I was at an investor’s meeting not too long ago talking with a young, idealistic, newbie investor who brushed off one of my real estate suggestions and told me he was looking for passive income. He wanted -in short order- to work only 4 hours per week. Ahh, yes, the fabled four-hour workweek, I’ve heard of it so many times yet I’ve never actually known anybody who had one, not anybody making any money at least. I think it must be next to the pot of gold at the end of the rainbow.
I admit, I’m going a little overboard with the pot of gold bit, but it’s for a much-needed theatrical effect. To be fair, real estate is like any business and there are some investors out there who have worked hard, became successful and were able to build a system that they could back away from a little and turn more operations responsibilities over to others. Make no mistake, however, it took a lot of work to build that system.
When they say passive income they are usually talking about rental properties. They tell you to go buy a property. Rent out said property to a tenant who pays the mortgage and expenses and you keep the difference. Easy right? Maybe if your Donald Trump and you start out with a million dollars to put down and pay management.
Lets analyze a more realistic scenario. The consumers of these passive income systems are most likely newbie investors looking for a way to build wealth. They often have very little money to throw at deals so they are looking for high leverage, possibly no money down properties. It is very difficult to get a significant amount of cash flow out of property that is financed to the brim. But, don’t even worry about cash flow yet. Good high leverage deals are not easy to come across. Our newbie investor is probably going to bust his hump for the first few years just trying to find properties. There’s nothing passive about that.
Here’s the anatomy of a real good investment property. Our newbie investor finds this deal. The purchase price is $100,000 and it will rent for $1,000 per month. Better yet, with the seller’s cooperation the home can be purchased with no money out of our newbie’s pocket. We won’t even complicate the deal by talking about closing costs but be assured you will have to deal with closing costs in your purchases. They close the deal. The blended interest rate on the home is 7% for thirty years. Trust me, that’s a good rate for a no money down deal. The principle and interest payment on the mortgage is $665.30 plus taxes of say $75 per month and insurance of $50 per month. That’s a grand total of $790.30. But wait there’s more. I always figure that a rental home is going to be empty or vacant for at least 1 month out of every 13 months. That’s because I have a one-year lease and I expect the tenant will move out at the end of the lease. Just count on it taking a month to get a new tenant in the home. So I figure vacancy expenses at about 7% of the rent or in this case $70 per month. And, lets not forget maintenance. If you can get through the year without having maintenance costs then congratulations, you’re a slum landlord. In my case I figure about 5% of the months rent should be squirreled away for future maintenance expenses. That’s another $50 per month. Believe me that is a minimal amount. If the fridge goes out you’re there. You can save money if you do the work yourself rather than hire a handyman but then you’re another step further away from passive income. Pipes don’t often break between the hours of 9am to 5pm. So with vacancy and maintenance you’re now up to $910.30. If you were really looking to have passive income you’d hire a property manager. That will cost you another 10% or 100 dollars per month and that would bring your total up to $1010.30 per month. Now you’re loosing money.
Nah, it’s no problem. You’ll manage it yourself. So start by running adds and taking phone calls for prospective tenants. Make yourself available to run over to the property on a call from a prospective tenant that is so excited about the house they just can’t wait and then stand there for an hour because they don’t show up. I’m not kidding. In my experience, I say maybe 1 out of every 3 people who make an appointment to view a property will actually show up. Finally you find a candidate who has the deposit and the first months rent in their hand. Don’t you dare jump on it yet. You had better do a background check first. You won’t want to. You’ll be eager to be done showing the home and start collecting your passive income but you’ll have a whole lot more work to do in a couple months if you have to evict this person.
The tenants in place and you’re done, right, not even close. First get a good lease signed and money exchanged. Open up a separate bank account for deposits (required in most states) and start your accounting system. You also better make sure the tenant changes over all of the utilities into their name. On one of my properties the water company makes me sign and fax in authorization to change over the service every time I get a new tenant. Of course we’ve already mentioned maintenance. Tenants are not known for taking care of a rental property but they demand their rich landlord (because all landlords are rich) keep the property in top-notch condition. So unless you want to pay a $50 service fee every time something is leaking, or squeaking you’ll be making trips over to the house and like I said things don’t break during normal business hours. I also highly recommend that you go personally pick up the rent every month.
Now, look back at our profit margin. You’re pulling down $90 per month for all of this effort. So if you’re going to make a living at this you’re going to need at least 20 of these properties. Believe me, the tasks I’ve listed above are very summarized there are many more things that can and will come up. Trust me, if you have 20 of these things you will have 2 full time jobs.
Despite all of this, have faith and know there is no better wealth builder. 15 years down the road these homes will likely rent for $1500/mon and the mortgage will be paid down 20-25%. If you bought right the home has probably also gone up in value. Then you’ll have some breathing room. Then you can hire a property manager and you can afford to pay that handyman the service charge. Believe me, there will still be things for you to do, but you’ll be well compensated each month and you’ll have a very large net worth (20 properties with say $50,000 equity each makes you a millionaire.)
If you want easy money, trust me, real estate is not the right place for you. If you’re not afraid to work your but off and just need a place where the playing field is a little more leveled then welcome home my friend.