Many people talk about real estate passive income, without actually investing their own money. I’ve always been interested in buying my own rental property so I decided to find out if real estate can indeed be a great passive income investment.
This story will show the complete process of how I purchased my first rental property, renovated it, the problems I encountered along the way, a spreadsheet for the project finances and how COVID-19 affected me.
In the end, there is a summary of key takeaways from the whole process.
I will also answer the key question – can you generate passive income from investing in physical real estate?
Why Real Estate Passive Income?
In 2018 I was 26 years old. After working in financial consulting for a couple of years and side hustling, I had saved up about €20,000 for investing.
My main goal was to generate a relatively stable return. In other words, I didn’t want to gamble with capital appreciation nor I wanted to speculate with my hard-earned money. For those who don’t know what’s the difference between investing and speculating, here is a good definition by Ben Graham.
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” by Ben Graham
At the time, I believed that stocks and index funds were quite expensive, hence my principal was not very safe there. Physical real estate, however, had always appealed to me. That’s because it’s relatively easy to understand, provides shelter, and generates regular income (in theory).
Also, rent rates were sky high and mortgages were given at roughly 2% interest. This provided a great opportunity to invest in real estate.
I figured, even if I exceed my cost estimates or if the economy slows down, I should be able to generate a solid 5% return per year. I also hoped to learn more about real estate investing during the process.
Searching for a Property
After going through hundreds of ads, visiting several properties and almost giving up, I finally found an apartment that I liked. I immediately called the broker and scheduled viewing on the same day.
The apartment was in a very good location – it was in the city centre, close to many office buildings, schools and there was a supermarket opposite side of the street.
It was also quite cheap and within my price range. For learning and safety purposes, I wanted to start with a small property.
The apartment was 65 sqm (700 sqft), two bedrooms, located on the 3rd floor of a 5 storey building and it needed a complete renovation. I was specifically looking for an apartment that needed renovation so I could buy it cheap and hopefully add some value.
Buying My First Property
After the viewing, the broker told me that the seller is willing to accept a lower price. Instead of the initial listing price, which was €80,000, they were willing to sell the apartment for €75,000. I said that I will think about it and let them know within a couple of days.
Then, I triple-checked and stress-tested my numbers and decided to offer the full price of €75,000. I called the broker on Monday and we had a deal. Right now I realize that it was a rookie mistake and that I overpaid about €5,000 to €8,000. I didn’t have to close the deal so fast, seeing the apartment only once.
Nevertheless, I had finally purchased my first property and I was excited!
From my initial capital of €20,000, I spent €13,500 on the downpayment and €2,500 on commissions, which mainly included bank fees, stamp duty and notary fee. I also borrowed additional €15,000 for apartment renovation.
The Planning Process
Before I could start the renovation, I needed an architect to draw the new floor plan. The apartment had an outdated layout since the building was built in 1939. Luckily for me, a friend helped me out and I incurred no cost for the floor plans.
It took me about 3 months to draw the new floor plans and to get all the necessary paperwork done before the construction could start. I initially expected this stage to take no more than a month, which was clearly a mistake.
Renovating the Apartment
This was definitely the hardest part of the project.
I was still working in financial consulting full-time and every day I would receive dozens of calls from the workers. I also had to make quick decisions for problems that I had never encountered before, which was very stressful and my productivity at my consulting job went down significantly.
For about 4 months, my typical day looked like this:
At 8 AM I was at the apartment checking the previous day’s work and discussing problems that the workers faced. I would then drive to buy the building materials. Finally, at 10.00 AM I was at the office.
Very often, something unexpected happened and I had to go back to the apartment or drive to the building material store during my lunch breaks or after work. In the evenings, I was completely exhausted, physically and mentally and didn’t have the stamina to do anything else.
Managing the Project by Yourself
Initially, I decided to manage the whole project by myself (questionable decision) to lower the costs. That meant that I had to hire workers for each specific task, buy all of the materials and furniture, manage the timing of each work and control the quality of work.
Looking back, this was definitely a great lesson for me, but I don’t think everyone has to do it this way. If you decide to manage the project by yourself, you will definitely learn much more about the property and you will gain lots of experience for your next projects. However, the opportunity cost is your time, productivity at your full-time job and additional stress.
Another danger of managing the renovation process by yourself is that you can make serious mistakes and increase your costs significantly if you don’t know what you are doing.
The alternative way is to hire a contractor that will do the entire project for you. It might be more expensive, but it’s probably a lot better option if you have a full-time job to focus on and if you don’t have any construction-related experience.
Another option, of course, is to buy a property that doesn’t need renovation, but then you are likely to pay a premium and get a lower annual return. This is a more passive approach wich definitely would suit many investors.
Issues With the Apartment Renovation (Lessons Learned)
Once we started demolition, I quickly realized why the previous owner happily accepted a lower price. Below is a list of some unforeseen problems that I encountered (they were unforeseen mainly due to my inexperience and lack of due diligence).
Lesson #1: Bring a construction expert with you when viewing a potential property and make sure you have a laser level.
Estimated extra cost: €4,000
Description: The floors were uneven and skewed to one side much more than I thought. This was clearly visible when I removed all of the furniture and demolished some non-load bearing walls. As a result, I had to take off the wooden floor, re-level it and buy a new wooden floor for the entire apartment. This was probably the largest mistake in my project.
Lesson #2: Expect significant delays if you are inexperienced and decide to manage the entire project by yourself.
Estimated extra cost: €3,000
Description: Initially, I expected to renovate the apartment in 3 months and then rent it out. In reality, it took me 7 months (+ 1 month trying to rent out the apartment). As a result, I lost at least 5 months of potential rental income. My current monthly rent is €600 per month, so the total for five months would be €3,000.
Lesson #3: When buying an apartment in an old building you should expect “old building problems” and factor them into the purchase price even if you don’t see them at first.
Estimated extra cost: €2,000
Description: Among all the possible “old building problems” I had to change electrical wiring for the entire apartment (expected), change old windows (expected), deal with an outdated layout (expected), fix skewed floors (unexpected) and most importantly, fix drainage problems in the bathroom and in the kitchen (unexpected). Drainage problems were especially annoying since they continued even after the renovation was complete. Luckily they are solved right now!
Old Building Problems
Here’s a short list with some of the typical old building problems:
- Leaking roof (especially dangerous if you buy an apartment on the last storey)
- Foundation issues for the building
- Poor drainage, plumbing and waterproofing
- Outdated layouts
- Old windows
- Mould
- Bad building insulation
- Electrical wiring issues
Total Project Cost
I started with €20,000 of investable capital but ended up investing €34,500 in total (72% more than expected). During these 7 months, I lived “ultra frugally” since I had to save all of my discretionary income to finish the apartment. Looking back, this wasn’t so bad. I forced myself to save way more than I otherwise would during those 7 months.
The total cost of the project was €111,000, which is about €1,700 per sqm (€158 per sqft). If I wanted to buy a renovated apartment in the same area, I would have to pay around €2,000 per sqm (€187 per sqft). So taking on the whole project by myself ended up costing me less than buying a new apartment.
Of course, if I account for the hourly rate that I receive in my consulting job, the picture is quite different.
Real Estate Passive Income
Once I completed the renovation I started looking for tenants. After 4 weeks and meeting 10 potential tenants, I signed the rental contract for 12 months. The monthly rent is €600. I also took €1,200 security deposit.
Up until April 2020, everything was great. Except for drainage problems that I had to fix during the 2nd month of the rental contract. It took me 4 visits to the apartment and hiring two different firms to fix the issue.
I made an 8.5% return on my money before taxes (or 6.4% after taxes). This is still better than the 5% that I aimed for before starting the project.
You can find the full spreadsheet with detailed calculations here.
Is Real Estate Passive Income Really That Passive?
The short answer is – NO. Real estate tends to be semi-passive income since you always have to be involved to some extent.
The first 7 months of my investment were very active when renovating the apartment. It was pretty much a full-time job for me. After renting out the apartment, I still spent about 30 minutes every month reviewing and sending utility bills, collecting water metering results and answering my tenant’s questions. Now, with the COVID-19 my involvement will likely increase.
I’m convinced that if you buy an old property with an intention to increase your return, expect that your involvement will increase significantly. You may need to fix more issues and visit the property more often compared to a newly built property. But it’s not always the case since every house and every building is different.
If you want to generate passive income without any involvement, then physical real estate might not be the best option for you. You might want to look into real estate crowdfunding, which allows individuals to buy a small share of real estate and diversify among many properties.
However, you can also consider physical real estate if you can find someone that you trust who can manage the property for a small fee.
COVID-19 and Problems With Tenants
When I started writing this article, my tenant was paying all monthly payments on time. Today, on 9 April 2020, the tenant informed me that he will no longer be able to pay the full rent amount. I have to say, given what’s happening around the world with the COVID-19, I wasn’t surprised.
If possible, I will try negotiating with my tenant and come up with a reasonable solution. If not, I will likely have to reduce my monthly rental income to find a new tenant. It will be more difficult than 6 months ago since empty Airbnb properties have increased the rental property supply.
I think I should be able to rent out the apartment for €500 per month even with the economy slowing down. This would yield me a 5.0% pre-tax return and I will cover my mortgage payments. If that works, I think I shouldn’t complain.
The good thing is that when buying the property I stress-tested a potential scenario of a recession. Even if I lose 100% of the rental income and receive no salary, I should be able to survive for 12 months and keep the apartment. This shows the importance of starting with a small property that is within your budget. It also shows the importance of having an emergency fund.
Key Takeaways
1) Physical real estate usually generates semi-passive income.
2) Inspect the property together with a professional if you don’t know what you are doing.
3) Select your tenants very carefully and do an online background check.
4) Location, location, location! Look for proximity to major roads, public transportation, schools, supermarkets and offices. Research rents in the area you want to pursue.
5) If you are investing in physical real estate for the first time, start with a smaller property. You don’t want to make huge mistakes with large amounts of money.
6) Stress-test your numbers. When I purchased the property I tested: What if % rates go up? What if rent rates go down? What if I lose my job? Only when I knew I could survive worst-case scenarios I decided to go ahead with the purchase.
7) Triple-check your building estimate and always expect to spend more. I went 72% over my budget. Luckily I could save the extra money and I didn’t have to freeze the entire project.
8) Think about the project’s difficulty and your capabilities before buying a property.
9) Improve the property just enough to attract high rents. Use durable, but stylish materials that will last longer. Before the renovation, think who will be your target tenant.
10) Don’t invest 100% of your money in real estate. The current crisis shows that having a solid emergency fund is very useful. The last thing you want is to have no savings, no rental income and bank pressuring you to pay interest or even the principal. The worst-case result would be losing the property and selling it at depressed prices.