In this article we will discuss ways of active and passive income using real estate as an example, the pros and cons, as well as the advantages of receiving passive income from real estate.
Any income falls into one of two categories: passive and active income. While most people have heard of passive and active income, many are unsure of the difference between the two or how to make passive income.
Many believe that understanding how to create passive income is the key to creating wealth and financial freedom. As Robert Kiyosaki (bestselling author of Rich Dad, Poor Dad) once said, “The key to financial freedom and great wealth is a person’s ability or skill to convert earned income into passive income or capital gains.”
What is Active Income?
Active income is payment for time spent – wages, gratuities received for services rendered, commissions, or tips.
For most people, active income is earned before passive income can be earned.
Often, real estate investors work full-time to earn active income and then reinvest as much as they can to start creating a stream of passive income from things like rental properties. So, let’s look at ways to make active and passive income.
Examples of Active Income:
- A wage is the most common way to earn active income, whether part-time or full-time. A wage is a fixed amount of money received for working a regular schedule, such as 8 to 5, Monday through Friday. Salaried employees effectively exchange 40 hours of their time per week in exchange for a guaranteed amount of active income.
- Commissions are another form of active income, although the amount of money received can vary greatly from job to job. For example, real estate agents typically receive a commission of 3% to 6% for the sale of a property and a commission on a rental equal to one month’s rent. However, people who work on commission often see their income rise and fall depending on the time of year and transactions made.
- Tipping is an active income earned based on the level of service provided. People who work in the food service and hospitality industries often receive a fixed salary or hourly rate in addition to tips from satisfied customers.
- Freelance fees and consulting income are two other types of active income. People with marketable skills, such as graphic designers or software developers, often start freelance businesses and work for clients as independent contractors.
What is Passive Income?
Passive income is usually derived from an income-producing asset in which the investor is not actively involved.Often this asset was purchased with savings from active income sources such as wages, compensation or other compensation.
Now let’s look at some examples of passive income:
- Interest income can be earned in several ways, such as depositing money in a bank deposit or owning a bond. Unfortunately, the interest income earned on such investments may be less than the rate of inflation. This means that an investor may actually lose principal by investing in an asset that earns passive interest income.
- Dividends from publicly traded stocks are another potential source of passive income. Some well-known blue chip companies that pay dividends include Apple, Nike and Mastercard, Sber, Gazprom, and Norilsk Nickel. However, as with interest income, dividends paid by companies can often be low.
- Income from a limited partnership as a silent partner in a business or real estate investment can be a better way to generate passive income with higher potential returns from regular payments plus a percentage of the profits if and when the business is sold. Of course, higher returns often come with greater potential risks. Investors who invest in a limited liability partnership as a silent, passive partner run the risk of losing their entire investment.
- Rental property income can often provide an attractive risk-adjusted return by generating passive periodic net income along with the potential gain from appreciation when the property is sold. The average sales price of apartments, has risen nearly 56% since the last two years. Rents are also rising, albeit not at such a gigantic rate. But keep in mind that real estate markets historically go through both up and down cycles. For example, home prices declined between 2007 and 2009 from the market peak before the last recession began.
How to generate income from real estate
Real estate can generate active or passive income, or sometimes both. The type of income generated from real estate depends on the investor’s strategy and whether the investment objective is to generate potential income in the short or long term.
Active Real Estate Income
Resale and wholesale real estate investors seek to generate income from real estate over a short period of time.
Another type of investor buys properties in need of renovation at below market value, makes necessary upgrades, and then resells at a profit to a buy-to-let investor or a buyer looking for a property to live in or run their own business. The job of such investors is to find a property that is undervalued by the market, which is often a non-trivial task.
Wholesalers are experts at identifying undervalued properties. Interacting with a real estate wholesaler can be a good way to find over-the-counter deals that can have instant capital gains after closing and making necessary repairs.
Generating active income from real estate usually involves a high level of risk in exchange for the promise of high rewards and can be similar to working full-time. If the property stops selling or the rental market sags, active income from the property will also decline. This is basically the difference between active and passive income methods.
Passive income from real estate
Passive income from real estate is generated by investors buying and holding real estate in two different ways:
- Permanent net income after rents are collected and bills are paid
- and the potential gain from appreciation generated by the sale of the property.
Many investors describe passive income from real estate as making money in their sleep, paraphrasing, “Landlords make money in their sleep without working, taking risks or saving money.”
To be fair, making passive income from real estate does require some work, even when the day-to-day details of managing a rental property are delegated to a local property manager.
For example, a passive real estate investor regularly reviews financial statements such as the income statement and cash flow statement, periodically visits new potential properties to invest in, and identifies new opportunities to expand and expand the rental property portfolio.
One of the best things about owning real estate that generates passive income is that the investor can spend as little or as much time on his business as he wishes. Whereas active real estate investors, when they stop working, they stop making money.
This is why many real estate investors seek to earn passive income through real estate.
Ways of active and passive income. Key takeaways.
- The two main types of income are passive and active.
- Passive income includes money received in interest, dividends, and rental property.
- Active income includes wages, work and service fees, tips, and commissions.
- Real estate investors can earn both active and passive income, depending on the investment strategy used.