There was surprisingly little debate regarding my passive income investment rankings. Figuring out the five factor scores for each of the seven investments took about 10 hours to produce, so perhaps I was thorough enough to address all the points. Everybody agreed that dividend investing is one of the best ways to generate passive income. The two main investments that had the most discussion were Real Estate and Creating Your Own Product.
The pushback on real estate investing is that it feels too much like work. When you’re trying to find the perfect tenant and keep up with property taxes, real estate can feel like a bear. Meanwhile, nobody disagreed with Creating Your Own Product as being a top passive income generating asset. However, I just didn’t get the sense that anybody really got motivated to start creating something.
In this short post, I want to demonstrate via some charts and logical reasoning the power of purchasing rental property and creating a product.
HISTORICAL INTEREST RATE CHART
First, I’d like everybody to take a look at the 10-year Treasury yield from 2005 to 2015.
As you can tell from the chart, the 10-year bond yield has fallen from around 6.3% to around 2% in 2016. Some reasons for the fall include: the Federal Reserve lowering the Fed Funds rate, declining inflation, improved monetary efficiency, economic slack, the continued global demand for US assets, and relative stability in the US vs. other markets. Bond yields have actually been falling since July 1, 1981 when the 10-year yield was at 15.84%.
In a declining interest rate environment one must invest more capital to generate a fixed amount of income. Declining interest rates are a big problem for retirees who have investments in annuities, bonds, CDs, and dividend stocks because everything is relative to the risk free rate. A bank isn’t going to issue a 10% yielding CD, when the bank itself can only earn 2.5% on its money! A corporation isn’t going to pay an 8% dividend yield unless it has completely run out of ways to reinvest its earnings.
Take a look at this chart I put together highlighting income streams from real estate and a product.
At a 6% interest rate, it takes only $917,000 and $333,333 in capital to generate $55,000 in rental income and $20,000 in eBook income respectively. If the interest rate falls to only 2% as we have now, then it takes $2,750,000 and $1,000,000 of capital to generate the same $55,000 in rental income and $20,000 in eBook income!
Put it another way, if you are the owner of such real estate and eBook, you’ve seen the value of your asset rise by 500%! A persistent decline in interest rates has generated a lot of wealth for income producing owners.
To calculate the values in each column, simply divide the income stream by the interest rate.
WHAT’S HARDER TO DO? SAVE OR CREATE?
Let’s say the Real Estate Rental produces the same $20,000 a year in annual income (after all expenses, pre-tax) like the FS eBook. In my simplistic model, based on the current risk-free rate of 2%, the value of the eBook and Real Estate Rental are both worth $1,000,000.
To buy a $1,000,000 home will require a $200,000 downpayment and an income of roughly $200,000 a year if we apply a 4:1 ratio on mortgage to income at today’s rates. It’s not particularly easy to make $200,000 a year. Even if you do make $200,000 a year, you might not have much left in disposable income. (See: How To Make $200,000 A Year And Not Feel Rich) Even if you do make $200,000 a year, it will take a while for the average person to save up $200,000 in after tax money for a downpayment.
Now let’s talk about creating a product. It took me about three months of spending at least five hours a day writing my 100-page severance package negotiation eBook. The book then went through over 20 revisions with the help of my father and my best friend. I then had to spend several hundred bucks on design and packaging work. Finally, I had to pay $55 to register my book with The Library of Congress and $295 for 10 ISBN codes.
One can say I wouldn’t have been able to write my book if it hadn’t been for my years of experience working in Corporate America. But the book was an X Factor, because I was going to work for years in Corporate America anyway. I wasn’t working in Corporate America in order to try and write this book! I was just diligent enough to take copious notes during my severance negotiation process and actually create something.
In other words, I think creating your own product that generates $20,000 a year is a much easier than trying to make $200,000 a year in income, save $200,000 for a downpayment, and then buy and manage a property that generates $20,000 a year.
DON’T FORGET THE RISK PREMIUM!
Of course, my interest rate model in the chart above is simplistic. Nobody is going to invest $2,750,000 in a property that generates $55,000 for a 2% return when they can invest $2,750,000 in a 10-year Treasury bond for a 2% return and do nothing. There needs to be a risk premium to compensate the investor for taking on the risk and hassle of owning such a non-risk free asset.
The risk premium is why there’s a market for assets. In a bull market, the risk premium collapses, because people are risk loving. They believe the risk for a downward change in value of the asset or income stream is small. In a bear market, the risk premium widens. Let’s say we’re seeing a rise in the unemployment rate and Congress passes an act that completely removes the mortgage interest deduction for ALL income earners. Clearly, the risk premium would increase for property.
In a very real way, even our jobs have become more valuable in a declining interest rate environment if you can find one that pays you a steady or ever increasing amount. The problem is that everything is Yin Yang in finance. I believe income producing assets are undervalued due to this egregious fear that interest rates will soon skyrocket. As more people believe the way I believe, prices of such assets increase in value. Therefore, use your steady day job income to invest in as many income producing assets as possible.
Since 2003, I’ve taken a stance that we will be in a low interest rate environment for years. I continue to believe that low interest rates will stay for years to come. Even if the Federal Reserve raises the Fed Funds rate from 0.25% to 2%, interest rates are still low and what’s more important is following the market (Treasury yields). The good thing about technology is that it has enabled us to do more with less.
The real question is: will you actually take action to improve your financial future? One of the best ways to create semi-passive income is to start a lifestyle business with a blog. It’s never been easier and cheaper to start your own website and leverage the 3 billion people on the internet. Once you build your brand online, you can find plenty of consulting work, new full-time work opportunities, earn revenue by selling your own product or someone else’s product, and even earn advertising revenue. Not a day goes by where I’m not thankful for starting Financial Samurai in 2009. If I didn’t, I wouldn’t be free now!
Wealth Building Recommendations
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About the Author: Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $210,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2017 and beyond.