You hop on a flight to Brazil or Costa Rica or Thailand. You spend a month reveling in the sand and surf. You taste new foods. You discover new music. You spot wildlife you’ve never imagined.
You don’t check email the entire time. Heck, you don’t even post photos to Facebook. You’re radically offline — like it’s 1972.
You return to the U.S., check your bank account, and notice your balance has grown while you’ve been away. You’ve returned from your month-long trip with more money than you had when you started.
Sound like a fantasy?
This can be your life — if you create self-sustaining passive income.
What’s Passive Income?
Passive income is money that flows into your pocket while you’re sleeping. Or eating cake. Or eating cake while sleeping (a Nobel-worthy achievement).
When you’re collecting passive income, your money is disproportionate to the hours or minutes you work. Actually, “disproportionate” isn’t the right term: it’s un-proportionate. Your income loses correlation to your hours.
At any job, regardless of your income level, there’s a relationship between time and money. This is active income, the status quo of the default world, and you can hear echoes of this in everyday conversation:
I charge $230 per hour.
He makes $78,600 per year.
She earns $4,250 per month.
These statements reflect a link between time and money. The more hours you log, the more money you make.
(I hand-drew this graph. Long live MS Paint!)
Passive income shatters this association — as it should. Time is limited; money is infinite. Time is precious and in short supply; money is abundant. It makes no sense to trade time for money; it’s unsustainable.
“Sounds great in theory, Paula. But I need to pay the bills.”
Of course. Unless you’re Paris Hilton or the offspring of a Real Housewife, you’re forced to trade time-for-money temporarily, but this is a stepping stone. Unless you’d like to keep making this trade forever?
Yeah, I didn’t think so.
“Okay. So if I want passive income — I just snap my fingers, and voila, it appears?”
Nice try, but no.
Passive income isn’t a euphemism for free money. Building passive income necessitates upfront work. Ramp up, so later you can ramp down. Front-load your workload.
“What are some examples of passive income?”
Great question. A few examples include:
- Dividends from stocks, index funds and exchange-traded funds
- Rental income from properties that others manage
- Royalties from books, music and other creative works
- Income from businesses you own but don’t operate
- Peer-to-peer lending
- REITs and other income-oriented market investments
- Bonds and bond ladders
- Owning vending machines, laundromats or other hands-off income sources
More specific examples:
- If you’re the Rolling Stones, that track that you recorded for (I Can’t Get No) Satisfaction creates passive income every month, even though you recorded it years ago.
- If you’re Miley Cyrus at age 58, you’re still collecting royalties for … (ughhh. Actually, I’m going to end this sentence here.)
I’ve built financial independence from rental properties, so I tend to focus my conversation and content in this area, but this isn’t meant to denigrate the other avenues listed above. Everything within those bullet points are effective at creating self-sustaining assets. They each have their own timelines and risks, of course, but sooner or later, they’ll get the job done.
“But real estate isn’t passive, is it? You have to buy the house, and that takes work …”
I get this question all the time. To answer it as best I can, I drew a graph of how the real estate experience plays out:
Check out the lower-left-hand piece of the graph, which shows the start of the adventure.
In the beginning, you invest time (and some money) but don’t earn any immediate income. This feels like the worst of both worlds, and this is why the vast majority of people — the Conformists — shy away from passive income investments.
(The Conformists, unsurprisingly, are also stuck in 9-to-5 jobs for 40+ years. The key word is “stuck.” They’re not choosing to work because they love their job. They’re forced to work to buy groceries.)
Let’s assume that you decide to build passive income through rental property investing. At the start of the game, you’re:
- Reading and learning about investments and businesses
- Hunting for properties
- Analyzing deals
- Negotiating and closing deals
- Renovating and repairing properties
- Building your team — hiring property managers, contractors and other support staff. This is the most important step if you want to scale, a lesson I learned the hard way. (If you choose to handle day-to-day work, pay yourself for your time. Never conflate “investor profit,” which is passive, with “manager pay,” which is active. If you bought a McDonalds franchise, you wouldn’t stand at the cash register, would you?)
After a few months of front-loading your workload, you rent the property. The hard work pays off. You get your first rental deposit. Cha-ching! At this point, you’ve experienced two phases:
- Active: Work, but no income. Your Conformist friends think you’re nuts.
- Passive: Income, even though it’s been weeks since you last did a shred of work on this project. Your Conformist friends are envious. “Oh, it must be nice,” they gush.
You now have two choices:
- Option A: Kick back and enjoy the fruits of your labor.You’ve finished the upfront work, built systems, hired a team to run your business, and now the checks are rolling in. Passive income will flow into your bank account, with little-to-no input from you (less than 1 hour per week), for the next 15-20 years, until it’s time to remodel the property. Several decades in the future, you’ll spend about 3-6 weeks overseeing a renovation, and then you’ll enjoy passive gains for the next 15-20 years.
- Option B: Squeeze more juice from this orange (er, “optimize your investment”). Embrace optional work that can bump your rental prices and stick even more money into your pocket. Temporarily revert back to “active” work so that you can enjoy even more passive income for the next two decades.
If you choose Option B — and remember, it’s optional — you’re playing in the space on the graph between the two dotted lines. You’re in the space where the x-axis, representing time, starts moving horizontally again, while our payout, the y-axis, also grows in lockstep.
At this point, we’re doing things like:
- Swapping out an “okay” fixture for a “wow” centerpiece
- Staging the unit with furniture and fresh flowers, for an impressive showing
- Snapping amazing Pinterest-worthy photos of the rental unit
- Writing a damn good advertisement for Craigslist.
Here’s an example of the optional kitchen upgrade we gave House #5.
I didn’t need to upgrade the kitchen, but I wanted to squeeze more juice from the orange. After analyzing the local market, I knew a kitchen facelift could increase prospects and lower vacancies, ballooning the bottom line.
This work was optional, but I chose it because I knew that a few weeks of work will create thousands of additional dollars that sustain for 15-20+ years.
The Difference Between Active and Passive
Here’s another example:
If I spend 30 minutes crafting an ultra-compelling Craigslist posting for one of my rental units, I might slice one month off my vacancy rate (for an extra $900) plus snag an extra $50 per month ($600 per year) in rent. Over the span of the year, this could create an extra $1,500 for 30 minutes of work.
Since I can re-use that same posting at every turnover (or send it to my property manager, who will re-use this at every turnover), that 30 minutes of work can generate an extra $1,500 every year, in perpetuity.
But — and here’s the but —
Let’s say that I take that to its logical extreme. Let’s imagine that I spend 100x time, 50 hours, crafting some amazing Craigslist posting. That would be ridiculous. I wouldn’t get a return on my time. I’m not going to rent the space 100x faster, nor will I collect an extra $5,000 per month.
The relationship between time and money disappears.
This is the point on the graph where you really should stop working. Additional work won’t yield additional income. You’ve juiced the orange to its max. Your biggest return-on-time comes upfront, and it pays to NOT devote too much more time to the endeavor.
That’s right, it makes economic sense to stop working.
Check out this point on the graph — everything to the right of the dotted line. Money stays high (the y-axis). It doesn’t drop or decline. The time investment is behind you (everything left of the second dotted line). In fact, putting in more hours is counterproductive. Its time to kick back and enjoy the money flowing in.
Contrast this with the traditional employment model, in which you charge by the hour or year. There’s a direct correlation between the hours you work and the money you make. Work 10 times the hours (or work for 10 years), and you’ll get 10 times the pay. Quit your job — and the paychecks end. That’s scary.
The time-for-money trade is also limited by the number of hours you can work. You have 168 hours per week, and every hour you devote to working is an hour you can’t spend making guacamole and drinking pineapple juice.
Passive income, by contrast, is unlimited. Once you’ve wrapped up one project, you can move onto the next while the assets start to pile.
This is the critical difference between active and passive income. Active income offers short-term rewards. Passive income creates rewards that self-sustain.
I want to address the natural follow-up question: “I’d like to create passive income. How do I start?”
This article is already nearly 2,000 words long, so I’m going to save that answer for Part II, which you can read here. Enjoy!