How to Create $5,000/Month in Passive Income Using Real Estate: A Case Study
Here at BiggerPockets, we sometimes need to look at the bigger picture. It’s of course imperative that we ask ourselves what we want to achieve and why. After we do that, we then need to figure out HOW to do it.
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Let’s say your goal is to generate $5,000 per month in passive income from your real estate investments. How will you get there? How many rental houses or apartment building units will you need?
Here’s a step-by-step methodology to answer this, followed by a more detailed case study to illustrate the concept.
How to Create $5,000/Month in Passive Income Using Real Estate
Step #1: Create a Realistic Financial Model
The first thing you need is a financial model you can use to forecast the projected cash flow for a property over the life of the project. For income, you should have line items for rental income, but also account for concessions, vacancies and delinquencies. For expenses, include property management expenses (if applicable), real estate taxes, insurance, repairs and maintenance, utilities, trash and snow removal, landscaping, and legal expenses.
Step #2: Determine the Projected Cash Flow Per Unit
Once you have a financial model, then it’s time to populate it with data. To get the data, you will need to do some research and use some assumptions. The more data and research you do, the more accurate your projections will be. As sources for your data, talk to other landlords and brokers about their rents and expenses. If you’re looking at apartment buildings, review lots of marketing packages to get a sense for the potential cash flow of a property.
Create a financial model for as many houses or apartment buildings you can find. Then create ONE financial model with an average of all of these.
This one financial model will tell you how much cash flow to expect from a single rental property or a single unit in an apartment building.
What you’re looking for is the Expected Cash Flow of One Unit.
Step #3: Calculate the Number of Units You’ll Need to Achieve Your Goal
The last step is easy. In order to answer the question “how many units do I need to generate $5,000 of income per month,” use this formula:
# Units Needed = $5,000 / Expected Cash Flow of One Unit
How Many Units to Generate $5,000 Per Month: A Case Study
This is all pretty abstract, so let’s talk about a specific example. Let’s continue the case study we started in my previous article “How to Use Commercial Real Estate to Add $1M to Your Net Worth in 5 Years.”
In that article, we purchased a 21-unit apartment building for a reasonable cap rate of 8%. Over the course of 5 years, we raised the rents by $100 per month per unit and kept the expenses about the same.
If we sold the property after 5 years and combined the principal reduction, cash flows, and appreciation, then the total profit was $963,544. It’s amazing how a little change in income can make such HUGE difference in value.
Now let’s apply our 3-step methodology and try to figure out what the expected cash flow per unit is in this case study. Once we know that, we would then know how many units we would have to acquire to generate $5,000 per month.
I’m creating the numbers in this article using my easy-to-use yet sophisticated deal analyzer, so I’m going to wave my hands a little bit in the interest of time. Just know there’s some higher math going on somewhere.
OK, here goes.
If I examine the 5-year Profit and Loss statement of my deal analyzer model and divide the total cash flow per month by the number of units, I get the following cash flow per unit per month:
As we increase the rents, the cash flow per unit also increases.
Let’s see how many units we need to purchase to generate $5,000 per month:
In Year 1, when cash flow per unit per month is $124, we would need 40 units like that to generate $5,000. This building is only 21-units, so to achieve our goal of $5,000, we would need to purchase two of these buildings.
Look at Year 2. In Year 2 the cash flow is now $224 per month per unit because we’ve been able to raise the rents a bit. Based on that cash flow, we would need 22 units like that to achieve our goal of $5,000.
Hey, what do you know? This happens to be a 21-unit so we’re already there! Our income is $5,000 per month!
As we reach our goal of raising the rents of ALL of the units by $100 after Year 3, our cash flow continues to increase.
OK — so far, so good. But you say “OK, Michael, I get it, but how much capital will I need to GENERATE that $5,000 per month?”
Well, that’s a great question. Let’s take a look.
In our case study, we projected that we would need a 25% down payment, which was $354,250 (we left off other costs like closing costs or repairs to keep the numbers simple).
If we continue to use that figure, then if we divide that by the number of units (21), then the cash required to purchase one unit would be $16,869. Applying this logic to our 5-year model we get the following:
Obviously the higher the cash flow, the fewer units you need and the less capital you’ll need as well.
Hopefully you can see from this example how to go about answering the question, “How many units do I need to purchase to achieve $5,000 per month in passive income?” and the related question, “How much cash do I need?”
As I always say, “Where’s there’s a will, there’s a way; and where there is no will, there is no way.”
Know first what is possible, believe it, and then do it.
Now get out pencil and paper and figure out how many units you will need to accumulate to retire early!
Do you agree with my assessment? How have you created passive income through real estate?
Leave your comments below, and let’s talk!