After about the 30th day in a row of working 12+ hour days and eating rubber chicken dinners at our company’s free cafeteria, I decided I had enough.
There was no way I could last for more than five years working in a pressure cooker environment like Wall Street. I became obsessed with generating passive income starting in 1999, the year I graduated from college.
We’ve discussed how to get started building passive income for financial freedom before. Now I’d like to rank the various passive income streams based on risk, return, feasibility, liquidity, and activity.
The rankings are somewhat subjective, but they are born from my own real life experiences attempting to generate multiple types of passive income sources over the past 20 years.
The passive income journey is a long one. But thanks to innovation and technology, the ability to generate meaningful passive income is accelerating!
Passive Income Starts With Saving
Generally speaking, it’s much more pleasurable to spend than to save. If saving was easy, we’d never have to read another story again about a multimillionaire who ended up broke.
By far the most important reason to save is so you can have enough money to do what you want, when you want, without anybody telling you what to do. Financial freedom is the best!
Sounds nice right? If only there was a formula or a chart like the 401k by Age chart which gives people guidance on how much to save and for how long in order to reach financial freedom. Unfortunately, saving money is only the first step in building passive income. Figuring out how to properly invest your savings is even more important.
If you can max out your 401k or max out your IRA and then save an additional 20%+ of your after-tax, after-retirement contribution, good things really start to happen.
Ranking Various Passive Income Investments
Below are eight main passive income investments to consider. Each passive income stream will be ranked based on Risk, Return, Feasibility, Liquidity, and Activity. Each criteria will get a score of between 1-10. The higher the score, the better.
- A Risk Score of 10 means no risk.
- A Return Score of 1 means the returns are horrible compared to the risk-free rate.
- A Feasibility score of 10 means everybody can do it.
- A Liquidity Score of 1 means it’s very difficult to withdraw your money without a massive penalty.
- An Activity Score of 10 means you can kick back and do nothing to earn income.
To make the ranking as realistic as possible, every score is relative to each other. Furthermore, the return criteria is based off trying to generate $10,000 a year in passive income.
1) Certificate of Deposit (CD) / Money Market
There was a time when CDs would produce a respectable 4%+ yield. Nowadays, you’ll be lucky to find a 5-7 year CD that provides anything above 2.5% The great thing about CDs is that there are no income or net worth minimums to invest, unlike many alternative investments, which require investors to be accredited.
Anybody can go to their local bank and open up a CD of their desired duration. Furthermore, a CD and money market account are FDIC insured for up to $250,000 per individual, and $500,000 per joint account.
Everybody needs to take advantage of higher short term rates and save more. Just several years ago, money market and CD rates were only 0.1%. Now you can get an online money market account paying 1.75% as of 1H2020. This is a great rate compared to the 10-year Treasury bond yield at under 0.7%.
Risk: 10 (no risk), Return: 3 (as rates have increased), Feasibility: 10. Liquidity: 6. Activity: 10. Total Score: 39
2) Fixed Income / Bonds
As interest rates have been going down over the past 30 years, bond prices have continued to go up. With the 10-year yield (risk free rate) at roughly 0.8% in 1H2020 (from 1.45% in 2H2019), it’s hard to see interest rates declining much further. That said, long term interest rates can stay low for a long time. Just look at Japanese interest rates, which are negative (inflation is higher than nominal interest rate).
Bonds provide a terrific defensive allocation to an investment portfolio, especially during times of uncertainty like we are seeing with the US-China trade wars. If you hold a government bond until maturity, you will get all your coupon payments and principal back. But just like stocks, there are plenty of different types of bond investments to choose from.
Anybody can buy a bond ETF such as IEF (7-10 Year Treasury), MUB (muni bond fund), or a fixed income fund like PTTRX (Pimco Total Return Fund). You can also buy individual corporate or municipal bonds. Municipal bonds are especially enticing for higher income earners who face a high marginal tax rate. You can also directly buy Treasury bonds through your online brokerage platform.
The main concern is the future of interest rates. If interest rates do go higher, bonds will decline in value, all else being equal. That said, so long as you hold the bond to maturity, you should get your initial principal back along with all the coupon payments if you are buying a highly rated bond e.g. AA.
Bonds are a great investment to help decrease volatility in your portfolio. I hope everybody at least takes advantage of lower interest rates and refinances their mortgage. Check out Credible, my favorite lending marketplace where pre-vetted lenders compete for your business. Mortgage rates are now at ALL-TIME lows.
Risk: 8, Return: 5, Feasibility: 10, Liquidity: 8. Activity: 9. Total Score: 40
3) Physical Real Estate
Real estate is my favorite asset class to build wealth because it’s easy to understand, provides shelter, and generates income. The only bad thing about owning physical real estate is that it ranks poorly on the passive variable due to tenants and maintenance issues.
Owning your primary residence means you are neutral the real estate market. Renting means you are short the real estate market, and only after buying two or more properties are you actually long real estate. This is why everybody should own their primary residence as soon as they know they want to stay put for 5-10 years. Inflation is too powerful a force to combat.
In order to generate $10,000 in Net Operating Profit After Tax (NOPAT) through a rental property, you must own a $50,000 property with an unheard of 20% net rental yield, a $100,000 property with a rare 10% net rental yield, or a more realistic $200,000 property with a 5% net rental yield.
In expensive cities like San Francisco and New York City, net rental yields (cap rates) can fall as low as 2.5%. This is a sign that there is a lot of liquidity buying property mainly for appreciation and not so much for income generation. This is a riskier proposition than buying property based on rental income.
In inexpensive cities, such as those in the Midwest and South, net rental yields can easily be in the range of 7% – 12%, although appreciation may be slower. I’m personally bullish on the heartland of America real estate and have been actively buying commercial real estate there through real estate crowdfunding and speciality REITs, which we will discuss more below.
I believe there is an absolute golden opportunity to buy physical real estate in 2020 and beyond because prices have lagged the S&P 500 (+31% in 2019), mortgage rates have come down, and affordability has gone up.
Risk: 5, Return: 8, Feasibility: 7. Liquidity: 3. Activity: 6. Total Score: 29
4) Peer-to-Peer Lending (P2P)
P2P lending started in San Francisco with Lending Club and Prosper in mid-2000. The idea of peer-to-peer lending is to disintermediate banks and help denied borrowers get loans at potentially lower rates compared to the rates of larger financial institutions. What was once a very nascent industry has now grown into a multi-billion dollar business with full regulation.
With a diversified portfolio of 100 or more notes, the leading P2P lenders claim investors can make an annual return between 5% – 7%. The returns used to be higher, but the increased supply of money has brought returns down.
The biggest problem I have with P2P lending is people not paying me back. There’s something that just doesn’t sit right with people breaking their contract obligations.
Risk: 5, Return: 6, Feasibility: 9. Liquidity: 6. Activity: 8. Total Score: 34
5) Dividend Investing
Investing in large cap dividend companies is one of the best ways to build passive income. The “Dividend Aristocrats” are a list of blue chip companies in the S&P 500 that have demonstrated a consistent increase in dividend payouts over the years.
Let’s say a company earns $1 a share and pays out 75 cents in the form of a dividend. That’s a 75% dividend payout ratio. Let’s say the next year the company earns $2 a share and pays out $1 in the form of dividends. Although the dividend payout ratio declines to 50%, due the company wanting to spend more CAPEX on expansion, at least the absolute dividend amount increases.
Dividend stocks tend to be more mature companies that are past their high growth stage. As a result, they are less volatile. Utilities, telecoms, and financial sectors tend to make up the majority of dividend paying companies.
Tech, Internet, and biotech, on the other hand, tend not to pay any dividends because they are reinvesting most of their retained earnings back into their company for further growth. But growth stocks can easily lose investors tremendous value over a short period of time.
To achieve $10,000 in annual passive income at the S&P 500’s ~1.8% dividend yield, you would need to invest roughly $555,000. Instead, you could invest only $154,000 into AT&T stock given its 6.5% estimated dividend yield. It all depends on your risk tolerance.
One of the easiest ways to get exposure to dividend stocks is to buy ETFs like DVY, VYM, and NOBL or index funds. You can also use a digital wealth advisor like Betterment to automatically invest your money for you at a low fee. The key is to investment consistently over time.
In the long run, it is very hard to outperform any index, therefore, the key is to pay the lowest fees possible while being mostly invested in index fund. It’s fine to take 10% – 20% of your investable assets and try to pick outperformers.
Risk: 6, Return: 7, Feasibility: 10. Liquidity: 8. Activity: 10. Total Score: 41
6) Private Equity Investing
Private equity investing can be a tremendous source of passive income with the right investments. If you find the next Uber, the returns will blow every single other passive income investment out of the water. But of course, finding the next Uber is a tough task since most private companies fail and the investment opportunities always go to the most connected investors.
The most liquid of the private investments are investing in equity or credit hedge funds, real estate funds, and private company funds. There will usually be 3-10-year lockup periods. The least liquid of the private investments is when you invest directly into a private company.
Access to private investments are restricted to accredited investors ($250K income per individual or $1 million net worth excluding primary residence), which is why the Feasibility Score is only a 4. But the Activity Score is a 10, because you can’t do anything even if you wanted to. You’re investing for the long term. The Risk and Return score greatly depends on your investing acumen and access.
Gaining $10,000 a year in private equity investing is difficult to quantify unless you are investing in a real estate or fixed income fund. Such funds generally target 8-15% annual returns, which equates to a need for $83,000 – $125,000 in capital.
Risk: 4. Return: 7. Feasibility: 4. Liquidity: 2. Activity: 10. Total Score 27
7) Real Estate Crowdsourcing
Currently, my favorite passive income source is real estate crowdfunding, which allows individuals to buy a piece of a commercial real estate project that was once only available to ultra high net worth individuals or institutional investors.
Owning individual physical real estate is great, but it’s like going all-in on one asset in a particular location with leverage. If the market goes down, your concentrated investment could lose big time if you are forced to sell like many did during the last financial crisis.
Real estate crowdsourcing allows you to surgically invest as little as $500 into a residential or commercial real estate project for potentially 7 – 13% annual returns based off historical data. Such returns are much better than the average private equity, CD, bond market, P2P lending, and dividend investing returns.
Unlike P2P lending, with real estate crowdfunding, you at least have a physical asset as collateral.
For those of you who don’t want to come up with a $300,000 downpayment and a $1,200,000 mortgage to buy the median home in an expensive coastal city like SF or NYC, who don’t want to deal with tenants or remodeling, and who wants to sit back after an investment is made, check out Fundrise, my favorite real estate crowdsourcing company founded in 2012. It’s free to sign up and explore.
In mid-2017, I sold my San Francisco rental property for 30X annual gross rent and reinvested $500,000 of the proceeds in real estate crowdfunding to take advantage of lower valuations across the country with much higher net rental yields.
Coastal city real estate has become too expensive, and I expect people and capital to naturally flow towards lower cost areas of the country. The future of work is remote. Take advantage of a multi-decade demographic shift inland.
Further, the performance of Fundrise’s eREITs have been relatively steady during stock market downturns or flat markets, as we saw in 2015 and 2018. I expect the same type of outperformance to continue in 2020 as the S&P 500 corrects. Real estate is defensive because it becomes more affordable as mortgage rates decline. Investors want real assets that provide shelter and income.
Just know that when you invest in a Fundrise eREIT or specific real estate crowdfunding investments through a platform like CrowdStreet, that you need to have a multiple-year investment time frame. These investments are not liquid, so only invest using the money that you don’t need to tap for years.
Risk: 7, Return: 8, Feasibility: 10, Liquidity: 7, Activity: 10. Total Score: 42
8) Creating Your Own Products
Finally, if you’re a creative person, you might be able to produce a product that’s able to generate a steady flow of passive income for years to come. At the extreme, Michael Jackson, makes more dead than alive due to the royalties his estate makes from all the songs he produced in his career. Since Michael’s death, his estate has made over $2.1 billion according to Forbes.
Of course it’s unlikely any one of us will replicate the genius of Michael Jackson, but you could produce your own eBook, e-course, award-winning photo, or song to create your own slice of passive income.
In 2012, I wrote a 180-page eBook about severance package negotiations that regularly sells about ~50 copies a month at $87 each without much ongoing maintenance. The book has since been revised and updated for 2019 to teach people how to negotiate a severance to give themselves a financial runway for their next chapter in life.
In order to generate $51,000 a year in passive income from the book as I do now, I would need to invest $1,275,000 in an asset that generates a 4% yield. To earn $10,000 a year in passive income would therefore need roughly $250,000 in capital.
Who would have thought a book about engineering your layoff could regularly generate so much revenue? We’re so busy with our jobs that our childhood creativity sadly vanishes over time.
Leveraging the internet to create, connect, and sell is something every person should attempt to do given the startup cost is so low. The only risk is lost time and a wounded ego. Here’s my step-by-step guide on how to start your own profitable site in under 30 minutes.
Below is a real income statement of a personal finance blogger who started his website on the side while working.
Risk: 10, Return: 9, Feasibility: 7, Liquidity: 8, Activity: 9. Total Score: 43
Passive Income Ranking Review
Based on my five-factor model in ranking the best passive income investments, dividend investing, real estate crowdfunding, and creating your own products are the top three.
For those in the highest marginal income tax brackets, investing in municipal bonds is attractive given there is no federal and state tax to pay if you buy your state’s muni bonds.
All eight passive income investments are appropriate for somebody. It all depends on your personal preference, understanding of the investments, creativity, and interests.
For most people, I strongly believe real estate crowdfunding, public REITs, and dividend investing are the best sources of truly passive income with the highest potential risk-adjusted returns and the least amount of work required.
For those who are the creative types, starting your own website like this one and creating products online is even better given the lack of capital necessary. Being creative requires putting yourself out there. But over time, good things tend to happen if you stick around long enough.
Invest Early And Often
Enthusiasm for work is strongest when you are young and have very little money. After four years of high school, followed by another four years of college, work sounds like an exciting adventure! But after a while, your job can begin to beat you down.
Perhaps a coworker purposefully tries to make your life miserable because they resent your success. Maybe you get passed over for a promotion and a raise because you weren’t vocal enough about your abilities. Maybe you mistakenly thought you worked in a meritocracy. Whatever the case may be, you will eventually tire.
This is why it is important to take action, while you still have the energy. With interest rates at rock bottom levels, building passive income will take a lot of effort and patience. The sooner you get started, the better!
Below is my latest passive income streams that I’ve been building since 1999. Our passive income allows both my wife and I to be stay at home parents to our two-year-old boy. Our next goal is to relocate to Hawaii from San Francisco and spend more time with family.
Saving early and often is no sacrifice at all. Instead, the biggest sacrifice is living a life on someone else’s terms due to a lack of funds.
On your journey towards financial freedom, please diligently track your net worth, analyze your investment portfolios for excessive fees, and regularly calculate your retirement cash flow needs through a free financial tool.
If the amount of money you’re saving and investing doesn’t hurt, you’re not saving and investing enough. At the end of the day, nobody cares more about your money than you.
Time to get cracking!