Owning a rental property can be a lot of work. I know that firsthand, and I have barely even started.
My wife and I are currently looking into turning our former home into a rental property. I’ve spent countless hours just talking to potential property managers about the process. I’ve learned that getting a tenant in the home will cost us a lot of money out of pocket, and that’s on top of our investment in the property.
We initially bought the property because we thought it could be an ideal future rental if we couldn’t sell it when we were ready to move (which turned out to be the case). Even with all the costs involved, it looks like we can get enough rental income to make it worthwhile if we find the right tenant.
That passive income aside, I can vouch for the fact that owning a rental property requires a lot more work and money than investing in a real estate investment trust (REIT).
Sometimes, it’s better to pass on the passive income
The main draw of buying a rental property is to make passive income from real estate. Owning a high-quality property in a great location can be very lucrative.
An ideal rental property will generate enough income to cover the mortgage and any other property expenses with room to spare, providing passive income to the landlord. In addition to that income, the owners will benefit from rising equity as they pay down their mortgage and the property’s value appreciates.
However, rental properties require a high initial investment. You typically need to put at least 20% down to buy one and pay closing costs on top of that. There are also rental start-up costs, like needed repairs and marketing expenditures to find a high-quality tenant.
Add it all up, and it can cost well over $100,000 to buy a rental property and place a tenant. That’s beyond the reach of many first-time real estate investors.
Meanwhile, there’s the time factor. While the Internal Revenue Service defines rental property income as passive income, it’s not exactly a passive investment, even if you hire a property manager.
Just finding a property manager takes a lot of work since you need to understand the rates each one charges and the services provided, which can differ significantly. While some take care of all the maintenance and repairs for you (which comes at a cost), others tell you about the problem so you can address the issue yourself.
Given the large up-front investment of time and money, many people are better off forgetting about buying a rental property. It might not be worth the few hundred dollars of extra passive income that you’ll receive each month if the tenant pays rent on time and there are no repairs needed.
A much easier and lower-cost alternative
Whereas rental properties aren’t exactly passive investments, REITs are as passive as they get. You’ll need to do some due diligence before making any investment, but once you buy shares of a high-quality REIT, you can sit back and watch the passive dividend income flow into your account. There are many great REITs to buy.
Realty Income (NYSE: O) is one of the best. It owns an increasingly diversified commercial real estate portfolio in the retail, industrial, and gambling sectors (think grocery stores, warehouses, and casinos).
It leases these properties back to high-quality tenants under long-term net leases that raise the rent each year. Those leases require that tenants cover all of a property’s operating costs, including building insurance, routine maintenance, and real estate taxes. That enables Realty Income to collect very steady rental income.
It pays about 75% of its cash flow in dividends each month and retains the rest to invest in new income-generating properties. Realty Income has a remarkably consistent track record for paying dividends: 652 consecutive monthly payments throughout its history.
It has raised its payment 127 times since going public in 1994, including for 108 straight quarters. Given the stability of its portfolio and the strength of its balance sheet, investors should continue banking on a steadily rising dividend from this REIT.
You can buy shares for a little over $60 these days. You would earn a more than 5% yield at its current stock price. At that rate, every $1,000 invested in the REIT’s shares would generate over $50 of dividend income each year, or a little more than $4 each month. The more you invest, the more of the REIT’s steadily rising dividend income you collect every month.
Consider what’s best for your situation
Buying a rental property isn’t for everyone. It requires a high up-front investment and can take up a lot of your time. It might not produce as much income as you expect if there’s a bad tenant or maintenance issues.
That’s why many would-be real estate investors should forget about buying a rental property and consider investing in a REIT like Realty Income instead. It has a very low up-front cost and offers passive income, enabling anyone to start making money quickly.
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Matt DiLallo has positions in Realty Income. The Motley Fool has positions in and recommends Realty Income. The Motley Fool has a disclosure policy.
Should You Forget About Buying a Rental Property and Consider This Easier Passive Income Investment Instead? was originally published by The Motley Fool
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