The easiest ways to get started
Historically, real estate has been one of the best methods for generating passive income in America. Rental real estate tends to be a strong hedge against inflation, it comes with a multitude of tax benefits, and can carry less risk than other types of investments.
However, it does not come without risk and may not be the best investment type for everyone. In this article, I intend to explain the benefits and drawbacks of using real estate to build wealth.
Is real estate the right investment for me?
Like every answer to a hard question, it depends.
It depends on your personality, location, budget, credit, willingness to be an active landlord, and many other variables.
Some people simply do not want to be a landlord. They may have ethical considerations around charging rent, or they may not want to deal with the workload that comes with owning property. For others, it’s a perfect fit. They want to provide a good product and enjoy offering a home to someone who will take pride in living there.
The first question you must ask yourself is “Do I want to be a landlord?” If the answer is “yes,” then read on. Note: If you’re not in a situation where you can purchase a home but have a little bit of money available for investing in real estate, check out our review of the Arrived App instead. You can invest small amounts of money into real estate projects without the management overhead from traditional real estate investing.
Can I afford to be a landlord?
This is largely dependent on you. Owning real estate does not have to be expensive. The first step in using property values and deciding if you can afford it is looking at properties you might be interested in buying.
5 Ways to make money as a landlord
1. Use your personal home as a rental home
If you already own a home, you could consider renting out a room to make extra money. The downside to this is that you now have a roommate who will be sharing your home, and your ability to maximize tax deductions is limited to the amount of space you rent out.
2. Build or rent an accessory dwelling unit (ADU)
If you have a habitable space such as a finished garage, an accessory dwelling unit (ADU), or other space separate from your home and on your property, this can become a rental home.
Before you move forward with this approach, you’ll want to make sure that your ADU complies with all local, state, and federal regulations around rental properties. There is nothing worse than getting a letter from the city saying that your ADU is illegal or not habitable. Contact a local professional to determine if your ADU can be considered a legal habitable space.
3. Rent out the spare unit in a duplex or a multifamily building
This may be one of the easiest forms of owning rental property. You can enjoy living in your own private space, and rent out an adjacent space in the building to a tenant. If there are issues with the rental unit, you are close by and can usually resolve problems quickly and cheaply.
There are tradeoffs to this approach as well. Your tenant lives right next door to you and they know it. You may have someone quick to contact you for any small detail and that could become problematic or create tension in the relationship.
You’ll want to make sure the person who will be renting from you understands the scope of your relationship and what service you are willing to provide. You must always provide an adequate, safe living space that follows regulations, so the quality of the duplex you purchase should be a factor in determining whether or not this approach makes sense for you.
4. Convert your personal home into a rental property
Do you already own your home and are thinking of moving? Consider converting your personal home into an investment property instead of selling it. There are several scenarios you will want to examine when deciding if this is the right choice. I discuss that in a separate section in this article further below.
5. Buy a rental property
Sometimes it’s easiest to start from scratch. Buying rental property takes a combination of research, skill, and even some luck. Many property investors have their own strategies for buying and owning rental property, and I’ll get into some of those a little later on.
Should I convert my personal home into a rental property?
So you’re thinking about moving and you want to know if you should rent out your existing home versus selling it. There are a few things to think about here:
Have you lived in the home for 2 out of the last 5 years?
If so, then you can deduct up to $250,000 of the increased value from your taxes if you sell your home. If you’re married and file your taxes jointly, that amount increases to $500,000. If the value of your home has gone up substantially, you could be giving up this deduction if you used the home as a rental property.
This isn’t a dealbreaker if you plan to own the rental property for a long time, or want to eventually own larger rental properties — because other tax benefits can outweigh giving up this large deduction.
Can you afford it?
If you are planning on purchasing another home and using your current property as a rental unit, then you’ll need to come up with a down payment and qualify for another mortgage for that new home.
You may be able to take a home equity line of credit toward your rental property to help with the down payment if there are no loans on your current home or the balance of the existing mortgage is much lower than the value of the property.
These types of loans can be more expensive and when you combine it with a new mortgage payment, your monthly payments may not be enough to cover the costs associated with the rental property — even with monthly rental income.
You should talk to an accountant or financial advisor if you are not sure if you can afford to do this. You never want to be in a situation where you can’t afford to make repairs or pay insurance and taxes on your properties.
What are the benefits of converting my home into a rental property?
One of the biggest benefits of property ownership is taxes. With a rental property, you collect rental income. Normally, you must pay taxes on any income you take in. However, the IRS is very generous to landlords. You may deduct most expenses associated with rental properties.
For example, if there is an upgrade or repair that you need to do on your home, you can’t deduct those costs when it is your personal home. Once it’s a rental unit, you can replace the floors, upgrade the HVAC, or do a number of other things and deduct those expenses from your income.
Another huge tax benefit is known as depreciation. Simply put, take the amount you paid for the home, divide it by 27.5 and magically subtract that from your income. You can do this every year until you have deducted the complete purchase price from your taxes over time.
For example, if you paid $250,000 for your home, every year you will receive a deduction of $9,090 from your income right off the top for 27.5 years! When it comes time to sell the rental property, you will have to “recapture” that depreciation (i.e. pay taxes), unless you take advantage of another benefit known as a “1031 exchange.”
The 1031 exchange is where you “trade up” your property. That is, you sell the rental property and upgrade to a more expensive similar type of rental property. In that situation, you could never pay taxes on any of the depreciation that you have accumulated. How to do this is beyond the scope of this article, but just know that if you are in it for the long haul, the tax benefits are very beneficial.
How to buy a rental property
So you’ve decided to get into the real estate market and buy a new rental property. Congratulations! This initial investment is your first step in investing passive real estate, into a long-term, income-producing asset.
Now it’s time to learn how to evaluate a prospective rental property. For simplicity, we will focus on single-family houses in this section.
Costs of ownership
Owning a rental property isn’t just about buying a property and collecting rent. You’ll need to understand what your true costs of ownership will be, and whether or not the rental income for that property will be a good investment. There are both fixed costs and flexible costs.
Fixed expenses:
Mortgage Payment
This is a payment that covers your mortgage principal and interest. Your loan interest rate will determine how much interest is charged on the mortgage, and a higher interest rate will result in lower returns. You can deduct interest payments from the annual income that you earn for an added tax benefit.
Annual Taxes
These are taxes typically assessed by the local municipality where the property is located. In most cases, you can find property taxes directly from the city or even on listing sites like Zillow.
Insurance
If your property is a condo or in a larger building, there will be two types of insurance. There will be building insurance, which is typically paid by the building management company, and also condo insurance which is usually cheaper and insures everything from the walls of the unit to the interior.
You will also want to consider where your property is located, and whether or not you need flood insurance, earthquake insurance, or other large hazard insurance such as coverage for wildfires. These additional insurance costs can quickly make a good investment start to look bad.
HOA dues
This information is usually provided by the seller. HOA dues cover the costs of management for properties that are located inside larger buildings and communities. You are always required to pay HOA dues. High HOA dues can affect your net income significantly, and can also reduce the attractiveness of the property when it comes time to sell it, which can also result in lower home values.
Flexible expenses:
Monthly bills
What utilities are you paying for and which ones are the tenant paying for?
Typically, tenants pay for internet, phone service, gas, and electricity. Sometimes, they also pay for services such as water and trash pickup. This is usually based on the market you are renting in. Look at other rental properties in the area and see what utilities are covered. You’ll want to be competitive with those other owners
Repairs
Expect the unexpected, because it always happens. Just like owning a personal home, you will need to have the resources available to cover repairs, both large and small. Large expenses include new roofs, siding, driveways, sidewalks, tree removal, major plumbing and electrical work, and replacing large appliances.
You’ll need to repaint the interior and change the locks when tenants leave, as all homes need to be maintained. Budgeting for repairs will depend on the age of the home and the types of appliances and finishes it has. High-end appliances are more expensive to replace, and older homes usually have more repairs than newer homes. If you are local and skilled, you can save money by doing repairs yourself. Otherwise, you’ll need to hire professionals each time and that can add up quickly.
Vacancy and default
Many new investors don’t consider vacancy or default when they are thinking about real estate investment. You generate income while someone is living in the unit and paying rent, but what happens when they move out or have trouble paying? Your expenses do not stop when rent payments stop coming in. This is why tenant screening is important and maintaining a good relationship and keeping your tenants happy can be a boon to your bottom line.
A good rule of thumb is to estimate an average of 5-10% annually will be lost due to vacancy or nonpayment of rent. It may not happen for years, and then a tenant loses their job or moves out and you can’t find a new renter quickly. You should always reserve cash for this situation.
Estimating Income and Expenses
Once you’ve found a rental property that you think might be part of a good investment portfolio buy, it’s time to estimate your income and expenses.
Income
This one is mostly straightforward. Look at the rental market rent for similar properties in the area. Be sure to look at homes with similar features: bedrooms, bathrooms, finishes, and amenities such as outdoor space.
There are also third-party tools you can use to get an estimate of income potential. Additionally, there may be other types of income such as furnishing the apartment, providing coin laundry, maid service, selling additional storage space, and parking — this will depend on the market. Some markets will not be able to sell these types of services, but others will. Estimate your total annual income based on these details.
Expenses
Add up all of your fixed expenses using the best possible estimates for each expense category. This is what you know you are going to have to spend each month. Next, put together an estimate of your flexible expenses. If you’re having trouble with some expense estimates, here are some models you can use:
- Repairs: 1.5% of the value of the home. For example, if your property is worth $250,000 – then estimate about $3,750 in repairs.
- Vacancy: 5-10%. When a tenant moves out, it can take weeks or longer before a new tenant moves in. If the market you’re in is hot, that number can be lower. You will still need time to clean the apartment, paint, and perform any needed repairs between tenants. This is why having a long-term high-quality tenant with a good relationship can make or break your return on a rental property.
- Default: This can be bundled with the vacancy rate. Default rates depend on the overall economic climate and the type of market your property is located in. For example, during the COVID-19 pandemic, default rates were much higher due to unemployment. As with vacancies, it is important to have enough cash set aside for unexpected situations that may arise. It is always better to have a good relationship with your tenants and to communicate with them so that you can have a plan to help get them through tough times.
Evaluating the Results
Once you have reviewed potential income and expenses, you can decide if this investment is the right choice for you.
- Take the total estimated income, subtract the total estimated expenses, and this will provide the net income for the property.
- Then divide the net income by the purchase price to produce what is called the CAP rate. If the number is negative, this is probably not a good investment. The higher the CAP rate, the better potential cash flow you will have.
Many properties have CAP rates between 3-10%. This means that you will earn between 3-10% on average against the purchase price of the property. If everything sounds good to you, then make an offer and get started!
FAQs
Can you make passive income with real estate?
Yes, it is absolutely possible to earn passive income with real estate. However, real estate investments do not come without risk. It is important to evaluate a real estate purchase, analyze the income and expenses, and have a plan for when things go wrong. In this business, cash is king!
You will want to always make sure you have access to enough cash in situations where a tenant moves out or doesn’t pay rent, or when there are large repairs and unexpected expenses. If you want passive real estate investing to be truly passive, you can hire a property manager to handle the day-to-day operations of the property. This will reduce your net income but can allow you to enjoy passive income.
How much money do I need to invest to make $3,000 a month?
This largely depends on the property itself. If you have taken all the steps to come up with a CAP rate, and you are confident that the CAP right is achievable, then you can use the CAP rate to determine your potential monthly income:
Monthly Income = CAP Rate (as a percentage) x Home Purchase Price ÷ 12
So, if your cap rate is 5%, then your formula is:
$3,000 = 0.05 x Home Purchase Price ÷ 12
With this formula, the home purchase price would need to be at least $720,000 to achieve $3,000 a month. If you are getting a loan, you will need to factor in your interest rate and mortgage payments as well, but you will need much less money as a down payment.
Can real estate make you a millionaire?
The short answer is yes. The long and most truthful answer is, yes but it is not guaranteed and it can take a long time.
In this article, we did not go into every aspect of real estate investment, such as property appreciation.
The goal of this article is to educate you on how to get started with passive investing in real estate. The longer you own property and have solid tenants whose rental income pays for the property costs, the more benefits you will see.
For those who do make money through owning and renting out real estate, you will see that your principal loan decreases faster and faster the longer you own the property. It also comes with numerous tax benefits which results in direct cash back into your pocket. When it comes time to sell the property, you will typically be able to sell the home at a higher price. All of that results in more income and creating long-term wealth.
