What Is Passive Income and How Can I Generate It

You’ve probably heard the term “passive income” thrown around, and you may be looking for a good definition for passive income.

Or maybe you know what passive income is, and you’re looking for ways to create passive income.

Regardless, we hope that this article on passive income will encourage you to start generating your own streams of passive income today.

What Is Passive Income?

Let’s start with the basic question of defining passive income.

Let’s start with what passive income is not.

What Passive Income Is Not

So you have a job. Or a gig or a hustle or a stint. For simplicity’s sake, let’s just all them all “jobs.” So here’s the basic equation for how you make money from a job. Ready for it? Here it is:

Your Job + Your Time = Your Money

OK, so it’s not E = mc², but it’s a lot easier to understand.

You have a job, and the more time you put into your job, the more money you make.

This is pretty obvious if you’re paid hourly but also true if you’re paid salary.

The more hours you put in, the more money you make.

The more years you put in, the more money you make.

And that’s great. Working is a good thing.

Without people working, society wouldn’t function.

Without you working, you couldn’t eat or put food on the table or pay off your debt or have the capital to invest in the kinds of passive income investments we’re going to be talking about below.

Could I live off my passive income streams? Yes, but it’d be a very minimal existence, and I couldn’t save much to invest in more passive income streams. I still work at my business so that I can accelerate the amount of money that I can “level up” and put more money into passive income streams.

What Passive Income Is

What is passive income, you ask?

Let me give you the equation:

Your Passive Income Stream + Your Time = Your Money

Notice what’s missing there? The “Your” before “Time”.

Because with passive income streams, it’s not your time that makes you money; it’s time in general.

Your tenants paid rent today, and give it a month, and your tenants will put that money in your bank account again without you spending any more of your time.

Or let’s say you get involved in lending. Your borrowers paid you their payment today, and give it a month, and they’ll pay you again.

It’s the same thing with stock dividends or limited partnership distributions or royalties or any other passive income stream.

The Definition of Passive Income

So if one were to define passive income, it would be any money-making activity into which you put your own time and money at some point in the past that now generates cash flow for you disproportionate to the minimal (or non-existent) time and money you are putting into it in the present.

Note those two little words cash flow. This means that the activity is generating more cash output than cash input and putting cash in your pocket throughout the year. This is different than appreciation, which is the increase in market value of the assets.

Passive Income Example

To give an illustration of these basic concepts, say at the beginning of the year, you buy 20 shares of stock of ABC Corp for $100 per share for a total investment of $2,000.

ABC Corp pays a dividend of $1.25 per share every quarter, representing an annual dividend yield of 5.00% ($1.25 quarterly dividend x 4 quarters in a year / $100 per share).

At year-end, ABC Corp is worth $110 per share (and assuming the quarterly dividend amount has not changed, the annual dividend yield is now 4.55%).

Your annual cash flow was $100: 20 shares x $1.25 quarterly dividend x 4 quarters in a year.

Your annual appreciation was $200: $10 increase per share x 20 shares = $200.

When I’m talking about passive income, I’m talking about cash flow, not appreciation, because having an unrealized paper gain doesn’t pay the bills or change your lifestyle.

Cash Flow vs. Appreciation

So in our discussion from here on out, we’re going to focus strictly on cash flow rather than appreciation because cash flow from passive income sources is the key to financial freedom.

Why?

Because once you have enough streams of passive income coming in such that your cash flow from these sources exceeds your living expenses, you no longer have to trade time for money, and you can instead invest your time into living free, doing what you want to do.

Below we’re going to talk about the major categories of passive income: stocks, real estate, and loans.

Passive Income Example 1: Paper Assets

Paper assets such as stocks, bonds, and notes are assets that only exist on paper or, these days, on a computer screen.

They generally represent ownership in something, like a company, or a right to something, like principal and interest payments.

So while the only visual evidence of your asset is a mere piece of paper or code, what what you’ve actually bought is obviously much more than that.

Make sense? Then let’s go!

Paper Assets: The Basics

• Ease of Entry: Easy.  You can set up an account and start buying stocks today.
• Money Requirement: Low. You can get started with just a few bucks. They have no account minimums.
• Time Requirement: Low. If you have an hour or two of time right now, you can start investing in paper assets.
• Potential Payoff (cash flow): Low. Apart from certain investments (such as REITs), dividend yields in companies that you want to invest in typically won’t cross 4% per year, and bond yields are even less (but safer).
• Potential Payoff (appreciation): High. And note the keyword “potential” here. Yes, in theory, you can buy a stock, and five years from now, it could be worth five times as much. But no one can predict the future.

Although there are countless types of paper assets with varying degrees of complexity and entry requirements (some investments require that you be an accredited investor), we’ll only talk about the three most basic paper assets here that are accessible to most everybody reading this, stocks, bonds, and notes.

Dividend Stocks

Stocks represent an equity stake in a company.

The source of cash flow in a stock investment is called a dividend, or a certain amount of money that a company periodically pays out to its shareholders out of its profits.

Established companies in steady industries such as energy, consumer staples, and utilities tend to pay decent dividend yields (>3% in the current market) with relatively low risk.

Coca-Cola Co., Procter & Gamble, General Electric, Boeing, and Chevron are all companies that boast a dividend yield of greater than 3% as of close of market today (2/10/17).

These companies have been around for decades and are not looking to grow by leaps and bounds in the near future.

They are looking to maintain their market share and provide stability for their shareholders.

Some stocks, of course, do not pay dividends.

This is typically true of younger companies and those in sectors, notably tech, that are more focused on reinvesting earnings back in the company rather than paying them out to investors as dividend.

As of today, Amazon, Facebook, and Google, all do not pay dividends.

These kinds of companies are all about growth — and fast growth at that, which translates to rapidly-appreciating stock prices, because that’s what shareholders want to get out of investing in these companies.

So instead of paying out cash from their earnings to their shareholders, who are typically more interested in appreciation than cash flow, these companies invest all of their profits back into themselves to fund more research, projects, purchases, etc., which all translate to more growth.

So these companies appeal more to investors who are looking for rapid growth and appreciation potential rather than a stable, cash-flowing investment.

Of course, many companies in this second category happen to be high-flying tech companies.

But this doesn’t mean that technology companies as rule don’t pay out dividends.

IBM pays a dividend, but of course IBM is a much more mature company than say Google or certainly Facebook.

Apple pays a dividend as well, but of course it does have something like $160 billion in cash as of the end of last year, so it has a little more leeway and can afford to pay out a bit of its profits every quarter while still plowing a lot of cash into research and development.

So which is better? That’s all up to you.

Bonds

Bonds represent a creditor stake in a company or government.

Here’s how it works: companies and governments need money, which is typically called “capital” in this context, to grow or provide more programs, respectively.

Companies raise most of this capital from profits and issuing stocks (see above), and governments do so by imposing taxes on their citizens, but oftentimes these entities decide to borrow money instead.

Of course, companies can go out and borrow from banks, and governments can go out and borrow from other governments, but another useful way for these entities to obtain access to cash is by issuing bonds, which are, for all intents and purposes, mini-loans that investors can purchase and on which they receive interest payments at a certain yield.

And unlike dividends, this yield is fixed.

Company did really well this quarter? You still get the same interest payment.

Company did horribly this quarter? You still get the same interest payment.

Company went bankrupt? You’ll get paid before the shareholders. So bonds are seen generally as a much more predictable and stable asset class than stocks.

Notes

Notes are similar to bonds in that they involve debt, but at least for our purposes, they involve you lending money to individual people rather than corporations or governments.

And, of course, these people you lend money to will pay you back with interest.

The two kinds of note investing that I like are 1) notes secured by real property and 2) peer-to-peer lending notes.

I’ll reserve real estate notes for another time since these are typically more capital-intensive and require much more due diligence, but I’ll tell you a bit about peer-to-peer lending platforms now.

What Is Peer-to-Peer (or P2P) Lending?

Peer-to-peer lending happens when potential lenders (investors) and potential borrowers get together on an online platform, and the lenders lend money to the borrowers.

Sounds simple enough, right? Well, it is! And the great thing about it is that you as a potential lender don’t have to lend all of your money to one borrower. That would be extremely risky.

On the leading P2P lending platforms, you can invest as little as $25 in a note!

And who the heck borrows only $25 on a P2P lending platform?  No one! See, your $25 would be combined with 1,000 other people to lend $25,000 to a borrower on the platform, and in this way all of you investors have spread out your risk.

Instead of one investor lending $25,000 to this borrower, 1,000 investors are lending $25 each to this investor.

If the borrower doesn’t pay (the word for this is “defaults”), then you’re out $25 rather than $25,000. Win-win!

Putting It All Together

So which is best? Stocks, bonds, or notes? The answer is all of them!

They all have different pros and cons.

Stocks are more risky, but over the long run, you’ll probably enjoy the highest return on them in terms of both cash flow and appreciation.

Debt investments, such as bonds and notes, are typically less risky (assuming the borrower has a decent credit rating/score) and provide stable cash flow now, but they won’t go up in value like stocks.

I would encourage my readers to set up both a brokerage account and a P2P lending account just to get experience.

Passive Income Example 2: Real Estate

People need places to live, and people need places to work.  It doesn’t get much more basic than that.

When you buy a piece of property, you need to be convinced that people — whether prospective tenants or prospective buyers — will find such value in it that it will be profitable for you, first and foremost as a stream of passive income, and later, if you choose to sell it, as a windfall of capital gain.

Of course, there are real estate investments that don’t make money for you as a passive income stream, such as vacant land or a house flip, and while those kinds of real estate investments can be very profitable, they should be reserved for another time as they are much more risky.

Real Estate: The Basics

• Ease of Entry: Medium. You can’t just wake up one day, decide you want to buy a piece of property, go online, and buy one like you can with stocks. There are many moving parts to a real estate purchase (finding a deal, obtaining financing, inspecting the property, etc.). Notable exceptions to this rule are the recent real estate crowdfunding sites that have become very popular in the past few years.
• Money Requirement: Medium – High. You can have $100 to buy a stock, but to buy real estate, you generally need some capital reserves for a down payment. There are ways to creatively finance a real estate purchase so that you do not have to come out of pocket so much, but that is beyond the scope of this discussion.
• Time Requirement: Low – Medium, depending on if you pay a property manager or not.
• Potential Payoff (cash flow): Low – Medium
• Potential Payoff (appreciation): Medium – High

There are many different kinds of real estate investments you can make, but today I am just going to cover the most common kinds of passive income-producing real estate investments.

Single-Family Residences

Single-family residences (or “SFRs”) are residential properties having only one dwelling unit.

Pros:

• Availability of good deals: it’s a lot easier to find a deal (say, buying a property for way below market value or finding a seller who will consent to seller financing) on a single family residence than on other property types since the majority of owners of this property type are Average Joe’s and Jane’s, so to speak, which is to say that they are typically far less sophisticated than, say, an owner of a multi-family or commercial property. And the less sophisticated someone is financially, the more prone they are to get in over their heads, and when people get in over their heads and find themselves in a bind, they’re often willing to part with their assets at far less than market values because they need to sell fast.
• Exit strategy: about 14,000 single-family residences are sold in the United States every day. There are far more people in the market to buy single-family residences than other types of property.

Cons:

• Inefficient: if you plan on building your real estate empire on single-family residences, keep in mind that you’re going to have to manage different tenants in different buildings around town, which may make property management difficult once you start owning more than a few houses. Also, major repairs will add up quickly. It’s typically less expensive to hire a roofer to replace one 20-square roof than two 10-square roofs. This concept is even more relevant when dealing with foundation issues.

Multi-Family Residences

Multi-family residences are residential properties having more than one unit. This could be a two-unit duplex or a 500-unit apartment complex.

Pros:

• Economies of scale: two tenants in the same place, under the same roof, are easier to manage than two tenants who live on the opposite sides of town in two different buildings. And the bigger you go, the more economies of scale you achieve.
• More bang for your buck: generally, a duplex will cost less than two single-family homes in the same area and of the same quality.
• Low down payment options: by purchasing a 2-4 unit property with FHA financing, you can jumpstart your real estate investing career even if you don’t have much money saved up. I devoted a full article to this strategy here.

Cons:

• Price: they may cost less per unit, but still, on an absolute basis, two units will cost more than one unit of similar quality and geography, so you obviously need access to more capital to buy a multiple-unit building in a given area than a single-family residence in a given area.
• Savvy sellers: unless they’re very small (say, 2-4 units), multi-family properties are typically owned by a wealthy investor or, more commonly, by a group of wealthy investors. Moreover, many of these owners aren’t even individuals at all, but rather corporations or pension funds with smart attorneys and advisors on their side, so it’s a lot more difficult to negotiate a good deal out of these sophisticated investors for their 100-unit complex on 456 2^nd Street than it would be to negotiate with Average Joe for his 3-bed, 2-bath on 789 Sycamore Drive.

Vacation/Short-Term Rentals

These are properties that you rent out for short periods of time, typically less than a month. So it’s sort of like running a hotel/motel/inn on a miniature scale.

Pros:

• Rent: you can charge a lot more for short-term rentals than you can for long-term leases. For example, a single-family residence may be able to be leased to a long-term tenant for $1,000/month, but this same single-family residence may be able to fetch $100/night on a short-term basis. Assuming you’re able to fill 20 nights out of the month, that’s $2,000/month renting to short-term tenants rather than $1,000/month renting to a long-term tenant.
• Ease of marketing: sites like Airbnb have basically taken over this space and centralized most all non-hotel short-term rentals on one website, and they make it very easy to post your property.

Cons:

• More time-intensive property management: multiple people are coming in and out of your living space every month, and after each one leaves, you have to clean the place and get it ready for the next tenant.
• Legislation: some cities are currently attempting to stop short-term rentals or heavily tax them.
• Location: while location is key to any piece of property, it matters even more for short-term rentals than for long-term rentals. While a short-term rental will probably have no problem in a downtown or touristy area, you may be hard-pressed to find a steady stream of tenants for a short-term rental in suburbia or on the outskirts of town and may be better off renting to long-term tenants in these locations. Sure, $100/night sounds better than $1,000/month on paper, but if you can only fill five nights out of the month, that $100/night has become $500/month with more hassle than simply renting to a long-term tenant for $1,000/month.
• Competition: yes, Airbnb and its competitors have made marketing easier, but of course that is true for everybody. You have to work hard to distinguish yourself.

Commercial Buildings

These are properties occupied by businesses. This covers everything from strip malls to skyscrapers.

Pros:

• Costs: it is customary in many markets and for many types of commercial properties for the tenants to pay things like maintenance, insurance, and even property taxes (Google “NNN” for elaboration).
• Longer leases: while it’s rare for a residential lease to be longer than 12 months, it is not uncommon to write a commercial lease for five, ten, or twenty years. This provides stability (as long as the tenant doesn’t go broke!).

Cons:

• Savvy sellers: the same thing that could be said of multi-family properties with regard to owner sophistication can be said about commercial properties as well.
• Complexity: from the variations in lease provisions to the financing to tenant evaluation, investing in commercial properties is more complicated and less intuitive than investing in residential properties.
• Vacancies: vacancies in commercial units are typically longer than in residential units, especially for smaller mom-and-pop type oddball properties. People always need a place to live, in good times and bad. But in bad times, lots of businesses go under.
• Liquidity: although real estate in general is not a liquid asset, you may have to wait even longer to unload a commercial property than a residential property since there are fewer potential buyers of commercial properties.

But Is Real Estate Truly Passive?

Yes, real estate can be a truly passive investment if you’re willing to pay for it. And by “willing to pay for it”, I mean willing to pay a property manager 8 – 10% of your gross rents to take care of the everyday operations of the property for you.

But if you aren’t willing to pay somebody to do this, you will certainly have to invest your own time into keeping your properties running smoothly. For example, my first real estate investment was a 4-unit property in which I lived in one unit and rented out the other three. Here is a list of things I had to attend to — all in the first six weeks!

• fix ceiling fan in Unit 2
• fix bathroom faucet in Unit 2
• replace entire roof for Unit 1
• replace flat portion of roof for Unit 3
• treat soil near front door of Unit 4 for termites
• put down metal flashing behind add-on portion of Unit 4 to prevent seepage during rain
• replace stove in Unit 4
• convert stove in Unit 4 from natural gas to propane

So real estate can be an amazing wealth-building tool and source of passive income, but keep in mind that passivity in real estate comes at a price! 🙂

Passive Income Example 3: Business

In this section, I am not talking about starting your own small business in the traditional sense. I am talking about either buying or starting a business that has the potential to become truly passive in a relatively short period of time (let’s say one year).

Of course, the vast majority of businesses never become passive for their owners.

Ask anyone who owns a dry cleaner or a roofing business if their business is “passive”. Nope!

It often requires more time investment than working as a W-2 employee.

Oftentimes when people start their own business, they’ve essentially just created a new job for one — and employed themselves.

Although running their own shop may be infinitely more satisfying than working hard to make the Boss Man rich, they still have to go to work and trade time for money, which is the opposite of passive income.

But what we’re talking about here are business opportunities that we can put a lot of work into today and in a year from now sit back and reap the rewards indefinitely.

Businesses: The Basics

• Ease of Entry: Difficult. Buying stocks takes an hour, buying a property may take a month — and your agent and title company or attorney are really doing all the work — but building a truly passive business will take you at least six months of your own hard work.
• Money Requirement: Depends on the business. It obviously takes more capital to start a manufacturing business than it does to start an Internet business.
• Time Requirement: High. A lot of “sweat equity” goes into building a business.
• Potential Payoff (cash flow): High. The sky’s the limit because you’re in control.
• Potential Payoff (appreciation): High. Ditto.

Businesses You Can Buy

There are plenty of business opportunities out there if you have the cash. Now, I don’t have any experience with buying businesses, so I’m just going to drop a few examples below to get your wheels turning.

• Vending Machines: maybe you’ll find a rare coin and really strike it rich.
• Car Washes: scrub, scrub, scrub.
• Laundromat: just make sure you sell detergent too!

Business You Can Start Yourself And Eventually Turn Into Passive Income Sources

This is the route I’m taking with this blog. It doesn’t take a lot of money to get started, and you have the potential to make a lot of money if you’re willing to put in the work.

• Internet Business: this can be anything from a blog that generates ad revenue for you to an e-commerce website that sells digital products or courses you’ve created and can now sell for incredibly high prices.
• Creative Business: write an ebook and put it on the Kindle Store or write a song and collect royalties.
• Mini-Rentals: buy an ATM, game machine, vending machine, etc., and collect your quarters every week.
• T-Shirt Business: produce a creative shirt design on Teespring.com, and let them do the printing and selling (for a fee, of course).