Real Estate Investments as a Second Source of Income

Real estate investments are an excellent source of income.

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Real estate investments frequently produce both cash flow and appreciation. Depending on the type of property you buy, you can change the ratio between the two types of return to find an investment that can produce significant additional income. Given that many real estate investors live exclusively from their income, turning a real estate portfolio into a second income source should be within the reach of most investors.

Cash Flow Properties

The key to using real estate as a source of income as opposed to using it as a general wealth-building tool is to look for properties that offer the ability to receive regular cash flow from rents. For example, when you buy a distressed house, you will probably have to spend out-of-pocket money to hold onto it and fix it up, but you will receive a windfall profit when it sells. On the other hand, a bread-and-butter apartment building might not appreciate in value rapidly, but you can earn a healthy profit every month by collecting rents, paying expenses and keeping what's left.

Diversification vs. Stability

There are two opposite schools of thought on how to structure a real estate investment portfolio for safe cash flow. Some investors buy a large, single-tenant, net-leased asset that has a large company on a long-term lease. Although the lease will end some day, the investor can count on anywhere from 10 to 25 years of stable cash flow until that day. Other investors prefer to own many small properties or larger properties with multiple tenants. They feel that having many different people paying the rent makes it more likely that they'll collect some rent every month, even if it fluctuates a bit.

Active vs. Passive

Another important factor in buying real estate for income is how much work you want to do to earn that income. Some properties either require a great deal of paid third-party management or attention from their owner. Others are more passive and produce income without owners having to get very involved. While a 12-unit apartment might require a lot of attention, a small office building with two tenants -- a doctor and an optometrist, say -- will probably be relatively easy to own.

Potential Cash Flow

What you will earn on real estate will vary depending on what type of property you buy and how you manage it. A building's capitalization rate measures the cash flow it produces relative to the purchase price. If you buy a $1.5 million building at an 8 percent cap rate, it generates $120,000 per year in income. Generally speaking, higher-quality and easier-to-own properties carry lower cap rates while riskier and more management-intensive properties have higher cap rates and will put more money in their owner's pocket if everything goes well.

What About REITs?

Investors don't have to buy real estate to get income from real estate, though. Real estate investment trusts are like mutual funds that own buildings instead of stocks. When you buy an REIT, you get a tiny piece of the returns from its portfolio of investment real estate. You get exposed to the real estate market and you get some or all of the cash flow that a direct real estate investment would bring you, but you have all of the conveniences of owning stock.