The Secret to Generating Passive Income Is This / Pexels

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Sarah Landrum
Sarah Landrum20

Looking for another income stream or streams? Perhaps a passive income stream that requires little to no work while you focus on your full-time job? A passive income stream sounds like a good idea, and you can probably find passive income idea after passive income idea on the internet from people who are very convincing of get-rich-quick schemes that require no work at all.

Generating passive income automatically leads to thoughts of pyramid schemes, blogging, surveys and apps that farm your personal data. There's everything from opening a different kind of savings account, to starting a blog with affiliate marketing as your income stream, to investing in the stock market (even if that sometimes means cutting your losses). People throw tons of ideas out there to help you earn money through some passive income online and add to your full-time job income.

So what's legitimate and what's not? The truth is that no savings account, blog with special affiliate marketing techniques, or mutual fund will be quite as successful a passive income source as the real estate investment. You can earn money the traditional way and add to your income streams buy purchasing real estate, as making passive income through real estate investment provides a realistic and accessible way to put more money in the bank without worrying about your identity being stolen.

But you have to be smart about this passive income source. Isn't that time-consuming and expensive? You can find a traditional brick and mortar building to fix up and rent out to generate passive income, but once you have a few units, the return on investment flows back in. Besides, there's more than one way to generate passive income through real estate investing.

Investing in Real Estate the Traditional Way

Successful real estate investment requires solid strategy. You'll need to consider the condition and maintenance of the property, cash flow and potential tenants. Every neighborhood holds potential — from fringe neighborhoods to up-and-coming and more established, wealthy ones.

Calculate the effects on expenses, profits and expected income — high returns will come with increased risk. Remember, smaller monthly profits aren't necessarily a bad thing if the property sits in an established neighborhood — it offers higher appreciation as the years pass.

Do you plan to target a particular type of client, such as a convenience store or restaurant, or will you invest in housing? Consider each tenant wisely, and take a thorough look at business plans if going commercial. Riskier tenants leave you with less income and expensive repairs.

Avoid investment properties with skyrocket vacancy rates. Look for potential stability over high appreciation in this case since your expenses won't make the investment worth the effort.

Always Assess Property Condition With Inspection

Never assume you can assess property conditions on your own. Before purchasing any property, you need an inspection from an independent and professional inspector.

A property may appear renovated superbly on the surface, but you could find out after hastily buying it that bad plumbing and wiring mean you face code violations. A quality inspector will estimate the remaining life of the roof, structure, hot water supply and HVAC system.

Managing Your Investment Property

As you've learned by now, there's nothing passive about getting your property ready, but the passive income flows in once you have everything established and your property is ready for management. Begin your research on property managers to oversee your polished investment — they're present in every city and rural area for both residential and commercial properties.

Think of property management companies as the middlemen who directly deal with applicants and tenants. They save you the headache that comes with staying on top of marketing rental properties, collecting rent, pursuing evictions, settling complaints and handling repair and maintenance issues. A quality management company will provide experience and know-how to elevate your investment successfully, and you're not considered to be an employer since rental property managers are independent contractors.

Rental property management companies offer many advantages, but you may feel torn about hiring one if focusing on expenses. The central idea behind generating passive income revolves completely around as much of a hands-off approach as possible. You'll benefit more from hiring a management company if you own multiple rentals and units, but you should also consider these factors:

  • Limited time: Remember, to earn passive income, focus your time on locating new properties and financing their renovations to boost your revenue. Meanwhile, the property management company can look after your existing investments.
  • Money: Can you afford the fees? You'll hear quotes from five to 10 percent of rent revenue, but in a down market, it may be easier and less expensive to manage it all yourself for a little while. Still, five to 10 percent isn't unreasonable for the services provided.
  • Convenience: You may have the know-how yourself, but you feel overwhelmed with endless management tasks when you should search for other properties or take time to enjoy life.
  • Affordable housing compliance: Do you participate in an affordable housing program? The regulations and details get complicated quickly. In such programs, the landlord accepts financial assistance via a tax credit, grant or low-interest loan when renting out some units to those who earn below a particular income level. To continue receiving this assistance, the landlord must comply with specific rules a rental property manager will be more familiar with and quickly address.

Commercial Properties Offer Great ROI

Still struggling over whether to invest in either residential or commercial properties? If invested in residential already, you may overlook the advantages of investing in commercial real estate next. Moving outside your comfort zone offers advantages, especially for your wallet:

  • Greater income: What costs more to rent — commercial properties or residential properties of a similar size? The answer is obvious: If you purchase a multi-family home, there are more units to rent than in a single-family home. More units mean more returns on investment: You’ll see a better ROI if you buy a property with five rentable units instead of a property with one. Raising the rental rate over the lease period is also an option with commercial properties.
  • Appreciation: The value of commercial properties appreciate over time, and when the market is right, you can sell the property. You may risk losing out on more passive income if you sell since appreciation means more chargeable rent when signing new tenants to a lease.
  • Longer lease terms: Commercial properties, such as retail or business office spaces, typically have tenants who sign multi-year leases, limiting the time you or the property manager need to check in or advertise for new tenants. You're more likely to retain your tenants should you include an acceleration clause: If they break a five-year lease, the balance immediately becomes due.
  • Fewer expenses: Depending on the lease, you may pay less out of pocket when renting out commercial properties. Sometimes, tenants will sign to pay property taxes and all utilities in exchange for the flexibility to decorate and design the property to their pleasing. Some limitations or guidelines may be negotiated if the tenant dreams bigger than you'd prefer. Negotiation is part of business, and in this case, it works to your mutual benefit. A talented agent is vital in these exchanges.

While it's not kind to generalize, business tenants tend to be less difficult to deal with than residential tenants since an organization puts its reputation to its name when signing a lease. Commercial properties offer great returns on investment with better appreciation value over time, longer lease terms and few expenses.

Residential rentals also offer sustainable perks but more hands-on management — residential owners will have less space to advertise for and worry about filling when a tenant vacates. Sometimes, it's down to preference.

Peer-to-Peer Lending and Real Estate Investment

Many real estate investors may seek out a bridge loan to gain assistance with a renovation project, but rather than going to a bank, they turn to peer-to-peer real estate lending since the loan amount comes directly from someone who knows about the business — someone like themselves.

Sometimes, these investors only help finance the loan while others take on ownership positions with commercial properties, pointing to an equity upside. By participating in this role, these investors gain access to commercial properties — such as shopping centers and self-storage facilities — that they may not otherwise access. Such equity investments provide these peer-to-peer lending real estate investors with the tax benefits minus the associations of management.

Lending for Rehabilitation, Purchase and More

Many major financial institutions don't fit well with real estate investments and only fund the purchase of the building. What about the renovation? Peer-to-peer lending platforms in real estate present perfect alternatives, with investors who understand the project and provide funds that would normally have to come directly out of pocket. These funds come through rehabilitation loans as repairs are made on buildings.

On such platforms, such as Realty Mogul and Groundfloor, investors may contribute as little as $100 to assist with rehabilitation and purchase, among other needs. The individual needing the loan provides information such as property location, budget for rehabilitation, purchase price and their net worth and income, for example. Underwriters take a look at the application and communicate with the investors to approve the funding.

Passive Investors Access New and Diverse Projects

Passive investors gain access to potential projects they want to get a feel for, and peer-to-peer lending platforms provide an excellent pipeline to expertise. Real estate companies also review listings and maintain close relationships with financial institutions, and these platforms give passive investors the opportunity to invest alongside real estate companies to participate rather than miss out.

Lower Amounts to Invest

Commercial properties involve extensive areas featuring office, shopping and apartment buildings with multiple units, and small investors struggle to compete with larger investors who can offer $100,000 or more on a multi-million dollar project.

Peer-to-peer lending platforms provide passive lenders with the opportunity to access these projects and contribute lower amounts. When small investors pool money, they diversify investments and add their power and participation into the mix.

No Closing Issues and Banks

Passive investors gain the expertise of real estate companies who have dealt with closing and the property reports. Active borrowers seeking funding from peer-to-peer lenders may also have connections with service providers that speed the closing process up. No one likes paperwork.

No Management Needs

The joy of passive income centers around letting others take care of management needs. Who wants a call in the middle of the night about a tenant's property flooding? When you spearhead property management, you're constantly on-call and have to deal with delegating every little detail and chore.

Once legal documents are signed, tenants continue paying rent, and the sponsor fine-tunes the operations. The income aspect of commercial properties makes this investment not as volatile as other assets, such as stocks where price movement greatly affects return rates. Longer lease terms also help offset any economic fluctuations and income impact, proving to be more stable and conservative in the long-term than a new passive investor might assume.

Investing in Private and Public REITs

Many investors allocate 25 percent of their portfolio to real estate to diversify their portfolios smartly and boost income. Many buy and rent out properties while others like to participate in the lending role or invest in other related stocks and funds. You may choose to own shares in a Private REIT over a Public REIT, known as real estate investment trusts (REITs). With these, you invest in a brick and mortar diversified portfolio, such as retail or multi-family assets, starting small at five to 20 percent.

At first, investing directly into commercial property will be hands-on as you elect to ready and rehabilitate properties, whether you choose to take on the property management aspect or hire a contractor.

Strategizing the purchase of REITs over purchasing a property may be more appealing since it's liquid and consumes less time and money. It may also prove more volatile, as it's linked to the broader stock market. REITs typically focus solely on real estate through the purchase and operation of properties but pay hardly any federal income tax. Still, REITs are obligated to pay 90 percent of gross income as dividends to investors, an underlying difference from bonds and stocks.

REITs provide an accessible option to include real estate in a portfolio, particularly for tax-protected accounts such as Roth IRAs and 401(k) plans. While subject to interest rate shifts, they provide a way to diversify your portfolio, including real estate with regular stocks.

For the passive investor, REITs are easy to invest in and track. Some examples include American Tower Corporation — highly diversified, Host Hotels and Resorts — a hotel REIT, and Senior Housing Properties — a senior housing REIT. Diversifying your portfolio with REITs while generating passive income as a brick and mortar residential or commercial building owner can majorly boost your income, especially in retirement years as the income continues to increase.

Tax Benefits and Reduced Liability

Direct participation in commercial real estate investment offers tax benefits through deductions connected to interest expense and depreciation value, for example. Such tax benefits may be claimed at property sale, but in the interim, investors may access the distributed funds typically tax-free. Investors who desire less active participation prefer peer-to-peer lending options in real estate marketplaces, which still allow them to reap tax benefits.

Several options exist for the real estate investor and owner looking to sell an asset while minimizing their tax liability, from 1031 exchanges and home-equality loans to the deduction of mortgage interest, depreciation and property taxes. Capital interest gains tax becomes deferrable when you reinvest property sale proceeds into another one — your heirs inherit the property and may make a sale without needing to pay tax on the lifetime appreciation. Here is a quick overview of a few tax benefits:

1. Depreciation

Recover costs through deducting depreciation as an allowance for reasonable wear and tear and obsolescence. Investors use the Modified Accelerated Cost Recovery System (MACRS) method whereby fixtures and appliances depreciate over five years while structural improvement and residential rental properties depreciate over 27.5 years. Depreciation typically results in net loss on the investment property, even with cash flow, but such losses and expenses are then reported on Schedule E — tax form 1040, deducted from your ordinary income.

2. 1031 Exchange

1031 exchanges are named after Section 1031 of the Internal Revenue Code and allow for tax deferment through the sale of an investment property and use of the equity for the purchase of another like-kind property at a similar or higher value. The exchange must be done within 180 days.

3. Mortgage Interest

An owner deducts the part of their mortgage referable to interest contributions on their tax return. The payments made will be higher at the start of the mortgage and decrease as it gets paid off.

The Growth of Real Estate Investment Continues

Investing in real estate has grown from the traditional purchase and flipping of brick and mortar properties to encompass aspects of peer-to-peer lending, allowing investors of all sizes and interests to get involved and diversify.

Some have a strong interest in “landlording” while others prefer a hands-off approach hiring property managers or investing in REITs, for example. From residential properties to net-leased commercial properties, real estate contains various niches.

Single-family residential properties may provide more security to someone who prefers hands-on involvement in day-to-day maintenance while not having to worry about looking for someone to take over a previously inhabited commercial property, like a Dollar General. While investment may require more intense involvement, properties with excellent locations offer high returns over the long-term, and the same may be said of commercial properties to a degree. Though, commercial properties will offer a better ROI over the long term.

Methods of generating passive income through real estate depend on personal preference, goals and circumstance like any other investment. There is no one correct strategy. Meanwhile, the growth of real estate investment as a lucrative form of passive income continues through investor innovation.