Using rental property for passive income is my absolute favorite way to create wealth! If you want to create more wealth for your family in the future, then investing in a rental property could be a great solution.
Of course, there are plenty of things to consider when you are starting to look at rental properties to determine if this is the right course to take. Are you financially prepared for something like this? Are you knowledgeable enough about the market to start investing?
To help you see if using a rental property for passive income is the best option for you, I made this quick guide to help you see if this is a sound investment. You mat also want to read about passive vs. nonpassive income to get a good understanding of the difference.
Disclaimer: I am not a financial advisor, and this is not financial advice. Contact your financial advisor for individualized financial advice.
Why Buy Rental Properties?
If you are looking to invest in a new method of passive income, purchasing rental properties is an amazing option.
On average, real estate investors earn an annual return of over 10% for commercial real estate and over 16% of residential real estate. That makes your return on investment (ROI) pretty darn good!
Investing in real estate is helping families retire as early as their 30’s. This is my hands-down favorite way to invest to get to that financial freedom number!
Generate Passive Income
Essentially, using rental property as a way to generate passive income involves finding tenants that are willing to pay to live in, or use your property for business (depending on the type of property).
Of course, if it were that simple, everyone would be doing it. There are many parts to consider when you are looking at how you want to rent property.
From what type of building you want to own to how you will pay for it to the actual maintenance once you own the property- there are a TON of things to consider before you begin investing.
Luckily, I go over all of the things that you need to consider before using rental property for passive income in this article.
What Type of Building
Aside from commercial vs. residential properties, you will need to look at if you want to invest in an apartment building, single family rental, an office building, or a single room in your house (yes, you can rent out a room in your house if you have extra space).
Most experts recommend that beginning investors start off with a single family rental while they get their feet wet. With fewer tenants, you will be able to get over the learning curve of a new investment faster. This is what I do currently.
Location, Location, Location
The three most important parts of any real estate investment- where is the property?
The location of where you are hoping to begin renting is extremely important. If it’s a single family home, is it on the corner of a busy intersection, a part of town with a lot of crime, or an area where you won’t make any money renting (ahem…expensive California real estate)?
If it’s an office building, is it in an area with a lot of small companies? You want to get a feel for the area and the needs of the area before you begin buying property so that you can make top dollar for your rental property.
If you are unable to do the research yourself, hire a professional, but just know that it needs to be done before you purchase any property.
If you can, you want to look in an area that you can physically visit in order to look at the condition of the building. You’re investing a lot and you don’t want to risk missing on the crack in the foundation.
That said – ALWAYS hire a property inspector when you get started with investing to make sure you’re not buying a total lemon (trust me – lemons suck).
Short Term Rental vs. Long Term Rental
Decide whether you want to use the property as a short term rental or a long term rental.
Short term rentals are rentals that typically don’t last more than a few weeks at most (think like an AirBnB). These can be a great rental option for someone looking to stay in a place for a short amount of time.
If you have ever stayed in one, you know that you can rent out a room, an entire house, even a tree-house in the backyard! This gives you the opportunity to become creative and meet people from around the world.
Note – you’ll want to check the laws in your area to see what kinds of restrictions are in place for short term rentals.
Long term rentals are the traditional rental where you rent out a space for a 6,12, or 18 month lease (or any time period longer than 30 days). This can be a room, an apartment, or an entire home.
With decent tenants, you will find that this is one of the simpler ways to rent out a space. Since it is theirs for an extended period of time, they are able to own the space and- more importantly- help give you a consistent income every month.
90% of my rental properties are single family homes I find the rents to be very stable.
Being Financially Prepared
There is this preconceived notion that for someone to begin investing in rental properties that they need to be able to buy the entire building for cash. Luckily, that isn’t true.
If you are able to, look into acquiring a mortgage to help you pay for the rental property. You won’t be able to get quite the favorable terms as when buying your personal residence, but right now interest rates are at an all time low!
Just make sure you look into every single option for purchasing a rental unit so that you make the wisest financial decision for you. Since every lender is going to have different conditions, make sure you shop around to find the best fit for you.
And, of course, look into your monthly expenses vs. your ROI to make sure that this purchase is the best one for you.
If your mortgage is $1000 a month but you are only able to charge $400 a month in rent, then you still need to be able to afford that extra $600 each month. This is not a good passive income investment, it’s a money pit!
Looking at your CAP rate and the ROI on a Rental Property
Figuring out your capitalization (CAP) rate as well as your ROI will help you determine the worth of your rental property.
Your CAP rate is what your property is worth based on rental income generated. Calculating your CAP rate will help you compare your property to similar properties in the area. Note: CAP rate is only used for commercial properties
You also should review and understand your ROI so that you are able to calculate the value of your rental property.
In general, an ROI of 10% is considered good for anyone looking into investing in a rental property. Many real estate investors, however, won’t even look at a property unless the ROI is at a 20% minimum.
I personally look for about 12-15% ROI, but those are my own personal goals.
After You Invest
Like all passive income that is worth investing in, not all of it will be completely work free. There will always be little things here and there for you to do in order to keep your income coming from your rental property.
This goes for risk as well – every investment holds some risk. You may have to cover expenses while finding new tenants, replace an expensive roof, etc. etc.
Here are a few things to consider after you invest…
Finding the Right Tenants
Whether you decide to vet your tenants yourself or hire out that service, you want to choose your tenants wisely. Remember- these people will be living in your home and need to treat it with respect as well as pay the rent on time.
Doing background checks as well as looking at their credit scores is incredibly important to ensure you choose the right tenants for your property.
Having to evict your tenants can be costly and time consuming (depending on your state laws). Doing the work up front to screen properly can help you avoid these issues.
Things Break
Depending on your contract, there are certain things that the landlord is responsible for when they break in a rental unit (most things, unless your tenant negligently broke it). You need to make sure that you are prepared financially to deal with those problems!
Whether a toilet gets clogged, a dishwasher breaks, or the mailbox falls off its post (it happened to me!), you need to be able to have the funds to fix certain things.
Most people that use rental properties for passive income will save up to 20% of their rental income for emergencies like this.
Sure, you might be able to come in and fix the job yourself, but you want to be able to pay a professional in case something big breaks. If not, it can cost you a lot more in a legal battle.
And honestly, can you replace a roof? fix electrical issues, eliminate pests, etc.? You’ll probably need to hire a professional so make sure to have the appropriate cash reserves!
Does Something Need to be Replaced?
With rentals, things can happen and things just need to be replaced. A kid might throw a ball and break a window, the bathtub cracks, or the washing machine needs an upgrade. It can happen to anyone, and you need the funds to be able to pay for it.
Happy tenants are the best tenants, and the best way to keep them happy is to be able to replace things in a timely manner. If you are wise, that 20% savings mentioned above can help you in those tight spots replace anything broken, quickly.
Even if it’s not an emergency, properties get wear and tear over time. You’ll need to update appliances, paint, replace flooring, replace the roof and HVAC units, water heater, and the list goes on.
Again – be sure to have cash reserves when you start investing in real estate!
In Summary
Using rental properties to generate passive income is an amazing way to build wealth more quickly. In fact, there is plenty of evidence that says that this can be one of the best investment opportunities for you and your family.
Sure, there is a lot to consider. You need to make sure that you are financially ready to take on a rental property as well as the skills to determine if your ROI is worth it.
If you are wise, however, you can make a significant amount of money and potentially meet your wildest wealth dreams!
Do you own rental properties? What is your number one tip for anyone looking to try it out? Tell me in the comments below!
