Monday, June 4, 2007

Way #2 to Generate An Alternative Stream of Income

Hello everyone.
In my last post, I outlined five different ways to generate an alternative stream of income. I also said that I would dedicate an article/post to each one of them. Last time, I spoke about stocks, stock price appreciation, and income from dividends. Today, I will discuss rental property.

A lot of personal finance gurus talk about how buying a home is one of the best investments you can ever make. And in some instances, it may be a good purchase. It allows you to "build wealth" through equity and moderate price appreciation, and you can live in it and enjoy plenty of memorable experiences with family and friends.

But I disagree that it is the best investment one can ever make. Not if you want to get rich! If you want to get rich, you will think of a home as a liability, not necessarily an asset. Why is this? Well, when you buy a house, you usually have a real estate agent help you and he or she generally gets a 3 or 4% commission on the purchase price. There are also closing costs, which include document preparation fees, wire transfer fees, inspections - to see if you're in a flood zone, and title insurance and escrow fees. All of these fees can easily add up to several tens of thousands of dollars.

And on top of this, every month, you have to pay property taxes and the mortgage. This greatly decreases your cash flow - the income you use to survive. However, if you buy a property, and rent it out, while living in it, you have turned that liability into asset. Why? Because the renters who inhabit your house are paying you to be there. Here's a greatly simplified example.

Let's say that you've bought a house in College Town, USA, where the median house price is $225,000. (Median means that half of the prices are above this number, and half are below.) After including all costs for various types of insurances, property taxes, and the mortgage payment, the monthly bill for this property is $1,650. If this property has three rooms, in addition to a basement (where you'll be living), after performing thorough credit and background checks on the tenants, you can rent out each room for $550 ($1650/3) a piece.

Most students - and their parents for that matter - would jump at so great a price. By renting the rooms at $550 a piece, you are breaking even, which means that your revenue is covering your expenses and there is no profit left over. But if you've done your research beforehand, and you know that there is an impending housing crunch on the local campus, or the neighborhood is hot, you could raise rents by a moderate $100 a month for each room. This would mean $300 in profit per month, or $3,600 a year. And this is in addition to the renters paying off your mortgage.

Of course, things are much more difficult than I'm making them appear here, as you will have leaky roofs and other problems that as a landlord, you will legally be rquired to take care of. But if you maintain your property well, buy properties in areas that have favorable demographic trends (i.e. the South, with baby boomers headed there for retirement and the explosion in Mexican population growth), you can profit nicely, albeit slowly as a landlord.

The Internal Revenue Service and the tax code also provide one advantage to the small property investor. The government allows you to use $10,000 worth of contributions and gains from your Roth IRA to purchase your first home, provided that Roth IRA (a retirement investment vehicle) has been open for at least five years. So if you think you want to try your hand at property investing, and want to save for it in an a tax effective way, open a Roth IRA. For more information on what this is, check out the post entitled, "How to Open a Brokerage Account/Different Types of Accounts."

Landlording is not for everyone, but it is a way to put extra cash in your pocket while putting a roof over your head at someone else's expense. I recommend picking up Robert Griswold's "Property Management for Dummies." It's a good resource to get started.

Thanks for reading and please feel free to post with any questions or comments you may have.


Jonha Ducayag Revesencio said...

Me and my mom are afraid to take the responsibility of being a landlord because of some of the issues you've mentioned and besides, the credit rating of the people in our area are not really good. I guess I would have to stick with the other options that you mentioned in your other posts.

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