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Purchase Rental Property For Passive Income: How Does It Work?

There are different types of real estate – commercial (offices), residential (flats), industrial, retail and others. Regardless of the type, you would like to buy, most investors earn a passive income by leasing their property.This article is a four-step guide for people who want to join the rental business.

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Table Of Content

There are different types of real estate – commercial (offices), residential (flats), industrial, retail and others. Regardless of the type, you would like to buy, most investors earn a passive income by leasing their property. In spite of it, there are a couple of things you must consider before getting into this business.

Rental Property as Passive Income

Passive income is a terrific method to augment your present income and generate financial streams that can help you secure your retirement years. Rental properties are one of the most common ways to produce real estate passive income. Investors who play their cards well can generate a continuous stream of cash from rental income while simultaneously improving the property and building equity.

It's a prevalent misconception that passive income real estate investing necessitates little or no effort. Those seeking passive income from real estate, on the other hand, should participate actively in what should be viewed as a company. Owning passive income properties necessitates some level of effort, whether it's searching for properties, screening tenants, employing a property manager, or dealing with problems. This is especially true for those who want to make the most money.

What Rental Property Should I Buy?

First and foremost, you must determine what you want to receive out of the rental. Do you want a place where you can count on regular renters and money flowing in for a long time? Or are you looking for a home that you can sell for a profit in a few years?

If you’re looking for a new home, you may wonder about the most common types of homes purchased today. In this chart using 2020 NAR Trends data, 83% of homes purchased are single family homes. This is significantly more than the second most popular homes, which is townhouses at 6%.

Type of Home Purchased

If you plan to sell your home soon after buying it and refurbishing it, buying foreclosures can be a smart method to obtain a good deal. When it comes to renting a home, though, you should stay away from money pits and fixer-uppers. You want something that's appealing and virtually move-in ready—not a major effort to complete within the first few months of the transaction. If you don't intend to manage the home yourself, a property agent will take care of practically everything for you, from collecting rent to dealing with maintenance and complaints, as well as evictions. You'll have to pay the agent a commission, but it will relieve you of the worry if you're too busy to deal with these concerns on your own.

Always with a real estate professional to determine how much rent you should charge so you don't overpay. Also, be sure that the monthly rent includes expenses such as upkeep, HOA fees, and homeowner's insurance.

Which Places Are Best For Rental Property?

Homes in neighborhoods with outstanding schools and a high reputation tend to appreciate more than ones in lower-priced areas (like apartments or condos). Look for properties in a well-established community where home values have risen steadily over time.

It will also attract the types of tenants you want—responsible tenants who are less likely to damage the property or be late with their rent payments.

Renters prefer rental properties that are close to public transportation or major routes into town. Keep a look out for large corporations relocating headquarters or manufacturing to different regions of a city.

Finding the perfect home can be a challenge, but over time how we shop for homes has changed. In the past, it was common practice to search for properties through a real estate agent. However, as this 2020 NAR Trends chart shows, 52% of buyers found the home they purchased through the internet.

This highlights how the internet has changed our purchasing patterns. Finding a home on the internet is not only convenient, but many sites allow you to enjoy virtual tours, ask questions and schedule a physical tour. This can eliminate much of the stress of finding a superb home.

Where Buyers Found the Home They Purchased.pptm

For your first rental property, it's usually ideal to stay close to home so you can keep a close check on your investment. You don't want your first rental to be out of state, where you can't check on the property on a regular basis.

If that's the case, you'll need to delegate management to someone else (more on that in a minute). However, in some cases, choosing a city with a strong rental market and job development, as well as low state taxes, can pay off.

Finding a new home can be a challenge. Fortunately, today there is a wealth of information sources to help you in your home search. In this chart created with 2020 NAR Trends data, you can see that 93% of people use online websites in their home search. However, 87% still relied on their real estate agent.

What is interesting is that traditional methods such as print newspaper ads are now rarely used, with just 11% of people using them.

Information Sources Used in Home Search

  • What is Your Return On Investment (ROI)

In today's market, real estate investors might expect returns on investment properties, but the most savvy investors assess their estimated return on investment (ROI) rates before purchasing a property. Follow these procedures to calculate your return on potential property investments.

1. Evaluate The Potential Rental Income

The first step prior to buying a property is to estimate the potential rental income. The whole process includes assessment of the area, the type of property and the condition. In order to do that, you need to use four main approaches: Sales Comparison Approach (SCA), Capital Asset Pricing Model (CAPM), Income Approach (IA) and Cost Approach (CA). 

Let's explain:

The first one (SCA) compares prices of properties which have been sold, let's say over the last year. Keep in mind that you have to narrow down the comparison to real estate only in the area. Also, compare the same type of property. It's advisable to use a longer period since it reflects price movements better and might show some negative trends in the long run.

The second indicator, Capital Asset Pricing Model, is a model which aims to determine the potential rate of return of the given asset. This model explores the relationship between an expected return on investment to all the risks associated with it.

Then, once you have evaluated the potential price and rate of return, it's time to use the Income Approach. This tool is primarily used when comparing commercial real estate and relies on one major thing: the annual capitalization rate.

How to calculate it? Multiply the gross rent income by 12 (the number of months in a year) and divide it by the current price of the asset.

Example: The price of a rental property is currently $200,000 and the expected rent is $2,000. So, the formula will be: (12x$2,000)/$200,000= 0,12. Turn it into percent and you will have an annual capitalization rate of 12%.

The last method to use is the Cost Approach. The main idea behind this is to show a buyer how much the desired property would cost if it were built today a new. Take into account also the value of the land and any depreciation.

The general formula is: value=reproduction cost – depreciation + land value

2. Calculate The Annual Expenses

Once you have finished the first step, you can move on to the next one – calculation of the annual expenses. They are usually two types – fixed and variable expenses:

  • Fixed Annual Expenses – Fixed expenses are those that your property will incur each year – taxes, maintenance, and insurance. If the property is located in the city, the taxes will be higher if it's in the country. Moreover, the tax rate on properties varies within a city. In the central parts, it tends to be higher in comparison with real estate on the outskirts. Occasionally, the taxes on a property are higher if it serves the purpose of investment rather than home.
  • Variable Annual Expenses – In this category, you might include annual repairs, new furniture, roof repair, plumbing services and others. Even though it is hard to estimate how much the variable annual expenses will be, set aside an amount of money equal to fixed annual expenses.  Assuming the latter is $1,500, then set aside $1,500 for variable expenses. This makes $3,000. If the annual rent is $10,000, then you will make  a $7,000 profit

Bear in mind: This calculation is valid only if you have tenants throughout the whole year. There is always the possibility of months when you won't collect rent.

3. Calculate ROI

To calculate your total return on investment, divide your net operating income by the total value of your mortgage (ROI).

Let's imagine you invest $600,000 in a property that you can rent out for $2,000 each month. $2,000 multiplied by 12 months equals $24,000 in total potential earnings. Let's also assume that the property's monthly expenses are around $300.

  • $300 multiplied by 12 equals a total of $3,600 in expected operational costs.
  • Subtract your overall rent potential from your running expenses: Net operating income is $3,600, which is $24,000 minus $3,600.
  • Subtract your net operating income from the total amount you owe on your mortgage: $20,400 divided by $600,000 equals 0.034, resulting in a 3.4 percent return on investment for this property.

A 3.4% return on investment is wonderful if you buy a house in a good region and know you can rent it to trustworthy renters. A 3.4% ROI, on the other hand, may not be worth your time and effort if the property is in an area where short-term tenants are common.

  • Evaluate Market Sentiment

One of the main factors which affect any type of asset, both its price and future income, is the so-called market sentiment. This indicator is also known as investor attention, and it shows the prevailing sentiment of investors towards the price of a specific asset.

If you start understanding the market and all the forces that drive it, including crowd psychology, most probably you will end up making the right decision. For example, most investors buy properties when the market is euphoric (it's at its peak). However, when the market is down, you can buy many cheap assets which you can resell later or let them.

According to analysts, in the real estate market, there are cycles which last for 10 years. Normally, during a decade there is a bottom as well as a peak.

Generally speaking, there are two key factors that drive all markets: demand and supply. The basic principle is that if there is a higher demand for an asset, its price will start increasing. Also, if the supply is low, in a condition where there are enough buyers, the price will go up.

In our particular case, large cities are a place where more people live as well as salaries are higher. Therefore, the demand for rental property is higher which will eventually lead to higher rents.

  • Understand The Risks

Even though investing in real estate is a relatively risk-free endeavor, as with anything else you need to have a risk-management strategy.

Let's look at the main risks associated with owning a property:

  • High Expenses: the property generates more expenses than initially planned and calculated. This includes months when there are no tenants occupying the place. This, of course, will negatively impact and lower the potential return on the estate.
  • Problematic tenants: sometimes, tenants “forget” to pay their bills or refuse to leave the place even though they don't pay the monthly rent. This will result in unwanted expenses to evict the tenants and also bills which you have to cover yourself. It's recommended to consult with a property management company prior to any action you might take. They are professionals and know their job. However, they will charge approximately 10% of the rent.
  • The housing market: there is no need to lecture you on this since we all remember the US housing bubble in 2008-2009. What if you invest in a property in a city whose economy starts going down? This is a serious risk since the expected rent might go so low that won't cover all the expenses or you won't be able to find tenants.

Getting a Mortgage For a Rental Property

Managing a second mortgage payment on top of your first mortgage may be necessary when financing a rental property. Furthermore, rental income is not always reliable. Lenders are aware of this and will require you to meet certain criteria before approving a loan. To get an idea of rates and monthly payments, use a mortgage calculator, and then get preapproved to discover how much money you qualify for. Make sure to inform your lender you're looking to buy an investment home, as these have different requirements than a primary residence.

  • Credit rating – When financing a rental property, lenders often want a minimum credit score of 620. However, in order to get the best interest rates and conditions, you'll need a credit score of 740 or above, which falls into the “very good” category.
  • DTI – Your debt-to-income ratio is another important issue that lenders analyze. This is the percentage of your total monthly revenue that goes toward debt repayment. Your DTI should ideally fall between 36 percent and 45 percent to qualify for a rental property mortgage.
  • Savings – You'll also need to show that you have enough money in the bank to address financial setbacks in addition to demonstrating that you have enough revenue compared to your debt obligations. Three to six months' worth of reserves, comprising the full mortgage payment, principal, interest, taxes, and insurance, should be kept in a liquid bank account.

Searching for a home before securing finance is one of the most common mistakes that home buyers do. Let's imagine you find the ideal rental house after months of looking. However, by the time you get preapproved for a mortgage, the house has already been sold to someone else.

Another issue with looking before getting preapproved is that you have no idea how much money you are eligible for. It would be upsetting to be looking at houses in one price range only to discover that you are only eligible for a lower price range. Preapproval gives you the information you need to make an informed decision about the investment property you want to buy.

Is An Investment Property Right For You?

It is not for the faint of heart to purchase a rental property. Not only must you examine the mortgage and operational expenditures, but you must also consider the tenants, who can make or break your investment. Owning a rental property usually entails more risk than investing in the stock market.

After all, if you end up with terrible renters who don't pay their rent on time, your profits aren't just diminished; they're completely gone. Sure, the stock market only generates 4% to 5% annual returns, but you can bet on it. With an investment property, you're taking a higher risk.

Small adjustments, such as a new door or some minor kitchen renovations, might boost the likelihood of attracting decent renters at higher monthly rentals when it comes to an investment property. You are not only riding the wave with investment properties, but you are also the wave's owner. It's an excellent option for the investor who prefers a more hands-on approach.

Conclusion

By following these four steps, an investor can have an actual and accurate idea as to how much income to expect from a property. It's crucial not to skip any of the steps so that you can have a broader picture.

Buy a Rental Property - FAQs

Generally speaking, achieving at least $100 profit on your rental property will make it worthwhile. This provides a consistent cash flow, but you will need to consider all of your costs to determine your genuine profit potential. Factor in ancillary costs such as repairs, non occupancy and mortgage expenses to determine your profit.

If you’re using a mortgage to purchase your rental property, you are still likely to need a down payment to secure your loan. Many lenders have higher down payment requirements for rental properties as they tend to carry a higher risk.

This is because the property will not be used as your primary residence and you may rely on rent payments to cover your mortgage. This means that if the tenant fails to pay or the property is empty, you may struggle to meet your monthly repayment requirements.

Generally, mortgage lenders write it into the terms and conditions of a loan that the property will be your primary residence. This means that if you rent out your home and fail to tell your mortgage lender, you may violate your loan agreement. This could lead to penalties and in a worst case scenario, the lender may demand full repayment immediately.

So, if you are considering renting out your home, be sure to inform your mortgage lender.

Generally, landlords can expect to pay approximately 15% more for landlord insurance compared to standard homeowner policies. Currently, the national average for landlord insurance is $1,481 per year.

While you are not likely to be arrested for it, renting out your property that has a residential mortgage is likely to violate the loan terms. This means that your lender may impose fines and fees or in some cases demand immediate repayment of the full loan amount. If you plan on renting out a property, it is important to obtain a landlord mortgage to ensure you comply with all the loan terms and conditions.