Ultimate Guide to Passive Income Real Estate Investing
Most of us have been conditioned to fully rely on the income from our day job to pay our bills, take vacations and save for the future. But there is another way, and those who take it will get ahead financially and create a unique type of freedom for their lives – the freedom to choose how and what they do with their time.
Sure, people who have figured out the key to passive real estate investing still have responsibilities, jobs, and work hard to provide for their families. But, they can approach life more freely because they are creating multiple streams of income by diversifying investments, increasing income and protecting themselves from a financial loss. How can you start investing in real estate to earn passive income?
Maybe you have been around others who reap the benefits of passive income from their real estate investments and are ready to start investing yourself. It takes time, knowledge and capital, but earning passive income from real estate is very possible.
What is Passive Income?
By definition, passive income is any money earned that doesn’t require much effort. According to the IRS, passive income can come from two sources, real estate investments and business ventures, which don’t require you to actively participate in the daily operations of the enterprise, like dividends from stock investments or royalties from a patented product you designed. Passive income can be an important part of a wealth planning strategy because we don’t have to trade our time for earning money.
There is a limit to the number of hours we can work in a day or week, but there is technically no limit to the amount of passive income you can earn or the number of passive income streams you can have.
Tips for Obtaining Passive Income From Real Estate
You may have heard that the three most important things when looking at real estate are location, location, location. There is a lot of truth to this statement. Real estate is unique, meaning it can not be created or destroyed — barring natural disasters — and it can not be moved. When looking for income-producing properties, start your search by thinking about the type of property and type of tenants you want to attract. A Triple Net (NNN) neighborhood retail property will need to be in a prime location with great visibility and good ingress/egress. A last-mile warehouse would be placed best near the center of a city, most likely in an industrial area with easy access to major streets connecting the warehouse to anywhere in the city. Either property type could be a good investment but they have very different location requirements.
Hire a Contractor
To save money, it might be tempting to do some, or all, of a property’s repairs on your own. Some of you may have the necessary skills, tools and time to do so, but chances are investing in a good contractor will be worth your while. When tenants move into a new location, they commonly want to make the space their own. Some tenants will hire their own contractors while others will want you, the landlord, to handle the build-out process.
A highly reputable and skilled contractor will be ready to navigate the municipal system to obtain building permits and have designers and engineers ready to assist with layout and design, as well as have qualified labor crews and project managers to keep the project on time and on budget. The more time your building sits empty (even when construction is underway), the longer you wait to see any profit from your investment.
Find the Best Tenants
As an investor, your job is to maintain high occupancy rates by a tenant, or tenants, who pay consistently and on time. Screen tenants on the front end by reviewing their balance sheet, understanding their business and researching the company and its principals. By choosing the right tenants, you can safeguard yourself from the expense and hassle of having tenants who don’t pay. Brand name, corporate-backed tenants are less risky than a small “mom and pop” business, even if the projected annual revenue and balance sheets look similar at first glance. Because leasing space is a larger portion of the operating budget for a smaller business, if there is a downturn in the economy, the smaller business may struggle to pay rent.
On the other hand, real estate costs for larger corporate tenants are often considered as a cost of doing business that is spread across multiple locations, not just a single location. That means if one location experiences a downturn but the other locations are doing well, the tenant still has the funds to continue paying rent.
Have Significant Cash Flow
Investors can expect earnings on an investment property in two forms: cash flow and appreciation. As a property’s value increases, an investor earns equity that can be realized upon selling the property. Appreciation is based on how much you buy a property for and the market conditions at the time of sale. You can control what you pay for a property, but market conditions are outside of your control. Therefore, cash flow will be the main source of income from an investment property.
Cash flow is the flow of money in and out of a property. In other words, rent comes in, expenses are paid and the leftover money is profit. Ideally, a property will have a positive cash flow and the investor will earn a decent return on their investment. If the property has negative cash flow, the investor will have to pay the difference out of pocket.
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Get a Detailed Inspection
Once you have found the right property that will attract high-quality tenants in the right location and generate significant cash flow, you’re under contract and in your due diligence period. Now is the time to get a detailed inspection of the building and facilities. Unless you have constructed the building yourself, there is no way to know the condition of the foundation, structure or mechanical systems.
Even if construction went perfectly, buildings and systems have temporary lives and begin to deteriorate. Over time, foundations can settle, cracks can form and mechanical systems can fail; all would be costly to repair. A detailed inspection will look into each component of a property and produce a report outlining the condition.
Issues found during the inspection can be used as negotiation points to either ask the property owner to repair or replace certain things or reduce the cost of the property. Buying a property without an inspection could lead to costly expenses and a lower return than expected.
Calculate Your ROI
Return on Investment (ROI) is the ratio representing the overall return you can reasonably expect to make on an investment. In its most basic formula, an ROI can be calculated by subtracting the cost of an investment from the increase in value, then dividing by the cost of the investment. Costs associated with an income-producing property include maintenance and repairs, improvements to the building and grounds, taxes and insurance, and loan carry costs to name a few (with an NNN lease, the tenant will be responsible for most of these expenses).
A property’s value increase comes from combining the cash flow produced by the property and the appreciation in the property. The ROI can be used before purchasing a property to understand how much profit you can reasonably expect to see from an investment. Set anticipated ROI goals before looking at real estate. If a property meets or exceeds your goal, it could be a viable option. If it doesn’t meet your ROI goal, keep looking. The right property is out there.
Hire a Professional
Well, two professionals. Before you begin your property search, hire a top-rated, qualified broker who specializes in the property type you are interested in purchasing. Brokers add value in two ways: 1) they have a deep understanding of the market and will have a pulse on properties that are for sale, may become available and on owners who aren’t actively listing a property but would be interested in selling; and 2) brokers are skilled negotiators and can use their market knowledge to help negotiate the best possible deal for you. Working with a broker can save time, frustration and money. The second professional to hire is a property manager. If your goal is passive income, letting someone else handle the daily operations of a property will free you up to do what you want. Property managers handle everything from rent collection to working with tenants to resolving issues that might arise. Property managers and brokers should be indispensable members of your team.
Use Your Equity to Buy More Properties
Coming up with the down payment for your first property is always the most challenging and it often takes time to have the 20% requirement. But once you own income-producing property, buying your second property is much easier. You can save some of the positive cash flow to help you reach your goal and use the positive equity to make up part, or all of, your down payment. As the value of a property increases and the principal loan amount decreases, equity builds. By refinancing, you can secure a new loan for the value of the property, pay the original loan and use the leftover cash for a down payment. If you continue this process of buying properties that build positive equity quickly and have refinancing as well as use the equity to buy additional properties, your portfolio will grow at exponential rates.
Examples of Passive Real Estate Investments
There are typically considered to be four types of real estate: residential, industrial, commercial and land, with several sub-property types. Any property type can become a good passive real estate investment as long as it fits your investment strategy, including meeting your ROI and cash flow requirements.
Residential properties (single-family rentals) might be the most affordable properties to invest in and may have a decent ROI, but cash flow will likely be lower than other property types. Industrial properties include warehouses, flex space and manufacturing facilities. With an increase in our reliance on eCommerce and demand for supply chain and logistics infrastructure, last-mile warehousing requirements will only continue to grow for the foreseeable future, creating stable investment opportunities.
Commercial properties include office, retail, multi-family and mixed-use. Office buildings usually house multiple tenants who have gross leases on their individual spaces. With gross leases, tenants pay their portion of the rent, usually calculated based on the square footage each tenant leases and from the rent collected; the landlord is responsible for paying property taxes, insurance, and maintenance and repairs.
Retail could be a shopping mall, grocery-anchored strip center, neighborhood shopping center or stand-alone single-tenant building. Usually, retail properties use Triple Net (NNN) leases in which the tenants pay their portion of the rent to the landlord and are additionally responsible for taxes, insurance, and repairs and maintenance. From an investor standpoint, putting responsibility for most costs associated with a property on the tenants reduces the property management responsibilities and eases ownership of the property.
Multi-family (apartments, student housing, condominiums, age-restricted buildings, etc…) can be great investments, especially if they are in the right location and provide the type and quality of housing that the surrounding area demands. Multi-family properties tend to require slightly more involved management and often an onsite staff to carry out day-to-day tasks. As the name implies, mixed-use properties house a mixture of property types, including multifamily, office and retail. For the right investor, multi-use properties can check a lot of boxes; however, the initial investment tends to be relatively high and may price out a lot of competition.
Land can be an interesting income-producing investment because it requires very little hands-on involvement from the investor and can produce a high ROI, but it also requires finding the right tenant and risks potentially sitting vacant for a long time before seeing any return from the investment. Property developers are often willing to sign long-term leases (25 years, 50 years, 100 years or more) and develop the site to their specifications. For example, a fast-food restaurant might want to build a new site but not have the capital required to buy a site then develop it. One solution is to lease the land, which would require a significantly lower initial investment for the fast-food restaurant and provide passive cash flow for the property owner.
Investing in real estate and earning passive income is an attainable goal for many of us, especially since there are several routes to property ownership depending on what you are looking for in an investment. As an investor, take an inventory of your portfolio, investment needs and anticipated returns, then develop an investment strategy.
When looking for properties, let your strategy dictate the property types you consider and let the numbers guide your purchasing decisions. If one property doesn’t work, there are other options available and surely you’ll be able to find a property that fits your specific criteria. Passive income from real estate investments can generate additional income and, as your portfolio grows, eventually replace your active income altogether.
Liberty Real Estate Fund offers easy access to Stable and Tradable Private Real Estate with a diverse portfolio of Net Lease properties specially designed to provide you consistent monthly income and cash flow. Put your money to work for you where where you live with investments in auto services, healthcare, pharmacies, necessity shopping, mobile communications and convenience stores. Contact us today to get started!