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Former Lehman ETF Head: There’s no such thing as passive income

Source: Flickr/Charleston’s The Digitel

Jared Dillian is former head of the ETF trading desk at Lehman Brothers. Read more from him at Mauldin Economics.

Passive income is this strange idea that you can earn money without lifting a finger. It’s an illusion that people will pursue until insanity or death.

If I had a nickel for every time I heard this one:

“All I have to do is buy a few investment properties, then I can sit back and make $100,000 a year in passive income. I will be set, and I will never have to work again.”

Note: I’ll only talk here about passive income from real estate, for simplicity’s sake. I know there are plenty of other kinds of passive income.

Passive income isn’t really passive

If you own 4 or 5 houses/apartment buildings and you are renting them out, you are going to have to deal (directly or indirectly) with constant nonsense from the tenants: leaky roofs, plumbing, people getting drunk and setting off fire extinguishers.

Back in 2002, a passive income guy in New Jersey explained to me that there is an inverse correlation between the number of issues you must deal with and the quality of the rental property.

He said thatA” properties generally had no issues but only had a 5–6% cap rate.

“B” properties had some issues and had a 7–8% cap rate.

“C” properties, where people are getting drunk and setting off fire extinguishers, had a 10–12% cap rate.

You got paid more for “B” and “C”, but it was more work… which leads me to the main point of this article:

Passive income isn’t really passive.

Passive income sounds attractive to lazy people. The idea of sitting back and collecting checks is irresistible. But anyone who has done it will tell you that there is a lot of work involved—just as much as a real job. Plus, there’s the additional stress of debt.

Debt Is No Fun

Most people can’t buy an investment property with cash, at least not at first.

You must put 20% down and borrow the rest. A lot of the time, the rental income barely covers the mortgage payment, property taxes, and insurance.

From a cash flow perspective, you’re not really any better off.

Where you win is the taxes: the deductibility of mortgage interest, the depreciation you take on the property, and the ability to roll the gains into another property with a 1031 exchange.

Then, there’s this issue of having debt. Say you bought 4 or 5 rental properties—with debt. You now have a giant balance sheet with lots of assets and lots of liabilities.

If the asset side of the balance sheet goes down, then you are trapped and bankruptcy becomes a real possibility.

Over the years, I have known several people who got themselves in way over their heads with rental property. Debt is no fun. Debt causes massive amounts of stress and can drive people to do desperate things.

The passive income which seemed so easy is suddenly elusive, typically then people stop paying rent concurrently with property values going down.

I have a healthy fear and respect for leverage.

Most passive income people are in such a big hurry to build a real estate empire that they use leverage to buy a bunch of properties in quick succession, instead of waiting until they had more cash to use less leverage.

There are countless examples of real estate empires that have been built and lost because of too much leverage.

Some people make it work

I’ve found that passive income investors are either:

  1. Very smart about market cycles or
  1. Incredibly lucky.

If you started building your real estate empire in 2010, you are probably doing fine. But if you started building your real estate empire in 2018, good luck to you. You are getting skinny returns on top of insane leverage.

Here in Myrtle Beach, seven years ago, you could have bought properties at the tax auction for pennies on the dollar. Now, people are paying full price, and people are doing fix-and-flips for $10,000 or less. Skinny returns, insane leverage, and too much risk.

But if you really want to do this, the key is patience—the ability to wait until the cycle hits the bottom. Which may take a while.

There are lots of great real estate investors. Sam Zell. Even Donald Sterling (the Clippers guy). If you are interested in doing this, you should study what made them great.

But with regard to passive income in real estate, I have a deep suspicion of it. I am more of an active income guy.