This article was contributed by Wealth Advisor John Zachary.
I get asked a lot of questions about generating passive income. The idea folks envision is that if they can generate enough passive income streams, they can quit their day job, and retire somewhere with a scenic backdrop and cocktail in hand. Sounds great, right? However, in many cases, this is purely an idealistic dream, not a realistic possibility.
Let’s first start by answering the question, what is passive income? While a somewhat complicated concept, the answer is relatively simple. Passive income is income that you receive from something that you are not actively involved in. For example, the paycheck you get from your employer is not passive income because you are “actively” involved in earning that paycheck. The most common sources of passive income are real estate (rental income), investment income (dividends, capital gains, & interest), and limited partnerships. I do not include “side-hustles” as passive income unless you personally don’t have to put in man-hours to earn the money.
In most cases, generating passive income is not something that can be done overnight. It usually takes capital (i.e. money) that can take years to build. Let’s use real estate as an example.
To purchase an investment property, most lenders require a 20% down payment and charge a higher interest rate than if it was for a primary residence. For a $150,000 property, that is $30,000 in upfront capital. If you don’t have that money handy, it can take some time to save. In many cases, even with historically low interest rates, real estate investors barely breakeven the first years of their rental, and the lion's share of passive income doesn’t come until much further down the road when the property is paid off.
But what if you took that $30,000 down payment and invested it in a portfolio of stocks? With the growth rate of real estate averaging 4.12% (1) annually over the last 12 years and the stock market averaging 10.52% (2), in this hypothetical example, at the end of 30 years your debt-free rental property would be worth $503,635 and your investment account would be worth $603,042, with a lot less hassle involved.
To be fair, since your mortgage payment is usually fixed and rental rates should go up with inflation, your net cash flow should increase over time with real estate. However, there are lots of unknowns with owning real estate…insurance, taxes, repairs, management costs, and maintenance all grow with inflation too and can easily wipe out a years’ worth of net rental income. Not to mention tenant issues and catastrophic risks like hurricanes and flooding. Also, real estate is an illiquid investment, meaning in most cases you can’t sell your property and get the proceeds quickly. It can often be a costly and time-consuming process.
Let me be clear, this is in no way an attack on real estate investing. I think real estate can be a fantastic way to build wealth, but only if done carefully and considered as part of your overall financial plan. As with any investment, there are risks, and it is important to understand those risks before committing.
One of the simplest ways to generate passive income is by investing in stocks (and bonds, if appropriate). And here’s the secret: by contributing to your company’s 401(k) plan, an IRA, or a brokerage account, you are building up assets that can be used to generate passive income in the future. By generating passive income this way, you can potentially reduce costs and the headaches that can come with property management.
As always, we remind you that it is important to look at your financial situation with a comprehensive view, considering your goals, time horizon, and risk tolerance.
At Pathfinder Wealth Consulting, our team of CERTIFIED PROFESSIONAL PLANNER® Professionals will take these factors into consideration and more, to help determine a financial path that is the most appropriate for you. We are here to guide you forward.
(1) S&P CoreLogic Case-Shiller US National Home Price Index from 03/31/2010 to 03/31/2020
(2) S&P 500 total annualized return from 03/31/2010 to 03/31/2020
John Zachary is a Wealth Advisor at Pathfinder Wealth Consulting. Pathfinder specializes in comprehensive financial, estate and tax planning services, investment management, and risk management (insurance) for business owners and successful executives. Advisory services offered through Commonwealth Financial Network®, a Registered Investment Adviser. To learn more about Pathfinder Wealth Consulting, visit www.pwcpath.com. John can be reached at [email protected] or 910-793-0616.
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