks in a row and your rental property is held by your LLC, the plaintiff will be forced to sue your LLC. This means that any assets held by you personally, like your residence, cars, bank accounts, will be safe in the event a judgment is issued against your LLC.
Who wants to give the IRS anymore than they absolutely have to? With an LLC, you’ll be forced to keep your business expenses separate from your personal expenses. This will make it easier to claim business deductions when the taxman comes knocking in April.
Additionally, LLC’s are subject to “pass-thru” taxation, meaning the LLC’s income will be taxed as part of your personal income.
Clearly Defines Rights and Responsibilities with Partners
If you’re purchasing a rental property with a partner, other than your spouse, you’ll want to make the rights and responsibilities of each partner clear. When you form an LLC, you create what’s called an “operating agreement.”
This important document addresses all sorts of events, such as the death of a partner and how profits are to be distributed. Without an LLC, you run the risk of running into a situation where you and your partner come to a disagreement and have no legal document to address the situation. That leaves compromise or a lawsuit as your only options.
When Should I Setup the LLC for My Rental?
As soon as possible! Ideally, when you sign the purchase agreement, your LLC will be listed as the purchaser. Waiting until later can create all sorts of headaches that you could have avoided.
For one thing, if you have mortgage against the property, you’ll have to receive permission from the bank to transfer title to the property from you to your LLC. Not all lenders will be easily persuaded to allow this.
Additionally, if you already have a signed lease, you’ll have to update it to make sure your tenant understands you are no longer personally the landlord.
Finally, some states assess title transfer fees anytime title to real estate changes hands. While some states may provide an exemption for transferring property from you personally to your LLC, others may levy charges against you.
How to Setup an LLC
Do It Yourself
Scour the internet and you’ll find do-it-yourself guides for setting up an LLC all on your own. Some sites even provide free fill-in-the-blank documents for doing so.
Be very cautious if you go done this path. Some states have very specific requirements for LLC formation and not every site has accurate or updated information.
Use a Legal Site
There are dedicated websites out there, like LegalZoom and Nolo, that will help you create an LLC for a fee. These sites are reputable and work with attorneys around the country to ensure your LLC is legitimate. Many will even file the necessary paperwork with your state or city directly and save you the trouble of doing so.
Hire an Attorney
By far this will be the most expensive method for creating your LLC. However, an experienced attorney possesses a wealth of knowledge that can be invaluable. You should especially consider hiring an attorney if you’re looking to setup a complex LLC or need special customizations in your documents.
Wrapping Up: Make Passive Income On Rental Properties
While purchasing real estate takes a lot of research and careful decision-making, the return on investment can be high. If you play your cards right, you can make a lot of money with rental properties. The more properties you buy, the sharper you will get at making the best buying decisions and choosing the best property managers and tenants. You’ll also begin to increase your passive income more and more.
The goal is to have so much passive income that one vacancy in a house doesn’t stress you out anymore. Better yet, make your goal to have so much passive income that you get to quit your day job!
If investing in and managing rental properties is too much involvement for your taste, you may consider investing in REITs to generate passive income from dividends.