What Is Real Estate Passive Income?

Passive income is money you earn without a daily time investment. Creating a passive income stream from rental income requires work on the front end 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.

Let’s 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 For Rental Properties?

Creating passive income in real estate usually involves buying a property and renting it out to tenants. Managing a rental property, or multiple properties, can be a great 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 this classification is a positive for real estate investors, because it allows them to avoid the self-employment tax.

How To Invest In Real Estate For Passive Income

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 investment property. You also need to spend 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 The Area

Before you even think about buying a rental property, you’ll need to do a substantial amount of research in your local area. First, find the rental units 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 should charge.

You’ll also need to spend time learning about the laws you must follow as a landlord. Most states have myriad housing laws that control what a landlord can and can’t do. Violating your state’s housing laws can leave you in serious legal trouble. The American Apartment Owners Association has landlord-specific state laws that you would be wise to review at your leisure.

Step 2: Select A Property And Budget Accordingly

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 purchase the property, you should also research current interest rates.

Once you find the perfect property, calculate what you’ll need to charge in rent to create a profit so your purchase will turn into a good investment. Some items you’ll need to account for include:

Your Monthly Mortgage Payment

If you’re getting 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 the one from Rocket Mortgage®. Estimate your home’s principal and interest for an idea of the percentage of your monthly rent that’ll go to your mortgage.

Landlord Insurance

A type of insurance that protects your property when you have long-term tenants, landlord insurance provides many of the same benefits as homeowners insurance. However, it 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.

Property Taxes

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 – which all 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. Each year, you can expect to pay about 1% of your property’s total value in maintenance. For example, if you own a property worth $200,000, you’ll likely pay about $2,000 annually in maintenance expenses.

After you calculate your anticipated monthly and yearly 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 can’t 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.

Investment property loans are considered a bigger risk to lenders than the mortgage on your primary residence. To qualify for an investment property loan, you must put more money down while facing 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 put at least 20% down. Even 25% – 30% down payments are fairly common.

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 likely pay more in interest.

Lower Debt-To-Income Ratio

If you have a debt-to-income ratio (DTI) above 45%, you may have trouble finding a lender willing to finance your loan. If possible, lower your DTI 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 end up stuck with bad tenants. Most lenders will require that you have at least 4 – 6 months’ worth of mortgage payments in reserve.

Once you meet these requirements, you can apply for a mortgage preapproval and buy the home.

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 those who are interested 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 choosy about your tenants and wait for a few applications to roll in before deciding. Some states have strong tenants’ rights laws, so you’ll want to be 100% confident in your choices for tenants.

As a landlord, you can use a lot of discretion in who you pick as tenants, but you must comply with the Fair Housing Act’s prohibition of 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’ll 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, consider asking 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 with a low credit score might be able to make up for it by proving they have a steady job and 6 months’ worth of rent saved up.

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 details as the tenant’s monthly rent, how long they may live there and the 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 you and the tenant, so double-check that all information is correct before you sign.

Step 5: Be A Great Landlord

Now that your tenants have moved in, all that’s left to do is be a great landlord! It’s your responsibility to respond to maintenance requests quickly and provide your tenants with clear expectations concerning rent.

Real Estate Passive Income FAQs

Now that you know how to create passive income by owning real estate, let’s take a look at some frequently asked questions about passive income and rental properties.

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 job and retire. In reality, it can take years of hard work before you’re able to 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 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. You can choose a niche – like medical office buildings, hotels or self-storage facilities – and buy shares in a REIT as easily as shares in a mutual fund. Talk with a 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 with your financial adviser 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.

Ready to start investing and track your net worth? Sign up for Rocket Money^SM to lower your bills, save up money and begin earning passive income once you’re an investor.