Looking for ways to make a few extra bucks? Join the club! These days, everyone’s searching high and low for new and creative ways to earn more cash.
Whether it’s starting a new side hustle, opening a small business, or investing in a rental property, people on social media have tons of ideas to add to your monthly income. A lot of them can be super helpful and give your net worth a boost—not to mention some extra peace of mind in this wacky economy. But some of them, especially investing in real estate, can have a lot more to them than what the internet is telling you.
We’re big fans of investing in property to earn passive real estate income and build wealth—if you’re prepared for the work that goes into it. Before you jump in feet first, there are a few things you need to know about rental real estate as a source of passive income.
What Is Passive Real Estate Income?
Passive income is money that sometimes takes little effort from you to earn. On one hand, you have truly passive ways to generate income that require little oversight on your part, like investing in stocks or bonds. On the other hand, some forms of passive income are more hands-on and require more time or effort, like owning a rental property.
In general, passive income is great. It can boost your retirement savings, help you retire early, or simply help you reach your wealth-building goals faster.
When most people think of investing in real estate, they think of buying rental properties, but let’s press pause for a minute and set the record straight—there’s nothing passive about being a landlord. (Just ask someone who’s done it.) You can absolutely make lots of money on rental properties, especially if you invest the Ramsey way by paying for your rentals with cash. But managing a rental property is anything but passive. It’s hard work!
If you’re looking for something less hands-on than managing rental properties, good news—there are lots of other ways to invest in real estate besides owning and managing rentals.
So first let’s look at the difference between passive and active real estate investing, then we’ll break down all your options (including owning rental properties) for boosting your income from passive real estate investing. Let’s go!
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Active vs. Passive Real Estate Investing
If you’re looking for investing options in real estate and don’t know where to start, consider how much time and effort you want to put into your investment. That will help you decide whether you should look into active or passive real estate income options.
Check out a few key differences and similarities:
- Property management: Like we said above, there’s nothing passive about managing a rental property. In fact, with passive investing, you generally don’t manage a property in person. Issues like lease agreements and property maintenance are handled by a property manager or the real estate company you invest in. In some cases, you may never even see the property you invest in.
Active investing means you not only own the property, but you’re also responsible for managing and maintaining it. So, when Benji the gerbil escapes his rolling-ball prison and chews through the dryer power cord, it’s on you to fix it. You have more control over the property, but also more responsibilities.
- Tax benefits: Active real estate investors are eligible for several tax deductions related to buying, operating and maintaining their property, including mortgage interest, property taxes, rental property depreciation, and repairs and improvements.
A lot of passive investors usually hire a management company and take a more hands-off approach to the property, and they can write off whatever they pay the property manager, including any additional expenses like damage repair or unexpected costs besides their manager’s regular monthly charges.
- Liquidity (aka the ability to cash out): Passive investments tend be more liquid than active real estate investments. Here’s what we mean: Selling an active investment like a rental property you own is way more complicated and time-consuming than cashing out a passive investment like shares in a real estate investment trust (REIT). More on REITs later.
Okay, so we got a little technical there. But that info will help you understand what type of investing’s a good fit for you. You’ve got extremely passive investing options on one end of the spectrum (like REITs) and extremely active ones on the other (like being a hands-on landlord).
Ways to Make Passive Income From Real Estate
Okay folks, when it comes to passive income real estate, you’ve got options. Let’s break them down and see which one is right for you:
Owning Rental Property
Ready to be a landlord? See if these income-generating properties are the right fit for you:
- Rental properties: A lot of people generate extra income by owning single-family homes, duplexes or condos and renting them out on a monthly or 12-month basis. But renting out a house isn’t for the faint of heart, even if you hire a property manager. First of all, you have to pay for that house or condo up front. Do yourself a favor and never buy a rental unless you’re completely out of debt with a fully funded emergency fund and can pay cash for it. If you go into debt to buy a rental, you’re just begging for trouble.
You’ll also have the ongoing costs of repairs and maintenance (or the cost of hiring a managing company) to deal with. Those fluctuating costs plus property taxes can really eat into your profit.
- Short-term vacation rentals: More and more people are going the short-term rental route, especially if their property is near a popular vacation spot. One of the perks of renting out a property short-term is that it can make a lot more money per week than you can through a 12-month rental lease, plus you can control which weeks you want to rent out your property and which weeks to reserve for you and your family. A little fun in the sand and sun, anyone?
Investing in a short-term vacation rental at the beach sounds amazing. But before you invest in a condo by the seashore, consider this: Short-term rentals may bring in more money in a week than a long-term rental would, but depending on location, your rental could sit empty during off-peak seasons. And that means an unpredictable income for you. Yikes—talk about stressful! That’s why we’re so hard-core about never buying any type of investment property unless you have the cash to pay for it up front.
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Another thing to keep in mind with short-term vacation rentals is that you’ll probably hire a local property manager to take care of everything from handling reservations to routine maintenance and emergencies, and that can really tear into your profits.
- House hacking: House hacking is when you use your own home to generate passive (or active) real estate income. Maybe you convert your basement into a small apartment to rent out, or you rent out an extra bedroom. House hacking also includes buying a duplex and living in one side while renting out the other.
The good news about house hacking is you don’t have to search very far for your tenant when the rent comes due. The bad news? Your tenant knows exactly where to find you when something goes wrong. And when you’re the landlord, something will eventually go wrong.
- Ground leases: If you have the cash to purchase land, a ground lease (sometimes called a land lease) is a great low-risk real estate investment option. With a ground lease you own the land underneath a building you don’t own or manage, and you lease the land to the building owner.
Ground leases are usually long-term agreements—we’re talking 50 or 99 years—between the landowner and a tenant who constructs a building on the property. The great thing about a ground lease is it allows the landowner to avoid any capital gains taxes while generating income and avoiding any construction, repair or improvement costs.
Real Estate Investment Trusts (REITs)
A REIT (pronounced “reet”) works a lot like a mutual fund, except you’re investing in portfolios of real estate instead of stocks in a bunch of different companies.
With a REIT, you earn a share of the income the properties produce without having to buy, manage or finance them. REITs can be a good option for people who want to invest in real estate outside of their retirement accounts, but don’t want to be a landlord.
There are five kinds of REITs:
- Equity REITs: These are the most common. They own and manage properties like apartment complexes, malls and office buildings. How do they make money for their investors? Through rent collection, increasing property values and strategic purchases (buying low and selling high).
- Mortgage REITs: This type of REIT borrows cash at short-term interest rates to purchase mortgages that pay higher long-term interest rates. Borrowing cash? Yep, it’s as risky as it sounds. The profit is in the difference between those short- and long-term interest rates, but here’s the deal—that short-term interest rate could go up, and if it does, it eats into the profit. So, mortgage REITs values are all over the place and their dividends (the money they pay you, aka your passive income) are unpredictable.
- Non-traded REITs: Some REITs aren’t publicly traded on national stock exchanges, even if they’re registered with the Securities and Exchange Commission (SEC), which means you don’t always know their value until years after you’ve invested.1 Another disadvantage of non-traded REITs is they usually come with higher up-front fees—we’re talking 10% of the value of your investment!2
- Private REITs: A private REIT is neither registered with the SEC nor available for trade on stock exchanges.3 This is the most risky type of REIT because it’s usually illiquid—a fancy term that means an investment can’t be easily turned back into cash. To get the best returns, you probably won’t have access to the money for a long time. That makes it very difficult to get out of a private REIT once you’re in one. It’s not as easy as selling a mutual fund. Save yourself a big headache down the road and take the option of private REITs off the table.
- Hybrid REITs: A hybrid REIT is basically a combination between an equity REIT and a mortgage REIT—meaning the fund has company-owned properties and mortgage loans as well. This might sound like a smart and balanced way to invest in REITs. But in many cases, hybrid REITs will lean more heavily toward one type of investment over the other. This means you need to be very careful when looking at hybrid REITs—especially if they look more like those mortgage REITs we talked about earlier that borrow a lot of money to try to generate profits for investors. That’s a dangerous game—one you should avoid.
So, should you invest in REITs? Once you’re on Baby Step 7 and you’re maxing out your retirement, REITs could be a good option for you. Work with an investing advisor to choose a well-run REIT with a good track record of returns similar to a good growth stock mutual fund (10–12% average annual returns). Limit your REIT investment to no more than 10% of your net worth.
How to Invest in a Rental Property for Passive Income
Okay guys, we’ve discussed all the different ways you can invest in passive income real estate, including buying rental property. So let’s go over the basics of how to invest in real estate. It all comes down to picking which property to invest in and what you should look for in a rental property and in potential tenants.
How Much to Spend
Listen: If you’re looking to buy a property to rent and you’re brand-new to the rental game, think modest, stable and middle of the road. Don’t get fancy with your very first rental. And always pay cash for the place you want to rent out. Going hundreds of thousands of dollars into debt to “invest” in real estate is never a good idea! The deal is made at the buy, so aim to buy property that’s priced at about 70% of what it’s worth in the current market. It’s a lot easier to make money when your property value has nowhere to go but up!
Where to Buy
In general, homes in areas with good schools and a good reputation tend to grow in value better than lower-priced properties (like apartments or condos). Look for properties in a solid neighborhood where real estate prices have been increasing over the years. It’ll also attract the kinds of renters you need—responsible tenants who are less likely to wreck the place or be unpredictable about paying their rent.
Rentals that are close to public transportation or major highways are usually popular with renters. Keep your eye out for any big companies moving to parts of a city to open offices or other factories. You know what they say about real estate—location, location, location!
Local is usually best for your first rental property so you can keep a close eye on your investment. You don’t want your first rental to be in a place where you can’t regularly check in on what’s going on. If that’s the case, you’re better off hiring someone else to manage it (more on that in a minute). But if you choose a city with a good rental market and job growth along with reasonable state taxes, it can pay off in certain situations.
What to Buy
First, you need to decide what you want to get out of the rental. Do you want an apartment with regular renters and money coming in for a longer period of time? Or do you want a house you can sell for a profit within a few years?
Buying foreclosures can be a good way to get a good deal on a property if you’re thinking about selling pretty soon after buying and renovating. However, you generally want to avoid money pits and fixer-uppers when you’re planning to rent a place. The ideal rental property is attractive and almost move-in-ready—not a huge project you have to invest a bunch of time and money into on the front end of the deal.
If you don’t plan to manage the property yourself, a property agent will handle almost everything for you—from collecting the rent to dealing with repairs and complaints and even evictions. You’ll pay a commission to the agent, but it takes the stress off you if you’re too busy to deal with these issues or just want to less to worry about.
A real estate agent is invaluable when it comes to finding a deal in your local market. They’ll also help you handle the tasks of negotiating and closing a purchase when you find the right property and figure out how much rent you should charge. You want to be sure the rent coming in each month covers expenses like maintenance, HOA fees and homeowners insurance. Otherwise, you won’t make any money!
Happy Tenants Are Easier Tenants
If you do plan to manage the rental yourself, do the right thing and contact your tenants every few months to make sure they don’t have any concerns. A simple email will usually work. Don’t call them every week or make unannounced visits. Honor their privacy, but let them know you’re available if they have any issues.
Before tenants move in, make sure the hot water and heating and cooling systems work well. If your rental is a house, get a professional home inspection before you rent it so you can fix any urgent repairs. It’s all about taking care of your tenants, folks. When they see you care and that you’re proactive in addressing any concerns, they’re more likely to take care of your property and be responsible tenants.
When Should You Consider Investing in a Rental Property?
We can’t stress this enough—any real estate investment needs to wait until you can check off all these boxes:
- You’re completely debt-free—including your mortgage.
- You have a fully funded emergency fund of 3–6 months of expenses.
- You’re investing 15% of your monthly income into retirement accounts such as 401(k)s and/or IRAs and buying the rental won’t affect your ability to keep that up.
- You have the cash to buy the property in full.
No source of passive income is worth going into debt or slowing down progress toward any of your other financial goals!
Passive Income Investor Mistakes to Avoid
When you add passive income real estate to your portfolio of investments the right way, you’ve got the potential for a well-oiled money-making machine. But too often investors make mistakes that limit the income potential of their real estate investment, which kind of defeats the purpose! Let’s talk about the mistakes you’ll want to avoid when you invest in passive income real estate:
- You’re not debt-free and don’t have an emergency fund. Listen folks, when you invest in real estate before you pay off those student loans and credit cards, you’re inviting Murphy in—and Murphy’s Law basically says anything that can go wrong will go wrong. Adding more debt on top of debt won’t get you out of debt any faster! Push pause on your dreams of owning rental property until you kick debt out the door and have an emergency fund of 3–6 months’ worth of expenses saved. Your future self will thank you.
- You’re not paying in cash. There’s always a certain amount of risk involved with buying a rental property, but a lot of that risk comes down to not having the money to cover maintenance and emergencies because all your cash is going to mortgage payments. Here’s a fix for that: Pay cash for your rental. That way, any growth in your property value goes directly to your net worth. And each month, your rental earns you a steady cash flow.
- You’re not purchasing landlord insurance. If you’re a rental property owner of any kind and care about protecting your investment, at the very least, you should have basic landlord insurance coverage (property damage, liability and lost rental income). A lot of first-time real estate investors assume their homeowners insurance will cover any damage to a rental property, but it’s not true. And depending on factors like the location and age of your property, buying additional landlord coverage (including coverage for vandalism, burglary and building codes) could be a smart way to protect yourself, both legally and financially.
- You’re not ready to be a landlord. We’ve said it before, but it’s worth repeating—being a landlord is anything but “passive.” A lot of first-time investors think owning a rental is a simple, easy way to add to their monthly income. But even if you hire a property manager, you still have plenty of responsibilities, paperwork and taxes to consider as the property owner.
- You’re not choosing the right tenants. Whether you’re looking to invest in a long-term rental property just down the road or a short-term vacation rental down on the coast, choosing the right tenants can make or break you as a landlord. It’s part of the risk that comes with owning rental property, so it’s always a plus when you have a thorough screening process in place before you have someone sign on the dotted line. This brings us to . . .
- You’re not being clear with tenant rules and expectations. We can’t stress this enough—when it comes to being a landlord, being kind means being clear. Make sure your rules for the property and your expectations for paying rent are clear before you offer prospective tenants a lease. Hold them accountable by being consistent about enforcing those rules and collecting rent. Setting expectations early on will help tenants trust you and know you’re serious about the agreements they signed on to.
- You’re not keeping an active role in management. Hiring a property manager is a great option if you want a more hands-off approach to owning passive income real estate. They can help with everything from collecting rent to regular landscaping maintenance to responding to emergency repairs in the middle of the night. But you’re still the landlord. It’s up to you to stay in contact with your tenants and make sure their needs are met. When you take an active role in working with your property manager and your tenants, you create a more positive and less stressful experience for everyone.
Get Help From Professionals
If you’re still wondering if a rental investment is right for you and you’re not sure where to invest, then you need the help of a good real estate agent and an investing expert to guide you.
This is too big of a decision to make alone, and RamseyTrusted real estate agents are experts when it comes to the local market and all the details of buying and selling.
Plus, it’s a good idea to get connected with a SmartVestor Pro in your area who you can help you stay on track with your investing goals.
This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.