- Making Passive Income On Rental Properties: Starting Off
- Preparing Financially
- Figuring Out The Cap Rate And ROI
- Choosing A Rental Property
- Inspecting The Property
- Finding The Right Tenants For Your Rental Property
- Getting A Property Manager
- Wrapping Up: Make Passive Income On Rental Properties
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! If you aren’t smart with this, 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.
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.
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.
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.
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, 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.
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!