Here at the ol’ FU machine, we’re big fans of passive income. And by we, I really mean me and my 14 imaginary friends. One went back in time to kill Hitler. His name is, ironically, Adolf.
There are quite a few ways you can generate a stream of passive income. Probably the most popular is to buy a stream of steady dividend payers, preferably stocks that raise said dividend each year. I’ve already said my piece against that a million times so I’ll just say this. I would encourage anyone to prefer investing in stocks that pay dividends, but don’t insist on it.
Anyhoo, the other really popular way to generate a nice stream of passive income is to invest in real estate. Real estate is attractive because it’s pretty passive — especially if you get a property manager to do your dirty work — it’s easy to leverage, the assets are very tangible, and hey, people are always going to need a place to live. If that place happens to be the crapbox you own, all the more power to you.
Friend of the blog (i.e. she once took pity on me enough to read this thing) Afford Anything is a big proponent of such thinking, building a mini real estate empire in Atlanta. I guess all the real estate in nice cities were taken, so she was stuck with Hotlanta. She’s done well at it, currently owning a handful of properties that she can manage from anywhere thanks to the help of property managers, general contractors, and a random guy named Billy who likes to point at things.
As someone who has bought rentals before, I can see the attraction in doing it this way. But I also think Paula really glossed over the cost of hiring good property managers, especially if they’re doing stuff like general maintenance for her. We’re talking 10-25% of the value of gross rent, which is a huge cost to pay. Some people might be willing to pay that cost in order to have a passive investment, but take it from someone who used to be in the industry. It’s hard to find a good property manager. They have no incentive to be proactive, so they’ll just be reactive.
Which is why for the folks reading this, I will issue a blanket statement that most of you should probably just give up the dream of building your own real estate empire, especially in Canada’s overheated market. Instead, I think you’d be far better off buying a handful of REITs and just investing in real estate that way.
The big advantage (and risk) of buying individual rental houses is the ability to leverage. You put down your 20%, pay your $800 per month mortgage payment and your $200 per month in expenses, pocket $1300 in rent, and eventually some sucker has paid for the place. Con some banker into letting you do that 4 or 5 times at once, and you’ve got yourself some nice cash flow.
But if you’re feeling frisky (and let me be very clear that I’m not recommending this in any way, shape, or form), you could do something similar with REITs. We’ll use the BMO Equal Weights REIT ETF (TSX:ZRE) as an example, which currently yields 5.6%.
The first thing you do is scrounge up your “down payment,” which we’ll assume is $20k. I suggest looking in the couch cushions first. Then go to your bank and borrow another $40k, and you’re looking at a $60k original investment. You then take that money and use it to borrow another 50% in margin from your stock broker, and boom. You’ve turned $20,000 into $90,000. You then fire that whole $90k into the investment, which would get you 4,912 shares.
Each share pays a monthly dividend of 8.8 cents, meaning you’d end up with $432 in monthly dividends. That works out to $5,187 per year in “rent.”
You’ll have to pay back those loans, obviously. If you borrow $40,000 at prime (currently 2.7%), you’ll be looking at $1,080 per year in interest. And if we use the current margin rates at Interactive Brokers (which has by far the lowest margin rates out there at 2%), you’re looking at another $600 per year in interest.
Sum it all up and you’re collecting $5,187 in rent, and paying just $1,680 in interest. That’s a profit of $3,507 per year on just $20,000 out of your own pocket, for a cool return of 17.54%. That’s not even including capital gains into the equation, since every real estate investor should probably be treating them as an added bonus anyway. You could funnel the profit back into paying back some of your margin loans, or let it ride, baby! I’d be paying it back as fast as I could, but hey. I’m a little scared of outside.
And that’s all there really is to it. Yeah, it’s a risky move, but so is buying real estate heavily on leverage. This way you literally do nothing except collect your dividends. You don’t have to remodel anything, or yell at your property manager. It’s about as passive as it gets. You could even spice up the risk by just buying a handful of REITs that yield more than ZRE.
The only downfall in building your real estate empire this way? You can’t take your lady for a drive past the places you own. Sorry slugger, you’ll have to charm her pants off another way. I suggest loud engines.