What Constitutes Passive Income?

A recent BiggerPockets forum thread discussed bonds versus real estate and how real estate wasn’t passive. Real estate investors often employ property managers to help them manage their assets so that they can focus their time and effort on making quality offers on good product. Gurus often use the idea of sit-in-the-hammock lifestyle to sell their program and the notion of investing money in real estate in general.

What constitutes truly passive income? Where is the line drawn?

First of all, strictly speaking bonds are not truly passive investments either. If you want to get nitpicky about things there are big risks with investing in bonds or even bond funds. Individual bonds carry default risk and funds are still largely exposed to inflation risk. Try sitting in a hammock owning long-term bonds when inflation is clicking off at double the coupon rate for the bond! Your frozen daiquiris may start to get a little less appetizing when they cost twice as much and your fixed income is still kicking along at the same rate. There are certainly things that can be done to immunize this risk, but all bonds suffer when interest rates follow inflation expectations north.

So is there really an appreciable difference between investing in real estate “passively” and bond funds?
The goal of both investments seems to be to limit management activity while supplying ample spendable cash for fixed income. Free and clear real estate exhibits many of the same features that a bond does, but is intrinsically valuable and thus does a decent job of hedging inflation risk. With the government’s spendthrift policies many believe inflation will rear its ugly head in the long run. However, real estate has many negative factors like capital expenditures and high transaction costs.

Real estate has the capacity to be highly leveraged rather easily and thus carries higher risks in many cases. Investors generally try to optimize their ROE by employing high leverage and thus the capital expenditures and other gotchas make it seem less passive than bonds. Free and clear real estate kicks off large annual cash flows and thus provides a high margin of safety for downside risk. Thus I would argue that real estate can be every bit as passive as bonds if you have a competent manager and low levels of leverage to cover risk. Vacancies and roofs leaking are traded off for a lack of inflation protection and default risk.

Photo: Brendan Riley

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.