INTRODUCTION Passive income is generally defined as money you get with almost no effort and time consumed. Interests rates are close to 0% in most major economies. They could become negative due to the stimulus announced as a result of coronavirus and the government shutdowns. This short guide will explain how you can get a passive income from investing in this environment, and the steps you need to take to make it a reality. WHY DOES IT MATTER? How much did a Coca-Cola can, a house or car cost when you were a child? The chances are, it would have cost significantly less than now. Even 2%-3% yearly inflation compounded over time makes a huge difference. Based on those figures, $100,000 will be worth the equivalent of over $121,000 in 10 years, even assuming an inflation rate of just 2% per annum. In many emerging and developing countries, inflation is regularly running at 4%-5% per year or more. In this context, you are often guaranteed to lose money in the bank. So, getting a good yield in this environment is crucial. BANK DEPOSIT Let’s start with the worst option first! It is possible to make small amounts of income in the banks. There are broadly three types of countries: 1. Countries with 0% or negative real interest rates. This applies to countless countries in Europe and the developed world more generally. In these countries interest rates are generally below inflation 2. Countries with positive local interest rates. In South Africa, India and countless other countries, you can make reasonable amounts keeping the money in the bank. This has huge currency and sometimes inflation risks. In recent times, somebody who kept their money in the bank earning 8% in South Africa or India, would have lost money in USD terms as per the graphs below: 20 15 10 5 2009 2015 Would have lost money in USD terms as per the graph below 3. Countries with reasonable USD interest rates. Cambodia and Georgia are two countries that offer 4%+ per year in USD terms. Both countries have their issues though in terms of the safety of the banking system. So you either have to take a big risk by going to an emerging country which accepts USD, or accept a direct loss to inflation. In general then, keeping significant money in the bank doesn’t make sense. However, it is sensible to have a small amount in case you have an emergency. DIRECT PROPERTY Direct property, the conventional way to invest in real estate, can be a good way to get access to income but often it isn’t truly passive income. Property can be anything but passive unless you outsource it to a property management company, and even then, the process of setting up a mortgage can be time consuming and costly. In many ways, running a “property empire” is like running your own business. You have costs such as maintenance and taxes, and revenues from rentals. Tenants might also ask you for help and that is time consuming. Property can be a good passive income play if you can find a reliable property management company. That is easier said than done. POSITIVES You can use debt/leverage to your advantage. With an interest-only mortgage, you only pay the interest each month. This means that you cover the debt at the end of the loan and not in the middle. Let’s look at a simple example. If you brought an 150,000 Pound Sterling house in the UK in 1995, it would be the equivalent of 300,0000 today adjusted for inflation. That means that if you bought a property for £150,000 with a 80% mortgage, you would still only owe 120,000, yet the property would be worth 300,000. The ability to use other people’s money to pay off the mortgage for buy-to-let owners. You can make money both from the capital increase and rental income. If you can find a reliable property management company, it can become a passive income, once the hassles of setting up the property are dealt with If you are willing to take a risk, you can focus on emerging markets which have huge growth potential but also risks. NEGATIVES Property isn’t usually truly passive. It takes a long time to set up due to mortgage approvals, the maintenance takes time and most tenants have demands on your time. The only way to make it passive is to outsource it to a property management company and that is expensive The costs and taxes in some countries are now huge on direct property. Using the UK as an example, the upfront buying cost (stamp duty) is typically 5%-15% for overseas and second home buyers. In addition to that, the maintenance costs and capital gains taxes when you sell are enormous (18%-28%). So, your gross returns will be very different to your net returns. Property values on average don’t beat stock markets on capital values as per the chart below. So you can only “win” using leverage and yields. 600% 500% 400% 300% 200% 100% 0% Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 01 1987 1988 1989 1990 1991 1992 1994 1995 1996 1997 1998 1999 2001 2002 2003 2004 2005 2006 2008 2009 2010 2011 2012 2013 INDIRECT PROPERTY An excellent alternative to direct property is indirect access to property from real estate investment trusts (REITs) and loan notes. REITs is a company that owns, and usually operates, income-producing real estate. Often this real estate is both in the residential and commercial sector, which means you can also get access to property which businesses rent. As these firms are doing the work for you, and there are less taxes and costs in most countries associated with these types of investments, the net returns can be higher than direct property which is highly taxed in most countries. The only negative about this option relative to the first option is that you can’t use other people’s money in the way that buy-to-let investors can do. POSITIVES In general, it is a much cheaper way to get access to property, costing from just 0.1% per year. This will help your net returns. You have access to both residential and commercial property. Commercial property with blue-chip clients like Starbucks, Amazon or Lidl is generally safer than relying on individual families. Smaller capital outlays compared to more traditional real estate, often from $5,000 or $10,000 onwards. Commitment periods are usually lower than traditional investments as well with 2 - 3 year investments being common. It is quicker to set up with less hassles than direct property. NEGATIVES Just like direct property, it isn’t a liquid asset in the case of loan notes. So, you can’t easily sell quickly unlike some of the options we will speak about below. The only exception to that is REITS which are usually liquid. The risks can be higher than some liquid investments. A LIQUID PORTFOLIO OF ETFS For people with significant sums of money, a good way to gain passive income is to have a two-stage wealth management process; the accumulation and drawdown phase. By accumulating wealth in index funds, ETFs and other sensible investments, it will become possible to withdraw some money safely each year. The “4% rule of retirement” holds that it is safe to withdraw four percent of a portfolio every year. That means that even during extreme times like the market crashes of 1929 and 2008, it is possible to withdraw this money without running out. Whilst four percent might not sound like a lot, it is a safe withdrawal rate which has held up even during the worst times. Held together with REITS and other investments, this can give you significant passive income in retirement or before full retirement. A key mistake to avoid here is focusing solely on dividend stocks. It is true that many top names pay high dividends, especially in the UK. That doesn’t make them a free lunch though. Some of the best performing stocks such as Amazon and Berkshire Hathaway don’t pay out any dividends. POSITIVES A low risk way of making passive income. So this the best option for people who have sold their homes, business or have an inheritance and therefore have a large amount of capital. Liquid portfolios allow you to withdraw quickly if you need the cash Despite the volatility, markets like the S&P500, Dow Jones and Nasdaq are great investments long-term. $10,000 invested in the S&P500 in 1945 would now be worth $50m. $10,000 invested in 1992 would be worth about $120,000. The Nasdaq has done even better Like REITs and loan notes, you can set up accounts quickly Small monthly investments will really build up over 20-50 years and compound. NEGATIVES It takes a long-time to fully build up the strategy unless you have big starting capital. The two-stage process works fantastically but only if you are patient or have a lot of cash to begin with. PEER TO PEER LENDING This short guide can’t review all the riskier options for passive income so we will focus on one of the more common investments; peer to peer lending. Peer-to-peer lending is when investors give money to others, in exchange for a return on their investment. There are now many online options, and apps, which allow borrowers and lenders to match up together. The typical rates of return are 5%-8% per year. This seems good, but the risk:return ratio is often poor. When we consider that REITs, index funds and many other kinds of investments have historically produced higher returns, for lower average risk, we should be careful with this option. The reality is, most of the people who need money from others, often aren’t considered credit worthy by banks and other institutions providing lower rates of return. If you really want to take the risk, some options include Lending Club, Upstart and Kiva. POSITIVES You can diversify your income options with a small percentage of your portfolio Some of the options on the internet are well-regulated and allow for partial liquidity in case you have an emergency NEGATIVES The risk:return ratio is very poor compared to other options in the market. You are taking a relatively big risk to get 5%-8% returns in most cases. REITs, loan notes and stock indexes have historically higher returns for lower risk. FREQUENTLY ASKED QUESTIONS What is the biggest mistake people make in passive income investing? Many people are either too conservative or don’t consider risks carefully enough. Interest rates above 15% are highly likely to be too risky or too good to be true. By the same token, there are some excellent fixed return options which have excellent rates of return. A balance is needed between being too conservative and too adventurous. How about the average minimum investment size? Typically, investment minimums are at least $50,000 when it comes to direct property. That is because you usually need to put down a reasonable deposit these days, unless you can find a cheap house. For REITs and loan notes, $6,000-$10,000 is a big enough minimum to get started, whilst liquid portfolios tend to have higher starting points. What are the main risks associated with passive income investing? Yourself to begin with. Many of the safest and best passive income options are locked in for 1-3 years, with no option for early withdrawal, apart from the coupon/dividend payments themselves. Apart from that, we have to remember that the only two certainties in life is death and taxes. Every investment has some risk. Cash in the bank has significant inflation and currency risks. In fact, in most countries in the world now, you are guaranteed to lose money to inflation because interest rates are so low. What is the process for going ahead with these passive income plans? Each of the options listed above usually has some of the same processes anti money laundering rules (AML) and know your client (KYC). That usually means providing your proof of ID and address, in addition to application forms that ask you basic questions about where the money has come from. The biggest difference between the options listed above is time. Getting a mortgage and finding a direct property can take months. REITs, loan notes and a liquid portfolio can be set up in 1-3 days online. How can you help? We have numerous passive income options available at adamfayed.com. The typical duration is 2-5 years, with interest rates ranging from 2%-11.3% per annum, depending on the project. We match up our clients to the right passive income investment, depending on how long they want to invest and individual circumstances. Will there be a webinar on this subject? Yes we will have a webinar on passive income investing on June 25. +819098510589 advice@adamfayed.com www.adamfayed.com
