Increasing Passive Income Through Leverage And Arbitrage

Consider increasing passive income through leverage and arbitrage. I did just that in 2014 when I bought a new home just five miles west of where I used to live in San Francisco. I took on a new mortgage to buy this home and I ended up renting out my previous home for $7,500 – $8,500.

Reinvesting The Funds Of an Expiring CD

Earlier in the year, I had a nice conversation with a well-known San Francisco angel investor about risk and reward. I had a chunk of money coming due from an expiring 5-year CD and I wanted to get some advice on what to do with it.

I asked him whether he would be leveraging up or paying down debt in this bull market. He responded, “Sam, I always like leveraging up. It's how I made my fortune.” This angel investor is worth between $50 – $100 million dollars.

Of course you can't just leverage up into any old investment. The investment has to be something you know fairly well and has a good risk/reward profile. The only thing I have confidence leveraging up on is property. Everything else seems a little bit like funny money.

Real Estate As A Passive Income Generator

Although I quit my job a couple years ago to try my hand at entrepreneurship, I'm a relatively risk-averse person because I've seen so many fortunes made and lost over the past 15 years.

If I was risk-loving, I would have done what so many brave folks do nowadays and quit as soon as I had a business idea, instead of methodically moonlight before and after work for three years before negotiating a severance.

The breakfast sandwich guy I used to go to for 10 years while I was working told me he was worth $3 million dollars during the dot com boom in 2000. I went back for old times sake last month and he is still there!

Despite my risk-aversion, I do believe money should be used to increase the quality of your life and the people you care about. As a result, I did something recently that might seem financially risky, but I think the move actually lowers my financial risk profile now that I've had a chance to fully process the situation.

Leveraging Up And Arbitrating

I finally found my panoramic ocean view Golden Gate Heights home! A room with a view has been on my bucket list forever. But it never occurred to me to look in San Francisco, despite being so close to the ocean because I thought such homes would be unaffordable.

San Francisco already has the highest median single family home price in the nation at $1 million (in 2014) and now $1.9 million in 2022. To add on a panoramic ocean view would make prices outrageous, or so I thought.

It's the same curmudgeon as never asking out a super model because you think she or he will say no. You've just got to ask and I'm sure you'll be delightfully surprised once you try.

After spending months aggressively looking for my next ideal property within my budget, I found a view home for less than half the cost of my existing home on a price/square foot basis. How is this possible you might ask?

Geoarbitrage To Save Money

The farther west you go from downtown and the established neighborhoods, the cheaper prices are in general (see the graphic I created in The Best Place To Buy Property In San Francisco Today).

But the farthest away you'll ever be is 7 miles because San Francisco is 7 X 7 miles large. Given I'm only going into a downtown office two times a week, I don't mind the extra 15 commute. To be able to watch the sun go into the ocean every day for the rest of my life is priceless.

The Risk Of Buying Real Estate Now

Buying property in 2014 is not as good as buying property in 2011-2013. Buying property in 2022 is not as good as buying property in 2014. Prices in major cities such as Miami, Las Vegas, Phoenix, Los Angeles, New York City, and San Francisco have risen quite aggressively over the past several years.

But I couldn't have bought property in 2011-2013 because I was in the middle of leaving my job and I didn't have a large enough downpayment for what I wanted. I needed to prove I could create wealth on my own for at least a couple years before buying another property.

See: How Much Do I Need To Make A An Entrepreneur To Replace My Day Job Income?

Some positive things happened since I left work. First, I didn't sink to the bottom of the deep blue sea, but caught a wave of growth in my business. I got over my fear of failure with every new minute I spent online. Second, a large chunk of change was coming due from a 5-year CD I mentioned previously.

The great thing about putting your money away in a CD or long-term investment is that you get used to not seeing or needing the money – very similar to paying yourself first or maxing out your 401k.

I wanted to invest the CD proceeds into something more tangible or rewarding than just trying to make more money. Finally and most importantly, my primary property's valuation went ballistic.

Are We In A Housing Bubble?

I wrote a post on March 13, 2014 entitled, “Zillow Is Broken Or We Are In A Massive Housing Bubble” to get my mind straight before actually buying another property. When I wrote the post, the valuation had risen every single day for nine months in a row for a 60% gain, which didn't make any sense.

I was absolutely sure the chart would start leveling out. But that wasn't the case at all. Its valuation actually spiked by another 30% four months later as of today!

Here is a price chart of my previous primary residence of 10 years on Zillow:

San Francisco Home Prices On Fire

Without property price appreciation from my existing properties I purchased in 2003 and 2004, I would have a much more difficult decision buying more property in SF, even with rents skyrocketing. But by coupling the property portfolio appreciation with the fact that I was buying a home 50% cheaper than my existing home, I mustered up the courage.

Real Estate Appraisal Opinions

I had a 30+ year real estate veteran and #1 nationwide producer for her firm come by and do a free assessment of my house. She said I could get the first absurd value in the chart above “no problem.” I didn't believe her because I know my home and I know the strategy of buttering up clients to snag a listing.

I then had to do an official appraisal on my primary residence as part of my mortgage application process for the new Golden Gate Heights home. That figure coincidentally came out to the first absurd value as well. So maybe, just MAYBE, the house is worth Zillow's first estimate, but definitely not the latest estimate.

Several houses close by recently closed for $1,500 and $2,200 per square foot, which is causing the entire neighborhood to go bonkers. But these houses are on quieter streets or are more upgraded, and Zillow can't tell the difference.

Housing Keeps Going Up

Logic would say that when prices are going crazy, it's a good time to sell. But I thought 2012 was a decent time to sell too (thank goodness I didn't). Maybe I'm being absolutely stupid for not selling now, but if I sell my home, I wouldn't know what to comfortably do with the proceeds because I already have proceeds from my 5-year CD which I have to put to work.

Earning 0.1-0.2% in a money market is not an option. Furthermore, if I sold my home, I fear I will be priced out of the north end of San Francisco forever (Pac Heights, Marina, Cow Hollow, Presidio Heights).

The best time to buy property is when you can afford it, because long-term price appreciation is generally always up and to the right due to inflation. Because the property price point is multiple times higher than your salary, it's hard for individuals to catch up e.g. a 10% appreciation on a $1,000,000 home requires a 100% appreciation on a $100,000 salary just to stay even.

Note: I decided not to highlight the specific valuation of my home, even though it would make the illustration easier to understand because there are readers from all over the country and the world who would find doing so to be poor taste. Percentages should be able to make the point. But because I have already publicly stated in prior posts my desire to make $200,000 in passive income, I am highlighting the debt and rental numbers in the next section. 

Increasing Passive Income By Leveraging Up

The ideal mortgage amount is $750,000 (was $1 million) if you can generate a ~$200,000 income. The interest on a $750,000 mortgage is the maximum mortgage indebtedness you can deduct from your income excluding $100,000 in HELOC money for home improvements.

I'm not really down with individuals taking out a HELOC because the interest rates are always higher, and I've found people to get in trouble by spending money on unnecessary things e.g. cars, vacations, etc.

Sunset in San Francisco, Golden Gate Heights -- increasing passive income by buy-in in Golden Gate Heights
Priceless View Of The Sunset In Golden Gate Heights, San Francisco

You might think I'm crazy for taking on a lot more mortgage debt after already having a $1 million dollar mortgage for my other residence in the chart above, but hear me out. The interest I currently pay on my old primary residence is $2,200 a month at 2.65%. Add on property taxes and insurance, and the total cost is roughly $4,000 a month, all of which is deductible.

But the rent I locked down was $8,700 a month, for a $4,700 a month profit for a two year lease. The incredible thing is that I had multiple sets of people who were interested in renting at this price or higher. One rental agent actually e-mailed me asking how come I was charging too little.

More Passive Income Despite More Debt

I've essentially extracted $56,400 a year in relatively passive income while still controlling an asset that has the potential to continue appreciating over the next 30 years. In the short-term, I have no doubt the asset could correct by 15%. In fact, I'm counting on it to eventually correct because trees don't grow to the sky forever.

I have a fundamental problem with paying a 5% or greater selling commission in this internet age. It is amazing that the internet has cut costs for every single industry except for the real estate industry.

I encourage sellers to go on strike and never sell their property until such costs are lowered to a flat rate or more reasonable rate. Selling a property now means you are automatically losing 5%-6% to fees.

Furthermore, if my return on equity can beat the 4% per annum ownership cost, I'll essentially be able to live in my home for free all these years.

Increasing Passive Income By Paying Down Expensive Debt

The other reason why I decided to take on a $1 million mortgage at 2.5% was to conduct debt arbitrage. I was originally going to put down $200,000 more for the home as stated in my no financing contingency offer. But the bank said that all I needed to do was put down 20% since the loan was already approved by the underwriter. And given the bank makes more money the more they lend, they were happy to lend me at a 80% LTV once my finances were approved.

Originally I was a little wary of the bank giving me more money than I assumed. But I took them up on the offer by only putting 20% down. I used the extra money to pay down my other rental property mortgage at 3.375% for an annual savings of $1,750.

Always maximize your financial arbitrage opportunities when you see them. They don't come around very often.

My Passive Income Determination

In 2012, I set out a goal to build a $200,000 passive income stream by June 2015. Year one produced roughly $78,000 a year in passive income. Year two produced roughly $110,000 a year in passive income.

With the move to rent out my long time primary residence, passive income is now +$56,400 – $16,000 lost from annual CD income for a total passive income stream of ~$150,000, assuming I do nothing else. I also ended up saving a lot of money by geoarbitraging moving out west.

I'm shooting for $200,000 year in passive income because I believe $200,000 is the ideal income for maximum happiness. The government starts going after you if you make much more than $200,000 with higher taxes, AMT, credit eliminations, and deduction phaseouts.

$200,000 keeps you in the respected and not-hated mass affluent crowd. $200,000 is also a level where one should be able to comfortably raise a family of three in almost any expensive city around the world.

A $50,000 a year passive income gap is going to be very hard to overcome in one year, but I'm definitely going to try. There is something about writing out goals and making them known that really helps keep people accountable. Even if I fail, I always think about an old Chinese saying, “If the direction is correct, sooner or later you will get there.

More Passive Income Required With Kids

The older I get, the more aggressively I'm going after my bucket list items. I know several people who've died at the age of 50, and that's only 13 years away for me. With the pandemic and now another war, there's no time like the present to live your best life.

I've always wanted a room with a view of the ocean and I've finally found it. Hopefully the real estate market won't crash tomorrow. But if it does, I'll work hard to make sure I don't exacerbate the decline and I'll remind myself that a forever home is never to be sold.

Below was my 2018 – 2019 passive investment income. Building passive investment income is the key to financial independence. It's even more important than your net worth.

Financial Samurai Passive Income Report 2018
You can click the chart to read about my passive income in detail

In mid-2017, I decided to finally deleverage by selling my SF rental house I owned since 2005 for $2.74M. I bought it for $1.525M in 2005, tried to sell it for $1.7M in 2012 and nobody wanted to buy it. I felt like an offer worth 30X annual gross rent was too attractive to passive up.

As a new father, I wanted to simplify life and found ways to reinvest $500,000 of the proceeds in the heartland via real estate crowdfunding. Valuations are much cheaper and the net rental yields are 3-5X higher. It feels so much better to earn real estate income passively versus manage tenants.

Latest Passive Income Streams

Below is my latest passive income investments. What I find surprising about this latest chart is how passive income compounds. Just five years ago, I was saying that growing passive income to $200,000 was enough. But thanks to a bull market and consistent investing of my cash flow, my passive income has grown by another 80% to over $350,000.

In 2019, I bought another ocean-view home with cash. Then in 2020, I bought a forever home so I decided to rent out the home I bought in 2019. Although I didn't leverage up, the value of the properties have done well.

Financial Samurai passive income investments 2023

Wealth Building Recommendations

Invest in real estate passively. If you don't have the downpayment to buy a property, don't want to deal with the hassle of managing real estate, or don't want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdfunding companies today.

I've personally invested $810,000 in private real estate funds to earn more passive income. Fundrise specifically invests in the Sunbelt, where rental yields are higher and valuations are lower. Their speciality is in single-family and multi-family homes.

So far, Fundrise manages over $2.5 billion in assets and has over 230,000 clients. Fundrise is my favorite real estate crowdfunding platform today.

Fundrise Due Diligence Funnel - Increasing passive income with real estate
Less than 5% of the real estate deals shown gets through the Fundrise funnel

Manage Your Finances In One Place

One of the best way to become financially independent is to get a handle on your finances by signing up with Empower Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize your money.

Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts to manage my finances. Now, I can just log into Personal Capital to see how all my accounts are doing, including my net worth. I can also see how much I’m spending and saving every month through their cash flow tool.

My favorite tool of theirs is the Retirement Planning Calculator. It pulls in your real data and runs a Monte Carlo simulation to give you deep insights into your financial future.

Personal Capital is free, and less than one minute to sign up. Ever since I started using the tools in 2012, I've been able to maximize my own net worth and see it grow tremendously. Increasing passive income has been a fun journey.

For more nuanced personal finance content, join 55,000+ others and sign up for the free Financial Samurai newsletter. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009. To get my posts in your inbox as soon as they are published, sign up here

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81 thoughts on “Increasing Passive Income Through Leverage And Arbitrage”

  1. Hi FS, congratulations on the great timing with your RE giving you 8700.00! I believe success in RE is due to excellent due diligence and a bit of luck on top of that. Failure is generally due to lack of thorough due diligence, which makes bad luck easy to happen.

    We have my husband’s first home in Latin America, where we met and used to live. When I met him he had still about 8 years to pay on it, now it is free and clear, rented out.

    We then bought a place to live when in the DC area (MD), bought at its highest value (in 2005) so not such a good deal, but we bought it as principal place of residence so we were OK with that. It hasn’t gone down (like it did in many places) or up since, but should pick up soon – fingers crossed. It has been rented all the time in those 11 years, except for two months. So, people are paying our mortgage, month after month.

    We now also have just bought a new unit in Australia where we’re living, but as an investment property purely and at the moment we are at -30.00 each month, with should become positive in a year.

    Since we have better savings capacity for a few years before my husband retires, we are going to try and buy a few more, as well as reduce debt by paying down more, on top of what the tenants pay.

    We hope to be FI in about 10 years, hopefully also with about 200.000 per year.

    What I like very much about RE, is that once it’s paid down, you have a “forever” income, generally going more or less to par with inflation on the medium to long term. So if you happen to live to 110, you’ll have neverending income to pay the exorbitant price of a good nursing home or even at-home good quality care, if needed.

    It means also that your kids inherit a tangible asset that keeps giving them cashflow from day one, and as you said somewhere, to persue the fine arts if they wish (although I am not thinking about giving them everything I’ve saved for, I don’t want them to be “lazy”!!! – I am thinking I would love to put some of our RE properties as a “forever” income for charities of my choice for instance).

    While I have been wondering if we should try stocks etc, it seems to me that it would be too much of time investment for me to learn about it, without as much of a return; on the other hadn I am learning more and more about RE, which will allow me to invest more wisely in RE. But that’s just me.

    Thanks again for your great site that provides a lot of food for thought!

      1. Thank you :)

        Woohoo, it must be such a great feeling to have paid one mortgage down!!!

        I’ll have a look a those two links, thanks very much!

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