Passive income is income that you earn without directly working for it. What does this mean? Well, there are really only two ways of earning money and these are directly and indirectly. By ‘directly’ I mean you render a service and are paid for it. Either as and when the service is complete or by the hour. By ‘indirectly’ I mean, you have other people or other assets generating money for you. Passive income is indirect income.
Still not sure of the difference? Ok, put it this way, if you stopped working today, how much money would come in each month? If the answer is ‘nil’, you don't have any passive income. Fine, so where does this 'passive income' come from and how do you get it?
There are a number of forms of passive income and here are a few of the better known forms:
1. Owning income generating real estate
2. An online referral business
3. Owning shares, bonds and other financial instruments
I specialize in the first one, “owning income generating real estate”.
This is probably the most important and common form of passive income seen in the world. Just about all the wealthy people of the world own real estate in some shape or form. The way it works is dead simple. You a buy a house/apartment/office and you rent it out.
For example if you buy an apartment for $100,000 and you let it out for 10% a year, that is $10,000 a year income that you receive. Of course there are taxes etc and some maintenance of the property is required but for purposes of this example I am working on 10%. In reality, this number is not far off the mark. Now, multiply that out to 10 apartments that you own and you suddenly are looking at $100,000 per year! To make things easier, you can appoint a managing agent (usually paid approximately 10% of the income generated by the properties that the agent manages) to manage the portfolio. By ‘manage’ I mean, make sure the maintenance is done, make sure the apartments are fully let and that the rental is collected. So that means if you have one apartment generating $833 a month, you would have to pay your agent around $84 per month to manage it which leaves you with +-R750 per month and now…you have just about nothing else to do. Of course you would only consider getting a managing agent involved once you have built up a portfolio of at least three properties as with one or two properties it is easy enough (and cheaper) to manage them yourself.
You see, herein lies the beauty of passive income. Once you have one self-sustaining income stream set up as in the example above, you are free to start setting up the next as the income stream does not need you there to continue. Compare this to a doctor or lawyer. If a doctor or lawyer does not work…guess what? He does not get paid. Also, if he has 10 clients, a great reputation and is working as hard as he can…what if another 5 clients walk through the door? He simply cannot deal with them as he can only work so many hours in a day.
If you have your apartment income stream up and running as I have set out above and tomorrow you decide to stop working…guess what? Your money still comes rolling in! Also, if you spot another opportunity to buy another apartment…there is nothing stopping you from taking it and adding it to your portfolio. Well, nothing except the financial hurdle which I get to now.
How does one get the money to buy this apartment? Most of us don’t have a trust fund or family riches that can be used to set up a passive income stream so we have to do it another way and that way is called ‘using the bank’s money’! You have to borrow the money from the bank to buy the apartment. Now, when you borrow money from the bank, they rather unfairly expect you to pay it back, with interest. This is not a problem. On a loan of $100,000 the interest and capital repayments are approximately 10%, so that means your rental received and your payments to the bank each month are just about the same. So what is so great about that? There is no money coming in as it is all going to the bank! True, but watch this. At the end of the first year, the rental charged normally goes up by about 10 %, the loan repayments remain the same and guess what? You now have about $10,000 coming into your account each year after paying the bank! You are cash positive by $10,000 after year one! Also the value of your apartment has gone up by whatever the growth rate for real estate is in your area. A 10% increase in real estate prices year on year is quite common. This means you own a $110,000 apartment which is making you $10,000 after the first year and guess what? From year two, the rental goes up again and so does the value of your apartment! Now, just multiply this formula out by about 10 (i.e. you buy 10 apartments this way) and you are looking at $100,000 a year and growing. This money will keep rolling in whether you get out of bed or not! Pretty nice! I must just add here that the amount you have to pay back to the bank varies from place to place and is not always 10% of the loan. That is irrelevant, the only thing you need to check is that the monthly rental and the monthly repayment are the same. If they are not, it is not good a good buy! Keep searching until you find an apartment which, if you buy, will have give you a cash neutral position from day one.
Okay, here is some other advice though. Banks don’t want to lend you money unless they feel you can make the payments. Also, they don’t care that you are buying an income generating apartment (well, most times they don’t care anyway) so it is important that you can make the payments from your existing income. I can just hear the next question: But how can we accumulate 10 apartments if the banks require us to be able to make the payments from our existing income? Quite simply it works like this. Banks look at all your income and your expenses when assessing whether you can afford to make payments. So, if you are looking to borrow money to buy your second apartment, they will look at the income from your normal job and they will look at the income (and expenditure) generated by your first apartment. The income and the expenditure net each other off and so that bank will just look at your income from your job (your existing income) and it is pretty much as if you are buying an apartment for the first time again. So, they approve the loan. Now you have two apartments, both resulting in a cash neutral position (for the first year). Now you are able to look at your third apartment…and so on. Make sense?
What I have described above is pretty much how most millionaires in real estate built up their fortunes.
You know have the framework and understanding of how to create a passive income through real estate but there are some great books on the details which are absolutely essential for any budding real estate tycoon. These books deal with (amongst other important topics) the following:
1. How to buy an apartment at the right price (the lower the price, the smaller the loan and consequently, the smaller the size of the monthly repayments)
2. How to add value to your apartment (so you can charge more rental)
3. How to get the best loan to buy the apartment (the lower the interest rate you can get, the lower the monthly repayments)
4. How to identify the best location (so you get the most growth in the value of your apartment)
5. How to pick the right tenants (so that they not only pay but pay on time and look after your asset)
6. How to pick the right managing agent (so that they can do no.5 above, collect the rent, sort out minor maintenance issues and pay you…basically so you are free to concentrate on building your portfolio and are not bogged down by the day to day administration hassle)
7. How to pay as little tax as legally possible on your passive income stream (no explanation required here!)
The following books I recommend without hesitation:
“Real Estate Riches” by Dolf de Roos Click here to buy
“Think and Grow Rich!” By Napoleon Hill Click here to buy
“Real Estate Loopholes” by Diane Kennedy and Garret Sutton Click here to buy
“Rich Dad, Poor Dad” by Robert T Kiyosaki and Sharon L Lechter Click here to buy
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