The critical guide to passive income - james g. puffin

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Titan Read © 2015 Titan Read Christianshavn 1428 Copenhagen Denmark E-mail: titan@titanread.com Twitter: @titanread T H E C R I T I C A L G U I D E T O P A S S I V E I N C O M E A Thorough Exploration By James G. Puffin Table of Content Preface Chapter 1 - What Is Passive Income? Chapter 2 - So What Is Passive Income Not? Chapter 3 - Property Income Chapter 4 - Royalties Chapter 5 - Arbitrage Chapter 6 - The Internet Chapter 7 - Digital Goods Chapter 8 - All the Many Other Ways of Making Money Online Chapter 9 - Summary and A Word About Opportunity Costs Chapter 10 - The Long List of Ways to Generate Passive Income Preface Passive income is the powerful idea that you can set up ways to earn yourself money that will keep earning you money even after you stop working on them - this is what makes it passive income. Sometime the term SWISS - Sales While I Sleep Soundly - income is used to emphasize this alluring aspect of passive income. In this book we take a critical look at the many different ways of generating passive income that exist. The world is already littered with overly optimistic and, unfortunately, often wildly unrealistic how-to guides for how to generate passive income. Our goal in this book is therefore to provide a somber and critical guide to passive income. The starting point for us is what is possible for a single, ordinary person. We recommend forms of passive income that are possible for a single, ordinary person to have success with and recommend against forms of passive income that are not viable for a single, ordinary person. For instance we recommend trying retail arbitrage and recommend against trying arbitrage betting. This is not because money cannot be made doing arbitrage betting - we even go as far as listing resources to use when trying arbitrage betting - but because a single, ordinary person will more than likely be wasting his or her time and money doing arbitrage betting without ever generating any kind of real, lasting income. This is therefore not a naively optimistic book that promises its readers the world in 15 easy steps. The reality is that easy money is hard to get by. We do, however, promise our readers that after reading this book they will be able to go out into the world and set up up some form of passive income for themselves. With enough hard work and - sometimes - luck some people will be able to make a very comfortable living for themselves using only passive income. Other people will have to settle for a side income from passive income. In this book we use the first-person, plural personal pronoun (we) because the information about the different forms of passive income we look at and describe was gathered by many different people who spent at lot of time testing and learning how things works in practice. James G. Puffin is merely the one who has written everything down and I (James G. Puffin) thank everyone for their time, hard work, and patience. Chapter 1 What Is Passive Income? This book is about passive income. What it is and how to earn it. Quite simple really. Well no. Not entirely simple. For starters no definite definition exists of the term passive income. This is obviously a problem if you want to write a book on the subject. In this chapter we therefore start by setting out to find a definition of the term passive income. After we have defined the term we compile a list of five different kinds of passive income that we believe cover all forms of passive income. We also briefly introduce each of these five categories. We end this chapter with a presentation of the structure of the rest of this book. A Definition For some passive income is the idea of a secondary income stream that might one day enable them to quit their day job and retire to a beach somewhere. For others the term denotes shady business practices and conmen hawking get-rich-right-this-minute schemes to hopeful dupes. Neither of these loose understanding are very useful since we are interested in an objective definition of the term passive income and not a subjective opinion. We therefore turn to some of the proposed definition of the term passive income floating about. Quite a few exist and we are going to take a look at three of them. For tax proposes passive income is earnings derived from rental property, limited partnership or other trade or business activities in which you do not materially participate. This is a good definition in so far as it is pretty clear-cut and objective. But the definition is also severely limited and it does not cover what most people think of when they hear the term passive income. Income from activities on the Internet if for instance not covered. This definition is therefore not useful as a tool to us. Pat Flynn famed creator of the blog Smart Passive Income defines passive income as “building online businesses that take advantage of systems of automation that allow transactions, cash flow, and growth to happen without requiring a real-time presence”. This is a much broader definition of passive income and hints at one of the desirable aspects of passive income, namely automation and cash flow. Flynn’s definition is, nevertheless, also limited. It focuses narrowly on online businesses, which leaves out offline forms of passive income. Income from rental property is in Flynn’s definition not passive income since it is not an online business. We must therefore also discard Flynn’s definition. Finally the Wikipedia article on passive income defines the term passive income as “income received on a regular basis, with little effort required to maintain it” (source: en.wikipedia.org/wiki/Passive_income). This definition is very broad. Both online businesses and offline businesses are cover. But the definition is not very clear-cut. How much is a little effort? Can a very laid-back job be passive income? For the term passive income to retain any meaning that answer has to be no. But under Wikipedia’s definition it is not clear that the answer to that question is, in fact, no. Wikipedia’s definition also requires regularity from passive income. The purpose of this part of the definition is unclear. A lump sum is still income. Wikipedia’s definition is in this way both to broad and at the same time oddly constricting. Not satisfied with the existing definitions we set out to coin our own. We are interested in a definition that is clear-cut like both the tax definition and Flynn’s definition but that unlike those definitions captures the full universe of types of incomes that are logically similar, e.g. both online and offline activities. To this end we propose the following definition: Passive income is income decoupled from the number of hours worked to generate it. Passive income hereby becomes the opposite of salaried work where there is a very direct (though not always perfect) coupling between the amount of time worked and the income earned. This fits nicely with how passive income is sometimes equated with unearned income - for better or for worse. It also subsumes both the tax definition and Flynn’s definitions. So there we have our answer. Passive income is income decoupled from the number of hours worked to generate it. Note how passive income in this definition is not inherently better - or worse - than salaried work. That income is decoupled from the number of hours worked simply means that there is no relationship. You can get lucky and earn a huge income on very little work or you can be unlucky and not earn a dime after having put in a huge amount of work. This downside of trying to generate passive income is something most people overlook in their eagerness to earn lots of money (or sell lots of passive income products). But it plainly exists. In salaried work you can never earn more than it says in your contract, say for a stray bonus or two, but you can also never make less. If you work, you are contractually guaranteed paid. To put it another way; passive income operates on a broader spectrum with a much larger upside but also a much larger downside than salaried work. This is why most people have salaried work. It is a safer bet and better suited to the risk averse, which the large majority of the population is. Another thing to note with this definition of passive income is that a decoupling of income and work does not mean that work is optional when trying to earn passive income. Generating most kinds of passive income, in fact, requires a substantial amount of work, and the kinds of passive income that requires little to no work will most often require a substantial amount of capital. What is more, the investment - be it work or capital - is required up front. You have to put in your work and/or your money before you see any kind of return on investment. This seems commonsensical at first glance. But the decoupling which by definition is the nature of passive income means that nothing is guaranteed. You might hit it big or you might not. Either way your time and/or your money is already spent. This might discourage some people and it should! Easy money is one of the hardest things to come by. 5 Categories Having now defined passive income, we can use our newly minted definition to compile a list of different categories of passive income. We arrive at five categories we believe cover the universe of all kinds types of passive income satisfactorily. In the following chapters chapters 3 through 7 - we will dive into the specifics of each categories and explore the different forms of passive income that fall in each category. We will also provide examples of potential businesses in each of the five categories. Below is a brief introduction of each of the five categories. 1. Property Income Property income comes in three varieties; rent, interest and profit. Rent comes from the ownership of property that is rented out. This can be houses, office buildings or even natural resources such as shale gas. Interest comes from the ownership of financial assets. This can be dividends and interest from owning securities such as stocks and bonds - this is sometimes also labeled portfolio income. Finally profit comes from the ownership of capital equipment. This can be as simple as owning your own car or as complicated as owning an entire factory. Common to property income is that it requires capital. If you don’t have a house to rent out, you need to buy one before you can start renting it out. Sometimes it also requires work. Running a rental service for example requires a lot of work. Owning stock not so much. 2. Royalties A royalty is a usage-based payment from the licensee to the licensor. The licensee pays the licensor for the right to use an asset - often an intellectual asset. Royalties can work in many ways but are typically a percentage of gross or net revenues derived by the licensee through the use of the asset. An author earns royalties by licensing out his book to a publishing house. Similarly a pharmaceutical company can earn royalties by licensing out a patent for a drug. Royalty income often requires little capital but lots of work. Think of the starving New York author. But it can also require lots of capital if the goal for instance is a new drug. 3. Arbitrage Arbitrage is put simply about buying low and selling high. Usually it involves taking advantage of a price differences between two markets. Arbitrage is usually thought of as the domain of large financial institutions that trade billions of dollars in split seconds. It is, however, also the domain of the lowly eBay seller that has figured out how to buy something cheap and sell it with a markup. Arbitrage in its pure form requires no capital, as it is a risk-free instantaneous trade. In practice, though, it usually requires at least some capital. It also requires a lot of legwork to figure out where there are arbitrage opportunities. 4. The Internet The great white whale of the Internet is passive income. Many hunt for it. Few capture it. There are generally three routes to earning passive income on the Internet; advertisements, affiliate marketing and subscription services. Advertisement, i.e. selling eyeballs, is the most common form of income on the Internet. Every blogger hopes that one day his or her blog is going to take off and the ad-money is going to start rolling in. It seldom happens and the competition is fierce. Affiliate marketing is something that mostly happens in the seedy underbelly of the Internet. The idea of affiliate marketing is that a business rewards affiliates for acquiring customers for them. It can be highly lucrative but it is often highly difficult. Finally subscription services involve getting an audience that is willing to pay to read/listen to what you have to say or for access to a community you have build. The barrier to entry on the Internet is very low and anybody can start building an audience in as little as a few minutes. But patience, hard work, and luck are required to succeed. 5. Digital goods Digital goods unlike physical goods have practically zero marginal cost. This means that producing an extra unit of a digital product costs nothing - or at least practically nothing. Digital goods also have very low distribution costs. Together these two aspects of digital goods mean that the sale of digital goods is fertile grounds for generating passive income. Digital goods include things such as e-books, software, downloadable music, graphics, audiobooks etc. The list is long and growing. What is important to note concerning digital goods is that most creators of digital goods do not sell their digital goods themselves. Instead they license (and get royalties) the sale of the good to a digital store. Think of an author independently publishing through Amazon. That author is not selling anything to anybody. Instead the author has licensed his or her book to Amazon who in return pays out royalties for every sale Amazon makes. When trying to generate passive income with digital goods the main goal should therefore not be to create but to sell. Selling digital goods requires both hard work and a small amount of capital to set up a store. It also requires some way to lure customers to your particular digital store. This can include advertising, an affiliate program of your own, having exclusive content, or presenting customers with an opportunity to save money or fantastic customer support. The Structure of the Rest of the Book So there we have it - five categories of passive income. These categories are meant to be an analytic tool that divvies up the world to increase our understanding of it. The categories are therefore meant to be exclusive; one form of passive income cannot belong to multiple categories, and exhaustive; no type of passive income exists outside of the five categories. But the world is messy and some forms of passive income straddle the boundary of multiple categories, and some types of passive income do not fit neatly into any category. We, however, find that the categories work in so far as they in a useful way sorts (almost) every form of passive income. The structure of the rest of the book is accordingly built around these five categories. In five chapters - chapters 3 through 7 - we are going to look at each of these five categories of passive income. For each category we are going to describe the general category more in depth, and then we are going to dive into specific examples of forms of passive income. This is meant to give the reader concrete examples of opportunities they might go out and explore. At then end of each of these chapters we concisely sum up the main points of the respective chapter. In the final chapter we are going to review and conclude on our findings of for each of the five categories and compare the results. It is not the case that any one of the five categories hold inherently better forms of passive income than the rest but some of the categories hold forms of passive income that tend to be capital-intense while other categories hold forms of passive income that tend to be labor-intense. This means that a person looking to begin generating passive income should evaluate which types of resources they have available to them and choose forms of passive income that best fit their resource-profile. Lastly we are also going to explore the concept of opportunity cost and the hidden costs of not doing anything at all. In chapter 10 we are going to review all the different forms of passive income that we have looked at in this book. We call this chapter The Long List of Ways to Generate Passive Income. Before all this we are, however, going to take a short detour and explore what passive income is not. Chapter 2 So What Is Passive Income Not? Okay. So we just defined what we mean by passive income and everybody is happy and ready to go. But first a short detour into what passive income is not. Simply starting a business or operating a business is not a way to generate passive income. In most normal businesses there is a pretty clear coupling between the amount of work put in and the income earned. If you open a pizza place there is going to be a pretty clear correlation between the number of pizzas you are making and the amount of money (*dough*) you are making. This doesn’t mean that it is a bad idea to open a pizza place. It might be a great idea if you are really good at making pizzas. But you are not going to be generating passive income from your pizza place until you parlay your mad pizza skills into for instance becoming a pizza place owner not needed for the day-to-day operation and earning property rent (profit or interest depending on your business setup), or into earning royalties on your patented pizza making process, or maybe through a third or fourth way. It is also not passive income to get a second job or work two jobs at the same type. Say you are working nights in a hotel and have plenty of time to work on your second job as a freelance editor. That is obviously a sweet situation to be in and good on you for getting into that situation. But you are not making passive income. Both are jobs and both have a clear coupling between hours worked and income earned. You need to be doing something else with you extra time in the hotel to begin generating passive income. Writing a book that can earn you royalties for instance. Saving money by cutting down on frivolous spending. A great idea. Also not passive income. Not income at all really. But definitely something you should be doing. A dollar saved is a dollar earned - actually more than a dollar since you are not paying taxes on dollars you save. And the money you are no longer spending frivolously can instead be made to work for you by investing them. Distinctions The things listed above are all things people at some point or another have conflated with passive income. This is why we are taking a moment to point out that these streams of income are, in fact, not forms of passive income - at least not in our definition of passive income. This is, it should be noted, not a normative statement. Passive income, as we have already established in the previous chapter, is not inherently better or worse than other forms income. But it is qualitatively different and the subject of this book is passive income. We are therefore concerning ourselves only with passive income and not other kinds income in this book - although we will be taking a another short detour from the world of passive income in chapter 9 to look at ways to make money on the Internet that are not passive income. With this little detour out of the way, we move onwards. Chapter 3 Property Income Property income comes in three distinct varieties; rent, interest and profit. We let this trichotomy structure this chapter and consequently divide this chapter into three subparts. First up we will tackle rent, then interest, and finally profit. Rent Rent comes from the ownership of property that is rented out. This can be houses, office buildings or even natural resources such as shale gas. We will, accordingly, in this book define rent as income from the ownership of property. This is a pretty straightforward definition, which makes the concept of rent pretty easy to understand. Person A owns property C that person B wants to use. Person B therefore offers person A money for the right to use property C. Person A accepts because person A do not need to use property C at the moment. A few things can be inferred from this general understanding of rent. Firstly person B must be in a position where obtaining ownership of property C is not possible. This might be because property C is exclusive (i.e. rare) or because person B does not have the capital to obtain ownership of property C and therefore is consigned to renting. Secondly person A must be in a position where he or she does not need to use property C. Person A can hereby be said to have a surplus with regard to property C. In this little thought experiment person A seems to be the winner and person B seems to be the loser. It is, however, important to note that in the real world property is not the only resource you can own. Person B might not want to own property C because person B would rather have his or her capital liquid or invested in something else than property. Person A conversely might be in surplus of property C because nobody wants to buy property C. It is therefore important to note that there is nothing inherently superior in being rentier (person A) instead of renter (person B). So to sum up we can conclude that to be a rentier you need to be in surplus of property for which there exists demand for the right to use. We can further conclude that being a rentier is not inherently better than being a renter. With that we have the theoretical footing to explore a couple of concrete examples of earning passive income by renting out property. Teenage Landlord Down in Florida the housing market experienced first an enormous boom in the early 2000s and then an even more enormous bust when the recession hit in 2008. That is the kind of market volatility that creates market opportunities. Willow Tufano was 14 in 2012 and had just come into a few thousand dollars, and so she decided to become a landlord. Willow’s mom, a real estate agent, had seen a two-bedroom, concrete-block home on auction for $12,000. The same house had cost $100,000 a few years earlier at the peak of the housing bubble. Willow, with the help of her mother, decided to invest and buy the house. Willow then cleaned the house and started renting it out for $700 a month (source: http://www.npr.org/blogs/money/2012/03/09/148218539/this-14-year-old-girl-just-boughta-house-in-florida). On a $12,000 house $700 dollars in monthly rent amount to yearly return on investment of 70%. 70% is a stratospherically high annual return. Famed investor Warren Buffet, the oracle of Omaha, historic average is only around 22%. Obviously some percentage of the $700 goes to maintenance and other expenditures that come with being a landlord. But even if we half the $700, a 35% return on investment is still something that would leave any hedge fund manager salivating uncontrollably. What is more, that $12,000 house will likely appreciate over time. This is more money directly in Willows pocket. All in all a pretty solid investment for a 14 year old. Now imagine a person wanting to generate $100,000 in yearly passive income on renting out properties. What would it take? Let’s be conservative and say that Willow can only pocket $200 a month on her $700 rent while $500 goes to maintaining the property and other expenditures connected to being a landlord including finding tenants. That gives us a yearly return on investment of 20% on our initial $12,000 housing investment. Now imagine we reinvest all our profit into new houses that we rent out terms similar to the terms for our original house. How long would we have to do that before our yearly return is $100,000? Not that long actually. After 21 years of compounding interest our small real estate empire will be throwing off $110,412 yearly and be worth $552,061. Willow will be 35 years old at that point. Not a bad time to retire. But it gets better because we haven’t factored in any appreciation. A conservative estimate is that our houses appreciate around 3% yearly (that’s the historic average). Our original $12,000 will therefore be worth $22,324 after 21 years. The rest of our housing empire will have appreciated similarly. If we factor in appreciation in our calculations, Willow will be ready to retire at 32 years with a yearly passive income of over $100,000. California Mogul Hold on you might say. Is this is any way replicable and scalable. Enter Donald Bren, chairman of the Irvine Company, a California-based real estate investment company. Bren is estimated to be good for $15.1 billion. Bren’s portfolio exceeds 105 million square feet and includes 500 office buildings, 41 retail centers, 130 apartment communities, five marinas, three hotels and three golf courses (source: https://www.irvinecompany.com/donald-bren). Things, however, didn’t begin this grand for Bren. In 1958 he built his first house in Newport Beach with a $10,000 loan. But 57 years of compounding interest is a long time. If we assume the $10,000 was Bren’s only capital in 1958, at what rate has he then been compounding that initial sum? At a stratospherically high annual return like 70% you might think. Well you’d be wrong. Bren has been compounding his housing capital at an annualize rate around 28%. That’s the same ballpark as Willow is playing in. So What Should You Do to Get In On This Thing? Well you need to start buying property and renting it out. It is really pretty simple. The trick, though, is to buy the right property at the right time and here we can’t help you, otherwise we would be real estate moguls and not authors. Should you buy property in San Francisco and ride the Silicon Valley train to riches? Maybe, or maybe the market is overheated and about to crash. Should you buy cheap property in Detroit and wait for the second coming of the American car industry? Maybe, or maybe Detroit is never going to bounce back. We don’t know and neither does anybody else. People can make educated guesses but nothing is certain in a dynamic world. What we can say is this: 1. Historically investing in real estate has been a solid investment almost everywhere. 2. The trend is towards increasing urbanization. That means investing in real estate in a metropolitan area is probably going to be a good idea. 3. The real estate market is going to continue to experience boom and bust cycles. That’s just the nature of the market. This creates opportunities to buy cheaply. Such opportunities should be taken. Being greedy when others are fearful is generally a good idea. Practical tips Build capital by renting out a room or by renting out your house on Airbnb and similar sites. Buy a multiple family house as your own house and rent out the part you aren’t using yourself. This way it is easy to be the landlord and keep an eye on your tenants. It also makes financing easier (look into the first-time home-buyer program if you are a first-time-buyer in the US). On a smaller scale the same can be done with a multibedroom house. Don’t buy buildings you wouldn’t want to live in yourself. That is how you become a slumlord. And you do not want to be a slumlord. It is more trouble than it is worth. Look into Real Estate Investment Trusts (REIT). REITs are securities that are traded like stocks and represents investments in real estate through either properties or through mortgages. REITs receive special tax considerations and generally offer investors high yields, as well as a highly liquid method of investing in real estate. With REITs you can earn rent (indirectly) without doing any of the work yourself. Pitfalls: A rentier needs renter - people often forget that it takes two to tango. If nobody wants to rent your property, you have expenditures and no income. That’s a real fast way to lose a lot of money. Make sure that there is demand before you buy. Bad tenants - sometimes no tenants are better than bad tenants because bad tenants can actively destroy your property and your life and they can be really hard to get rid of. Regulation - renting is regulated heavily. That is not necessarily a bad thing as a property owner but it requires you to stay on top of the regulation to make sure that you are not doing anything illegal. Not so passive, passive income - being a property owner is steady work and if you do
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