If income was a form of transportation to get you to and from your destinations, passive income would be like having your own dedicated driver to get you from place to place. Whereas active income would be driving yourself.
Most of the population drives themselves while the rich have their own personal drivers. Similarly, the wealthy have massive passive income that give them flexibility in where they spend their time. They still earn money while they spend their time vacationing with family, or attending their kids’ sporting events, or volunteering for community service. With enough passive income, working in the traditional sense becomes optional.
As an introduction to passive income, it’s important to understand the main differences between active and passive income. Here’s a quick table that we can use to compare the two. We realize that there are some exemptions to the below, as the below is a generalization.
Active income is money received from activities done by services, contract work, or salaries. Most of us are familiar with active income based on how most of us were raised traditionally – work hard in school to get good grades so we could get into a good school and get a good job to earn a salary. There are some other non-traditional methods that produce active income such as side-hustles, gig work, and house flipping. These are all activities that help someone get a bigger paycheck in exchange for their time.
Passive income is revenue received from sources that require no material participation on the part of the investor. This means that the investor is not in the day-to-day operations of the investment or business. Long term capital gains can also be seen as passive income. Passive income can be gained while you sleep.
The 5 R’s of Passive Income – How to check for quality investments
Passive income has all different types of qualities. Like having a good driver and a bad driver for your transportation, there are good deals and bad deals for passive income.
Reliability of Distributions: How reliable is the cash distribution?
There are some dividend stocks that have consistent yield, and provide a good option for retirees. Fixed income dividends are the most reliable, but don't take into account inflation. Other yield or rate based stock dividends have some variability in the amounts distributed. When you evaluate an investment, determine how reliable the recurrence is and amount paid to its investors. For syndications, check if there has been a point in time where the syndicator had to reduce or suspend its cash distributions, and if so, why? It’s important to gauge the reliability of the cash distributions.
Returns via Cash Flow: What is the minimum cash flow received from the investment?
When evaluating your investments, understand the dividend percentage or preferred returns for cash distributions. Even interest income is considered passive income, but interest on your bank deposit barely earns anything. For multifamily investments, you should expect around 6-8% annualized returns through distributions.
Recurrence of Distributions: How frequently do distributions occur?
We personally like passive income that gives their distributions as quickly as possible. Long term capital gains could take at least a year or more. Dividends from stocks or distributions from investments are mostly quarterly. We view the quality of the passive income also by the speed of which cash comes back to us.
Return of Capital: When will you get your initial investment back?
When an investment is doing well, it’s great to get your initial capital back as soon as possible so that you can redeploy it to other investments. If there is an opportunity to pull out your initial capital and leave additional equity in the deal so you can gain cash returns from it, that would be an infinite return on your initial capital.
Reward via Equity: Will there be any equity rewarded?
This one is the last quality check, since most of the time, the equity factor is heavily determined by market values. In an investment, you should at least get your initial capital back. If there is additional equity that comes along with the deal, that is even better! With many investments the investors hope there will be some equity or capital gain from the deal. With syndications, it’s easier for a syndicator to force more value into the property due to the way multifamily properties are valued: market value + income. If the income on the property is raised, the higher the apartment will be valued.
If you want to learn more about passive income, I'd be happy to discuss more. Book a consultation with me or join my investor club to be on your way to building a high-quality passive income portfolio.