Investing in the stock market for passive income needs big brains and massive know-how, right? No, I say we can all do it if we follow some straightforward guidelines.

The stock market has beaten other investments for more than a century, and I don’t expect that to change.

Step 1: strategy

Dividend stocks pay passive income, right? Yes, they could be just what we want… once we’ve reached our goal and want to take the income. But until then, our aim is to build as much cash as we can. The bigger the pot the better, no matter how we get there.

An investor who put £10,000 into top US growth stock Nvidia five years ago could be sitting on £155,000 today without any meaningful dividends.

They could then transfer it to a dividend stock like City of London Investment Trust (LSE: CTY) and expect to add £6,800 per year to their income from its 4.4% dividend yield. The dividend, incidentally, has been lifted for 58 years in a row.

Or they could just sell some Nvidia shares each year.

There are two stages to generating passive income. One is building up the pot in the first place. The other is taking the income. They don’t both need the same strategy. We can choose what suits us best.

Step 2: diversification

Investors often make a key mistake when they start. They focus on a small handful of stocks, often in a sector they know. And they can face shocks if they fall.

Diversification is always important. But the pain of a single stock or single sector crash is more likely to put off a new investor. Those of us with more years under our belts should more readily accept the occasional bump.

We could split our cash as many ways as possible, and put each portion into a stock in a different sector. But we should take care not to pay too much in trading costs from too many small buys.

I prefer to start with an investment trust, like City of London that I mentioned above. That puts its shareholders’ cash into HSBC Holdings, BAE Systems, Shell, Tesco… some big names among its top 10 holdings, with wide diversification.

It’s still managed as a single company, so there’s some risk there. And if the 58-year run of dividend rises should falter, I could see a share price fall. But there’s no risk-free stock market investment — and definitely no guaranteed dividends.

Step 3: time

Finally, keep on buying, maintaining diversification within our chosen strategy. Invest as much as we can for as long as we can.

Using City of London as an example, I’ll assume a consistent 4.4% dividend yield, plus 2% per year for share price growth — just guesswork, but I think reasonable.

An ISA allowance each year for 10 years could turn the total £200,000 invested into £315,000 for a 49% gain. Do it for 20 years and £400,000 could more than double to £863,000. Or 30 years could see £600,000 treble to £1.88m. Of course, that’s not guaranteed and returns can fall as well as rise.

We don’t all have that much money to invest. But whatever we have, the multiplication factor will be the same. And look at the difference the extra time makes.

Penny stocks are often tempting because they appear cheap and can offer explosive growth potential. But they come with significant downsides too. Many are unproven, lack consistent earnings, and rarely pay dividends.

On top of that, their tiny market-caps can lead to sharp price swings and thin liquidity.  This can be risky as it makes them more difficult to sell quickly in a downturn. That’s why it’s crucial to do proper due diligence when fishing in these small-cap waters.

I recently came across a penny stock that bucks many of these typical trends. In fact, it looks like it could be a lucrative income opportunity. That company is Alternative Income REIT (LSE: AIRE).

A lesser-known property stock

As the name suggests, Alternative Income REIT invests in commercial property assets, aiming to generate steady rental income for shareholders. Its portfolio’s diversified across sectors including industrial, retail warehousing, leisure and logistics. That gives it a spread of tenants and long leases — an attractive trait for income-focused investors.

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Financially, the £60m business seems to be on firm footing. Currently trading at around 75p, the share price is up a modest 49% over the past five years. Revenue’s crept up 4% year on year, but what really caught my eye was the steep 88% diluted earnings growth. This suggests the company has been successfully tightening costs or renegotiating lease deals to improve profitability.

The valuation also looks decent by REIT standards. Its price-to-earnings (P/E) ratio stands at 11.9, which is comfortably below the broader market average. Meanwhile, its price-to-book (P/B) ratio is just 0.92 — indicating the shares are trading at a slight discount to the value of the underlying property assets.

Strong income potential… with risks

It’s the dividend profile that really sets this penny stock apart. Alternative Income REIT currently pays 6p per share, which equates to an impressive 8.15% dividend yield. The payout ratio’s 96.9%, which is high, but that’s typical for REITs — they’re legally obliged to distribute the majority of rental profits to shareholders. 

Importantly, it’s been paying dividends consistently for the past seven years. For a penny stock, that’s a decent track record of delivering cash back to investors.

Of course, there’s always a catch. As a micro-cap, Alternative Income REIT remains vulnerable to market volatility and low trading volumes, which could amplify in any downturn. Being in commercial property, it’s also sensitive to economic slowdowns and changes in tenant demand. And with a small portfolio compared to larger real estate giants, losing a key tenant or facing unexpected vacancies could significantly hurt its rental income.

Even so, for investors seeking exposure to real estate with a chunky yield, this penny stock looks unusually attractive. As said, REITs are generally bound by regulations that ensure profits flow back to shareholders, and Alternative Income REIT appears to be executing well on that front. 

For my part, I wouldn’t bet the house on it — but as part of a diversified income portfolio, it looks like a penny stock worth considering.