Should pharmacists buy rental properties for passive income?
As with most personal finance bloggers, I’m a big proponent of passive income. It is easy to see the appeal of the idyllic form of passive income; walking out to the mailbox to collect a check (or receiving a phone notification about a direct deposit) with minimal work. For as much as I seem to hear about passive income, it is easy to start to feel bad because you aren’t generating some, right? So, why doesn’t everyone just get some passive income??
Because it’s hard to do…
Lots of real estate “gurus” or internet “gurus” are out there trying to sell you on some fool-proof system to generate income without any effort or risk. We obviously know that it isn’t as easy as the gurus make it out to be, but we are all guilty of getting caught up of the idea of easy money or a better life.
I’m going to walk you through some of the first steps to get you thinking about investing in real estate as a way to start generating additional income for yourself and your family.
I’m a big fan of real estate and while I would not call it passive income, per se; it can be a good way to generate an income that isn’t solely based on you going to work each day. Which is how I think Passive Income should be defined:
Income not solely generated by you clocking-in to work each day, or work that scales non-linearly with your effort
If you can apply some simple principles, be willing to continually learn more about real estate, have patience and discipline, and get a little lucky – you can be successful with real estate. However, if you don’t have the patience, don’t really want to learn about being a landlord, fixing things, etc; investing directly in real estate probably isn’t for you.
Luckily, there are other ways to invest in real estate. Which I’ll likely touch on in the future, but have also been discussed elsewhere. Maybe you don’t want to invest in Real Estate or pursue passive income at all. I have a great post on how to be a multi-millionaire just by saving in tax-advantaged retirement accounts…
A couple good examples: 1) this article from passiveincomemd where he lists off many different ways to get involved in real estate, 2) and this one from whitecoatinvestor.com that outlines how he invests and describes lots of different wants be in real estate.
Also, I feel compelled to point out that you need to be handling your other financial health issues. Namely, saving for retirement, making sure you are doing the Top 6 things new pharmacists should be doing, and paying down your debt.
Why all this fuss about passive income? What if I like my job?
Passive income shouldn’t only be about quitting work and painting in your backyard for the rest of your life (unless that is what you want!). Think about my definition above…
I personally pursue passive income because I want to create opportunity for myself and others.
I want the freedom to work as much or as little as I want. No one really wants to be at a job 5 days a week. I really enjoy my job, but I don’t want to be there 5 days a week, including weekend/holiday coverage, etc. What if you could work 2-3 days a week at a job you love and have your financial life in order that you could do something that paid little (or nothing) the other days of the week. Maybe volunteer at your child’s school, read that book you always meant to, start a charity, create an elective class at a local college, just sit around… whatever you want!
Maybe you just want to make more money, not work less. Passive income can do that too! Maybe you want to live a fancier lifestyle that you currently live, or you need to make more money in order to save enough for your family’s retirement? Maybe you need to save to help your parents in retirement? It doesn’t matter why.
So, what am I doing for my passive income plan?!?
My goal is to get to around $7,000 per month in passive income. If I can generate this much money consistently, I would consider myself financially independent. I’m not really into FIRE in general sense (Financially Independent, Retire Early) since I like my career. But I am really into the “FI” part. I could do anything I wanted with $7,000/month coming in without me having to go to work every day.
I don’t have children yet, but I plan to, and I could stay home with them. I could blog more, I could work on my woodworking more, read more books… anything!
So how do I get there?
My current plan is investing directly into real estate and I’m going to walk you through some basics to get you thinking correctly about real estate if you want to follow a similar path. I like real estate because:
- I feel as though I understand it,
- It is taxed very favorably,
- It is scalable, and
- I like the idea of owning something I can see.
With two rental buildings under my belt now, I am getting more confident about being able to get to $7000/month. Let’s get to the steps to take!
Step 1 – what type of investor do you want to be?
Spend some time thinking about what type of real estate are you interested in? Single family homes? Duplexes? Three or four-plexes? You may not know for sure yet, but think about it a little. I’m going to write a blog post about some pro’s and con’s of these (in my view) soon.
Step 2 – Network and start looking at properties!
Network and find a realtor who is willing to setup an MLS email with some simple criteria. You can setup an alert to email you whenever a duplex comes on the market in a specific area and price you are interested in. It doesn’t take any effort from the Realtor after the alert is setup and the link comes right to your email, so you can view the property online! I have one setup in my city and I get 1-3 links a day with properties that fit the criteria I’ve decided on.
This step is crucial for a few reasons:
- Networking to find a realtor is a good first step to see if you are motivated to get into real estate and it doesn’t cost anything. If you won’t even do this.. Real estate isn’t for you
- It gets you looking at real properties in your area and you can start getting a feel for the market in your area. This is important even before you have the money to buy since you’ll want a decent feel about value before you get serious about buying
- You can start getting a feel for evaluating the houses listed and see if they might be decent deals
Step 3 – practice evaluating properties!
This is my favorite part.. I do this for fun each day just because I enjoy looking at properties online and running estimated numbers. If you don’t love it, real estate investing may not be for you. When you are serious, you’ll need to be looking at 100 or more properties to find one good one, seriously.
Next week’s post is going to be more in-depth on how I go about evaluating deals I’m serious about investing in, but for this step we only need to practice and don’t need exact numbers. This step helps start making the numbers feel more comfortable so you can get a feel for ballpark expenses, income, etc.
The MLS emails you receive should have some number included in the prospectus about current rents for the property (for Single Family Homes there likely won’t be, but for 2-4 unit buildings it will). We’ll talk more about the issues about these stated rents (people like to “fudge them” a bit when listing a property), but for now we won’t worry too much.
I like to verify rents are in the ballpark by looking on craigslist in the “housing” section to see what the advertised rents are for that type of property and I also look at rentometer.com. Rentometer lets you put in an address and some basic bedroom information and it’ll give you rents in the area. This way you can try and verify the rental information on the MLS link.
Here is an example of a link you might get in your email, after setting up the criteria:
Once you have your monthly rent numbers, multiply them out to get the annual rent. For example, let’s say the above duplex rents for $1000 per side:
|Duplex rents $1,000 per side|
|Rent per month||$2,000|
|Rent per year||$24,000|
With me so far? Good. Now we need to estimate our expenses for this property. Again, I’m giving you the crude initial estimate. I usually assume 45% to 50% of the rents will need to go toward expenses to operate the property (not counting financing the property or your profit/income).
|Estimating Operating Expenses|
|Rent per year||$24,000|
|Operating Expenses (45%)||$10,800|
|Money left for financing and profit or Net Operating Income (NOI)||$13,200|
Step 4 – calculate your CAP rate (capitalization rate)
This is an easy thing to calculate, but tends to trip people up. This calculation is really only valuable to try and compare multiple opportunities together. Most rental CAP rates are going to be between 4-10% and higher is generally better. Most of the duplex and four-plexes I look at tend to be around 5-6%, but you’ll see people who only want 8-10% CAP rate properties that need some rehabbing, etc.
You calculate the CAP rate by taking the NOI and dividing by the price of the property. Look at this table below for examples of different CAP rates for our hypothetical Duplex.
|CAP Rate based on Price Paid|
|Net Operating Income (NOI)||$13,200|
|Property listed @ $150,000||8.8%|
|Property listed @ $200,000||6.6%|
|Property listed @ $250,000||5.3%|
This number can be useful to gauge what the overall market is doing. If you know that most of the houses you look at are selling at a CAP rate of 6% and you see a similar property listed with a CAP rate of 5% – you know the 5% is a worse deal (all other things being equal). And if the prevailing CAP rate is 6% and a similar one is 8% it’s a better deal (again, all other things being equal).
Step 5 – what would your financing costs be?
This step is pretty easy. We know our NOI and our CAP rate, but our NOI doesn’t include our financing costs (the mortgage for the home). Assume you will need at least 25% down (and maybe 30%) and your interest rates will not be as good as you see for a home purchased for yourself (mostly I’ve seen the interest rates been about 3/4 to one percentage point worse – e.g. if you could buy a house with 4.5%, estimate a rental house to be 5.25-5.5%).
Now we can go to any old mortgage loan calculator to figure out our financing costs.
- For a $200,000 price (25% down) @ 5.5% = $852/month ($10,224/year)
- For a $250,000 price (25% down) @ 5.5% = $1,065/month ($12,780/year)
- For a $150,000 price (25% down) @ 5.5% = $639/month ($7,668/year)
So going back to our Duplex example. If we bring in $13,200 per year before financing our annual profits would be:
|Estimated Annual Net Profit|
|Net Operating Income (NOI)||$13,200|
|$200,000; property mortgage $10,224||$2,976|
|$250,000; property mortgage $12,780||$420|
|$150,000; property mortgage $7,668||$5,532|
So this hypothetical duplex deal doesn’t necessarily look like a great deal unless you can get it for $150,000. These numbers are crude estimates and there is lots of nuance that exists in these deals. We’ll walk through my first 4-plex purchase next week and dive into more detail on some of the expenses we estimate in that “45% number”.
If I wanted to use duplexes like these to get to $7,000/month in passive income, I would need close to 15 of them @ $150,000. Something like this doesn’t happen overnight, so definitely beware any “gurus” telling you that you can become rich quickly with real estate.
Fifteen buildings probably sounds like a lot (I know it does to me!), but now imagine that while you don’t have enough buildings for $7000/month; you do have $2,500/month. Would that extra income positively impact your life?
What do you think? Are you more interested in Real Estate, or less? Have you looked at any rentals recently? Let me know, I want to hear about it!