What exactly is the real passive income? A lot of people talk about it, some even dream of having it, but the truth is they are missing the point completely. In order to get to the bottom of this, I went on Wikipedia, and I have to admit I was stunned by some of the passive income examples.
Today, we’ll take a closer look at the property income, and explain why it’s not really a passive income source. However, it’s still a very lucrative business, and if you want to find out the best way on how to get started with your investments, I suggest you pay close attention to the last paragraph.
What exactly is the property income?
When it comes down to it, you’re left with a very clear plan of action. First and foremost, you’ll have to save some money. In this case, let’s set that amount at $20,000. You’ll probably be looking at homes that cost around $100,000, considering that the down payment is usually 20%.
Next thing you’ll need to pay attention to is the mortgage, and in this case, you’ll be looking at a $500/month investment. If you add the property taxes, maintenance costs and the costs of insurance to the equation, the totals climb up to $750/month.
In order to cover those expenses, you then rent out the place for $1,000/month. By doing this, all of your bills are covered, and you actually have some extra money on the side, in case of an emergency. Be careful not to spend it all at once, as you’re gonna need to save a few bucks for repairs that will undoubtedly occur from time to time.
Furthermore, you might be forced to search for tenants for a long time, and as you know, time is money. If you’re lucky, and the apartment value in your neighborhood starts growing, you will be able to raise the price of rent, thus generating even more passive income.
Any possible appreciation in value is a plus, but as time moves forward, you’ll also be creating equity in your house by constantly honoring the mortgage payments. If you get cold feet, or get tired of dealing with annoying tenants, after, let’s say 5 years, you’ll also be able to sell your real estate.
Considering your initial investment costs, and the mortgage payments that “payed for themselves”, you’ll be looking at a decent profit at the end of the day! However, in case you decide to gut it out, and stick till the end of your mortgage payments, you’ll now be looking at a steady property income for years to come. Doesn’t that sound like a terrific deal?
Never settle and create your own real estate empire
Sometimes in life, you have to allow yourself to dream big. In order to achieve great things, this might actually be an essential step. To become a property investor, you have to think like one. To start, most investors never allow their homes to get paid off completely.
After a couple years, once the mortgage gets closer to the end, don’t be afraid to head back to the bank in order to borrow some more money off of that house. By that time, you’ll hopefully be able to save some money on the side as well. Combine the two, and invest again, and then repeat!
After a while, begin to settle down, and let the mortgages pay for themselves. Even better, you’ll still have some profit if you play your cards right. Once all of your debts are cleared, you’ll end up with several homes to your name, and the property income will become your most valuable asset. It’s all about that rent money life!
Finally, if you aren’t willing to wait for several years to get a return on your investment, and you’re looking to make a short-term profit, pay attention to this deal. Some individuals invest their time and efforts in realizing what the market wants, and they invest their savings into buying a property which is on the come up.
Once the prices increase, they put it on sale, and simply collect the difference. Additionally, if home improvement is your cup of tea, you can also head down that path, and turn it into profit. The possibilities are seemingly endless.
Property income can be unpredictable like the sun and the rainfall
Hope you caught that Depeche Mode reference. On a serious note, the thing that scares most businessmen away from investing in properties is the uncertainty of the whole industry. There are so many things that can possibly set you back that it can be scary. Where to begin? How about with vacancies and evictions?
Furthermore, if you live in a country where renter right laws are pretty liberal, and oftentimes change (rarely for the better), you might get the short end of the stick there as well. Due to the crazy times we live in, things like riots and crimes that hit the national news are also a thing worth considering, as they can bring down the property value in a second!
I wouldn’t want to be the bearer of bad news, but another recession is also knocking at the door. Ultimately, there are simply too many risks attached to property management.
This may also catch you by surprise, but a lot of people aren’t fully aware of the emotional, psychological and financial peace you destroy if you fall in debts. Not all of us can handle such pressure.
Passive income is supposed to be something you do on the side, which is not so time-consuming. At times, you might find yourself spending hours upon hours, talking to potential tenants, repairing the property, or dealing with eviction notices. Trust me, this can be extremely emotionally draining as well.
In case you’re still interested in property income
Let’s assume that you’re still more than willing to invest your time and effort into the real estate business. If that’s the case, the process comes down to this: educate yourself on the topic as much as possible, do some number crunching, and make your final decisions based on the data you collected.
There’s no place for emotions when it comes to business.
The process starts with finding a house. I advise you to focus on houses that are in “poor” condition. This way, you won’t have to bid with conventional buyers who are looking to move in on short notice.
Sometimes, these homes are in pretty rough condition, and require tons of repair work, but if you’re lucky, you’ll stumble upon some which are pretty workable.
- Related: Building a House Without a Bank Loan
Furthermore, pay close attention to individuals in need of some instant cash (the ones dealing with debts, divorces, or houses in which the owners died). A friend of mine once bought a house for just $40,000. That sounds impressive in its own right, but especially so if you consider that the worth of the entire real estate was estimated at around $100,000!
Unfortunately for people looking to generate some property income, these things don’t happen all that often. In fact, they rarely occur at all, so you’ll probably need to come up with a decent plan of action instead.
Let’s assume you’ve found a house that captured your imagination. The first thing you’ll need to do is look at the price, and estimate the cost of repairs.
To get a better idea of the perceived value at the end, look at the houses in the neighborhood, and find out what they usually go for. Sometimes, minor cosmetic work is all it takes to glamour up the place.
Seriously, a couple of nice carpets, fresh paint job, some nice decorative features, and you’ll be good to go. You won’t believe how much these small details can affect the rent price.
How to invest smart and keep your finances in check
Ok, so you’ve got the choices narrowed down, and now it’s time to jump into action.
Place your bid on the house, and hope that it gets accepted. Arrange financing in your preferred method, whether it be through a bank loan, or a hard-money lender.
Assemble your crew, and start working on fixing the issues as soon as possible. It’s in your best interest to get the job done as soon as possible, in order to get your hands on that sweet property income.
Create a schedule, and stick to it, no matter what. You’ll probably have to pay your first check in advance, but as the renovation continues, you’ll usually pay up at the end of each separate milestone you have previously set.
If you aren’t so sure about the price of rent you should ask for, try getting the advice from your property manager, as he’ll probably know the market through and through.
Finally, when you find your tenants, you’ll have the option to sit back and watch that passive income rolling in. Naturally, if you chose a hard loan, you might want to first take care of your debts, as you wouldn’t want to pay those ridiculous interest rates.
Key metrics you need to watch out for
We kick things off with a metric known as the after repair value, or ARV. This simply means to compare the price of the property you bought, and the price after your renovations take place.
Expenses: even once the house is renovated, you’ll still be forced to repair a few things from time to time. According to my calculations, this amounts to 15% for repairs, and around 10% gross rents intended for vacancies.
Here’s a free tip, don’t buy a home you won’t be able to repair completely, as the sudden costs will become too much to handle.
Return on equity: At times, the property value skyrockets, and that is when the RoE becomes a very important metric.
During those times, you might be looking at up to 50% return on cash, but the return on equity could drop to as low as 8%. When that happens, selling the real estate in question might be your best option.
Cash on cash return: Simply put, you estimate the amount of cash you have to invest, versus the cash flow that comes your way, based on annual terms.
In my experience, you’ll want to achieve at least 20%, and hopefully even 30%. That way, once you pay off all of your taxes and other expenses, you’ll still be looking at a decent number. Now, I intentionally didn’t include appreciation into this equation, but if that happens, it’s only the cherry on top!
Net cash flow/gross rent: The bottom line is that all of your properties need to be making enough money to cover for all of the expenses you might encounter. Those expenses include a fee for your property management as well.
Return of capital gain: As far as safety nets go, this one is vital when it comes to real estate business. Most investors don’t necessarily look to sell the house immediately after repairing it, but it’s nice to have this option in your back pocket.
To explain things in layman’s terms, if you can make a profit from your sale that exceeds the amount of money you spent on buying and renovating, you’ll be in a good place.
Now, when it comes to setting goals, I would put the safety margin at 15%, meaning that you can still sell the property 10% below its perceived market value, and turn in some profit.
By now, you’ve probably realized just how much stress there is involved in the real estate industry.
From initial research to renovation, finding reliable tenants you can rent the house to, fixing any issues that may appear out of the blue, and having to deal with a complicated tax system, it definitely starts looking less fun the more you look into the finer details.
In comparison, managing a bond/stock portfolio takes only a couple hours per week, and it will provide you with a more diversified portfolio.
Let’s also mention that it’s never smart putting all of your eggs in one basket, as housing costs are susceptible to sudden price drops. If you decide to own a number of properties in one area, and the inevitable fluctuation happens, you’ll instantly notice the difference with your returns.
On the other hand, the stock market can (and in all likelihood) will crash at a point in time, but those crashes tend to be a lot less dramatic, compared to the housing crises. In the long run, you’re probably a lot safer investing your funds in stocks. With all that being said, property investment can never be considered a passive income stream, as there’s simply too much work involved with it.
A smart man once said that the goal is to work smarter, not harder.