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Why You Might Want To Think Twice Before Seeking Out “Passive” Income Via Real Estate... Thumbnail

Why You Might Want To Think Twice Before Seeking Out “Passive” Income Via Real Estate...

                WRITTEN BY: GIDEON DRUCKER, CFP® AIF® ECA


I have a dozen calls 📞 a week with professionals who hope we might be the right fit to become their financial partner...

On these calls, I get to hear a bit about their financial dreams, their family & financial dynamics, areas they think they could use some help with, and what they've been doing thus far both financially and professionally. It's an awesome thing that I get to hear and learn about so many different perspectives.

From time to time, I like sharing epiphanies I gather through these calls so others can benefit from the insight too! 🤩

Every so often, I hear prospective clients seeking to attain "passive income" usually by way of rental properties; "How do I earn passive income," "How can I quickly increase my passive income," and the list of questions I hear continues...

I can't help but wonder if they truly understand all that would be involved in such a venture or if it just SOUNDS like what they should want. There is a lot of buzz about rental properties on social media and I get it. It can seem very appealing.

Here's my two cents 🤔:

I think young people are drawn to the idea of passive income via rental properties because it seems easy, quick, and (the key part) a way to replace having to work for living.

You may start to think "Well, If I could have enough income coming in each month to cover my rent, groceries etc. than I would be able to stop working and just live off my rental income and drift off into Paradise..."

Now, don't get me wrong...you can absolutely make money through real estate/renting out properties and it might make sense for you, but it's worth asking yourself, "Are you drawn to rental properties as a potential long term investment or because you think it can/will replace your earned income?"

👉In our experience working with clients for 60+ years, for the truly financially independent, rental income is not a substitute for earned income and it is absolutely not the primary source of their income.

Most of the time, it's supplemental...it's merely "extra" income that allows them to power save, do more with their lives, and serve as the cherry on top of their retirement sundae.

(Relatedly…I’m always kind of awestruck when I read those articles on CNBC or wherever that talk about how Jake is 35, has $$1mm and is retired, living off his “passive income”. For starters, what sort of life is Jake living to be able to live off that amount of money for the rest of his life? $1mm does not translate to a retired life for 40 years. When people talk about “retirement” they don’t typically mean literal fact of “not being employed”, but rather “not working + getting to live a life they want” Second, what is Jake doing for the next 50+ years? We’ve already established he’s living on a tight budget…I guess it’s just that my clients and I have more purposeful & exciting lives planned out than what you find in these pieces! Suffice it to say I think those articles are wantonly misleading.)

Warren Buffett was once asked why more people didn't follow his sage advice, financial behaviors etc....He's obviously had a modicum of success, why not just try to replicate what he's done? When asked this, he replied, "Oh, that's easy. No one wants to get rich slowly."

And Warren Buffett knew of what he spoke: 95% of his wealth was attained after he reached age 65... 95% 😲!

I have to be honest, every time a young person starting out talks to me about rental income...I think about Warren Buffett and the discipline, optimism, and commitment required to build wealth over time and how the impetus to buy "rental property" before it truly makes sense given your cash flow might just be an attempt to circumvent that process.

👉A few thoughts about rental properties:

  • Let's say you make $250g annually, with $100g in the bank, $200g in taxable investments, and $300g in retirement money and you say that you want to start generating passive income. Let's work through this...if you were to buy a $400g place and put 20% down...that's $60g right there. You're throwing in over 50% of your emergency fund into your first rental property. And how much is it generating per month? Let's say the mortgage, property taxes, HOA etc. cost you $2,000 per month and you're able to rent it out for $2,500...so you’re netting $500 per month...how much income was required to be able to profit off of rental properties?! And how much of your liquid net worth did you have to part with (after all real estate is not liquid) in order to obtain this "investment"? Having rental properties...plural...and at a large enough clip to generate substantial "passive" income requires some serious capital and income from other sources. Again, from experience❗, this typically makes the most sense "after" you've made your bones, have a sizable (and liquid net worth) and are ready to ponder new opportunities knowing that you are ALREADY on the cusp of financial independence.
  • A real estate broker client recently told me that when she talks to her clients about buying potential properties in order to rent them out...she always reminds them that doing so makes them a LANDLORD! Her point: It can feel like a second job...If a pipe bursts or there's a leak or people move unexpectedly and you have to find new renters, or your renters don't pay etc. it's all on you to deal with it...which is fine, maybe that doesn't seem too bad to you. But all of that potential work, liability, and responsibility does diminish the appeal of 'passive" income if your main incentive for thinking about going down this road is the passive part. Put another way, “passive’ income is a bit of a misnomer...someone will have to manage the properties. I remember once a doctor client of my dad's was asking him if he thought he should get into real estate "on the side." My dad's chief reply was simple, "What business do you want to be in?" And if your idea is to “flip properties” continuously, well that’s quite literally an entire second job in which your capital is constantly and consistently up in the air.
  • 👉I would argue that the clearest way to increase your income potential is through professional development and the acquiring of new skills that leads to getting paid more at your job or in your business. Admittedly, this is difficult to quantify and doesn't happen overnight...but in building out financial plans and looking through decades of cash flows...I can honestly say that continuously and gradually increasing your salary/bonus/commissions is the most meaningful & easiest way to generate additional income (and with substantially less capital spent along the way.) I know this sounds obvious, “duh, make more money” but I mention this because sometimes we spend so much time/energy trying to find a “second” or “passive” income source when it would far easier to focus your energies on increasing your primary income!
  • Home prices have only gone up about 4% per year over the last century. Meaning that if you bought a home for $300g and sold it for $600g 18 years later....which might sound good in the abstract (you made $300g!)…you’d have averaged only about a 4% annualized return. When you factor in all the upkeep, maintenance, HOA, and property taxes paid along the way, that diminishes the return even further. For comparison's sake, historically the S&P 500 (a gauge for the stock market as a whole) averages between 9-10% per year, without any of the drama mentioned above. (Of course, we all have that story of "that guy" that bought a property in Brooklyn for $40g 30 years ago and can now sell for $1.5mm. Do you know what the next where Williamsburg/Silicon Valley will be? And, again, the fact that we all have that "one" story makes it the exception that proves the rule.)

I can only speak for myself. Here are my 2 reasons for avoiding rental income as part of my financial strategy:

1. I don't want to be a landlord...

I don't want to have to deal with managing properties, dealing with issues that arise, finding renters etc.

I know that a more profitable use of MY time and energy is in building my business and working harder at what I do best so I can keep making more money.

2. I also know that when I invest my money in the capital markets (stock market), I can achieve consistent long term historic returns of 9-10% in a way that requires little labor, time, energy or hassle and without the loss of liquidity inherent to real estate. Why would I want to make any of this any harder in exchange for a lower income source?

I'm committed to playing the long game...because doing so is going to allow me to reach all of my financial goals. I'm committed to staying on course!

...

If you have any questions about your financial world, please set up a time to connect and Book a Right Fit call with me here.