The term “passive income” became a household word when Robert Kiyosaki started publishing his books in the 1990’s. The passive income we are referring to is not that defined by the IRS in the Tax Reform Act of 1986…it’s the mental shift to thinking about passive income that has affected the way investors make decisions. I would like to share with you some thoughts about what passive income really means.
To put things into perspective, let’s consider two extremes of passive income. One is hitting the lottery and getting annual payments, probably through direct deposit, so you do no work of going to the mailbox once a year to physically move a check into your checking account. That’s pretty passive. At the other extreme is rental real estate. In 2017, it was estimated that 17 million rental homes in the US were owned by “small time investors” so this is a huge segment of the passive income space, which includes me and most people reading this article. You can achieve true financial freedom through significant ongoing passive income from rental real estate. But the reality is that even after investing hundreds of hours to build a business by buying, fixing, renting & selling houses to achieve financial freedom, it still typically requires at least a few hours per month of ongoing property and tenant management (or few hours per week depending on whether a property manager is hired, whether the investor is actively acquiring new properties, etc.).
In reality, passive income has DIFFERENT LEVELS of “passiveness.” How to view the passiveness of the income is more than a question of semantics. For example, once a buying-fixing-renting machine is in place, much of the income is indeed passive, though some of it requires continuous investment of effort. Tenants are almost always involved in passive income from real estate, in contrast to “flipping” which is NOT passive...one project = one check + much involvement (usually).
No matter how you define "passive income," many (not all) of the most successful FULL-time real estate investors I know have their lives dominated by real estate activities. A large portion of the income is indeed passive but the full-time real estate “machine” allows for a bit less sunbathing in Hawaii than some of the 2:00 AM No-Money-Down infomercials suggest. Some people talk about outsourcing the machine and some are successful in doing so, but they are relatively few, at least in my sphere of influence.
Defining Passive Income
I define the "degree of passiveness" of the income by the ratio between the # of repetitive dollars received per unit of time invested. That's my personal definition based on owning my life since my time and effort are as important as the money. People usually talk about "passive income" as if it was an absolute concept with money continuously appearing with no ongoing effort and without accounting for the upfront effort. It's not just about "no money down" or "little money down" Let’s look at some examples of different “passiveness” for different types of investments.
Example #1 – Rental Real Estate
Veteran investors who have held on to single-family home rentals for a decade or more may have positive cash flow of about $500/month per house and may have a relatively stable tenant base since they improved their tenant screening process after being burned earlier in their investing careers. Even these rentals require some amount of time every month for accounting, inspections, repair calls and a variety of management and administrative activities. If the time invested in managing a rental by an experienced veteran with good tenant management practices averages about 2 hours per month, then the “passiveness” of the income may be estimated at about $6,000 / 24 hours or about $250 per hour of non-passive work. This does NOT take into account the time invested in buying the property, initial rehab and placing the first tenant.
In contrast, a newbie landlord may only have $100-$300/month of positive cash flow per single-family home rental and evict by the end of the first year due to overly lenient tenant screening practices. The positive cash flow is reduced by non-payment of rent and the cost to put the home back in shape (paint, flooring, cleaning, legal, etc.). The total profit for that first bad year may be only $1,200 and the time invested in dealing with all the issues of the poorly chosen tenant may be 50 hours, including tenant management, repairs and administration. If so, then the passiveness of the income may be estimated at $1,200 / 50 hours or $24 per hour of non-passive work.
As you can see the quality of screening tenants alone can result in an order of magnitude difference in the level of passiveness of the rental property!
Another level of passiveness when accumulating a lot of rental real estate, is to outsource the property management and not deal at all with tenants. You might think that using a third-party property manager relieves you of all work. It certainly does relieve you from most of the work BUT…[1] the property manager typically takes 6%-10% of the rent that can be 20%-35% of your positive cash flow, thereby reducing your passive income substantially, [2] the property manager has to be managed which takes up some of your time and [3] some property managers will never do as good a job of managing your properties as you if you have a small portfolio of 10 rental properties or less (like I will always have, by design). Having said that, there are some excellent property management companies who can manage your properties better than you and even justify their cost through late fees, less vacancies and, of course, less time invested by you.
If you want to learn more about how to more effectively manage your tenants so you can invest less time that will translate into higher passiveness of your income, watch the training video “How to Establish Acceptable Standards of Behavior with-Tenants, Tenant-Buyers, Other People’s Children and Other Humanoid Life Forms” in the Smarter Investing home study course.
Example #2 - Private Lending
According to the definition of passiveness of income, the closest I have come to nearly passive income was for several years in the early 2000’s doing private lending using OPM (other people’s money). Back in those days, I borrowed about $100K from 5 credit card companies at 0% interest and private loaned it to rehabbers at 15% interest secured by a mortgage. The total amount of work was [1] writing 5 "minimum payment" checks per month to the credit card companies, [2] once every 12 months doing a balance transfer at 0% interest and [3] depositing income checks from the borrowers once a month. I had $0 of my own money invested. This generated over $1200/month and the “work” involved never exceeded 30 minutes per month. The passiveness of private lending using this method in those days was about $14,400 annually for 6 hours of work annually which was about $2,400 per hour of non-passive work.
Just before the lending crisis hit in February 2008, the 0% offers for 12 months started to dry up (shorter term & higher interest rate) and I stopped my private lending activity using credit cards as the source. While it lasted, I still couldn't feed my family on $1200/month, but it was VERY worthwhile as one of several multiple streams of income. By 2011, I was totally out of private lending for many reasons and haven’t even considered making money from private lending in years.
As Robert Kiyosaki says, there is good debt and there is bad debt. Borrowing from a bank at a low interest rate (for example using HELOC funds from a primary residence or investment property) and private lending it to investors at a higher rate, is good debt IF THE LENDING IS DONE WITH PROPER DUE DILIGENCE (otherwise it can be a disaster…I have seen it!!!). As long as private lending works and the private borrower is paying on time, it does generate truly passive income.
For more information on private lending, watch the training video “Private Lending is Great…Until It Isn’t” in the Smarter Investing home study course.
Example #3 – Website Advertising
This next example was quite passive after doing a significant amount of upfront work but it was not bad. I invested (I never 'spend' only 'invest') 60 hours in front of the computer during three weekends in October 2002 setting up a website for “catalyst suppliers” in my field of expertise in the chemical industry.
It was one of the least visually pleasing websites you were ever likely to see. I then invested about 20 hours contacting catalyst suppliers around the world (by free E-mail of course) to ask them to advertise their products on this site. From 2002 to 2010, I generated $15-30K per year of passive income from advertising fees. The actual work involved after 2003 was about 3-4 hours per year for updating the catalyst product pages, invoicing and depositing checks (most of the payment came in by wire transfer, so I didn't even have to drag my butt all the way to the neighborhood bank). Again, I couldn’t sustain my family based on $15K-30K per year, but if you do the math, it was worthwhile to set this up as another of multiple streams of income. The passiveness of the income was good at $20,000 per year passive income / 4 hours per year of non-passive work which was about $5,000 per hour of non-passive work.
Remember that this measure of passiveness does NOT take into account the time it took to set up the stream of passive income.
The point is that this small business has a very good income-to-effort ratio. Most people should think about small businesses they could start based on their personal area of expertise that could generate passive income with low effort and low investment. In fact, maybe you should take a few minutes right now to do this mental exercise and see if you can come up with a practical idea. You probably have some area of expertise you could leverage, whether you are a teacher, a car mechanic or whatever you do for a living or as a hobby.
Example #4 - Royalties
I wrote a book on catalysis published in 1994 in which I invested about 500 hours of after-work time. In those days, I had a "real job" as Director of R&D at a local company with a 9-to-5 job. I still get royalties from the book, though they diminish every year. It's time to write another book on this subject and not share the profits with a large publishing company. The book sells new on amazon.com for $439 or used usually for over $300. Unfortunately, the royalties at this point are small, but it had a good run for a few years.
So, if I invested 500 hours writing a book and made money in author royalties plus it allowed me to launch another business…could that be considered “passive income”? Yes, but only after the book was written, sort of like rental real estate. A lot of upfront effort, then collect checks. Passive? Yes, after a lot of work.
Another example of royalties is developing and licensing patented technology. The risk is the upfront investment of time and money and there is no guarantee that it will generate income. I developed and patented an improvement for a production process for biodiesel. I invested a solid month of work plus about $10,000 in legal and patent filing fees. The goal was to license the technology to manufacturers and generate ongoing income streams. When and if this technology is successfully licensed, the income stream will be repetitive, passive and at that time, I thought potentially quite significant. The technology was hot in the late 2000’s but by the mid-2010’s, it didn’t catch on well in the US.
The point is, even if wildly successful, can patent royalties be truly defined as "passive income" after having invested much time and at-risk funds to get to this point? Should I count the 30 years invested in developing the expertise that enabled me to develop this process in 30 days? What if I never get a penny from this investment? If I make a million dollars or more in licensing fees, I will be able to retroactively say that the income-to-effort ratio was good. Until then, not so good, though it was fun to develop.
Example #5 – Multi-Level Marketing (MLM)
For decades, there have been multi-level marketing (MLM) businesses that are based on selling a product or service through a “downline” which is essentially a network of salespeople who are recruited to work for a person at a higher level in the organization. Examples of products are household items like cosmetics and kitchenware or services like satellite TV and deregulated electricity.
In MLM, there is some work and there is passive income. Not 100% passive, not 100% active. The downline must be maintained and that requires some activity as well.
Example #6 – Note Buying
Buying discounted mortgage notes is an excellent technique to generate chunks of cash as well as passive income. The concept involves buying mortgage notes at a discount that are either “performing” (debtors pay on time) or “non-performing” (debtors stop paying). There are MANY ways to make money by buying and flipping notes or working out forbearance agreements with the debtors to generate passive income. Once the work is done to reach a “workout” with a debtor, the income becomes very passive as long as the debtor continues paying. If not, you have to foreclose. Even then, you usually outsource that work to an attorney, though you still have to manage the attorney and the rest of the process to get your money out. When buying performing notes that are seasoned and have debtors who pay reliably on time, the income is passive after going through the process of buying the note.
Summary
The "passive income" mantra has many of us spellbound. Many oversimplify the concept of passive income and how to achieve it. There is no question that real estate is a major very do-able method to generate wealth, income and financial security by almost anyone's definition. However, the passive income aspect is obviously not as simple as some speakers make it sound. Everything you learn MUST be modified for your specific local market and for your very personal preferences and goals.
We have established that passive income is a matter of extent, not a black or white passive or not passive activity. We also know that time and effort are major Own Your Life issues. Periodically, I perform a simple calculation of the income-to-effort ratio for the different activities I do to generate money. It requires two pieces of paper and one pen and almost never more than about 30 minutes. Here it is:
Recommended Exercise
Get two pieces of paper. Divide each one into five columns.
Label the columns on page 1: Label the columns on page 2:
[1] activity that generates income [1] activity that generates income
[2] hours invested in the past 12 months [2] hours planned for the next 12 months
[3] income generated in the past 12 months [3] income planned for the next 12 months
[4] capital gains generated in the past 12 months [4] capital gains planned for the next 12 months
[5] income-to-time ratio [5] income-to-time ratio
Make sure you list EVERY financial activity including real estate, your day job, the # of minutes you spent on your stock portfolio and all of your hopefully multiple streams of income. Now write down the numbers for each activity. I did this on an airplane recently and it became obvious that I can make a lot more per time invested from writing another self-published book on catalysis than from some other activities (my next project?). That is also how I decided to create and sell the “Smarter Investing” home study course online as streaming video.
This once a year analysis will give you a pretty good idea of how effective you are in investing your resources (time, expertise and money) to generate financial gain. You may be surprised at what you learn about yourself and your investments. You might decide on course corrections. You might decide to own your life through part-time real estate investing or full-time real estate investing if you haven’t already done so.
Happy investing…passive, semi-passive or active!
