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The Horror of Passive Income

The Horror of Passive Income

If I had a nickel for every time I heard this one:

“All I have to do is buy a few investment properties, then I can sit back and make $100,000 a year in passive income. I will be set, and I will never have to work again.”

Passive income is an illusion that people will pursue until insanity or death.

Note: I know there are plenty of other kinds of passive income, but for our purposes here, I’m talking only about passive income regarding real estate.

Point 1: Passive Income Isn’t Really Passive

If you own 4-5 houses/apartment buildings and you are renting them out, you are going to have to deal (directly or indirectly) with constant nonsense from the tenants. Leaky roofs. Plumbing. People getting drunk and setting off fire extinguishers.

Back in 2002, a passive income guy in New Jersey explained to me that there is an inverse correlation between the number of issues you have to deal with and the quality of the property.

He said that ‘A’ properties generally had no issues but only had a 5-6% cap rate. ‘B’ properties had some issues and had a 7-8% cap rate. ‘C’ properties, where people are getting drunk and setting off fire extinguishers, had a 10-12% cap rate. You got paid more, but it was more work. Which leads me to the main point of this article, which is:

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Passive income isn’t really passive.

Passive income sounds attractive to lazy people. The idea of sitting back and collecting checks is irresistible. Anyone who has done it will tell you that there is a lot of work involved—just as much as a real job. Plus, you have the additional stress of the debt.

Point 2: The Debt

Most people can’t buy an investment property with cash, at least not at first. Just like any other chump, you have to put 20% down and borrow the rest. A lot of the time, the rental income barely covers the mortgage payment, property taxes, and insurance.

From a cash flow perspective, you’re not really any better off. Where you win is the taxes: the deductibility of mortgage interest, the depreciation you take on the property, and the ability to roll the gains into another property with a 1031 exchange.

But to my earlier point—the idea that you are sitting back and collecting checks is mostly false.

Then, there is this issue of the debt. Say you bought 4 or 5 rental properties—with debt. You now have a giant balance sheet with lots of assets and lots of liabilities. If the asset side of the balance sheet goes down, then you are underwater. And trapped. Bankruptcy becomes a real possibility.

Let me tell you, over the years I have known several people who got themselves way in over their heads with rental property. Debt is no fun. Debt causes massive amounts of stress. Debt can drive people to do desperate things. The passive income which seemed so easy is suddenly elusive. And usually people stop paying rent concurrently with property values going down.

I have a healthy fear and respect for leverage.

The thing with most passive income people is that they are in such a big hurry. They use leverage to buy a bunch of properties in quick succession, instead of waiting until they had more cash to use less leverage. They are intent on building a real estate empire. There are countless examples of real estate empires that have been built—and lost—because of too much leverage.

Some People Can Make It Work

I’m sure there are people reading this right now who are thinking to themselves, “What’s this guy’s problem? I am doing it successfully.” Good for you.

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I’ve found that passive income investors are either:

  1. Very smart about market cycles or
  1. Incredibly lucky.

If you started building your real estate empire in 2010, you are probably doing fine. If you started building your real estate empire in 2018, good luck to you. You are getting skinny returns on top of insane leverage.

Here in Myrtle Beach, seven years ago you could have bought properties at the tax auction for pennies on the dollar. Now, people are paying full price, and people are doing fix-and-flips for $10,000 or less. Skinny returns, insane leverage, and too much risk.

So if you really want to build your real estate empire, the key is patience—the ability to wait until the down part of the cycle. Which might take a while.

There are lots of great real estate investors. Sam Zell. Even Donald Sterling (the Clippers guy). If you are interested in doing this, you should study what made them great.

I have a deep suspicion of it. I am an active income guy. Yes, it may seem like the newsletter business is passive income—but it really isn’t.

A couple of final things—I got your feedback last week on what topics you would like me to cover in personal finance. Thank you. That helps out immensely. Thanks for being a part of this.

Second, I have a new podcast up—please check out my interview with Salem Abraham, who runs a Commodity Trading Advisor out of Canadian, Texas. If you have never heard of Canadian, Texas, that is the point of the podcast. Enjoy.

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Sep. 15, 2018, 7:15 p.m.

I think your thoughts on Passive Income are the same as if you or I invested in the S&P 500 index fund and expected great returns with no risk. Commercial real Estate is a business just as investing is a business. You have to work both in investing and commercial income property to get the returns and income you want or if you sit passively by you can wake up with nothing.
Sep. 13, 2018, 11:59 p.m.

Henry Massey

We should be careful with our terms here. I generally think of “passive income” in the Internal Revenue Code sense of income derived from investments in which the recipient has no material participation the management.  Passive losses can only be deducted against passive income.  If one owns an apartment and rents it out and manages the rental I would think that would be viewed as active income by the IRS.

I have invested in many private real estate syndications in which I am a passive investor, i.e., the management is performed by the sponsor. I don’t have to worry about the headaches of management.  I have done very well in most of these, with IRRs of 10-20% being pretty common.  And, there are the significant tax advantages of such investments, such as the tax-free rollover into another property and the ability to improve the property, refinance the debt and withdraw all or a portion of the proceeds without incurring a tax.  In a number of cases in the market of the last few years, these refinancing proceeds have meant that investors are playing only with “house money” going forward.

These investment entities are typically managed by very savvy people who certainly keep an eye on the interest rate trends and the real estate cycle and who also are skilled at improving the properties and adding significant value.  Some of the sponsors with whom I have invested and had great returns are Reliant Capital, McDowell Properties and Menlo Equities—all based on the west coast and typically investing in multi-family housing or office buildings.
Sep. 13, 2018, 2:03 p.m.

35% down is closer to what is needed.  After PITI, the remainder should go into reserves for future repairs and coverage for those periods where the unit(s) is/are empty.  No problem if you have really deep pockets elsewhere and don’t mind bleeding cash.
Sep. 13, 2018, 1:20 p.m.

We should be careful with our terms.  The article apparently uses the term “passive income” to describe income from a property owned and managed by the taxpayer.  I believe that under IRS rules, that would be “active income”, whereas income from a property in which the taxpayer does not materially participate in the management would be “passive income.”  In the latter case, passive losses are generally only deductible against passive income.  As with a previous comment from Mr. Leger, I have done extremely well with private real estate funds in which I am a “passive investor”.  Sponsor examples would be such organizations as Reliant Capital, McDowell Properties and Menlo Equities—all based on the west coast.  All of these are very experienced managers who are very sensitive to interest rate trends.  All have provided me with very nice returns.
Sep. 13, 2018, 12:14 p.m.

Re: Rental Properties - your attorney will usually advise you to create a LLC to operate the rentals, plus additional steps to safeguard any other valuable assets, in case of a negligence lawsuit.  Lawyers call rental properties “High legal risk investments” Otherwise, you may spend your retirement years collecting empty shopping carts at Walmart.

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