While there are many ways to make money in the real estate industry, in this article we will give an overview of how to create passive income streams using real estate. This would exclude being a real estate agent, a virtual assistant, or a wholesaler or other types of jobs that could be used as side hustles to build up seed money (extra cash) to invest in passive income opportunities. Real estate is an interesting asset class that many people and businesses need which means there are many ways to produce income.
What is Real Estate?
In it’s simplest form, real estate consists of land and physical properties. You can buy land and develop it into something or you can buy a physical structure. The typical path the majority of people take to making money from real estate is buying their own house. Similar to owning a stock, most people will buy a home and let the market appreciation increase the value of the asset they are holding. While this does happen, you can’t control the market.
Single family homes get valued based on the value of homes being bought and sold near by. If people near you are buying similar homes to yours for higher prices than what you paid for, then the perceived value of your home will increase. Land also appreciates as plots around it are bought for higher prices. Commercial properties, used for business purposes, are generally compared to their competitors as well but there is more emphasis on the income it is currently producing at the time of purchase.
As prices increase, it increasingly gets harder and harder to purchase real estate at higher and higher prices. That is why when interest rates are low, people can obtain larger, cheaper loans from banks to buy real estate when they can’t buy it for cash as we do with smaller purchases. The debt or loan is also known as leverage when you partner with a money lender to buy something (buildings, land, business, etc.) As you can see, acquiring and maintaining real estate is more hands on than investments in the BUY or BORROW categories of our site. However, real estate is a powerful investment that has many benefits and tax incentives that are hard to come by in other products on the market.
How does this grow my passive income?
The main source of passive income from real estate has to do with renting out the space you own to someone else who is willing to pay for the space for a contracted amount of time. People need a place to live and a place to conduct business, if they can’t afford to buy their own space then they rent it from you.
Once you’ve acquired a home, apartment, a billboard, land, storage, parking lot, etc. then depending on your investment strategy, it’s time to add value. This may include cleaning up the outside or inside of the building or land you purchased. In order for people to want to pay for it, it must be comparable to similar real estate offered in the surrounding area. You may do this personally or pay a contractor who specializes in renovations. At this point, you can either work with a property management company that specializes in advertising and maintaining properties similar to yours so that you can focus on other investments, or you can manage it all yourself.
As soon as you have a tenant, someone who is willing to pay for your space for a contracted amount of time, then they can start paying you. This is done typically on a monthly basis and the funds are sent to your bank account. Depending on whether you have a management company in place or not, that may be the last thing you do. Every month, the tenant will pay rent and you will receive money in your bank account. If you own your building by yourself, then you get to keep all the money. If owned in partnership with a lender, then you will use part of those funds to pay your lender back.
When those funds come in during a month you didn’t even think about the property, you will most likely start thinking about how to increase the amount of your new passive income stream. This can be done either by raising rent once the contract expires or reducing expenses (leverage payback, management company fees, contractor fees, etc.) which may be necessary in an inflationary economic environment. The other obvious option is to buy more real estate. If you think about real estate as you would stocks, mutual funds, etc. as you increase the number of shares you own, you increase your chances of having more money come to you. Likewise, as you increase the real estate you own, you increase your chances of having more money come to you.
Why do I want this passive income stream?
Like other investment products, real estate can also give you market appreciation and income. However, investment real estate also has a lot of expenses which can be used to potentially offset the taxable income like businesses do. Outside of the fees we spoke about earlier which can be used to reduce your taxable income, depreciation is another expense that you can use against your income. Depreciation is the gradual devaluing of an asset like a vehicle, machine, building, etc. until it reaches zero. Each year, it depreciates and is considered an expense even though you haven’t spent any money.
Example: You have a $100k investment property and it is currently making you $300/month after your management, landscaping, mortgage interest, insurance, and pest control expenses. Annual depreciation on a single family home is calculated as $100k/27.5 years = approximately $3,600, and your cash flow from the property is $300 x 12 months = $3,600. Thus, your $3,600 is reduced by the $3,600 in depreciation as an additional expense, leaving your taxable income as $0. You get to keep the $3,600 without paying taxes on it!
This is only amplified the more expensive the property is. Working with your accountant, you may even qualify to use any leftover depreciation to cover other passive income streams you have. Real estate becomes an essential portion of a passive income portfolio when you can decrease the taxes you have to pay on your income without having to spend additional money (beyond hiring a good accountant).
Risks and Considerations
“With great power, comes great responsibility”. When you begin building your own assets to produce income, you take on a different risk than other passive income streams you can buy or borrow, and that risk is you. As discussed, in real estate you are a landlord and will be held to the national and local law standards. You now control other’s fates in respect to where they reside or do business. It’s your job to hire the right help (accountants, lawyers, contractors, management company, insurance agent, broker, etc.) to make your dreams become a reality. Obviously, if that is too much for you there are private investments and REITs that specialize in doing the heavy lifting for you, but you are not in control and are at the mercy of the manager’s ability. The returns may not be as large as if you did it on your own but that is the trade off you must make as a passive investor.
Other risks that may not be in your control but that you have to deal with include:
- If the tenants damage the property, do you have the right insurance coverage, contractors, and processes in place to either fix it or remove the tenant, fix it, and then re-rent it quickly to cover the costs of owning real estate?
- What if the bank calls your loan due because they need the money, what is your plan of action?
- If the value of real estate drops due to economic factors and your tenant loses their job, do you have a plan in place of how your mortgage will still be paid and how you will handle a non-paying tenant? (Selling in this scenario might mean losing money depending on your initial purchase price)
- Since you are using expenses to offset your taxable income, are you and your accountant prepared for an audit from your national or state income tax regulating organization?
While there are a lot of risks, as mentioned earlier there are also a lot of rewards for those who can mitigate risk. One way to mitigate risk is to consume a lot of knowledge (podcasts, YouTube, local investor meetups, online forums, books, etc.).
Another way is to partner with another local investor who knows how to manage real estate risks and split the profits. You will learn way more being hands on with someone than watching hours of hearing other people talk about it. You may make mistakes, learn from them. Others may be willing to share what mistakes they’ve made, learn from them too! There are a lot of opportunities in real estate. Do some research and figure out if it’s the right fit for you, or you can use our Passive Investor Questionnaire to get an idea of which passive income streams are right for you to at least start with!