How To Earn Passive Income With Rental Property
Hanna Kielar8-minute read
December 08, 2021
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Passive income is money that you earn without a regular daily time investment. Creating a passive income stream from rental income involves work upfront but allows you to reap financial rewards for years to come.
One common passive income stream is real estate investing and rental management. But is owning a rental property right for you? Being a landlord is work, especially in the early stages. That’s when you’re choosing your properties, undertaking necessary renovations and learning the ropes.
Today, we’ll take a closer look at how you can create passive income by owning and managing a rental property. We’ll also introduce you to a few other strategies you can use to earn passive income.
What Is Passive Income From Rental Property?
Creating passive income in real estate usually involves buying a property and renting it out to tenants. Managing rental properties can be an excellent way to earn money.
Why is rental income considered passive? Because the IRS says it is. It’s grouped with income streams like royalties and licensing. And it’s a good thing for real estate investors, because it allows them to avoid the self-employment tax.
How Do You Invest In Real Estate?
Being a landlord isn’t totally passive and requires consistent effort, particularly when you’re getting started. Tenants will expect you to continuously maintain and upgrade your rental property. You also need to invest time researching your property options before purchasing and advertising your space to new tenants.
Follow these steps to start investing in real estate and earning rental income.
Step 1: Research, Research, Research
Before you even think about buying a rental property, you’ll need to do a substantial amount of research in your local area. First, take a look at what rental units are currently available in your area using a real estate database. This will give you a good idea of how much you can reasonably expect to charge in rent. Keep in mind that property amenities, location and size will also influence how much rent you can charge.
You’ll also need to spend time learning about the laws you need to follow as a landlord. Most states have myriad housing laws that control what a landlord can and cannot do. Violating your state’s housing laws can land you in serious legal trouble. Some examples of law classifications you’ll need to study include:
Laws Governing The Landlord-Tenant Relationship
Once you rent out your property, your tenant has the right to “quiet enjoyment” of the space. Each state has laws that dictate when you can enter your tenant’s property and how you need to communicate with your tenant when disputes arise.
Laws Against Housing Discrimination
It’s against the law to refuse to rent to someone based on their status as a member of a protected class. Studying discriminatory housing laws will help you understand how to find the best possible tenants for your space without unintentionally violating the law.
Laws Regarding The Eviction Process
Landlord-tenant law is guided by the laws of the state – and often the municipality or city – where the property is located. Be sure to familiarize yourself with the laws applicable to your property that regulate your treatment of tenants, particularly when it comes to the eviction process. You should consult an attorney who specializes in landlord-tenant law to represent you in eviction proceedings.
Never perform a “self-help eviction” by shutting off a tenant’s utilities, threatening them or in any other way making their home life difficult or unsafe. Owners who choose this route can be held legally and criminally liable for actions that jeopardize their tenants.
Another good idea: Sign up for a class on landlord-tenant law before you decide to buy a rental property. A local course can help you understand your state’s specific laws and responsibilities. It can also give you a more intimate look at exactly what you’ll need to do to keep your property habitable. This can help you decide if you’re really ready for the commitment of owning a rental property.
Step 2: Select A Property And Do The Math
After you’ve done your research on your local real estate market and housing laws, it’s time to choose a property. Select one that’s affordable and in an area where you can charge enough rent to cover the mortgage if you need one. Research the average cost of utilities in the area where you want to buy. If you’re using a mortgage loan to buy the property, you should also research current interest rates.
Once you find the perfect property, sit down and calculate what you’ll need to charge in rent to create a profit so that your purchase will turn into a good investment. Some things you’ll need to account for include:
Your Monthly Mortgage Payment
If you’re taking out a mortgage on your property, you’ll need to make more than enough money from rental income to cover your monthly payment. Start by using a mortgage calculator like this one from Rocket Mortgage®. Estimate your home’s principal and interest to get an idea of what percentage of your monthly rent will go to your mortgage.
Landlord insurance is a type of homeowners insurance that protects your property when you have long-term tenants. Landlord insurance provides many of the same benefits as homeowners insurance but can be more expensive due to additional tenant risk. Contact an insurance agent to learn more about what you can expect to pay for landlord insurance.
You’re responsible for covering your rental property’s tax burden – even if you don’t live there. Property taxes pay for local police and firefighters as well as schools – things that add to the value of your property.
Maintenance And Upkeep
As the landlord, you’re responsible for maintaining your property and making sure all systems are running. You can expect to pay about 1% of your property’s total value a year in maintenance. For example, if you own a property worth $200,000, you can expect to pay about $2,000 a year in maintenance expenses.
After you calculate your total monthly and annual expected expenses, you’ll need to decide on a final monthly rental price.
Step 3: Secure A Mortgage
If you don’t plan to pay for your rental property in cash, you’ll need to secure a mortgage. You cannot use a government-backed loan to buy a rental property. Instead, you’ll need to meet your lender’s requirements for a conventional investment property loan. These loans can be more difficult to qualify for, especially if you’ve never managed a rental property before.
Investment property loans are considered a bigger risk to lenders than the mortgage on your primary residence. To qualify for one, expect to put more money down and face a higher level of scrutiny.
Larger Down Payment
Mortgage insurance isn’t available for investment properties. This means that most lenders will require you to have at least 20% down. Even 25 – 30% down payments aren’t uncommon.
Higher Credit Score
The minimum credit score required to get a conventional loan for an investment property is 620. However, if you have a score below 740, you’ll pay more in interest.
Lower Debt-To-Income Ratio
If you have a DTI ratio above 45%, you’ll have trouble finding a lender willing to finance your loan. Ideally, you should try to lower your DTI ratio to 36% or less before you apply for a loan.
Higher Cash Reserves
Lenders need to know that you can continue to pay your mortgage even if you get a set of bad tenants. Most lenders will require that you have at least 4 – 6 months’ worth of monthly mortgage payments in reserve.
Step 4: Advertise Your Space And Choose Tenants
Once you’ve secured your home loan and your property is ready to go to market, it’s time to start advertising. You’ll want to use real estate database websites like Apartments.com and local online marketplaces like Craigslist to advertise your space. Be sure to offer interested parties a clear way to contact you or apply for the space.
When you receive applications, you should carefully consider each candidate. It’s best to be picky about your tenants and wait for a few applications to roll in before you decide. Some states have very strong tenants’ rights laws, so you’ll want to be 100% sure about who you rent to.
As a landlord, you have wide discretion about who to rent to, but you must comply with the Fair Housing Act’s prohibition against discrimination based on race, ethnicity, gender or other specified characteristics.
Let’s look at some common, legal ways to evaluate tenants.
Run Credit Checks
Run a credit check on each tenant who applies for your space. If you see an eviction or many missed loan payments on their record, it might signal that they may have trouble paying their bills on time.
Contact Previous Landlords
You should ask your tenant applicants for references from previous landlords. If the applicant has never rented an apartment before, you may want to ask for a reference from an employer or teacher.
Verify Income Information
Ask your applicant for permission to verify their income or bank account information. A tenant who has a lower credit score might be able to make up for it by proving they have 6 months’ worth of rent saved up and a steady job.
Get A Signed Lease Agreement
Once you find the right tenant, it’s time to ask them to sign a lease agreement. A lease agreement establishes such factors as the tenant’s monthly rent, how long they may live there and what utilities they must cover. You can find premade lease agreement templates online, or you can hire a real estate attorney to draw one up for you. Remember that a lease agreement is a legally binding document for both you and the tenant. Double-check that all information is correct before you sign.
Step 5: Be A Great Landlord
Now that your tenants have moved in, the only thing left to do is be a great landlord! It’s your responsibility to provide your tenants with clear expectations regarding rent, and to respond to maintenance requests quickly. If you respect your tenants, they’re more likely to respect your space.
How Much Passive Income From Real Estate Do You Need To Replace Traditional Employment?
Many people dream of the day when their passive income streams allow them to quit their day jobs and retire. In reality, it can take years of hard work before you can cover your expenses through passive income.
The amount of passive income you’ll need to live off your investment streams depends on your financial situation, lifestyle plans and location. If you have no debt obligations and you live in a more affordable area, you’ll need less money to cover your expenses. If you live in an area where the price of living is higher, you’ll need more money coming in before you can survive off passive income. For the best chance of success, create a plan to produce multiple streams of passive income.
Are There Other Ways To Invest In Real Estate Without Being A Landlord?
Yes, there are. And if passive is what you’re looking for, these investments might be the way to go.
Real Estate Investment Trusts (REITs)
REITs are investment products that let you own a share in managed real estate portfolios across the entire spectrum of residential and commercial real estate. Across that spectrum, you can choose a niche – like medical office buildings, hotels or self-storage facilities, for example. Shares in a REIT can be purchased as easily as shares in a mutual fund. Talk to your financial professional or open an account with an online brokerage that offers REITs.
Mortgage-Backed Securities (MBS)
When you buy a property, your lender doesn’t hold on to your conventional mortgage. If you have a conforming mortgage, your mortgage was sold to Fannie Mae or Freddie Mac. If yours is a non-conforming loan – like a jumbo loan – it was sold to a private company. In either case, it was pooled with similar mortgages – grouped by credit risk and loan characteristics – to create a fund for investors to purchase shares in. These shares are called agency or non-agency mortgage-backed securities (MBS).
If you invest in mortgage-backed securities, you’ll receive the monthly mortgage payments of homeowners as passive income.
Real Estate Exchange Traded Funds (ETFs)
Real estate exchange traded funds (ETFs) offer investors the opportunity to buy shares in multiple REITs instead of buying shares in just one, in order to diversify risk. As with REITs, you should talk to your financial advisor or open an account with an online brokerage that offers real estate ETFs.
The Bottom Line: Real Estate Generates A Variety Of Passive Income Opportunities For Investors
Real estate investment offers opportunities over a wide range of commitment levels – from the passive-in-name-only to the completely passive. Learn more about investing in your first rental property in our Learning Center.
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