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 “