The Buzz Around Passive Income
Passive income is a buzzword we see on TikTok, YouTube, and other social media sites. This has filtered into a lot of conversations with many of our clients. The concept of passive income is amazing – you don’t have to do anything to earn more money on your money. That sounds pretty sweet, right?
There are 158 million search results on Google when you search for passive income, so needless to say, there are a few options out there to consider, and more than a few people trying to sell you passive income opportunities or ideas on how to strike it rich while not having to do much in return! If it sounds too good to be true, it probably is. We will outline the types of investments that are truly passive in nature and when they might make sense in your financial plan (and when it doesn’t make sense!).
So, What is Passive Income Investing Anyway?
Conceptually, there are only two types of income: active and passive. A passive income investment is an asset that produces an income stream with little to no continuous work. (The IRS has specific ways to identify whether your income is passive or active.) Think about passive income as money that is earned with little to no effort and you can still make this money while you sleep, go on vacation, come down with an illness, or any other circumstance that would bar you from actively earning income.
It’s obvious why passive income is such a hot topic; we all want to make money with little to no effort. Unfortunately, the overwhelming amount of information thrown at you when researching passive income opportunities is not passive! So we feel it’s important to ensure you understand the different types of investments that could qualify as passive income investments and those that will require a lot more work.
Passive income takes the shape of earnings from real estate investments, limited partnerships, or other businesses where you are not actively involved (that’s the key here, not actively involved). This can also include interest from REITs, bonds, savings, stock dividends, or CDs. Let’s take a second to think about this with a few easy examples.
Example 1: Dividend Paying Stocks: If you buy a share of dividend-paying stock in your brokerage account, you create a passive income stream through dividend payments. Let’s say you decided to buy 1,000 shares of Coca-Cola Stock because you’re interested in generating another income stream for yourself. Each quarter the company would decide how much they will pay to their shareholders through dividends. In 2022 Coca-Cola paid $1.76/share to all their shareholders throughout the year. You would have received $1,760s in truly passive income in 2022 from this single investment. This is pretty cool because you didn’t have to do any work to earn that $1,760 of income last year!
Example 2: Interest paid on Bonds: Let’s say you invest $10,000 in a Corporate Bond; we can use Coca-Cola again for this example. You’ve agreed to loan them $10,000; in return, they will pay you a 4% coupon payment for the next 5 years and when the bond matures, you get your original investment back. You will have generated $400 of “passive” income from your arrangement in one year. Again, you didn’t need to actively do anything to earn this $400, so technically, you’ve created another passive income stream for yourself.
Passive Income Opportunities in Real Estate
Often, when clients bring up the idea of passive income investments, they typically want to talk about real estate investments. While real estate can be a fantastic investment and a great way to build wealth, most real estate investing strategies are more active than passive in nature. If you’re building a DIY real estate portfolio, you’re more than likely researching ways to buy properties where you’ll make money by renting them out. If this is the route you’re considering, you are 100% signing up as an active participant in creating this income. You would need to (or you need to hire someone) find a property to purchase, finance the purchase, market your property, manage rent payments, and maintain and repair your properties. You also must pay property taxes and carry insurance on these properties. You would also be evaluating and negotiating the buying and selling of these properties. If you want to go this route, you are essentially creating another job for yourself, so all the income profited would be considered ACTIVE income.
Rather, a real estate investment trust (REIT) or real estate partnership where you are not actively involved are great examples of ways to generate passive income from real estate. In this role, you are not making any of the decisions above, you are essentially only deciding if this investment opportunity and risks associated fit within your financial plan or not. You don’t get to choose the property, how much rent is charged, or what improvements are made. You trust that the team putting the deal together knows what they are doing and that their projections for future investor returns are on target. The risk associated is that the returns to you, the investor, do not work out as intended.
While any investment decision requires a very thorough risk vs. rewards analysis, real estate investments require extra attention. Not only are you considering if the income stream will be paid back to you as projected, but you must also consider that most real estate investments are illiquid. You must understand that you cannot change your mind and get your money out of this investment before there is an opportunity created by the investment manager to do so. Additionally, distributions or the passive income stream from these types of real estate investments are not guaranteed and can be stopped for various reasons. In some circumstances, you could even be required to put additional money into the investment (a capital call) if the property underperforms. If real estate is a viable option for you, you should limit your exposure to having some liquidity if life doesn’t always go according to plan.
Other Considerations for Passive Income Investing
You need to ask many questions before you can determine if this is the right investment for you. Do you need more income right now? What would you do with extra income? Would you increase your lifestyle spending? Do you want to quit your job and use that income to support you? Would you reinvest that income to continue to grow your wealth until you're ready to replace your income? Do you have enough liquid investments available to cover any unexpected expenses for a long period of time? Are you an accredited investor? This question is important because this is who may be eligible to participate in these real estate deals not directly offered to the public. Have you looked at all options for passive income or only considering the hottest trends in investing news?
Bottom Line
Investing in passive income-generating assets can sound like an interesting idea, but like any investment opportunity, you must decide if this is getting you closer to achieving your financial goals. When it comes to any investment decision, you must start with “WHY” and then let that guide your next steps.
Brandy Branstetter, CFP®