How to Win Game #2 - Create Passive Cash Flow
In this article I will share a two-part real estate game plan to win Game #2 - creating passive cash flow.
First, a definition.
My idea of passive cash flow is simply any type of regular income whose source is from an investment asset and not from your active involvement.
Sources of passive income could include rental properties, notes/mortgages secured by real estate, limited partnership shares, certificates of deposit (CDs), bonds, or dividend stocks.
Of course, my favorite source is real estate and notes secured by real estate.
My own big financial goal is to receive enough passive income to cover all of my personal overhead. At that point, the crossover point, active work is a matter of choice. I’ll keep working for money if it’s fun and fulfilling, but if it’s not, I’ll just do something else.
Not a bad goal to shoot for, right?
Here is my basic game plan to achieve this goal using real estate investing:
PART 1: SAVE AND PLANT CASH FLOW SEEDS
If you make a lot of money in Game #1 but you never save any seed capital, you will have to work hard your entire life and you will never get off of the rat wheel of earning and spending.
So, the first step to create passive cash flow is to simply SAVE MONEY. The cash savings will be used for down payments, closing costs, and emergency reserves for your purchases.
Creating passive cash flow is a lot like farming. You have to plant these money seeds, water and nurture the plants’ growth, and then harvest at the right time.
Planting seeds in real estate means buying properties or notes that produce regular monthly income. Fruitful results, like in farming, don’t come overnight, so you must be patient and persistent.
Here are a few different types of seeds you may want to plant to reach your goal:
Short-term Hold Rentals
Short-term holds are rental properties that you intend to rent and then sell for top dollar sometime in the next 1-7 years.
For example, you might purchase a single family house for $100,000. You then rent the house for $1,000/month for 3 years. After 3 years you sell the house to your tenants, who have saved up a down payment and improved their credit enough to get a bank loan.
If the sales price were $150,000, you would receive a gain of $50,000, along with other potential profit centers like equity paydown and the net cash flow received during the holding period.
How does a short-term hold get you to your final goal of passive income?
This is an intermediate step. It helps to turn a small nest egg (capital base) into a larger one. If you have $100,000 saved up, even a 10% cash-on-cash return would only be $10,000 per year. That’s a good start, but you’ll need more to replace your active income.
So after turning a number of properties for profits and building more capital, you can stop selling properties and start keeping them for income over the long run.
For example, if you had $100,000 to start, you might buy five $100,000 houses with $20,000 down and an $80,000 mortgage on each property.
After a few years, you could sell all five rentals for $150,000/house. A 20-year mortgage at 5% interest would have paid down to $73,000 in the mean time. So on each house you would get back $20,000 down, $7,000 in principal paydown, and $50,000 in profit ($77,000 total before tax) on your $20,000 initial investment.
This means before taxes you would have $385,000 to reinvest, and you started with only $100,000. You could do this again and again until you have enough capital to invest passively and meet your cash flow goal.
Long-term Hold Rentals
Long-term hold rentals are like the fruit trees of your cash flow farm. They often take time to start bearing fruit (i.e. to start producing cash flow in your pocket), but once they do they can feed you for a lifetime.
What if, for example, your long-term holds were 5 low-maintenance, brick duplexes (10 units), and each unit rented for $750 per month. If your operating expenses were $300 per month, you would net $750 - $300 = $450. For all ten units you’ll earn $4,500 per month once you own them free and clear.
If these are well located, the rents will possibly increase over time and the management could be outsourced or easily done part time by you.
You could purchase your long-term holds in the very beginning and then amortize your loans over time, or you could wait, use short term holds (see above) to create more seed capital, and then reinvest the profits into long-term holds later.
Once you’ve mastered the basics of investment rentals, you might want to consider owning notes secured by real estate (i.e. become the bank for others).
Financing can be much more passive than landlording. The borrower, not the lender, pays all the bills (taxes, insurance, maintenance) and handles all of the responsibilities (repairs and upkeep). Your role is to collect payments and to ensure your collateral is cared for properly.
Financing can also be very profitable and generate large cash-on-cash returns, especially with discounted notes. There are additional risks to be considered with note investments, but most can be handled with good team members, like a qualified attorney and a loan servicer.
Here’s an example of a discounted note deal that you can create.
Let’s say you buy a single family house for discounted price of $100,000 and use all cash to purchase it (no debt). You then decide to seller finance the house to someone for $150,000.
Your terms of the sale could be $15,000 down and a seller-carry-back mortgage of $135,000 at 8.5% interest for 20 years. The regular payment to you would be $1,171.56/month (see how I calculated).
Your effective cash investment is only $85,000 ($100,000 - $15,000 down payment), yet you own a note with a face value of $135,000 (which is why it’s called a discounted note).
Your total cash flow per year is over $14,000.
Using a few assumptions, your internal rate of return would be just over 18% for 20 years (see my spreadsheet here). Not bad.
It would only take a few of these to give you a very nice passive cash flow.
PART 2: PRUNE BACK (PAY OFF DEBT)
If you’re like me, you’ll eventually want to reduce investment risks and reduce anxiety levels by pruning back your portfolio and paying off at least a big chunk of your investment debt.
My definition of passive income is also associated with a more at-ease lifestyle provided by steady income and a smaller, easier to manage portfolio of properties. Having little or no debt on my properties is a key part of this equation.
Here are a few basic ideas to get to this free and clear point. I’ll write other articles that explain them even more.
If you buy your five long-term duplexes (10 units), put 20% down, and take out 20 year mortgages for the balance, you don’t HAVE to wait twenty years to pay them off.
You could use extra cash savings from your job, from fix-flip real estate deals, and from short-term holds to pay off mortgages more aggressively.
For the psychological satisfaction of progress, I would recommend plowing back all cash towards one mortgage at a time. Once that mortgage is paid off, you can add its free cash flow to your savings to pay off the 2nd, 3rd, 4th, and 5th mortgages even faster.
This works like a snowball or like falling dominoes. Each successive debt gets paid off faster and faster. This process is very effective, satisfying, and fun.
Buy 3, Sell 2, Keep 1
This idea combines the short-term holds and long-term holds explained above.
You can work hard to buy three rental properties during year 1. Around year 2 or 3, you’ll sell two of the rentals, pay taxes on the profits, and use your equity to pay off the loan on the third.
You now own a property free and clear, and you can repeat the process as many times as needed until you meet your free and clear goal.
Buy Using Your Retirement Funds (IRA or 401K)
If your goal is retirement income, you can usually do all of this plan inside an IRA or 401K. If you have big chunks of retirement account capital sitting idle or producing little income, you could put it to work with the tools I outlined above in the section on planting seeds.
To make this happen you will need to transfer custodians to one that specializes in self-directed IRA investing (I use American IRA), but then you can grow your money tax free and in the case of a ROTH-IRA, take it out tax free.
To put this in perspective, if you are in a 40% income tax bracket, you would have to earn $200,000 outside of your Roth IRA to get the equivalent spending power of $120,000 earned inside your Roth IRA.
If your investments return 10%, that means you would need $2 million outside your Roth versus only $1.2 million inside your Roth. That’s a BIG difference, and that means you can get to your lifestyle goals a lot faster by investing inside of your IRA.
Like any game plan, this is only a blueprint. It won’t work unless you take action and build the structure.
There are a lot of details to fill in, and of course your personal situation will require a few adjustments and adaptations.
But, the basic blueprint continues to be very helpful for me and for others that I coach 1-1. I hope it will give you a guide to reference and study as you build your own investment portfolio.
In future articles I will go into more detail about the end goal, free and clear houses, and I’ll continue to give you more tools to implement and make your own plan a success.
Enthusiastically your coach,